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Central Europe Another Downgrade Nigeria CBN to Back its Bark with its Bite View GEF Archive

		The Global Economics Team

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The collapse in activity across the region in 4Q08 looks truly extraordinary, and was correctly flagged by the PMI surveys, which sank to all-time lows. Trade data and industrial output and, to a lesser extent, retail sales all show a significant loss of momentum towards year-end. Much of this is due to weaker external demand, in particular in the auto sector, which is the region’s most important export. Car sales in the EU have weakened further, and several carmakers have announced a cut in their production plans for 2009. In the Czech Republic, Hyundai said that it plans to move to a four-day workweek and pay workers 70% of their salaries for a period of 1-3 months; Skoda also downgraded its production plans massively for 2009 (from 700k cars to 570k). In Hungary, Suzuki plans to lay off 21% of its workers and Audi announced output cuts for 2009. In Romania, Dacia announced that it might drop half of its employees, unless the market recovers. The auto sector accounts for around 3-4% of GVA across the region (a lot of components are imported), but its overall impact on the economy is probably much larger, given all the related activities (auto financing, real estate, car dealers, etc).

Central European industry is responding very aggressively to weaker demand by slashing output and running down inventories. The adjustment on the labor market side is happening, albeit more slowly of course. Employment growth has moderated significantly already, and we think that wages will follow in the coming months, even in those countries which were experiencing severe labor shortages, like Poland.

Indeed, looking at surveys of labor shortages and capacity utilization, labor market tightness has abated already. This will ease cost pressures on companies at a time when their profit margins are shrinking, but will also cut real disposable income. With access to credit likely to be severely impaired this year, consumers will not find it easy to borrow against future income and smooth out consumption patterns. So, in our forecast we have marked down household consumption (as well as exports and imports) across the region.

What Room for Policy?

By and large, it looks as though policymakers across the region will resort to monetary and not fiscal policy in order to cushion the downturn. This is for two reasons: some countries have no room whatsoever to ease fiscal policy, due to a weak starting point (Romania) or IMF constraints (Hungary). Other countries, like Poland and the Czech Republic, which have more room to ease policy, have chosen not to add to the measures that were already in the works (the PIT cut in Poland). And broadly, given the huge wall of supply of government paper and the lack of risk appetite for EM assets, CEE governments are aware that budget financing will not be easy this year.

Czech Republic: Rates to Fall to Sub-1%

The Czech monetary authorities recognized the severity of the downturn ahead of analysts and the market, and began cutting rates already last August. Since then, growth has turned out to be even weaker than the CNB expected, and inflation is tracking well below the last CPI projection. The CNB can be more tolerant of ongoing FX weakness than its regional peers, as the share of FX loans to households is low and therefore households do not face higher repayments on their loans (which they do elsewhere). And in the current growth environment, the inflationary consequences of a weaker CZK are negligible. Because of this, we think that the CNB will continue to cut rates in the coming months and bring the repo rate to as low as 0.75% by mid-year. As the economy recovers in 2H, we also think that the CNB will be the first central bank to start taking back some of the rate cuts.

Hungary: Rates Lower, with an Eye on HUF

The fiscal option is effectively unavailable – Hungary will have to tighten fiscal policy aggressively to meet the terms of the IMF package. And with both growth and inflation likely to be well below the MoF’s 2009 assumptions, fiscal tightening will have to be considerable. Monetary policy is therefore the only tool available to try to cushion the blow to the economy. The NBH has taken back half of the 300bp October emergency rate hike, and looks likely to continue to take rates lower at a moderate pace. Of course, given how fragile the risk environment is, the bank is likely to stop easing if it feels that the ongoing HUF depreciation might turn into a rout. While there is no fundamental opposition to HUF weakness at current levels, things may change if the sell-off gathers momentum or EURHUF approaches levels where asset quality becomes an issue (320-330) and households struggle to meet repayments on their FX mortgages.

