Wednesday, August 16, 2017 10:59AM / Vetiva Research
The Federal Executive Council recently approved plans by the Ministry of Finance to refinance $3 billion (₦915 billion) worth of Treasury Bills (T-bills) with Eurobonds.
As opposed to rolling over existing T-bills at maturity, the Federal Government (FG) will pay down the debt using inflows from the dollar-denominated borrowing of tenors as long as three years.
This is in line with the strategy of rebalancing FG debt away from short-term domestic debt and towards longer-term external financing. In addition, the Minister of Finance Kemi Adeosun highlighted the attractiveness of lower interest rates on external borrowing: Nigeria’s 15-year Eurobond has a coupon of 7.8750% vs. 16.2499% on the newest issue of the 20-year domestic bond.
Although we consider current domestic interest rates to be unattractive for the FG, we caution against underplaying the cost of external finance by ignoring the opportunity cost of foreign borrowing in the event of currency depreciation.
Currency risk amplifies real cost of external financing
Although currency depreciation will not affect dollar repayments and Nigeria’s oil revenue is a source of dollar earnings to service external debt, we highlight that the opportunity cost i.e. the naira equivalent of dollar borrowings, rises with currency depreciation.
Moreover, an assessment of the attractiveness of government borrowing must be done in naira terms as this shows the true cost implications of debt for the Nigerian economy and public finances.
So, although foreign borrowing comes at lower interest rates, currency depreciation could bloat the debt burden by increasing real debt servicing costs as well as the real cost of principal repayment at maturity.
For instance, Nigeria issued a $500 million 10-year Eurobond in July 2013 with a coupon of 6.38% – implying an annual coupon payment of $31.9 million.
At issuance, the amount raised was equivalent to ₦79.6 billion (coupon: ₦5.07 billion) estimated using average exchange rate of ₦159/$1.
Whilst the annual dollar coupon payment remains unchanged over the issue period, the naira equivalent amount varies with currency fluctuation.
Notably, following a consistent currency depreciation since issuance, the naira equivalent annual coupon payment is estimated to have risen from the ₦5.26 billion in 2014 to ₦9.73 billion in 2017 due to a 48% depreciation of the naira to ₦305/$1.
Beside the impact of currency depreciation on coupon payment, we highlight that the naira equivalent amount of principal repayment has also risen from the ₦79.6 billion at issuance to an estimate ₦152.5 billion (at the current exchange of ₦305/$1).
In comparison, an equivalent naira denominated 10- year bond issued in 2014 at the prevailing market rate of 14.20% would have made a constant annual coupon payment of ₦11.3 billion for the past four years. The table below offers an illustration.
Whilst the domestic bond appeared relatively more expensive at issuance, we note that the naira equivalent interest cost gap has significantly narrowed due to the impact of currency devaluation.
Given that the naira equivalent of principal repayment for the Eurobond has also almost doubled (Current: ₦152.5 billion vs. at issuance: ₦79.6 billion), we estimate the effective annual interest cost on the Eurobond from inception till date at 25% - significantly higher than the bond’s coupon rate of 6.38% and the cost of an equivalent local currency debt (14.20%) issued at the same time.
Based on our calculations, naira depreciation less below 25% over the four year period would have kept the effective annual interest cost below the 14.20% level of the equivalent domestic bond.
Given the 48% depreciation over the period, the cost was significantly greater.
Thus, we highlight that any increase in the effective annual interest cost of foreign borrowing woud depend on the magnitude of currency depreciation.
Our prognosis is that whilst foreign currency debt appears cheaper at issuance due to the lower coupon rate, a magnitude of currency depreciation makes it less so over the long term. Theoretically, the interest rate differential between the local and foreign currency cost of debt should give an indication of the currency direction when capital can flow from one country to another.
We note that the 2018 – 2010 Medium Term Expenditure Framework projects currency stability (at ₦305/$1) over the 3-year period but we consider this quite optimistic given the observed trend across emerging and frontier markets over the past few years as well as the lower for longer oil price outlook.
Moreover, expected tighter monetary policy in the United States and Europe would likely drive up global interest rates and increase the cost of external debt.
Overall, whilst we believe that need to support FX liquidity as well as to diversify borrowing base (in a bid to avoid the crowding out of the private sector borrowing) will continue to justify foreign currency borrowings, we are of the opinion that foreign currency borrowing is not necessarily a cheaper alternative – particularly for developing economies with unstable currency outlook.
Naira injection may induce interest rate moderation
With the government’s plan to refinance maturing T-bills with the proposed the $3 billion Eurobond rather than the typical roll overs we have observed historically, we expect the liquidity boost from the inflow to drive rates downwards.
Importantly, we highlight that the likely liquidity injection is at odds with current Central Bank of Nigeria (CBN) tight monetary policy stance typified by aggressive liquidity mop ups in recent times.
Though we do not completely preclude the possibility of the apex bank using other liquidity management tools, we do not expect the CBN to use alternative tools such as the Cash Reserve Ratio (CRR) to tighten liquidity as the apex bank looks to support economic growth and we foresee this easing naira liquidity in the medium term.
As highlighted by the Minister of Finance, inflows of $3 billion should boost Nigeria’s external reserves and support CBN efforts to ensure liquidity in the foreign exchange (FX) market.
Refinancingis positive for debt profile, liquidity
The refinancing plan is still subject to National Assembly approval and we are yet to receive clarification on a clear timeline.
Overall, whilst we consider the plan to notionally be positive for Nigeria’s debt profile, we warn that expected cost savings may be eroded by likely currency deprecation over the period.
Meanwhile, the scheme may have a significant liquidity impact, barring any further adjustments made to existing monetary policy levers.
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