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CBN Shuns Calls for Rate Cut, Says Tightening Cycle not Over Yet

27 Jan 2013

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The hope of a possible cut in the Monetary Policy Rate (MPR) by the Central Bank of Nigeria (CBN) at last week’s meeting of its Monetary Policy Committee was dashed, with the apex bank governor, Sanusi Lamido Sanusi, insisting that the prevailing local and international economic conditions make it risky for the CBN to relax its grip on the rate for now, Festus Akanbi reports

For obvious reasons, the build-up to last week’s meeting of the Monetary Policy Committee of the Central Bank of Nigeria (CBN) drew attention from both local and international economic commentators.

Interestingly, there were divisions on the line of action likely to be taken by the MPC based on emerging economic fundamentals both within and outside the country up till the eve of the meeting. Those who called for a moderation in the rate relied on the marginal fall in inflation figure, impressive foreign reserves, consistent stability in the naira exchange rate and the cry of the private sector for a regime of industrial-friendly interest rate.

The other camp, however, feared the marginal drop in inflation figure was too fragile to be used as a basis for lowering the monetary policy rate. They also argued that the foreign reserves accretion which was significantly aided by the flow of portfolio investment could be checkmated by a cut in the policy rate while the insistence of the National Assembly to raise oil benchmark price in the 2013 budget to $79 per barrel as against the $75 recommended by the Presidency also provided a justification for CBN to tighten its grip on the rate.

So the apex bank committee settled for the latter at the MPC meeting where it held its benchmark Monetary Policy Rate (MPR) steady at 12.0 percent, as expected, but said two of its 10 committee members had voted for a 25 basis point rate cut in light of the benign outlook for inflation.

The committee had considered the calls for a rate cut but decided the current level was “just about right” because the outlook for inflation “may be undermined by the increased sub-national government spending and Federal Government high expenditure in 2013, the higher benchmark oil price in the 2013 budget and the U.S. debt ceiling with possible impact on commodity prices.

The central bank, which said at its last meeting in November 2012 that a rate cut would send the wrong signal that the tightening cycle was over, noted the drop in headline inflation in December but also recognised that core inflation had risen, mainly due to cost-push factors in the face of sluggish growth in the monetary aggregates.

The apex bank started the tightening policy in September 2010 and last raised rates by 275 basis points in October 2011. The CBN said inflationary pressure was elevated in 2012 with the annual average at 12.24 percent while the average score was 13.87 percent and food inflation was 11.32 percent.

At last week’s meeting, the committee expressed satisfaction with the federal government’s efforts to keep deficits within the threshold prescribed but warned that the increase in the oil price benchmark to $79 from $75 in the budget may pose a risk to the inflation objective and constituted a pressure point for the low inflation objective and effective monetary policy.

“The committee reaffirmed its commitment to respond appropriately if panic spending in 2013 ultimately adds to inflationary pressures,” the CBN governor Sanusi said, adding that one of the choices facing the policy committee was to raise the MPR.
Giving a breakdown of the committee’s decision, Sanusi said the MPC raised banks’ cash reserve requirement to 12 percent from 8 percent and reduced net open foreign exchange positions to one percent from three percent to support the naira.
He added that consumer inflation rose to 12.9 percent year-on-year in June, up from 12.7 percent in May, saying that the CBN expects it to peak around 14 percent later this year.

New Pressure Points
To defend its grip on monetary policy in spite of the arguments put forward by those calling for a policy reversal, the CBN explained that developments in the domestic economy in the past three months highlighted some new pressure points to macroeconomic stability. The committee was of the view that shocks to the economy could come from significant fall in the demand for oil, leading to a fall in oil prices and government revenues, weaker exchange rate, rising inflationary pressures and depletion in external reserves mainly by cost-push factors even in the face of sluggish growth in the monetary aggregates.
Private Sector Operators Uncomfortable
However, as expected, criticisms have continued to trail the policy thrust of the MPC meeting. From the organised private sector comes the argument that the prevailing regime of high interest rate is making the economy to be vulnerable to the liquidity squeeze and tight cash flow condition.

