By Charles Robertson
Thoughts from a Renaissance man: Our new estimates for FX fair value
FRI, JANUARY 27 2017-We are often misunderstood when we talk about exchange rates, but hopefully this will clear up some potential confusion. We focus here on Nigeria, Egypt and South Africa, as well as other interesting results from our currency analysis.
Most important to note is that our analysis of what an exchange rate has averaged since 1995 is NOT the same as what we forecast a currency will be. We say in this the NGN average rate is 364/$ since 1995, but this does not mean we forecast that the NGN should be 364/$. We show the average EGP rate has been 12.9/$ over 22 years, but our forecast for the EGP for June 2017 is 15.5/$ and we don’t expect the EGP to ever get to EGP12.9/$ again.
This work focuses on what a real effective exchange rate (REER) model tells us about currencies. So if, for example, the NGN is at 300/$ on 1 January 2017, and inflation is 20% in Nigeria by 31 December 2017, and there is 1% inflation in the US over 2017, then the price of a good that was NGN300 on 1 January in Nigeria will have risen to 360 by 31 December. The price of a $1.00 item in the US will have risen to US$1.01 due to 1% inflation over the same period. So the currency should move to 360/1.01 (which if you get your calculator out, works out at NGN356/$1) to keep relative prices the same. If the NGN stays at 300/$ all year, then Nigerians will start buying imported goods, rather than Nigerian goods, because Nigerian goods will have risen in price by 20% but imported US goods will have only risen 1%. The NGN will have got a LOT stronger in real terms, even if the nominal exchange rate has not moved at all.
And Nigeria’s currency has indeed, got a LOT stronger, in nearly every year since 1995. The black line in the graph below shows what the NGN has done since 1995. Then it was about NGN800/$ in today’s money, and it got stronger and stronger until 2016 because inflation in Nigeria was always higher than it was in the US. Most people naturally look at the nominal exchange rate (the grey line) which show the naira got weaker, but to economists, we just see NGN strength. Over 20 years the naira may have been one of the strongest currencies in the world.
What we can do with these REER numbers, is work out what the naira exchange rate has averaged, in today’s (January 2017 naira) money, since 1995. This number is NGN364/$. We call it “fair value” but really it is just the average price of the naira in today’s money. It has moved significantly since May 2016 when we showed that in May 2016 naira terms, it was NBGN309/$. It has moved because Nigerian inflation has been higher than in most of its competitors. So a naira in January 2017 is worth less in real terms than a naira in May 2016 (one naira won’t buy you today, what it could buy you 7 months ago). That inflation also means that the weakest ever level (in January 1995) that we have seen for the naira has moved from around NGN700/$ to 816/$. The strongest ever level is around NGN220/$.
It’s a good question whether we should include a 22 year period to look at the naira or something shorter. I think the 22 year period is useful because it includes the 1990s when oil prices were low, and the 2005-14 period when oil prices were high. The oil price has averaged $54/bbl since 1995, but has averaged US$80 since 2005. Given that oil today is around $55/bbl, that 22-year model looks useful. But if you prefer a shorter dated model, then the average naira rate would be much stronger at 306/$.
Another problem with a 22 year model, is that economies change, trading partners change (Nigeria trades with many countries, each with different inflation figures) and even the way that inflation is measured can change.
So for Kenya, we think this REER model is giving us an extreme signal. We include it only for the sake of completeness, and to be a warning that we should be careful about REER models.
Fortunately, our excellent economist Yvonne Mhango does her own REER model since 2004, and this updates trade ties data annually. Her report is out next week, and is very important to us in analysing fair value. For Kenya it gives a much stronger figure of what “fair value” is.
For Egypt, our “fair value” estimate has moved significantly, from EGP10.9/$ to EGP12.9/$. We’ve been saying that in May 2016 Egyptian pounds, the weakest we’d ever seen the EGP was 16.7/$ in 2003. But in January 2017 Egyptian pounds, the weakest ever number has shifted to EGP20/$ in 2003. So today, we are close to the absolute weakest level we have ever seen, but not over that threshold. Egypt is still the cheapest currency in EM or Africa though, so we still like it, and we are stubbornly looking for appreciation to 15.5/$ by June. At 32% cheap, it just pips Mexico and Colombia which are 30% cheap.
We think the EGP can strengthen in nominal and real terms, similar to what the ZAR did in 2016 or Zambia’s kwacha in 2016.
South Africa – fair value has moved to 12.3/$ – so it is about 8% cheap. I don’t see why it should be stronger than the average rate of the last 22 years, unless commodity prices are above the average of the last 22 years.
Angola and Ethiopia are looking particularly overvalued right now. We should expect a big devaluation out of Angola and faster depreciation from Ethiopia. Ghana’s cedi though looks good value.
CONCLUSION: We still like the EGP and the GHS also offers value in Africa if relations with the IMF stay on track. This model suggests Angola and Ethiopia have two of the most overvalued currencies in Africa today.
Charles Robertson is Global Chief economist, Renaissance Capital
