The Naira has witnessed resurgence in 2012. At Wednesday’s WDAS auction, it closed at its highest level -- versus the US dollar -- since mid-November 2011, N155.75/USD. On the interbank market, it closed the week at N157.10/USD, just 0.32% shy of its 2012 high. On both the WDAS and Interbank markets, the Naira’s resurgence has been accompanied by reduced volatility (Figure. 1). This trend is a continuation of the declines in volatility which began in Q4’2011, after the CBN curtailed its US dollar supply at the official window, leading to a 39.94% YoY decline in weekly dollar supply at the WDAS to US$213.87 million in Q1’2012. Interestingly, the trend in volatility on the interbank market during Q1’2012 mirrored events in the official market.
We suspect that the events in the official window had a moderating effect on the entire FX market, even as a US dollar supply overhang–arising, arising from unprofitable US dollar hedge positions entered into in H2’2011 when the outlook for the Naira was negative, has been the primary driver of the Naira’s performance on the interbank market. This overhang is evident from the increase in supply of US dollars from International Oil Companies to the interbank market and the unanticipated compression in the spread between WDAS and Interbank USD/NGN exchange rates YTD; from 350bps in December 2011 to 110bps in March 2012. Instructively, both events -- which indicate the interbank market remains well supplied with US Dollars -- have occurred in spite of falling US Dollar supply, greater regulation and less transparency at the WDAS: the CBN has not published WDAS US dollar demand data since November 2011. However, despite the decidedly bullish environment, reserve accrual has been surprisingly muted.
Whither the reserves?
While the average price of Nigeria ’s benchmark Bonny Light Crude rose 7.3% QoQ to US$120.5 per barrel in Q1’2012, the country’s average daily crude oil production fell 8.3% QoQ to 2.15 million bpd. Consequently, the level of dollar inflows was largely unchanged at US$12.8 billion in Q1’2012, even as WDAS supply declined 17.2% QoQ to US$5.1 billion. Nevertheless, regressing past trends in Bonny Light crude prices, oil production and quarterly WDAS sales on reserve accrual, we estimate that net accrual to Nigeria’s foreign reserves in Q1’2012 should have been in the region of ~US$6.3 billion compared to the actual increase of US$1.7 billion QoQ (Figure. 1).
The differential between our estimate and actual accruals to foreign reserves in Q1’2012 points to subtle but alarming trend in Nigeria ’s US Dollar use. Interestingly, after the CBN’s policy interventions in Q4’2011—which included the review of all Class ‘B’ BDC trading activities since January 2010 and a downward revision to their transaction limits on the WDAS to $50,000 — US Dollar sales to BDC’s by the CBN in Q1’2012 increased 18.5% QoQ to US$2.5 billion. At the same time, total direct remittances rose 87.7% QoQ to US$1.85 billion. We estimate the effect of these increases in non-WDAS reserve use by the CBN is~US$1.3 billion, amounting to ~48% a total reduction in WDAS supply in Q1’2012. To us, this suggests that while CBN appears to have pruned excesses in the foreign exchange market, the fundamental interplay between demand and supply is shifting away from the WDAS and interbank markets into a more opaque “other market”, largely funded by the CBN. This suggests that the Naira’s position may not be as robust as suggested by movements in the official and interbank markets, even if it has apparently resulted in significantly improved confidence in the latter.
Our analysis reemphasizes the importance of structural demand on accruals to foreign reserves and to Naira’s stability, in spite of the CBN’s best efforts. Indeed, our apprehension about the Naira in Q2’2011 stems from the failure of the CBN to accrue reserve due to stunted inflows and leakages into the other market. This ebb in accruals leaves the Naira vulnerable to significant shocks to oil prices, which appear increasingly likely in light of the deceleration in global monetary easing and economic activity.
Our revised model estimates total accrual of US$2.7 billion in Q2’2012, based on assumptions of 2.2 million bpd oil production, average Bonny Light Crude price of US$120.5 per barrel and quarterly WDAS sales of US$ 5.3billion in Q2’2012. Accordingly, we see limited scope for naira appreciation assuming global stability, and some downside otherwise, particularly as the award of new oil import licenses will likely increase official demand, perhaps bringing new scrutiny to the currency’s fundamental position vis-à-vis global currencies and robbing inter-bank markets of its new found confidence.
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