Poland: All Doves Now

On the fiscal front, we believe that stimulus in 2009 will be limited to the tax cuts already approved years ago as part of a gradual move towards lower PIT rates. This stimulus is worth PLN 7-10 billion (0.7% of GDP). With Poland still trying to keep its budget deficit below 3% of GDP (the official EMU target is still 2012, though slippage is likely) and the budget numbers already worsening on the back of the weaker economy, further stimulus in 2009 is unlikely, we think. On the monetary side, the rapid deterioration in the macro data and easing elsewhere has caused a remarkable turnaround among MPC members’ preferences, with even hawks like Noga arguing that rate cuts are needed. In addition, domestic political obstacles and market volatility imply that ERM II entry in 1H09 (which would have necessitated tight monetary policy) is looking less likely. Our base case is that Polish rates will reach 3.50% by mid-year (current: 5%). The MPC has been relatively quiet about the recent zloty weakness, but we sense that we cannot be very far from levels at which it starts to play more of a role in monetary policy decisions. After all, Poland like Hungary faces a large stock of household FX debt (16% of GDP), and the PLN has depreciated sharply versus the CHF (the currency most FX mortgages are denominated in). Indeed, the current zloty level is over 20% weaker versus the average CHF rate at which we estimate most mortgages were taken out.

Romania: NBR Faces Constraints

The budget outlook deteriorated much faster than anyone expected in the last months of 2008, to an estimated deficit of 4.5% of GDP according to the MoF. With growth set to collapse in 2009, the cycle will put revenues under stress and the government will have little scope to ease fiscal policy if it wants to avoid a massive increase in the deficit. On the monetary policy front, the NBR is the only central bank in the region that has not started to cut rates, as it remains concerned about the external environment and RON weakness. Some rate cuts are likely in the coming months, but we believe that easing will proceed at a measured pace. The NBR also has other ways to stimulate the economy: this week, it relaxed the lending regulations on mortgage loans, in an effort to revive lending activity in that sector. In addition, the central bank has the option of cutting the RON reserve requirement ratio from the current level of 18% in an effort to boost liquidity and lending in RON. The obvious constraint here is that higher liquidity may push down market rates and attract speculative action against the RON. An IMF package in the coming weeks (which some local media hinted might be in the making) may serve to stabilize the currency and offer the NBR greater scope for action, in our view.

FX: Room for Further Near-Term Weakness

The turnaround in perceptions around CEEMEA currencies since last summer has been truly astonishing. Back in July, the pace of appreciation in these currencies versus the euro was far in excess of what is justified by productivity differentials (around 3% per annum) or the need to achieve price convergence with the EU while trying to keep inflation low. Since then, a radical change in the environment for risky assets, a flight to safety and a reassessment of the growth prospects in the region have caused a marked turnaround, with even currencies like CZK and PLN, usually looked upon as inherently safer bets than RON and HUF, having erased almost two years of gains versus the EUR. The sweet spot for CEEMEA FX last summer took these currencies to levels unjustified by fundamentals. The reversal of these dynamics makes it likely that we see an overshoot to the weaker side in the first half of this year as well.

The outlook for portfolio inflows, FDI, FX loans (which imply demand for local currency) and remittances from abroad looks far weaker than it did in 2008, and will likely continue to do so in 1H09. True, eventually weakening domestic demand will reduce imports and help to narrow the current account deficit, and foreign investors are likely to stop selling or even become net buyers of local assets once again, but the near-term outlook does not offer much hope for a return to strength, in our view. Adding to all this, central banks, though admittedly to differing degrees, appear to have capitulated and are willing to accept the current weakening trend, especially as its inflationary consequences are negligible in the current macro environment.

Nigeria
CBN to Back its Bark with its Bite
January 19, 2009

By Michael Kafe, CFA | Johannesburg

Following the failure of its use of ‘open mouth operations’ to effectively manage the upheaval in the Nigerian foreign exchange market over the past six weeks, the Monetary Policy Committee (MPC) of the Central Bank of Nigeria (CBN) eventually announced some more concrete measures to stem the tide of excessive naira depreciation at its January 14 meeting. Effective January 19, 2009, the CBN will replace the existing Wholesale Dutch Auction System (WDAS) with a Retail Dutch Auction System (RDAS) as an interim measure to deal with what it believes to be excessive demand for foreign exchange for ‘non-approved transactions’. RDAS auctions will be held on Mondays and Wednesdays.

Difference Between WDAS and RDAS

The basic difference between the existing WDAS and the RDAS is that the WDAS was essentially introduced in early 2006 to decentralize the allocation of foreign exchange to the market by creating an active interbank FX market where authorized bidders (including bureaux de change) are free to establish bid and offer rates for transactions with their customers and among themselves. The current regulatory environment leaves room for commercial banks to speculate in the currency market, as there are no legal restrictions to the buying and selling of foreign exchange in the interbank market.

