NIGERIA: The Battle over Devaluation of the Naira

After delisting Nigeria from its Emerging Market Government Bond Index, JP Morgan Chase and others may have lost the battle to influence Nigeria to devalue the Naira, but serious challenges remain. Challenges that can only be resolved when sound fiscal policies support the current monetary response, writes Festus Akanbi

The pressure on the Central Bank of Nigeria to devalue the Naira remain intense as certain members of the international financial community including JP Morgan Chase and Co ( JPMC) had raised the prospect of Naira devaluation amidst the global oil crisis which has continued to weaken the nation’s foreign exchange positions. JPMC wants an open unfettered two-way quote by the CBN in the sale of USD for Nigerian Naira. Instead, the CBN is opting for an order-based two-way quote saying that an unrestricted two-way quote, not tied to valid transactions, will result in a free fall of the Naira allowing speculators take control of the Nigerian economy.

This is at the root of the controversy between JP Morgan’s Emerging Market Government Bond Index and the Central Bank of Nigeria (CBN) over forex market liquidity in Nigeria. While JP Morgan is concerned about the adequacy of forex supply to the market, the CBN has passionately concerned itself with keeping the Naira stable by limiting and managing forex demand. Indeed traders in London are already quoting the Naira at N260/ 1 USD in forward trading and given the way Nigerians react, the rate could climb to a N300 threshold under any challenging condition. That is where portfolio investors who want to buy Nigerian stocks and assets on the cheap believe the market should be.

And according to the Managing Director of Financial Derivatives Company, Mr. Bismarck Rewane, the CBN was faced with the classic dilemma of either increasing interest rates and further strangulating a gasping economy or doing nothing and watch inflation erode household incomes as the Naira tumbles.

The CBN has refused to leave the Naira to a free fall, even as monetary options available are becoming fewer. Analysts believe it is time for the fiscal options to weigh in beginning with the appointment of a Finance Minister with heft who can engender global confidence. At which point the real handwork will begin, first with a serious dialogue with political leaders at federal and state levels to rein in government spending and deepen President Muhammed Buhari-led policies of cutting waste and plugging leakages at federal and state levels while beefing up revenues and fiscal buffers through taxation especially Value Added Tax (VAT). According to calculations of the THISDAY Board of Economists, should the Naira devalue to N260/ 1 USD as reflected in London forward quotes, inflation will rise double digit to 13.15 per cent instead of the current 9.2 per cent; interest rate in banks will rise by another 7.5 per cent from the over 20 per cent being availed by some banks all of which will further shrink GDP and increase unemployment in a nation where lack of jobs is impacting negatively on security.

Last week, JP Morgan announced that Nigeria will be phased out of the Emerging Market Government Bond Index (GBI-EM) index series over the next two months. According to the American bank, the alleged lack of a fully functional two-way FX market has given rise to uncertainty and a number of challenges for investors transacting in the naira. Thus, Africa‘s biggest economy would be partially excluded from the index by September-end and full exit will occur in October-end. Nigeria's current weighting in the $200 billion index is 1.50 per cent.

However, the federal government insisted that a functional two-way FX market already exists in Nigeria, explaining however that given the high propensity for speculation, round tripping, and rent-seeking in the market, it became imperative that participants are not allowed to simply trade currencies but are only in the market to fulfil genuine customer demands to pay for eligible imports and other transactions. This scenario informed the introduction of an order-based, two-way FX market, which has resulted in the stability of the exchange rate in the interbank market over the past seven months and largely, eliminated speculators from the market.

“Despite these positive outcomes, the JP Morgan would prefer that we remove this rule; even though it is obvious that doing so would lead to an indeterminate depreciation of the Naira. With dwindling oil prices, we believe that an order-based two-way market best serves Nigeria’s interest at the moment,” a joint statement from Federal Ministry of Finance, the Central Bank of Nigeria and Debt Management Office said.

