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CBN: How the MPC May Read the Economy


Dear Speculators,

The inflation report is finally out and inflation rate appears to have trended upwards again to an 11 year high of 16.5% Year-on-Year. You will think after the floating of the Naira in the exchange rate market, prices of goods and services will immediately start to fall to reflect the new economic fundamentals. Apparently not! Prices will fall eventually but not so soon. We expect that importers who start to enjoy the new exchange rate will want to maintain current prices or slightly higher prices until losses suffered during the early months of the year due to stringent exchange rate controls are fully recovered. After these marketers have recovered their losses, they will then embark on a price war to gain more market share which will force prices downwards until it fully reflects the new exchange rate value. It is for this reason that economists refer to prices as sticky in the short run and slow to respond to changes in the economic conditions of the country.

Since the last Monetary Policy Committee meeting held in May, the economy is beginning to stabilize. We have seen the fuel scarcity issues disappear, fuel prices become relatively stable nationwide, crude oil prices rising, a steady rise in the stock market, exchange rate concerns reduced and the major negative is the higher inflation rate.

We expect the MPC to keep Cash Reserve Ratio unchanged at 22.5%. This is because the upward movement in the inflation rate is caused by cost-push inflation. If the MPC decides to reduce the CRR, it will increase money supply and possibly add to the inflationary pressure. If they do increase the CRR, it will reduce money supply and cause prices to start falling which will push the country ever closer to a recession. A decision to increase the CRR is highly unlikely considering the implementation of the single treasury account by the government which removed trillions from the banking industry.

We also expect the monetary policy rate to be increased by 100 basis points. This will increase the cost of borrowing, further reflecting the bad loan asset quality of the banks, lower domestic savings rate and ration available credit which will ensure only credit worthy individuals and corporations receive new credit facility. A higher lending rate could help ease the pressure of the net interest margins of the banks, allowing them earn higher profits to cover the growing non-performing loans book.

We also expect the CBN to pick a new date for the enforcement of the new capital adequacy ratio for the systematically important banks to ensure certainty and financial stability in the country during this trying times. Although the ability for banks to raise new capital quickly to meet up with the requirement may be very difficult at this moment. Liquidity ratio will possibly remain unchanged at 30%.

Several economic analysts have called on the Central Bank to cut interest rates and reduce the CRR in response of the economic slowdown which is totally reasonable in normal circumstances but our current economic condition is completely abnormal at best. During a typical recession, prices of goods and services fall quickly, rather prices have risen quickly in the last one year. This then puts the CBN in a tight spot deciding which monetary policy measure will reduce inflation without hampering economic growth. With inflation rate now at 16.5% and MPR at 12%, any attempt to reduce the MPR will further stretch the gap between inflation rate and investment yield, meaning real income will slump further.

If the CBN does cut rates and reduce the CRR, the high NPL may weigh heavily on the new loans and put the banks in a critical financial state with CAR for the industry remaining at 10%. Investors may also refinance their debt at a lower cost to the detriment of the banks. On the other hand, lower rates can also encourage more borrowing and stimulate productivity in the real sector if only the banks will lend to the real sector.

Whatever the MPC decides will have very serious implications on the economy in both the short and long run. Nigeria needs wise decisions this week. We will be watching.

Signed:
Emeka Ucheaga,
Managing Partner,
Emeka Ucheaga Advisory

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