The RDAS, on the other hand, is designed to limit the demand for foreign exchange, as reflected in the auction market, to legitimate final-user requirements only (i.e., all commercial bank bids are to reflect only genuine end-user demand for legitimized transactions). With no interbank trading allowed under the RDAS, commercial banks simply play an agency role as Authorised Dealer Banks (ADBs) for end-users, and are not allowed to run naira positions on their books, unless they can provide documentation that such positions are customer-related or meant to fund authorized import requirements (e.g., capital imports). Also, all customer bids under the RDAS must be cash-backed at the time of the bid, while foreign exchange purchased from the CBN is not transferable in the FX interbank market. In fact, authorized dealers are to return to the CBN any unutilized funds within five business days, at the rate of purchase. Finally, the net open FX position of banks is constrained at no more than 5% of assets, and interest earned on non-settled letters of credit is to be repatriated to the CBN. It appears that these regulatory requirements are aimed at preventing domestic banks from funding short positions in the naira, and eliminating opportunities for round-tripping/rent-seeking behavior.

How Effective Will the RDAS Be?

We are under no illusions that the RDAS is a magic wand that will immediately stabilize the naira and completely eliminate the foreign exchange premium in the black market. Rather, we are fully cognizant of the fact that the continued existence of import quotas and outright bans on some uses of foreign exchange leave many Nigerians with no apparent choice but to resort to the black market for their FX needs. In fact, the tougher authorities are on funding only ‘eligible’ transactions at the official window, the more likely they are to push FX users out of the official market and onto the black market. This will likely ensure that the black market continues to trade at a premium, thereby exerting downward pressure on the currency. But this does not mean that the RDAS is completely inefficient. Despite its limitations, the RDAS has time and again proven to be the CBN’s most effective crisis resolution instrument. Here’s why:

The RDAS was originally introduced in 1984 as one of the various shades of managed float regimes that the CBN experimented with in the 1980s, after abandoning its pegged arrangement. Following its success at introducing significant flexibility in the FX rate-setting mechanism, it was re-introduced in 1990 to help unwind the disequilibrium in the FX market and eliminate the wide premium between official and parallel market rates of the naira at a time when the country’s FX reserves were woefully inadequate, and oil prices had fallen to a low US$15/bbl. Again in July 2002, the RDAS was the CBN’s preferred instrument that was co-opted to contain excessive demand for foreign exchange, curb rent-seeking, conserve the country’s dwindling foreign exchange reserves and help to stabilize the naira. One could therefore argue that, historically, the RDAS has not had a bad track record.

If truth be told, both the introduction of an Autonomous Foreign Exchange Market (AFEM) regime in 1995 and an Interbank Foreign Exchange Market (IFEM) regime in 1999 were remarkably unsuccessful in their attempts to rein in naira depreciation. It was only with the re-introduction of the WDAS in July 2002 that the CBN was able to arrest, and subsequently reverse, the persistent depreciation of the naira in the second half of the 1990s (see Nigeria: Looking Up, June 15, 2007). The naira depreciated consistently from NGN84.5 in 2H95 to NGN133 in July 2002 (a 57% move), but subsequently stabilized and range-traded in the NGN125-133 band for most of the July 2002 to December 2007 period. The CBN is careful to point out that not only did the currency stabilize under the 2002 RDAS regime, but the premium between the CBN rate and that of the bureaux de change also narrowed from NGN16.35 at the beginning of that year to NGN6.87 by December 2004.

Based on the historical performance of the RDAS, therefore, we believe that it will again play an important role in stabilizing the naira. The last time oil prices hovered around US$45-50/bbl (i.e., in 2005), the naira traded in the NGN132-135 range, with occasional breaks either way. At that time, however, import spend was much lower than presently anticipated, as there was no clearly delineated infrastructure program as currently exists. Also, the current account was then in surplus, and global liquidity conditions were fluid. With the current account likely to slip into deficit this year and global trade finance becoming increasingly difficult to source, we believe that, fundamentally, the naira is likely to remain weak. Given existing foreign exchange controls, were oil prices to average some US$50/bbl as suggested by the oil futures curve, the speculation-adjusted ‘fair value’ of the naira should come in at around the NGN140 level. In the near term, there’s no calling the top, as dividend repatriations by a major telecommunication company (MTN) are likely to skew the risks to the upside. However, we believe that, fundamentally, at current levels of NGN155, the naira is some 5-10% oversold.

Introduction of a Trading Band Likely

We also believe that, at some point in the future, the CBN could introduce a trading band of some 2-4% around the central RDAS rate to further stabilize the currency. This is all the more likely if the market fails to stabilize in the coming weeks.

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