Foreign portfolio investment (FPI) happens when foreigners’ claims on domestic resources are inflowed through securities (including government borrowing) and equity. It is different in this sense from more direct types of foreign investment, which sees foreigners’ claims with foot on the ground, as it were.
Yet, foreign portfolio investment tells the more interesting story about an economy. As the bottom fell out of the global oil market in 2014, portfolio investors began to leave Nigeria — unsure how the resultant revenue loss from lower oil export earnings was going to play. A devaluation of the naira was an almost inevitable consequence of the economy’s reduced earning power. And most such investors were not minded to include exchange losses in the panoply of risks they bore investing in the economy.
Of no less equal moment was the general acknowledgment that to the extent that lower oil prices operated through lower (if not negative) net exports and government spending, the economy was going to contract. Returns on domestic assets (the main draw for FPI) in a shrinking economy were always going to be that much lower. It did not help much that the Central Bank of Nigeria’s (CBN) exchange rate management policy further rendered markets even more opaque. Multiple currency practices did not just mean arbitrage opportunities, and less efficient allocation of scarce resources. They also meant that investors did not know how to price their Nigerian portfolios any more.
Not surprisingly, the naira came under pressure, as investors fled for the door (and, occasionally, the windows) out of the economy. Both the Nigeria Stock Exchange’s (NSE) All Share Index (ASI), and its market capitalisation trawled the bottom of the pool. Government gilts fared no less better. And over five consecutive quarters through to the second quarter of this year, the economy shrank.
Today, the narrative is more rose-tinted. The yield on government debt is up. The indices favoured by the Nigerian Stock Exchange for measuring the health of the market could not be better. And the economy is on the mend. Indeed, the return of foreign portfolio types to the markets has also helped keep the naira stable. The noisiest narrative is the official one. This insists that all this latter development, including the return of portfolio investors speak to the success of the incumbent administration’s policy responses.
Pay a little more attention, however, and the story from the foreign portfolio side is a wee bit more complicated. The liquid assets favoured by foreign portfolio investors reflect the degree of their responsiveness to volatility in the economies in which they invest. The more volatile the economy, the higher the coupon they ask for in order to hold domestic assets. And any vulnerability that threatens this risk-return relationship, including general elections, often sees these investor types up sticks.
We therefore expect a diminution (if not a reversal) in foreign portfolio investments into the economy, as we near the 2019 general elections. Despite what government boosters would have you believe, the one reason, however, why the inflow of this “hot money” has held up thus far is that returns on financial assets (especially government short-term borrowings) have been unusually high under the Buhari administration. The huge public sector borrowing requirement under the incumbent administration has helped push up domestic borrowing costs. In part because rather than support increases in domestic capacity or productivity, much of the borrowing has been inflationary.
Compared with the zero-bound interest rates available in much of the OECD countries, the real return on naira-denominated assets are thus a huge lure for portfolio investors. Sold on its “the economy is working” spiel, the Buhari government has contemplated this reality only to then try to eat its cake and have it. In a very bad example of fiscal dominance, the CBN is currently trying to push domestic borrowing rates lower (without first curbing government’s debt appetite).
Put differently, the naira is “healthy” because foreigners do not mind holding assets denominated in it. Government’s borrowing, by pushing up rates, makes naira assets attractive. By spending much of its borrowing in the recurrent bucket, government nudges inflation up. All of which hurt private sector borrowing and business investment. How to push down these costs, while keeping FPIs on side is the new challenge. This challenge will only get more difficult if (as most market watchers expect) the U.S. Federal Reserve hikes its benchmark rate by 25 basis points later this month.