Monetary Policy - interest rate trends (bank lending and deposit rates) and inflation (retail price and

consumer price).

Money supply moderates The brisk pace of money supply growth early in 2011 moderated in H2 2011. According to data from the CBN, up until November, broad money (M2) grew 0.35% MoM to N12.2 trillion, same level as in June 2011. Consequently, YTD growth remains at 6.3% (2010: 6.7%) with the stagnation in M2 in H2 2011 largely reflecting the impact of quasi money. Quasi money includes time, savings and foreign currency deposits with banks, and is the largest component of M2. It declined 2.4% in H2 2011 after a 9.8% growth in H1 2011, which had driven overall money supply growth during the first half of 2011. YTD, the moderate growth in M2 has largely been driven by an increase in net domestic credit (+25%YTD). However, in direct contrast to the situation in H1, more restricted measures of money supply showed a more robust trend than M2 in H2 2011. During the period, narrow money grew 2.4% (H1: 2%) compared to 0.3% growth in broad money. Similarly, YTD growth in base money accelerated to 29.8% from 14.5% as at H1. However, CBN reserves have by far shown the strongest growth, recording 123% YTD as at November, largely a result of aggressive CBNs tightening, in 2011 which saw the apex bank raising CRR from 2% in February to 8% in October. As MPC tightens The MPC hiked rates at every of its meetings through September, as well as at an extraordinary meeting in Octobereffecting its second doubling of CRR that month, amidst other complementary measures. Reflecting restrictive monetary conditions, currency in circulation has increased a meager 1% YTD while currency outside the banking system contracted 1.21% YTD, in spite of significant fiscal disbursements. In particular, measures taken at an extraordinary MPC in October have had a significant impact on money supply. The contraction in monetary measures that month has largely accounted for the more sedate increments in liquidity profile in H2 2011. In October, narrow money, broad money, demand deposits and quasi money contracted 3.4%, 3.5%, 4.6% and 3.7%, respectively. Driving interest rates higher The MPCs tightening through September added a cumulative 300 basis points to the anchor MPR. However, the impact on interest rates was relatively muted. Compared to December 2010 levels, oneyear deposit rates rose 100bps while prime and maximum lending rates rose 13 and 23bps, respectively, through September 2011. Though interbank (+134bps) and average t-bill rates (+145bps) showed a stronger response to tightening over the same period (especially the 100bps hike in March), the magnitude appears weak relative to the size of the hikes which were complemented by higher CRR and aggressive bill issuance. Interbank rates in particular were somewhat more volatile suggesting that considerations other than tightening were at play in determining rate movements. The overall muted reaction appears to reflect the impact of liquidity conditions/fiscal injections which repeatedly drove moderation in money market rates after any upward movement in response to the MPCs hikes. However, it was the additional tightening measures in October which engendered the years first appreciable uptrend in both lending and deposit rates. According to CBN data, the T-bill rate increased ~600bps MoM. Maximum lending, prime lending, interbank call and one year deposit rates also rose ~120bps, ~60bps, ~370bps and ~40bps over September levels. Nevertheless, due to a disproportionately stronger impact on lending rates, the spread between average term deposit and maximum lending rates widened from 17.7% in Q3 2011 to 18.04% as at November.

Interbank rates reacted particularly sharply. Going by the contraction in demand deposits and quasi money in October, it appears that deposit flight from the banking sector was significant in that month. Among the rescued banks in particular, we believe depositors reacted to concerns about the impact of much tighter monetary conditions after Octobers MPC, and the ensuing liquidity crunch in this segment may have been a factor in the CBNs reported intervention in buying back some AMCON bonds from some of the affected institutions. Attempts by banks in this category to secure customer deposits by these banks likely contributed to the uptick in average deposit rates. CBN filling coffers to the brim Although the CBN kept rate hikes on hold after October, it continued to use OMO aggressively ostensibly to counter rising fiscal injection in H2 2011. Through the year, the CBN issued ~N1.3 trillion worth of bills (net of maturities) in the OMO window alone compared to N54 billion in 2010. The unprecedented level of OMO, alongside a 6-year high in CRR sent CBNs reserves to the highest levels on record. It also held its largest single T-bill auction in the same month. In spite of the aggressive tightening, monetary aggregates maintained positive YTD growth as at November, reflecting the quantum of liquidity and aided by a pause in tightening at the November MPC. Thus, in conjunction with softer monetary tone and projected fiscal spending, we foresee significantly easier liquidity conditions in 2012. Consequently we expect interest rates to trend broadly lower with likely greater impact on lending rates which have more scope to fall. The hikes in CRR appears to have been effective in completely sterilizing increasing large portion of deposits flowing into the banking sector, possibly contributing to the uptick in deposit rates. Thus, in the face of sustained liquidity surges, the CBN might be tempted to use more of this tool. In conjunction with a suspension of the reserve averaging methodology which allowed more flexibility in meeting CRR requirements, the deposit sterilizing impact could be stronger, commensurately pushing up deposit rates. We expect increased T-bill demand from banks on the back of increased systemic liquidity. Already, the quantum of excess issuance in short term paper is set to result in significant inflows from maturing paper as from early 2012 and any increase in demand could amplify expected downtrend in T-bill rates, except issuance increases dramatically. Interbank rates appear to be signaling renewed confidence in that market as 7, 30 and 90-day NIBOR rates ended 2011 415bps, 375bps and 358bps lower than their respective Q4 highs, and this in spite of the expiry of the CBN guarantees to the rescued banks at year end. The sanguinity appears to be hinged on the supportive impact of acquirers and the implicit CBN guarantee on the three nationalized banks. These should limit volatility and spikes in interbank rates going forward, dictating a movement in tandem with general liquidity conditions. Nevertheless, signs of trouble with some acquisitions and possibility of direct liquidity controls disproportionately affecting smaller banks pose upside risks. Furthermore, depositors may not be as confident as sector peers in maintaining dealings with rescued/nationalized banks and could migrate their holdings in favour of larger banks. Even as a lower rate environment could make successful competition more difficult for the smaller banks. Potentially, attempts by smaller banks to attract deposits could keep deposit rates downward sticky to an extent. Ultimately, we believe the fundamentals foreshadow a contraction in the spreads between deposit and lending rates in 2012.

