Over a year since our last comprehensive update on Nigeria’s economy, not much has changed. Stagflation is still the word of the day, with persistently high inflation and endemically low growth.
Nigeria’s Covid-induced recession was the deepest in four decades, but its 1.8% real contraction in 2020 was notably better than the IMF’s initial 3.4% projection at the start of the pandemic. However, with real GDP per capita falling below 2010 levels in PPP terms last year, the pandemic has reversed a decade of economic progress.
Economic growth is expected to rebound this year, with forecasts ranging from 1.8% from the World Bank to 2.5% from the IMF (straddling the 2% Bloomberg consensus), but both organisations expect it to remain below Nigeria’s c2.6% population growth rate over the medium term.
At the same time, inflation has risen sharply over the past year, mirroring global trends but to a greater degree and from a double-digit starting point pre-Covid.
Inflation dropped slightly from a peak of 18.2% yoy in March to 17.8% in June as food price pressures started to wane but remains elevated and has been an endemic problem for much of the past decade, staying above the Central Bank of Nigeria’s (CBN) 6-9% target since February 2016.
The World Bank estimates that inflation alone pushed over 7mn Nigerians into poverty last year, not counting the impact of the pandemic, with the unemployment rate rising to 33.3% by end-2020 (or 56.1% including the underemployed) and the poverty rate above 40%. Although inflation is expected to keep falling in H2 21, the IMF thinks it will remain elevated at 15.5% by year-end.
The CBN maintains that inflation is being driven largely by structural factors, including insecurity in the agricultural middle belt of the country and supply-side constraints stemming from the Covid crisis.
And indeed, the World Bank estimates that food prices accounted for nearly 70% of the annual increase in inflation through April 2021.
However, inflation is also being driven in large part by policy factors, including FX restrictions and parallel market depreciation, expansionary monetary policy, monetisation of the budget, and the closure of land borders in August 2019 (Buhari asked that the border be reopened in December 2020, although there are still some restrictions in place).
Meanwhile, insecurity has continued to weigh on Nigeria’s outlook, with the Buhari administration facing criticism for its failure to bring the situation in check despite President Buhari’s law and order credentials.
Nigeria’s security forces are stretched incredibly thin and are facing threats on multiple fronts across the country, including: 1) battles with and between Boko Haram and the Islamic State’s West Africa Province (Iswap) in the northeast; 2) conflict between farmers and herders in the food-producing middle belt; 3) banditry and kidnapping in the food-producing northwest (with an estimated 800 school children kidnapped since December 2020); and 4) conflict with separatist movements, including the Indigenous People of Biafra (IPOB) in the southeast and a conglomerate of Yoruba groups in the southwest (with both movements’ leaders arrested by security forces in the past month).
While Nigeria’s public debt is still relatively low compared with its peers, endemically weak revenue collection has limited the fiscal space needed for pro-growth spending on infrastructure and human capital and undermined Nigeria’s long-term growth outlook. Meanwhile, monetisation of the deficit has put pressure on inflation, and, despite relatively benign solvency indicators, debt service is now consuming nearly 100% of federal revenue, leaving little room to ramp up pro-growth spending without reforms to boost revenue collection.
Monetary transmission mechanism is broken
At the heart of Nigeria’s inflation problem is its broken monetary transmission mechanism and lack of policy credibility, which has contributed to an un-anchoring of inflation expectations that has proved hard to reverse. The World Bank and IMF have both urged the CBN to move away from cash reserve requirements (CRR) as its main liquidity management tool, and to instead rely on open market operations (OMO), utilising short-term naira-denominated securities to manage system liquidity in a transparent and predictable manner.
Beyond the policy instrument itself, the CBN also needs to clarify its policy objectives if it hopes to achieve a durable decline in inflation and anchoring of expectations. As it currently stands, we believe the CBN’s objectives, in order of priority, are: 1) exchange rate stability; 2) maximising growth; and 3) low and stable inflation. The primary goals of exchange rate stability and growth are often at odds with the price stability objective, thus undermining the tertiary goal of price stability and pushing up inflation.
To be fair, the CBN has taken steps to boost interest rates this year, with the 12m T-bill yield rising from a trough of 0.8% at the end of 2020 to 9.8% by the middle of this year.
In our view, the main drivers have been the continued use of ad hoc CRR debits, alongside the securitisation of excess CRR debits over the 27.5% threshold as “special bills” that yield 0.5% in December 2020.
Banks have largely decided not to convert their special bills into cash given the losses they would incur (due to the low 0.5% interest rate at which they were issued, which is below the prevailing rate of c9%), and which the CBN has continued to rollover (withholding an estimated N4.1tn of liquidity from the market).
Retain Sell recommendation on T-bills and Hold on eurobonds
With NGN overvalued by c15% and negative real rates, there is no reason to invest in Nigeria’s local government debt market, and we retain our Sell recommendation on Nigerian T-bills (although FX shortages will make it difficult to repatriate sales proceeds).
Meanwhile, Nigerian credit has underperformed the EMBI Africa index by 0.4% ytd but outperformed the overall EMBI index by 1.4% on a total return basis, bringing its total outperformance to c2.5% over EMBI Africa and c7% over EMBI Global since its pre-Covid peak. Nigeria’s EMBI spread is still c50bps wider than it was pre-Covid (mid-February 2020), providing some room for further compression, but this compares to the EMBI Africa index which is still c90bps wide of pre-Covid levels, leaving less upside. Overall, Nigeria now trades c20bps wide of the EMBI Africa index and c230bps wide of the EMBI global.
Overall, we think Nigerian credit looks to be fairly valued on a relative basis. Nigeria’s economy is likely to keep muddling through over the medium term without any major reforms, which will continue to erode its fiscal space and undermine its ability to set growth on a more sustainable upward trajectory. However, this is the consensus view of the market so we think it is already priced in. While Nigerian credit could outperform if oil prices see another leg up, there is little else in the way of foreseeable positive catalysts in the near term and we think investors are better off expressing bullish views on oil via more directly exposed sovereigns like Iraq and Angola (or via oil itself).
On the downside, external imbalances could quickly build if prices drop. While a shock of this nature may be necessary to move Nigeria’s FX policy in the right direction, things will have to get worse before they get better. But annual debt service (principal and interest) on the cUS$11bn stock of bonded debt is still just a manageable US$1.1bn on average over the next 10 years, and besides the small US$300mn diaspora bond due in June 2022, the next maturity (amounting to only US$500mn) isn’t until 2023. Despite a weak macro outlook, the risk of default therefore remains relatively low for the time being (this is reflected in Nigeria’s high scores in our debt sustainability and external liquidity scorecards).
As such, we main our Hold recommendation on Nigerian eurobonds based on a mid-price of US$113.37 (yield of 6.81%) for the Nigeria 2031s as of cob on 23 July on Bloomberg.
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