By now, most of us have heard that J.P. Morgan removed Nigeria from it’s popular Emerging Markets Bond index, after months of warnings. In typical fashion, the Nigerian press has gone into victim mode, calling the bank insensitive to the “problems of the common man” and crying out against the ‘financial blackmail‘. To quote ThisDay,
“JP Morgan Index team as a member of the global financial mafia that seeks to blackmail Nigeria into a dangerous devaluation exercise so its members can profit should note that Nigerians are smart enough to see through their scheme”
They go on, for the rest of the article, to pour out the biggest pile of financial stupidity I’ve seen in a long time. At the same time, the DG of the Debt Management Office, Dr. Abraham Nwankwo, has ‘assured’ us that JP Morgan’s decision will not have any negative impact on our bond market because local investors are ready to step in and cover the demand. He didn’t present any analysis to support the position, even though by virtue of his office, I assume he’s got the data. We’re just supposed to take his word for it. Whatever.
For the rest of us, let’s try to parse what is going on here. JP ,Morgan has an index which tracks emerging market bonds so that bond funds across the financial world has an easy way to invest in a lot of countries’ debt at one go. An index is essentially a basket of different securities, collected according to a set weightings formula and pulled together as if they were one instrument. For instance, say I wanted to buy the top technology stocks: Apple, Google and Facebook, 100 units each. Based on today’s prices, that would be three orders of $11,107; $60,607 and $8983 for a total investment of $80,600. Now, because I don’t have that amount of money sitting in my account, I want to break my purchases up into smaller amounts. At the same time, I don’t want to be collecting 4 to 5 shares of each stock across so many different orders. What I can do is create an index called A-G-F comprised of 100 units of each stock, or 300 units. That index is worth exactly the same as the underlying stocks, $80,600. But now, I can chop it up into 1000 units, of $80.60 with each unit comprised of small amounts of each of the three stocks, and then buy ten units a month at $806 (or 20, 30 etc) until I’m fully invested. By buying units of the index, I’m placing indirect orders of the underlying stocks.
That’s essentially what JP Morgan did what it’s Emerging Market Bonds index, it put together the bonds of a number of emerging markets, and created a single index security that bond investors can then buy to automatically spread their investments across many of these countries. The goal of an index determines how it is designed and what weightings to give each of its components. Given that emerging markets are risky compared to mature markets, JP Morgan designed its index to balance the riskiest markets from those with the best yields. Nigeria’s bonds when it got included in the underlying assets that make up the index comprised about 1.9% of the total weightings, with a total holding value of about $3.4 billion dollars.
Now, on to their decision to remove our bonds from their index. They cited liquidity concerns. What exactly does this mean? Well, because indexes by nature aggregate the purchase of many different assets into one, one of the biggest rules is that the underlying assets must be easily tradeable and have comfortably large trading volumes: that is, it must be very liquid. Why is this the case? Imagine I knew that AB index composed of 3 shares of A and B each was trading for $12, and had 50% weightings each. That implies that A and B are each trading at $2 per share on their own. Now, let’s say that B, by it’s own, surges from $2 per share, to $5 per share. The three shares of B in AB index are now worth $15, leading the overall value of the index to climb to $21 from $12. All well and good. However, B’s weighting in the index has gone from 50% to 71%, which might throw off the risk calculation of the index. In order to return the weighting to 50:50 ratio, we’d need to sell off some of B’s stock in our index. And you want to get a natural market price, and be able to sell it on demand, without unduly pushing down the prices of the remaining Asset B still in your index which in summary means, you want Asset B to be highly liquid. This is just one reason why indexes demand liquidity. Others benefits: no single person can dump your underlying assets in the market and force your index to crash or pump it up and force you to sell to them in order to rebalance (harder to manipulate a liquid market); less opportunity for arbitrage where the underlying asset is trading slightly lower or higher than it’s implied price in your index, leading to people selling the asset to buy it back through your index or selling your index to buy the underlying asset directly. Also, since it’s emerging markets we’re talking about, the investors who buy JP Morgan’s index want to know that while they’re buying, they can get out of any bonds if Nigeria’s credit worthiness or capital controls turn negative.
Now, CBN has lately been tightening forex flows in and out of Nigeria in order to steady the slide in the naira. Because of this, the settling of dollar-to-naira transactions, a large part of which supports bond trading going on in JP Morgan’s index, are taking longer and are harder to make opening the traders up to duration, FX and liquidity risk. If a trade is taking longer to execute because CBN is trying to filter all dollar flows through a thin straw, the final settling price becomes more uncertain, and that increases both risk (imagine your trade went off when naira-dollar was at 212:1 and executed when it was at 200:1), liquidity (sellers may refuse to buy Nigerian bonds) and more, all of which defeats all the aforementioned reasons why an index requires liquidity. JP Morgan’s responsibility is to the markets and investors they serve, not to the common man of Nigeria. That’s Emefiele’s job.
When the announcement was made, Nigeria’s bond market, after an initial panic, rallied a bit, as did our stock market. Which made commentators declare that domestic demand is indeed countering the effects of JP Morgan’s decision and there’s nothing to worry about. Which again, seems to suggest we don’t really know how these things work (and the people that know seem not to think we’d get it). When JP Morgan made their announcement, no sales were triggered yet. Anyone still buying JP Morgan’s index was still picking up Nigeria’s bonds. Therefore, rally or not, we shouldn’t expect to see much decline in the market yet (the trading on Nigeria’s bonds is almost an even split between foreign traders and domestic ones, although domestic investors constitute majority of the holders which seems to suggest Nigeria’s domestic bond markets aren’t as liquid or active as they should be). Now JP Morgan has taken out half of the Nigerian bonds in their index today, with the remaining half expected to be taken out by end of October. This is when we should start to see sell orders coming to make sure that holders of JP Morgan’s index funds remove all Nigerian bonds in the index in order to reflect the new composition (this happens somewhat automatically in the market). Between now and end of October, we should see a majority of these foreign bond funds sell their Nigerian holdings. Another big trigger should come for many of the top bond funds who report their holdings at the end of the year. This is usually when they do their rebalancing and any ones who haven’t divested from Nigerian bonds will likely do so around December and early January. So between today and the next three to four months, an estimated $3.5 billion worth of Nigerian bonds will be sold. Being that our bond market (according to the information I got from africanbondmarkets.org) is a little over $30 billion in value, a sale of almost 10% of the total capitalization is bound to make a dent.
So when people say the decision doesn’t matter, I wonder what they mean. Is it a useful thing for anyone if we take two steps forward as a country, and then take five steps back?
At the end of the day, I imagine our bond markets will be fine. Cost of borrowing may go up some, and market activity may collapse, but it’s not like these things are bread, and sugar. In the immediate scheme of things, they don’t matter that much. We’ll be fine. But in the grand scheme of things, they do. They matter very much. We remain a country in astronomical need of investments for infrastructure, business, power, development and more, and we need all the investments we can get. We need to be building a robust, well respected and liquid debt and equity market, not taking reputational hits that undo the work many worthy people have put in. Finance is the lifeblood of any economy, and we know this. Somehow, we think finance falls from the sky. It doesn’t. And with the way Nigeria is set up, not much of it will come from domestic investors. Power alone needs close to $100bn investment which is worth more than our entire equity market. If we’re going to get long term cheap capital, it’s going to come from global banks, investors and traders so issues like this amount to shooting ourselves in the foot. Let’s be serious, as a country, for once.