In September 2015, J.P. Morgan ejected Nigeria from its Government Bond-Emerging Market Index, citing a lack of liquidity and transparency in Nigeria's foreign exchange (FX) due to strict restrictions placed on foreign exchange transactions by the Central Bank of Nigeria (CBN).
Despite defiant protests by Nigeria's economic chiefs who defended their FX stance, Nigeria's three Federal Government bonds were removed from the index in October 2015. Investors responded by selling off their holdings in the bonds, causing yields to rise before CBN intervention (leveraging on treasury Single Account liquidity) drove yields lower till the end of the year.
Notably, J.P. Morgan left the door open for a potential re-inclusion in the index after 12 months if Nigerian authorities could establish a consistent track record of upholding the inclusion criteria.
What has Changed Since September 2015?
Over the last two years, the CBN has made significant changes in its FX policy which have largely addressed the issues of illiquidity and opacity.
The CBN’s decision to defend the naira and maintain its USD peg at ₦197/USD fueled an ever-increasing backlog of unmet FX demand exacerbated by low FX revenue due to slumping crude oil prices and production disruptions in the Niger Delta. However, severe pressure on the naira forced the apex bank to officially devalue to ₦305/USD in August 2016 to enable it to service more dollar demand at a rate more in line with the market value of the currency. The move was welcomed by financial market experts, if not by the broader population.
In June 2016, the CBN introduced Non-Deliverable Forward (NDF) contracts in a bid to ease pressure on the naira. These contracts provided businesses and individuals with an outlet to hedge FX exposure while enabling the CBN to stratify FX demand and deploy scarce FX towards meeting immediate demand.
And on the 21st of April 2017, the CBN established the Investors’, Exporters and End-Users FX Window (I&E), a free-floating market-determined exchange rate market. Authorized FX dealers (banks), portfolio investors, exporters and other parties with foreign exchange needs were given access this market.
It was a masterstroke.
Although the naira depreciated to ₦360/USD at the I&E window, the existence of a proper free market to trade currency enticed those that had been stashing their dollars to come and exchange them at a market-determined rate. The result was a substantial increase in USD supply by autonomous (independent) dollar suppliers, boosting dollar liquidity in the country. The structure of this window, with market participants arranging deals with each other at agreed rates, ensures that the market is transparent and that the Naira will trade at its fair-value at rates agreed upon between two knowledgeable and willing participants.
The I&E window recorded $26 billion in 2017, and the CBN was not the dominant supplier in the market! We have also witnessed a convergence between the I&E FX rate and the parallel market rate suggesting the Naira is trading at a level close to its real value.
Does this pave the way for reentry?
The I&E window largely addresses the major factors cited by J.P. Morgan in 2015. To see why, we just follow the money.
Following the enactment of the I&E window, the Nigerian Stock market surged 42% higher as previously wary foreign investors piled into Nigerian securities. Renewed foreign investor interest indicated confidence in the workings of the I&E window and its status as a liquid and transparent platform for facilitating currency transactions and ensuring the free flow of capital.
Still following the money, Nigeria's foreign reserves have risen from $24 billion at the end of 2016 to $42 billion today, providing a much stronger buffer to ensure FX liquidity if the CBN is forced to step in and intervene with larger dollar sales.
Further reason for confidence is provided by Morgan Stanley, a rival to J.P. Morgan. In 2016, Morgan Staley Capital International (MSCI) put Nigeria on a watchlist for potential exclusion from its Emerging Market Indexes and reclassification to Standalone status for the same reason – FX illiquidity and opacity.
But, last year, the MSCI decided that it was satisfied with the improvements in Nigerian FX market, and chose to retain the country in its Frontier Markets Index. The case is slightly different – the J.P. Morgan Index is a bond index while the MSCI Index is an equity index and bond transactions are substantially larger, but the MSCI endorsement is a good omen for Nigeria's chances of inclusion in the J.P. Morgan Index.
It's also important to remember that on its own, Nigeria remains a key and attractive Emerging Market. The influx of foreign capital in 2017 is a reminder of this, and, more importantly, reintroducing Nigeria into the GBI-EM index will result in a more representative index which will enable J.P. Morgan, the index provider, capture more funds from global investors interested in Emerging Markets.
Unfortunately, reentry is dependent on consistently meeting set criteria over a 12-month period. The I&E Window will celebrate its first anniversary on the 21st of April 2018, and at that point, we may begin to make the case for reintroduction.
What is at stake?
A potential reintroduction into the Index will result in increased foreign demand for Nigerian sovereign debt instruments as Nigerian local currency bonds will be included in the investment universe of global asset managers tracking the Index. Put simply, this increase in foreign demand would reduce interest rates in Nigeria. Lower sovereign and corporate borrowing costs will enable the Government and Nigerian corporates raise cheaper debt capital required to fund necessary capital investments that will drive economic growth.
The benefits of reinclusion would be significant. Along with FGN bonds, the introduction of the Savings Bonds, Sukuk and Green Bond issued by the Debt Management Office (DMO) last year provides a broader range of sovereign debt instruments for potential inclusion if Nigeria is readmitted into the index. Reentry into the Bond Index will attract more much-needed foreign capital as we continue our slow and steady pace towards sustained economic development.