OMO and T-Bill issuance trend and implications Bill issuance increases In its persistent bid to mop up liquidity, the CBNs monetary tightening in 2011 was complemented by significant bill issuance. After issuing N1.22 trillion T-bills in H1 2011, the CBN issued a further N1.25 trillion in H2 2011, bringing total issuance for the year to N2.48 trillion, a 32.6% increase YoY. However, much of this increase was used to refinance maturing paper. At N2.3 trillion, maturing bills in 2011-largely created by aggressive issuance in H2 2010--were 63% above 2010 levels. OMO was the instrument of choice to mop liquidity Incidentally the open market operation (OMO) window featured prominently in CBNs activities. In H1 2011, CBN took up N282 billion in OMO, 23% above the total issuance for 2010. Not satisfied with this outcome, the apex bank issued an unprecedented N1.86 trillion in OMO paper in H2 2011. This took total OMO value to N2.1 trillionover eightfold the level in 2010. In all, the CBN undertook a record number of 69 OMO auctions in the year, compared to 15 in 2010. Rising interest burden. The increased issuance in H2 coincided with greater responsiveness in market rates to the CBNs tightening efforts, which became particularly intense in October, after a largely ineffectual first 9 months in 2011. In that month, the CBN sold a record N465 billion and N347 billion T-bills at its OMO and primary auctions respectively the latter including the highest single T-bill auction ever (N201 billion) on 13th October, 2011. With N195 billion in redemptions, the net issuance of N616 billion is the highest on record for a single month. Incidentally, feeding off measures at the MPCs extraordinary meeting (on 10th October), rates had jumped ~400bps on average earlier in the month and cut-off rates in October reflected this jump even as bid ranges widened significantly, reflecting heightened speculation. The combination of significantly higher rates and heavy issuances raised questions about the sustainability of the increasingly expensive bill issuance by the CBN. By our estimates, based on higher rates in 2011, interest expense on bills issued in the year could hit ~N380 billion, triple 2010 levels. tempers aggression Perhaps acknowledging that it might have overreached in its October measures which led to a seizure in money markets, the CBN has become less aggressive since October. Monetary authorities also appeared to have come to terms with the rising burden, making late efforts to elongate the average tenor of issuances in a bid to push repayment dates further out. In particular, the CBN started issuing 364-day paper at the primary window regularly after October, and lengthened average OMO tenor from 132 in November to 201 in December. It also began to consistently issue much less than actually offered, cutting off rates at much lower levels than average bids. In response, bid ranges have since narrowed (see figures 39 to 41) and the spectrum of rates has moved lower suggesting more tempered market expectations. Instructively, the sharp spikes late in the year had limited impact on the manifold increment in interest expense we estimated, which was largely based on much higher issuance levels and the more moderate rate rises over the course of the first 9 months of the year. Thus, interest expense on monetary operations will likely rise dramatically in 2012 if the apex bank persists in anchor policy on OMO.

However beyond interest expense, having issued almost N1.5 trillion new bills (net) in 2011 compared to net issuance of N483 billion in 2010, the CBN still faces the challenge of significantly higher maturities coming due in coming months. With about N1 trillion of the net issuance in Q4 2011, maturities in H1 2012 maintain the uptrend that started in 2010. With the quantum of maturing bills going into 2012, issuance will likely stay elevated. Indeed, having appeared to soft-pedal on rate hikes, signs that liquidity may continue to rise in the near to medium term suggest that T-bill issuance could even increase significantly. Consequently, considering the short duration of bills, there is a real danger that the CBN could get into a vicious cycle of ever increasing bill issuance, high levels of compounded interest, eventually creating a long term challenge in liquidity management. What can the CBN do? The apex bank may decide to issue fewer bills, allowing systemic liquidity to rise, contrary to its goals. On the other hand however, if it continues to issue at current rates, the interest burden may prove overwhelming, compounding its liquidity management problems. Thus the other option may be to increase bill issuance, focus on the longer end and attempt to take advantage of demand opportunistically. Considering that the apex bank may not be fully prepared to abandon its defense of the $/N exchange rates, we believe it may opt for the latter option. In keeping with the pattern from 2011, the primary market issuance could be largely driven by level of maturing paper with more frequent OMO than has been the case historically. This could possibly be complemented by cheaper measures to restrict liquidity including increasing CRR which has the benefit of not requiring interest payments. Unidirectional yields movements? Regardless of the path the CBN chooses, the fundamentals point towards the likelihood of a significant growth in liquidity, suggesting a further decline in yields going into 2011 as liquidity influx from maturing paper and rising government expenditure come against increasing limitations in the apex banks ability to curb liquidity. However, we believe the CBN may then be compelled to make greater use of cash reserve requirements, retreating somewhat on the use of interest rates and OMO. Optimistically, the quantum of maturities could even be useful counter-cyclically, if the global financial crises were to sufficiently dent global crude prices government revenue requiring measures to boost liquidity. Even then, rate cuts might be needed to support the liquidity situation with the likely outcome still a downtrend in yields later in 2012.