Bloomberg reported late on Tuesday, September 8 that JPMorgan has decided to eject Nigeria from its Government Bond Index-Emerging Markets (GBI-EM). Justifying its decision, the investment bank stated: “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 forex market and limited transparency.” Nigeria’s inclusion in the index will be phased out during the month of October. Abuja will not be eligible for re-inclusion for a period of 12 months.
JPMorgan’s decision to kick Nigeria out of its index will have widespread consequences. The most immediate concern is the possibility of a significant amount of portfolio outflows next month. JPMorgan reported that the GBI-EM fund was valued at $183.8bn and that Nigeria was assigned a 1.5% weighting in the index – this puts the value of potential portfolio outflows at just under $2.8bn. The actual amount of portfolio outflows might very well be even higher, as JPMorgan’s decision might push international investors that have yet to exit the market over the edge.
Another concern relates to government borrowing costs, as domestic debt yields are expected to trend higher – not the best outcome given the severe strain on the fiscus and weak emerging market sentiment which makes external borrowing more costly. We also expect further turmoil in the domestic equity and debt markets, while the parallel market exchange rate – which stabilised somewhat in recent weeks as the central bank provided dollar liquidity to some outlets – could well depreciate on increased forex demand stemming from heightened risk and investor concern.
Sovereign borrowing costs edged higher following JPMorgan’s announcement – the debt market regulator on Thursday increased the spread limit to calm bond market turmoil, widening the bid-ask spread from 0.3 naira to 1 naira. This move helped to mitigate volatility. The central bank has also cut the time limit for funding currency purchases from 48 hours to 24 hours.
This will hold implications for the domestic price environment. Apart from portfolio flows, inward capital investment in general may take a knock as JPMorgan’s decision arguably represents the first official condemnation of the central bank’s stance on the naira – this raises concern in relation to the financing of the current account deficit in a low crude oil price environment.
JPMorgan’s decision came much earlier than anticipated, with the investment bank previously stating that Nigeria had until end-2015 to address forex concerns. The fact that the decision was moved forward may be the result of fund trackers finding it increasingly difficult to clear positions due to tight forex liquidity. Even more concerning is what this decision portrays about the central bank’s stance. The investment bank cautioned against ejecting Nigeria from its index earlier in the year, and it is not implausible to expect that these warnings escalated through informal channels as yesterday’s decision drew nearer.
If one assumes that this was in fact the case, that the central bank deliberately decided not to act, then the order-based system could well remain in place for longer than originally anticipated. In actual fact, the central bank published a statement on September 9 in which it defends the order-based exchange system. The monetary regulator stated that it “strongly disagrees with the premise and the conclusions upon which the decision rests.” The regulator also noted that “JPMorgan would prefer that we remove this rule; even when it is obvious that doing so would lead to an indeterminate depreciation of the naira.”
Our baseline scenario is now that the naira will remain stable for the remainder of 2015. That said, the risk of a disorderly devaluation will certainly be elevated over the next two months, dependent on the severity of the impact of outbound portfolio flows. It is also worth noting that such a move would now entail an even larger adjustment to reach any resemblance of a market clearance level – Nigeria’s ejection from the GBI-EM will incentivise increased speculation on naira devaluation via non-deliverable forward agreements.
A large once-off devaluation still seems the less likely outcome in our view, as we believe the monetary regulator would rather opt for incremental steps (devaluations in the region of 10%) if indeed it decided to restore forex liquidity. How the central bank will justify such a decision, effectively backtracking on months of stating that the currency is accurately priced and that rent-seeking behaviour was to blame, is unclear.
A pressing question in this regard relates to how President Muhammadu Buhari, and his new finance minister to be appointed this month, will act given JPMorgan’s decision to make good on its earlier threats and the signal this sends about investor perception of the central bank’s stance on the naira. The central bank’s credibility nonetheless again took a massive hit in our view, and JPMorgan’s decision certainly raises the likelihood that rating action could be on the cards when we publish our Quarterly Update on Nigeria by the end of this month.
Cobus de Hart (Economist) & Irmgard Erasmus (Fixed Income Analyst)