Pains of Devaluation
However, financial experts explained that if devaluation had gone the way JP Morgan wanted it (a fully functional two-way FX market), Naira value would have plummeted, resulting in higher exchange rate against the dollar to as much as N300. Such scenario, they argued would have also led to a further spike in inflation (to double digit) and to the export of jobs.

To ordinary Nigerians, costs of living would have soared as imported goods would have become prohibitive, while cost of services would have spiked given the likelihood of a spontaneous rate review by service providers in transport, telecommunications and finance sectors of the economy.

It was also suggested that if there is devaluation, hot money will flow freely into the economy and that this will improve Nigeria’s foreign exchange position. However, experts warned that this hot money can disappear as quickly as they make their way into the economy under any serious situation.

Analysts also believed that had the CBN bowed to the pressure from JP Morgan and other organisations who prefer the safety of portfolio investment to Nigeria’s economic stability, the corresponding tension that would have normally followed the erosion of naira value would have ultimately affected the safety of the investments of fund managers which JP Morgan is protecting.

These fears were confirmed by a government source who insisted that “The government and CBN’s primary responsibility is to enunciate policies that would reverse the decline in the country’s GDP, create jobs and keep inflation low.
“A devaluation of the currency will hamper these objects. So if the price we have to pay for this is our ejection from the JP Morgan index, it is a temporary price we will have to live with until our finances improve,” he said.

No More Push for Devaluation
According to Renaissance Capital analyst, Yvonne Mhango, the JP Morgan’s verdict may push out the urgency of naira devaluation. She said: “We believe the recent build-up of FX restrictions likely accelerated JP Morgan’s decision to remove Nigeria from its EM bond index. Now that JP Morgan has removed Nigeria from the EM bond index, we think there is even less reason/urgency for the CBN to allow the naira to depreciate, and to relax the FX restrictions. We actually think the removal of Nigeria from the JP Morgan bond index pushes out the prospect of devaluation, as the threat of being removed from the index has come to pass.

India and China are also excluded from the index gauge due to the capital controls that limit access to a majority of foreign investors.
Russian bonds are also going to be removed from emerging markets indexes but will remain in other J.P. Morgan indexes that don‘t require a maximum credit rating. Malaysia Pakistan and Ukraine have been taken off the MSCI index as a result of capital restrictions.

Pains of Exclusion from the JP Morgan’s Index
However, some analysts calculated that the removal from the index will force the sale of Nigerian bonds by investors as they seek to rebalance their bond portfolios. This will result in significant capital outflows estimated at about $2.5 billion. There will also be a rise in borrowing costs as bond yields spike as a result.

Bond yields have already risen from 13.5 per cent to 16.2 per cent since May. With the battle to stay on the index having been lost it, there is less urgency to devalue the currency and remove forex restrictions.
There is also a legitimate fear by equity investors that the actions of JP Morgan could lead to action by the Morgan Stanley Capital International (MSCI) Index widely used as benchmarks for emerging and frontier equity funds. Nigeria has a 14.6 per cent weight on the MSCI index – the second largest.

In October 2012, Nigeria was included in the JP Morgan Emerging Market Government Bond Index (GBI-EM). The GBI-EM indices consist of regularly traded liquid fixed-rate domestic currency government bonds. Nigeria was expected to have a 0.59 per cent weight of the $170 billion of assets under management of the index. At the time Nigerian bonds were offering yields of up to 16 per cent compared to the GBI-EM Index yield of 5.8 per cent. Given the premium and possibility of higher returns, the inclusion brought along with it great prospects of large capital injections into the debt market with some predicting up to $1 billion in the first few months.

However, by 2013 end, Nigeria was struggling to maintain a sufficient level of liquidity – one of the requirements for the inclusion.
The currency market especially, had experienced significant blows. The more than 50 per cent plunge in oil prices led to an 11 per cent depreciation in the last quarter of 2014. This also sparked an outflow of capital.

