Naira Devaluation Toxic on Capital Markets
Essay
–
In this essay entitled: Naira Devaluation is Toxic on Capital Markets Oluwatobi Oyefeso, guest writer, Realnews details how the devaluation of Naira affects the market and argues that only regulatory injections can stabilise the system
| By Oluwatobi Oyefeso |
Introduction
Economic intuition postulates that the price of a commodity is determined by the market forces of demand and supply in a free economic system. Notwithstanding this economic postulation, it is logical to know the factors that inspire the movements of demand and supply. The readily available response is PRICE, although, not all the time that price directly determines the demand and supply. For example, in the primary and secondary segments of the capital markets, the price of equity is largely determined by a collection of micro factors which include Management and Product Quality, Ownership Structure, Research and Development, Book Value, B/V, of the firm, Dividend Per Share, DPS, Earnings Per Share, EPS, Price Earning Ratio, P/E Ratio, and Dividend Cover, DC. Similarly, there are macro factors that incorporate all the systematic (or undiversifiable) fundamentals such as politics, interest rate, inflation rate, exchange rate, unemployment and regulations. Generally, both the micro and macro factors fundamentally affect demand and supply, thereby shaping the investors’ psychology of the capital markets. Interestingly, the price factor is indirectly present in all the above quantitative and not the qualitative factors, as such, price unilaterally, cannot influence the demand and supply. In reality, there are several factors that constitute ‘market forces’, entwine with and influence ‘price’ of demand and supply in the capital markets.
Consequently, this write-up focusses on the effects of a particular factor, the exchange rate. More precisely, the subsequent discussion is on how the Naira devaluation affects the Nigerian capital markets.
Naira Devaluation Effects on the Nigerian Capital Markets
A currency exchange rate denotes the value of one currency with respect to another. Most exchange rate quotations are with respect to the U.S. dollar. Under a fixed exchange rate system, such as in China, the government determines the devaluation and revaluation of its currency. In a floating exchange rate regime or managed float, such as in the United States and Nigeria, market forces determine currency depreciation or appreciation. Recently, the Central Bank of Nigeria (CBN) depreciated the Naira value against the US Dollar and, unsurprisingly, such a monetary policy has been having domino effects on the capital markets performance. So, how and why has the Naira depreciation been affecting the capital markets?
Effects on Fixed Income Securities
Generally, the Naira exchange rate depreciation pushes up the domestic inflation through higher import prices. Investors would require higher returns to compensate for the inflation and the CBN may raise interest rates to fight off inflation, thereby pushing up interest rates even more. Considering the logical inverse relationship between the ‘existing’ fixed income securities’ prices and interest rates, so, Naira depreciation will result in the price crash of the fixed income securities, in consequence, increases the risk of fixed income securities like bonds and treasury bills (TBs). Expectedly, as the interest rate increases, investors will be aversed to investing in the ‘existing’ bonds and treasury bills that pay lower than the new rate. In the opposite, investors will have preference for the ‘new’ issues whose prices factor in the new and higher rate. Hence, the crash in the fixed income securities markets will only be applicable to the ‘existing’ instruments issued prior to the Naira depreciation and its associated inflation rate increase, while there will be a bullish markets for the new instruments under the new higher rate, post the Naira depreciation and inflation rate upsurge. Additionally, there is usually a capital flight from the capital markets to the money markets to capitalise on the new and higher rate in the money markets. Certainly, this often causes price crash and enhances the investors’ negative sentiments in the capital markets.
Effects on Shares
Certainly, a strong Naira can actually hurt the profits of the Nigerian companies when translating foreign income. In the contrast, a depreciated or weak Naira increases the exchange rate for the foreign-currency denominated sales and profits. Interestingly, a depreciated Naira will boost the Nigerian exporters’ trade and profits as the Nigerian products become more price competitive in overseas markets. Ideally, the domino effect of the increase in corporate profits is the bullish markets. However, because of import prices’ rise and leading to inflation, Naira depreciation can only lead to bearish markets in the short-run as the inflation impacts negatively on corporate profits and share prices respectively. Any perspective to Naira depreciation resulting in the bearish capital markets stems from two sources. One, the upsurge in interest rate from the increased inflation often encourages investors to divest from the capital markets. Two, the risk-aversed foreign investors are at disadvantage and are hesitant investing in inflation-ridden capital markets jurisdictions where investments usually become risker and more expensive. These ills often prompt investors to demand for higher risk premium, that is, higher returns compensating for the higher risk. Further, foreign investors suffer from low translation value of the local Naira vis-a-vis their home (foreign) currency. So, it is typical of the foreign investors to divest from the local capital markets of a depreciated currency.
Effects on the Mutual Funds
The contagion effects of the Naira depreciation on the mutual funds are quite similar to the effects on the individual investment assets discussed above. Precisely, the Naira depreciation will erode the value of the underlying asset(s) forming the mutual funds. In contrast, however, the Naira depreciation will create bullishness in the money markets via the increase in the demand and price as investors divest from the capital markets to invest in the money markets. In this case, the mutual funds on money markets instruments will experience market growth.
