Nigeria will float the naira on the interbank FX market, when trading begins on 20 June, in a single market structure. This will release a pressure valve for the economy. We see the economy beginning to thaw and green shoots emerge possibly as soon as a year from now. Before then, we believe the macro picture will deteriorate.
Where will the market put the naira?
When we said ‘we see Nigeria’s FX policy becoming more flexible, possibly as soon as mid-2016’, in our 22 April 2016 note, Nigeria: Policy-based financing: To spur more flexible FX policy, we never imagined a free-floating naira. Now the question is where the market will put the Nigerian naira (NGN). We look to the Kazakh tenge (KZT) for some guidance. Investors draw parallels between it and the NGN because they are both oil-exporting currencies, and have followed similar trajectories – at least until August 2015, when Kazakhstan floated the tenge, which resulted in it depreciating by almost 30% against the US dollar, over a couple of days. If the naira were to mimic that move next week, when trading begins, we could see the FX rate at NGN260/$1, which is close to our fair value estimate of NGN255/$1. (It is likely the central bank will anchor the FX market by setting the opening rate on 20 June.) However, this would just be the start. It took over six months for the KZT to fall to its low, representing an additional 50% fall. If the NGN follows this path, we may see the FX rate fall to NGN390/$1 by YE16, before retracing.
What a weaker naira means for the economy
A weaker naira will have an adverse effect on industries that depend on imported raw materials. The consumer will be hurt by the sharp increase in the naira cost of importing goods and services. Imported food accounts for 25% of food consumed by Nigerian households. Moreover, all of Nigeria’s fuel is imported, implying higher power and transportation costs too. We see the economy contracting by 0.1-1.0% in 2016 and forecast a modest recovery of c. 1% in 2017. Assuming oil output of 1.6mb/d and price of $50/bl in 2017, an FX rate of NGN300/$1 would give us a CA deficit (and budget deficit) of 4.3% of GDP (2.2%). At NGN350/$1, the CA deficit widens (and budget deficit narrows marginally) to 5.5% of GDP (2.0%). If Nigeria’s FX rate mimics that of the KZT, we estimate an average FX rate of c. NGN270/$1 in 2016 (vs NGN198/$1 in 2015), implying a fall in Nigeria’s dollar GDP to c. $400bn (vs $481bn).
Rate hikes to restore price stability
Nigeria’s inflation, which climbed to 15.6% YoY in May (vs 9.0% YoY a year earlier), has already begun to reflect the impact of a weaker currency (via the parallel market), on naira prices of consumer goods and services. In Kazakhstan, inflation increased more than fourfold in the nine months following the KZT flotation, to 16.7% YoY in May. Like Kazakhstan, we expect the biggest jump in inflation to take place in the quarter following the move to a free float. So we see inflation climbing to the mid-20s by the end of 3Q16. We expect the central bank to respond with bold rate hikes, from a policy rate of 12%. Last month, the central bank told us it would fight inflation despite anaemic growth, because high inflation was eroding real incomes anyhow. Kazakhstan hiked its policy rate by 6.5 ppts to 12%, a month after it floated the KZT, and by a further 5 ppts over the next five months. Our CIS and Russia economist, Oleg Kouzmin, expects Kazakhstan to cut rates in 2H16, a year after the KZT floated, owing to slower inflation. If Nigeria follows this path, we could see slower inflation and lower rates as soon as 2H17.
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