The CBN, in December 2014, reduced the Net Open Position (NOP) of Deposit Money Banks (DMB) to zero per cent from one per cent of shareholders fund, before revising it up to 0.1 per cent in January 2015. These measures reduced foreign exchange and bond trading making it difficult for foreign investors to replicate the gauge. Nigeria was placed on the negative index watch in January 2015. In June 2015, Nigeria was given a six-month deadline to restore liquidity, taking into account the arrival of a new administration before finally deciding earlier last week to exclude Nigerian bonds from the index.

The Road Ahead.
Managing Director, Cowry Assets Management Limited, Mr. Johnson Chukwu, believed Nigerian economy will survive the JP Morgan’s threat. The entire portfolio of funds that are tracking Nigerian instrument at the global bond market is about $3billion, just 1.5 per cent of the index. He explained however that with $3 billion leaving the country now will simply means that our reserves will be depreciated by about N28 billion.

Chukwu said: “We now have to reinvigorate the local economy so that we can have an indigenous growth in the local economy. What the government needs to do is to drop monetary policy rates and the cash reserve ratio so that liquidity will flow into the economy. We should increase lending to local production,” he said.
Also dismissing the fear that the JP Morgan’s verdict will negatively affect Nigerian economy, Rewane said all that was needed was a careful planning to stimulate local economy.

He pointed out that the decision of the American investment bank was purely informed by the need to satisfy portfolio’s investors’ interest. “I think first and foremost, we didn’t lobby JP Morgan to put us in the index. It was in our interest to do so and they thought it necessary. JP Morgan is not doing it because of Nigeria but for investors who will like to get the proceeds as at the time they want it. When there is liquidity, we can be in the index. You don’t have to be in the index – with just 1.5 per cent of the index but it is significant that we are leaving JP Morgan at a period when oil price is low and growth rate is low. It will increase our level of difficulty that we face at this point in time.

”The argument by the Central Bank is okay but as far as I’m concerned, I don’t think JP Morgan will come and tell us how to run our economy. JP Morgan is doing it on behalf of investors. When the market is sufficiently liquid, we will be included into the index again,” Rewane said.

Responding to the development, Research Associate, Eczellon Capital Limited, Mr. Mustapha Suberu, recalled that Nigeria had five bonds listed on the index as at 2013 which were: 4.0 per cent FGN April 2015; 7.0 per cent FGN October 2019; 16.39 per cent FGN January 2022; 15.10 per cent FGN April 2017; and 16 per cent FGN June 2019 – these bonds made up about 1.5 per cent of the total index, which translates to about US$2.8 billion as at end of August 2015.

“That said all these fears are short term and would not have a lasting impact on the economy of Nigeria, as domestic investors have always proved to have the capacity to absorb bonds being offloaded by foreign investors.
“For instance, total pension fund invested in FGN bonds as at May 2015 was N2.5 trillion (US$12.4 billion), which is over three folds larger than the c.N551.3 billion (US$2.5 billion) that is likely to be available for grabs from portfolio managers; this clearly point to the capacity of the local bond market to absolve the delisted bonds.

Return to Normalcy
“We expect gradual normalcy to return to financial markets by end of October when the delisting process should have been concluded, and the market would have a clearer view of other upcoming potential headwinds – possible rate hike in the US next week, CBN’s MPC outcome, likely in the next two weeks, and incoming cabinet of the President expected by end of this month.”

Dismissing the fear that the development could jolt the Nigerian economy, Head of Strategy, BGL Plc., Olufemi Ademola, explained that “while this is not a good development since the sell pressure is likely to lead to asset deflation, I don't think that the impact will be so large. This is because most international portfolio managers that invest in the bonds have already exited based on the fear of exchange devaluation following continuously dwindling oil price. However, the passive investors and those that follow a full index replication strategy will wait until the assets are removed from the index before selling down.

Having weighed the pros and cons of Nigeria’s exclusion from the JP Morgan's government bond index, there are sufficient reasons to say that although, Nigeria will pay the price with the anticipated outflow of investments, the fact remains that the nation cannot afford another round of devaluation at this critical period of lean revenue occasioned by the dip in oil price and the attendant erosion of the nation’s foreign exchange account.