Some Thoughts on NGN and EGP Devaluation

Falling dominos

There are two currencies that are likely to be devalued in the coming months – EGP and NGN. Below, we identify how much these currencies could potentially move when the exchange rate is finally adjusted. The overall process is likely to be painful for both. 

ARS YARDSTICK

Look at what happened with ARS last December. After the tightly managed float was abandoned then, USD/ARS immediately jumped to the parallel “Blue Chip” rate, a move of nearly 35%. A surge in inflation then kept pressure on the Argentine peso, leading to an even larger move in the peso.

We believe black market parallel exchange rates are a good guideline for where a freed up currency could initially move. Of course, the risk is that it overshoots. Furthermore, the policy response will be very important in determining the new equilibrium exchange rate.

NGN OUTLOOK

Despite the introduction in June of what was touted as a new “floating” FX regime, the Nigerian naira remains tightly controlled. To us, the only thing that really matters is whether importers and foreign investors will gain access to dollars. They still haven’t, and so the “new” system is simply window-dressing.

In June, the official rate was moved to around 280 per USD from around 199, where it had been since early 2015. And yet markets are not clearing at current prices. Investors continue to face problems repatriating funds, with the central bank disbursing very limited amounts of USD. Foreign reserves fell to $25.4 bln in August, the lowest since October 2005. Reserves cover only 4 months of import but are nearly 7 times larger than short-term external debt.

The black market rate is now reportedly around 462, which is 32% weaker than the current official rate near 315 today. Note that 3-month NDFs are trading around 350, 6-month NDFs around 370, and 12-month NDFs around 407. The black market is utilized mainly by domestic importers, while the NDF market can be used to hedge onshore positions.

We can easily envision a 30% move in USD/NGN that would put it close to the black market rate near 462. Indeed, the longer the central bank waits, the greater the risks of a large overshoot. The longer the adjustment is put off, the bigger the move that eventually happens. And whether it settles back towards 450 or careens above 500 will depend on further policy responses. Why?

Price pressures are still accelerating in Nigeria, with August inflation reported at 17.6% y/y. This is the high for this cycle and the highest rate since May 2006. If there is a devaluation, it will likely push inflation even higher and necessitate aggressive rate hikes.

If the central bank cannot get inflation back under control, then Nigeria risks falling into a vicious cycle of high inflation that leads to a weaker naira. That in turn can then feed into higher inflation. This is one reason why devaluations can be so painful, as central banks typically jack up interest rates afterwards to help limit inflation and inflation expectations. Recessions are often seen post-devaluation.

The central bank next meets November 22, but it has kept the policy rate steady at 14% since the last 200 bp hike in July. One can argue for an immediate (and large-scale) hike if and when the currency is finally devalued to a more realistic value.  

EGP OUTLOOK

The IMF and Egypt are reportedly close to finalizing a $12 bln aid package. We believe one key requirement will be that Egypt introduces greater flexibility in the exchange rate. There is simply no way that the IMF will provide funds to Egypt that would be used to prop up an unsustainable peg.

In March, EGP was devalued to 8.88 from around 7.80. Yet shortages of dollars persist. Investors continue to face difficulty repatriating funds. Foreign reserves rose $1 bln in August to $16.6 bln. This covers barely 2 months of imports, but is 1.33 times greater than short-term external debt. Egypt clearly needs to get foreign aid quickly.

The black market rate is now reportedly around 13.1, which is 33% weaker than the current official rate near 8.88 today. Note that 3-month NDFs are trading around 11.4, 6-month NDFs around 12.025, and 12-month NDFs around 12.925. The black market is utilized mainly by domestic importers, while the NDF market can be used to hedge onshore positions.

Here too, we can easily envision a 30% move in USD/EGP that would put it close to the black market rate near 13.1. An even bigger overshoot is possible. And once again whether it settles back below 13 or careens toward 15 will also depend on further policy responses.

Price pressures are still rising, with CPI rising 15.4% y/y in August. This is the cycle high and is also the highest rate since December 2008. This suggests that monetary policy will be tightened further.

Here too, the central bank needs to act aggressively to contain inflation and inflation expectations. Otherwise, the dynamic between higher inflation and a weaker pound could intensify.

The central bank hiked rates 150 bp in March and then another 100 bp in June to take the policy rate to 11.75% currently. It just met last week and left rates steady. The next policy meetings are November 17 and December 29. The next hike seems likely when the pound is devalued, and so we will have to watch how IMF talks go.

CONCLUSION

Both Nigeria and Egypt are in unsustainable situations. Given the nature of currency pegs, the adjustment is likely to be painful for both. Egypt will likely have an added benefit of having an IMF backstop.

From a longer-term perspective, freeing up the exchange rate and improving the availability of foreign exchange is good for both countries and for foreign investors. Yet the process is likely to be slow. Despite the ARS devaluation and other market-friendly measures taken by the Macri government, foreign investors have been slow to return.