JP Morgan Government Bond Index – The bad, and the good

JP Morgan removed Nigeria from its Government Bond Index for Emerging Markets in response to the Central Bank of Nigeria (CBN) taking unorthodox steps to shield Nigeria from the volatility triggered by a 60% drop in oil prices. To quote JP Morgan, “Investors who track the GBI-EM series continue to face challenges and uncertainty while transacting in the naira due to the lack of a fully functional two-way FX market and limited transparency… As a result, Nigeria will be removed.”

So here’s the bad news: delisting Nigeria from a major financial index for Emerging Markets sends a negative signal. In a doomsday scenario, a significant number of foreign investors will sell off some of their Nigerian assets. This is most likely amongst (but not limited to) investors who create portfolios that mirror the Index. If these investors are selling their Nigerian Government Bonds, economic theory predicts two things could happen: supply for bonds will rise, so their ‘price’ will drop, assuming demand stays the same (in reality the market could freeze up for a while or the CBN may need to intervene). These investors will also then sell the Naira received from selling off bonds to buy dollars and take those dollars out of Nigeria. Nigeria’s reserves could face yet another hit in the short term.

However, these are short term shocks – potentially a one-time hit. If investors sell off trillions of Naira worth of government bonds this will be damaging. There are some possible long-term implications. Nigerian policy makers, in their response to the oil price shocks have sent a clear signal that they will implement unorthodox policy measures to dampen exchange rate volatility even at a price of short-term liquidity crunches. This is bad news for those with short investment horizons, but for long-term investors it’s a mixed bag with some potential positives to go along with the negatives.

In the heady days of the mid-2000s as banks consolidated and companies rushed to raise capital on the stock market (and also in more recent times as Nigeria’s credentials as an emerging market grew) the Nigerian financial markets opened up to substantial inflows. Many liquidity controls were relaxed. There is some evidence to suggest foreign investors had pumped money into financial markets. Since the decline of oil prices, the Nigerian stock market has taken a beating. The All Share Index (an average measure of the value of shares) is down from 43,000 in July 2014 to 29,454 at the close of trading yesterday (a decline of almost 32%). Foreign investors whose investments come in form of buying financial instruments have clearly been reacting to oil prices and other issues (perhaps over-reacting). Nigeria is not currently a favourable investment destination for these types of investors.

But there are other types of investors. There are investors who are in it for the long haul. They invest, not by buying paper or ‘financial instruments’, but by bringing in equipment, technology and technical knowhow. They build factories and infrastructure and create new services for the Nigerian market. They train Nigerians to work in their new businesses. Their profits are not based on how quickly and easily they buy and sell financial instruments, but on the long-term health and growth of the Nigerian market. They need stability, rather than runaway inflation, much in the same way the man on the streets of Akure or Okigwe do. They also need a clear sense of direction in Nigeria’s policies. Nigeria getting delisted from one Index will not suddenly change their decisions, even as they might find the news interesting like any other person, and they might take a moment to reflect review their future plans.

We were initially perplexed by the policies of the CBN in stabilising the Naira. The CBN has attempted to control demand by creating an exclusion list of imports that can no longer by funded by dollars bought from it. The CBN placed a $300 limit on daily transactions and cash withdrawals. The CBN barred people from paying dollars held in cash into Nigerian foreign currency bank accounts. These actions are all very painful. But despite initial scepticism, they appear to have worked in killing speculation and ‘gambling’ on the Naira. Despite the fact that oil prices have been lower in the last couple of months, foreign reserves have risen, and the spread between the official and black market rates appear to have been moderated. Exports appear to be matching imports at the current exchange rate.

Are Nigerians better off by the unorthodox actions of the CBN? Only time will tell, but the Central Bank is currently making a strong case for itself that its policy intention is to moderate volatility in foreign exchange rates and inflation, even at the expense of short-term constraints of liquidity. This intent favours most of the Nigerian public, and long-term investors. The Central Bank is in uncharted territory by attempting policies that aren’t quite part of text book economics that suggests Central Banks act primarily on one thing: setting interest rates. There is a chance it won’t pay off, but so far if the relative stability of the Naira that’s been achieved is anything to go by, it is a good thing to try approaches that diverge from economics textbooks. Iceland did this in the face of the global financial crisis in 2008. That gambled paid off. Maybe Nigeria’s gamble will pay off as well.