For instance, Director General LCCI, Muda Yusuf, said the natural consequence of the decision to retain a high interest rate is the perpetuation of unfavorable economic conditions, which include depressed economic activities, which had manifested in low sales, weak consumer demand and huge inventories by manufacturers.

The chamber also identified liquidity squeeze and tight cash flow conditions in the economy as well as high cost of funds, which will impede competitiveness of firms as part of the negative consequences of the policy. “What is paramount at this time is the stimulation of the economy and that is the norm globally. Affordable and long time finance may not be a sufficient condition for economic growth, but it is a necessary condition,” Yusuf noted.

The chamber argued that the ultimate objective of the CBN is to strengthen the economy and improve the welfare of citizens. “The fixation of the CBN for curbing inflation and building reserves, in our view, is disproportionate,” it said.
Alternative to Inflation Targeting

In his contribution, Head, Research and Intelligence, BGL, Olufemi Ademola, explained that inflation targeting has been a very popular economic policy for a long time, the management of which has been the use of interest rate to steer actual inflation towards the target inflation. He said that recent developments especially the financial crisis and the declining global economic growth have started to question the appropriateness of price stability (inflation targeting) at the expense of overall economic stability.

“Analysts globally have been arguing that stabilising nominal economic growth would be better than inflation targeting; hence the move by several countries to monetary easing in order to stimulate economic growth. In addition, the use of interest rate to manage inflation is being seen as inappropriate. Rather, economists are now recommending the use of ‘credit channel’, that is Open Market Operation (OMO) to manage inflation. In my opinion, the use of OMO has also been very successful in bringing down inflation in Nigeria in recent time. Hence I will expect the CBN to use more of OMO rather than interest rate, going forward.

He said it would be wrong to assume that the CBN is obsessed with maintaining a strong naira. “I think what the monetary authority targets is a stable naira exchange rate (within the agreed band). Overvaluation presents its own problems just like undervaluation, but in most cases, developments in the economy and arbitrage activities will pull the rate back to optimal value.

“For a country that adopts a semi-fixed exchange rate regime (managed float), volatility would lead to macroeconomic instability and the country’s currency could suffer speculative attacks. Therefore, the policy focus of a stable exchange rate, which helps to build foreign reserves, will aid macroeconomic stability on which other economic reforms are built. However, I think there might be room for improvement on how the CBN manages the exchange rate.

“The adoption of a semi-fixed exchange rate regime, an independent monetary policy and a liberalised capital mobility may not be optimal as it appears to negate the principle of the ‘impossible trilogy’. We may need to either float the currency or put in place measures against capital reversal,” he said.

The BGL official disagreed with the notion that lowering interest rate could trigger the exit of hot monies in the short term. He said, “At slightly above 11%, yields on Nigerian bonds are still higher than most other markets at the moment while the inclusion of federal government bond in Barclay’s Capital Emerging Market Bond Index will increase appetite for Nigerian instruments as global portfolio managers that follow the index rebalance their portfolio. In addition, the expectation of lower inflation in 2013 makes the outlook for real yield on Nigerian bonds to be positive. However, sustained high interest rate in response to high inflation (which is structural) could put pressure on economic growth and increase the country’s risk outlook; a situation that is more likely to trigger the exit of hot monies.
“Overall, I think the decision of the MPC at the just concluded meeting to leave the rates unchanged is not totaling unexpected.

Fears of Inflation Risk
However, Regional Head of Research, Africa Global Research, Standard Chartered Bank, Razia Khan, who noted the desperation of the apex bank to guard against inflation risks, said, “We expect monetary policy to remain largely unchanged over the course of 2013.
Clearly, high loan-deposit spreads are a concern, but this is seen as a matter for the banks to resolve.  There appears to be recognition that it might be futile for this to be a driving influence of the policy rate, when broader macroeconomic stability has to be the focus for the CBN.  Likewise, the slowdown in the economy is also noted – as are the structural factors – well beyond the influence of the CBN (such as delayed passage of the Petroleum Industry Bill and the impact of this on oil-sector investment).

