Nigeria Q3'16 Capital Importation - Higher Yields Spur Recovery in Portfolio Inflows


Wednesday, November 09, 2016 8:43 AM / Vetiva Research

Following a dismal first half of the year, total capital imports into Nigeria reached $1,822 million in Q3’16 (Q1’16: $711 million, Q2’16: $1,042 million) on the back of a sharp uptick in foreign investments in financial assets (foreign portfolio inflows).

Although this figure still compares unfavorably to Q3’2015 (down 34% y/y), the improvement is consistent with recent trend as Q3 has accounted for the largest quarterly share of capital imports since 2014.

Apart from Foreign Portfolio Investment (up from $337 million to $920 million in Q3), the other two categories – Foreign Direct Investment (FDI) and Other Investment – also recorded quarterly rises of 85% and 8% respectively whilst also declining on a yearly basis.

Finally, we note that factoring in c.11% depreciation of the local currency in the quarter, the naira value of capital inflows nearly doubled compared to the previous quarter.  

Bond Investment: From 0 to 400, real quick

Traditionally the largest channel of capital inflows, FPI bounced back strongly to account for 50% of total inflows (Q2’16: 32%, Q3’15: 37%). In fact, inflows to bonds and money market instruments alone contributed 85% of the total increase in capital inflows during the quarter.

Having recorded precisely zero inflows in Q2’16, bond inflows rose to $369 million, the highest value since the start of 2015. Critical to this was the introduction of the flexible foreign exchange rate framework, which was positively received by international investors.

Unsurprisingly, the rebound also coincides with the increase in the monetary policy rate (MPR) and subsequent rise in average yields of government bonds. We would expect the increase in interest rate to further attract portfolio investors as they seek to exploit the higher returns available on fixed income instruments.

Also critical was the However, this is contingent upon improvement in dollar liquidity in the interbank market – in this regard, we think the news of improvement in crude oil production and the option of hedging through the forwards markets could have supported FPI during the quarter (13% of OTC FX futures demand has been from foreign portfolio investors).

It was a similar story for money market instruments (treasury bills) which rose to $350 million – a two year high. This accounted for 38% of total FPI during the quarter (Q2’16: 17%, Q3’15: 11%).

The larger proportion of inflows into money market instruments is mainly due to the extraordinary high rates available on these securities, reflected in increased activities in the space – FMQD reported that trading in treasury bills accounted for 37% of fixed income activity in Q3, four percentage points more than in the corresponding period of 2015.

Whilst we continue to expect higher levels of investment in fixed income securities and highlight such flows as a stop-gap solution to current foreign exchange (FX) illiquidity, the volatility of these flows cap their beneficial effects.

Looking at the normalized standard deviation of capital inflows (using data from 2013) can offer one view of this volatility. We find that on a normalized basis, FPI has the highest standard deviation of the three main categories, with capital inflows to bonds the most volatile component of all.

In contrast, FDI – rightfully seen as a more stable stream of capital inflows – has a significantly lower normalized standard deviation.

Capital Account concentrated in a few countries
The United Kingdom regained its position as the primary source of capital inflows into Nigeria, contributing $1,097 million which represents the highest amount from any country since the $1,374 million inflow from the US in Q3’15.

The top 3 source countries (U.K, U.S. Netherlands) alone account for 89% of capital flows into Nigeria (Q3’15: 80%) depicting an increased vulnerability and dependency even as total inflows have reduced. Meanwhile, India, Spain, and China, some of Nigeria’s largest visible trade partners, contributed negligible amounts to Nigeria’s capital account.  

Macroeconomic weakness undermines foreign investment
Accepting that Q3’16 capital import statistics show an improvement on previous quarters, they are still hovering around five year lows. This is despite the low-yield environment in the developed world as a result of unconventional monetary policy measures and large scale quantitative easing programs in large advanced economies.

We have witnessed softening risk appetite from international investors due to socio-political developments such as the Syrian and refugee crisis, the UK referendum vote, and US elections.

These have no doubt deterred some investment. However, internal factors are more relevant here. Nigeria’s economy has been on a downward trend since 2014, culminating in a recession as at Q2’16. This slump in aggregate demand makes the country a significantly less attractive destination for foreign capital.

Notwithstanding, we note that the long-term appeal as the largest consumer market in Africa should still hold sway and on this note, we highlight the increase improvement in FDI as a positive development.

Nigeria’s capital markets are particularly exposed to the ebb and flows of capital inflows. The Nigerian Stock Exchange (NSE) has significant foreign exposure although foreign participation has plummeted to 44.6% of total activity (66.8% in 2011) amidst a general market slump.

Equity FPI was the only category to record a quarterly decline (28%) as it lost its place as the largest contributor to FPI (since Q2’07), showcasing the dwindling appeal of stocks versus bonds.

FX illiquidity stifling rebound in capital flows
There are other reasons for why capital imports persist at such low levels. Though nominal returns to investment remain elevated, real return has been eroded by inflation (Q3 average: 17.5%). The downward trend in month on month inflation suggests that we are nearing a peak but further naira depreciation lurks in the horizon – creating another deterrent to foreign investment.

In addition, the visibility of Nigerian fixed income instruments remain lower after the eviction from the JP Morgan Emerging-Market Bond Index. Finally, the illiquidity of the FX market is a huge impediment as it discourages investors who worry for the return of their capital.

This is best seen through the plight of numerous airline operators who have struggled to remit earnings back to their home operations as dollar shortages continue. Amidst all this, FMDQ reported a total turnover of $36.7 billion in the FX spot market for the 9-month period up to September 2016, compared to a yearly turnover of $84.9 billion in 2015.

Conditions for foreign inflows remain unmet
FX market liquidity and inflationary pressure, amidst broader economic weakness, will continue to be urgent drivers of capital flows. A successful Eurobond offering could boost confidence in Nigeria’s fiscal authorities and set the scene for greater capital flows moving into next year.

Sticking to the current tight monetary stance will also keep yields attractive but more necessary is a resolution to the prevailing FX challenge. The current framework needs a shot in the arm as confidence is severely drained, and so are foreign reserves.

Longer term, we envisage capital flows will respond to improvement in economic fundamentals, infrastructure and institutional frameworks, all of which will be of particular importance to attract FDI. 

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