Nigeria's central bank holds key policy rate and agrees to adopt more flexible exchange rate regime

The monetary policy committee (MPC) of the Central Bank of Nigeria (CBN) met over 23-24 May. With 9 of the 12 members present, the MPC decided not to change its monetary policy stance, thus leaving its key policy rate (MPR) at 12%. However, the MPC voted unanimously to introduce greater flexibility in the inter-bank foreign exchange market structure to accommodate critical transactions, without providing specific details.

The MPC's communiqué (no 107) focused on the following economic developments:

• Negative first-quarter growth: Data from the National Bureau of Statistics (NBS) highlighted by the central bank showed that, in real terms, domestic economic output fell by 0.36% year-on-year (y/y) in first quarter of 2016. This growth contraction was in stark contrast to the expansion of 2.11%y/y recorded in the fourth quarter of 2015, as well as 3.96%y/y reported for the first quarter of 2015. Overall output declined in most economic sectors. Non-oil growth shrank by 0.18%y/y over this period, with growth gains registered for only agriculture by 0.68%y/y and trade by 0.4%y/y. Key sectors that saw negative growth include 0.93% for industry, 0.26%y/y for construction, and 0.08%y/y for services.
• Continued rise in inflation: Reflecting higher core and food inflation components, headline consumer price index (CPI) inflation rose steadily to 12.77%y/y in March and 13.72%y/y in April from 11.38%y/y in February. The MPC stressed the particularly sharp cumulative increase in core inflation to 13.35%y/y in April from 8.80%y/y in January. The upward path of food inflation to 13.19%y/y in April from 10.64%y/y in January was also noted. "Legacy factors" that were identified by the central bank as main inflation drivers included the energy crisis due to fuel scarcity, exchange rate pass-through from goods imports, high electricity and transportation costs, lower food output, elevated input costs and weak industrial output.
• Low growth in monetary aggregates and private-sector credit: The MPC revealed that growth in monetary aggregates stayed below their respective benchmarks, with the exception of credit to the government. Broad money (M2) supply expanded by 3.49% in April 2016 from its March level of 2.20, and was close to its 3.67% growth rate recorded in April 2015. On an annual basis, M2 increased by 10.47% in April 2016 which was slightly below the CNB's provisional benchmark of 10.98% for 2016. Net domestic credit rose by 7.87% over the same period, and its annualised growth rate of 23.61% was above the 17.94% benchmark for 2016. Strong growth in credit to the government of 35.97% last month, annualised to 107.91%, was responsible for this trend. By comparison, private sector credit increased by 3.52% in April 2016, and its annualised growth rate of 10.56% was under the benchmark 13.28 % growth for 2016.
• Increased foreign currency demand on the interbank market: On the interbank market, the central bank reported that the Nigerian naira opened and closed at NGN197 against the US dollar, with its daily average at the same rate, between 25 March and 13 May. However, greater pressure on the naira in the interbank market was observed by the MPC in the aftermath of the government's move to deregulate the downstream petroleum sector in mid-May by raising fuel retail prices. The MPC emphasised its commitment to supporting a stable naira exchange rate.

Outlook and implications

The Central Bank of Nigeria's decision not to increase its key policy rate from 12%, which was contrary to our expectations, shows the extent to which serious concerns about the short-term growth outlook are outweighing prevailing inflation risks (see Nigeria: 25 May 2016: Nigeria's real economy contracts by 0.4% in Q1, reviving recession fears). The CBN maintains its view that rising inflation is largely being driven by supply side factors beyond the direct influence of monetary policy, with an emphasis on: fuel scarcity; higher electricity tariffs and worsening power supply; higher petrol prices; higher input costs from a lack of foreign exchange; continued security challenges and their impact on agricultural output; and higher domestic prices of imported goods from exchange rate pass-through. In addition, the central bank believes that its previous decisions need more time to fully take effect; namely, a tighter monetary policy stance with the MPR set at 12%, a higher cash reserve ratio for commercial banks of 22.5%, and the narrower asymmetric corridor around the MPR of plus 200 basis points and minus 500 basis points (see Nigeria: 23 March 2016: Central Bank of Nigeria hikes key policy rate to 12% to temper rising inflation). We currently expect headline inflation to stay elevated over the coming months (see Nigeria: 17 May 2016: Stronger food and energy prices drive headline CPI inflation in Nigeria up to 13.7% y/y during April).

The unanimous MPC vote to allow greater exchange rate flexibility in the interbank segment of the foreign exchange market is welcome news for consumers and businesses alike, and if well-implemented, would bolster investor perceptions and improve the domestic business climate. The central bank likely sees this move as the best way to "kill two birds with one stone", by alleviating the acute foreign currency shortage and its negative inflationary impacts, while also supporting a more conducive growth environment. Political will for this decision appears steady given remarks on 11 May by Vice-President Yemi Osinbajo in an address during a foreign investor conference.

IHS expects a two-tiered foreign exchange market to be set-up, with the central bank availing hard currency via a small window at an established rate for "priority" business activities, such as fuel imports and manufacturing. A more flexible exchange rate (still determined by the central bank) would be used in the second market by a wider range of economic actors, including foreign investors, traders, importers, and institutions (see Nigeria: 17 February 2016: Nigeria's central bank considers two-tier foreign-exchange market to stem deepening currency crisis). While the MPC did not directly address the contentious issue of an official naira devaluation from its current NGN197:USD1 peg, its readiness to "restore the automatic adjustment properties of the exchange rate" indicates that such a move could be within sight. The government's approval of a lower NGN285:USD1 rate for fuel imports this month implies a 44.7% de facto devaluation is possible. This could be adopted as a precursor to eventually abandoning its naira-US dollar peg altogether.

Nigerian central bank policymakers are keen to avoid a protracted period of stagflation; that is, slowing economic growth, rising inflation, and high unemployment. They readily acknowledge that underlying inflationary pressures warrant a tight monetary policy stance, which is at odds with measures that could stimulate private sector credit growth and thus help revamp economic activity. Credible policy actions to revive overall growth require strong coordination on the fiscal front, as well as effective execution of sector-specific initiatives and progress on structural reforms.