Khan described the committee’s decision as a good, measured decision, weighing up the differing economic risks faced by the Nigerian economy.  “The naira should continue to receive support from the current level of interest rates, while issuance plans and offshore appetite for Nigerian debt will remain key drivers of bond yields,” she said.
Similarly, the Financial Derivative Company Limited, in its explanation for the position taken by the MPC said the CBN is proactive and is more aggressive in the execution of its strategy of maintaining price stability. Even though it talks of inflation targeting, the CBN’s body language reveals a near obsession with maintaining a strong naira with a tendency towards overvaluation.
Making A Case for Naira
FDC also noted that the naira has traded in the official market between N150/$ and 155.72/$ in the last 18 months, adding that the CBN through its comments has alluded to the fact that it believes the exchange rate is a major factor in the consumer inflation equation. This is because with a marginal propensity to import of 0.63, any movement in the exchange rate is pivotal to the general price level and by implication, its index.
“The reality is that a strong naira policy is symptomatic of a Dutch disease syndrome. It ties the hands of the CBN and limits its options in the use of interest rates and other money market instruments,” the FDC’s report said.
The fiscal deficit in 2012 is approximately N1.2trn in normal terms or 2.85% of GDP. FDC noted that government borrowing is now funding the deficit through the issuance of securities of varying maturities.

It said, “The profile of the borrowing shows the intent of the FGN to elongate the maturity profile into the seven and 10 years maturity buckets. The CBN has always been concerned about reckless expenditure and its impact on increasing liquidity and the impact of high-powered money in the system. This type of money has a magnified impact on the general price level. We however believe that as long as the FGN bonds are purchased by investors and not funded by ways and means advances of the CBN (printing of money) the fiscal deficit does not directly lead to inflation. It, however, crowds out credit available to the private sector.”

The MPC has consistently noted that even though the global recovery is underway, the probability of an extended slowdown or even a relapse in recessionary pressures in Europe could spill over and a cut in the demand for oil is a distinct possibility. The World Bank cut its outlook for global growth in 2013 to 2.4% from 3.6% in its October forecast. The decline in fiscal revenues will need to be bridged by increased government borrowing or a drawdown from the excess crude account.
Flight of Hot Money
The CBN has acknowledged the existence of inward investment flows in search of higher yields relative to the rate of inflation. Unofficial estimates of hot money are approximately $10-11bn. FDC is of the opinion that fears that a precipitous drop in rates or change to an accommodative stance could lead to a massive overflow of funds invested in fixed income securities are exaggerated. “This, according to the company’s argument, is because, current yields on three years bond of 11.4% if allowed to decline by two percent and discounted by three percent currency depreciation will result in a fully hedged yield of nine percent. This is still substantially higher than US’ 5years bond yields of 0.76% and remains competitive relative to other frontier or emerging market papers like Brazil where three years bond yields are approximately 8.56%,” it said.

Money Market
According to FDC, money market rates usually move in tandem with the MPR. Hence, we expect average NIBOR to remain 200-300bps above the MPR.
It noted that in anticipation of an imminent cut in interest rate in March, longer tenor rates (90-365 days) are estimated to ease by 100-150bps, indicating a downward trend of the yield curve. This will result in a flattening of the yield curve.

However, economists explained that a declining interest rate environment is subject to expectations of a fall in inflation rate. Therefore, FDC explained that, “Due to a high base effect in 2012, with inflation at an average of 12.24%, we anticipate a moderate inflation figure of single digits in Q1’13. The impact on government interest expense is expected to be neutral. “The naira should remain relatively stable at its current rate, hovering around N156/$1, N158/$1 and N160/$1 in the official, interbank and parallel markets respectively. The external reserves should accrete to $45.5bn dependent on the oil markets.

“We anticipate a decline in inflation to a single digit figure of 9.29% in Q1’13. The high base effect in January 2012 after the increase in pump price will have a downward effect on the price level. The possible drivers of inflation include M2 growth, wage pressures and alternative energy costs. Notwithstanding, these do not pose any imminent risks,” FDC said.

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