Effects on Portfolio of Assets
The impact of the Naira depreciation on the returns from assets’ portfolio, particularly, in the case of currency contagion, is best illustrated using example. Assume that you have invested 10% of your portfolio in Naira-denominated bonds with a current yield of 5 percent. Now if Naira undergoes a 20 percent depreciation, your net return from these bonds would be -15 percent (5 percent – 20 percent), rather than +5 percent. Certainly, the 20 percent depreciation is a decrease or loss in the value of those bonds. Consequently, the overall return on your portfolio would decrease by 1.5 percent (i.e. 15 percent loss of by 10 weight of the assets’ portfolio). However, assuming that you have a total 40 percent of your portfolio in the Nigerian capital markets assets affected by the Naira depreciation that decreases the assets’ value by 20 percent. The overall portfolio return would plunge by a very substantial 8% (i.e. 20 percent loss of 40 weight of the assets’ portfolio). Concisely, the value of assets’ portfolio usually falls lower, the higher the quantum (weighting) of each asset in the basket and the higher the currency depreciation rate.
Effects on the Market Liquidity
Generally, there bound to be negative multiplier effects of the Naira devaluation on the capital market liquidity. In the simplest form, liquidity connotes an asset’s feature of being easily converted into cash through buying and selling without causing significant upward movement in the price and significant loss in value that may result in low demand and supply. The essential characteristic of a liquid market is regular availability of the ready and willing buyers and sellers. The liquidity of an investment asset can be measured by the ‘buying and selling frequency’, which refers to volume. Expectedly, Naira devaluation with the associated higher inflation and falling demand resulting from the exit of foreign investors, can only result in the market bearishness and market illiquidity respectively. Even, the recent increase in the monetary policy rate and cash reserve ratio are definite stimulants to market illiquidity. In illiquid capital markets, investments instruments and derivatives contracts become riskier and non-attractive with significant plummeting demand. Put differently, investors will only demand if the efficient market forces and/or regulatory interventions can create enabling environment that guarantees liquidity of the investment assets.
Concluding Remarks
Consistent with the above analysis, our capital markets have become bearish since the announcement of the Naira depreciation some weeks’ ago. Indeed, the capital markets’ bearishness will be exacerbated by the on-going political activities and the usual forthcoming ‘January effect’. In fact, the bearishness may continue for as long it takes, especially, in absence of the appropriate regulatory stimulants.
It is interesting, albeit conventional to know that the CBN monetary policy affects the capital markets. An even more interesting question is, ‘why’ do these effects occur? Until now, our attention has been on the ‘how’. Without doubt, providing economically intuitive answer to this question will enhance our insight into why monetary policy affects the capital markets and the place of the capital markets in the macroeconomic policy decisions. In brief, an equity (a stock) represents a claim on the current and future dividends (or other cash flows, such as share buybacks) to be paid by a company. So, the following three key factors should affect stock prices. One, news that current or future dividends will be higher should raise stock prices. Two, news that current or future real short-term interest rates will be higher should lower stock prices. This truly depicts the current situation in our capital markets. Three, investors’ concern about risk and because shares are perceived as relatively risky, hence, investors generally demand a higher average return, relative to fixed incomes securities that are perceived to be less risk and safer investment assets. In effect, news that leads investors to demand a higher risk premium on stocks should lower stock prices. On the whole, the CBN monetary policy affects share prices only to the extent that they affect the investor expectations about dividends, short-term real interest rates, or the riskiness of stocks.
As depicted above, the toxic effects of the Naira depreciation on the capital markets cannot be over-emphasised, and can only be contained via the appropriate regulatory intervention policies of the Securities & Exchange Commission, SEC. Essentially, the SEC should now add another paradigm to its regulatory responsibility: the regular interventions in the capital markets similar to the CBN’s Monetary Policy Committee, MPC. Effective capital markets regulations should focus on creating the jurisdictions conducive to the uninterrupted supply by the corporate and government medium-to-long term funds’ seekers on the one hand, and demand by the private and institutional investors on the other hand. In our capital markets, there is need for the SEC’s appropriate stimulant interventions simultaneous to the fiscal policy or monetary policy pronouncements that may be designed to contract the economy with subsequent bearish contagion on the capital markets. Conclusively, this shift in the regulatory paradigm shall form the centrepiece of my subsequent publication on the Naira depreciation and the capital markets.
Oluwatobi Oyefeso, PhD, is the Group Chief Executive Officer, Morewits Financial Market Institute & Morewits Consulting Limited, Abuja.
Email: oluwatobi.oyefeso@morewitsinstitute.com
|
One thought on "Naira Devaluation Toxic on Capital Markets"
Related Posts
The EFCC, Yahaya Bello, Tom and Jerry: The Alawada circus show continues
By Prof, Mike Ozekhome, SAN I have just read a most sensational story about the EFCC saying it is still...
Read MoreNotes on restructuring and federalism in Nigeria
NAL Dialogue by Professor Godini G. Darah (FNAL) 12th September, 2024 The Bloody Birth of Colonial Nigeria THE process of restructuring...
Read MoreOne CJN, Two Oaths?
By Prof. Mike Ozekhome, SAN, INTRODUCTION IN a historic moment that has echoed through the corridors of Nigeria’s judicial history,...
Read MoreMost Read
Subscribe to Our Newsletter
Keep abreast of news and other developments from our website.
Very informative article, i’m regular reader
of your blog. I noticed that your website is outranked by
many other websites in google’s search results.
You deserve to be in top ten. I know what can help you, search in google for:
Omond’s tips outsource the work