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How long will the carry trade party last?


In June 2007, Citigroup CEO Chuck Prince famously told the Financial Times: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Under the leadership of Prince, Citi embraced more risky products like subprime mortgages in a bid to compete with other major investment banks of the time such as Goldman Sachs, Bear Stearns and Morgan Stanley.
Prince didn’t “dance” for much longer, as once the music stopped in late 2007, there were few places to hide, as almost all asset prices, from homes to commodities to stocks, began to crash.
When he made the now infamous statement in June, Prince did not know that the party was already ending. By November 2007, he had retired from Citigroup and the worst U.S. financial crisis since the Great Depression had begun.
Today in Nigeria the “carry trade” music is blaring and everyone that seems to matter is having a darn good time, including the banks, foreign investors and the regulator, which is the Central Bank of Nigeria (CBN).
A carry trade is a trading strategy typically based on borrowing in a low-interest rate currency and converting the borrowed amount into another currency, with proceeds placed on deposit in the second currency if it offers a higher rate of interest or deploying proceeds into assets – such as stocks, commodities, bonds – that are denominated in the second currency.
Today the Nigerian dance floor is once again full with carry trade investors, so what happens when the music stops?
Moody’s Investors Service came out to warn last week that Nigeria’s reliance on hot money is damaging its economy and leaves it vulnerable to outflows when sentiment turns.
The company cut its outlook on Nigeria’s B2 rating, which is five steps into junk territory, to negative on Wednesday. One of the problems it cited, along with “sluggish” economic growth, was the central bank’s increased issuance of short-term bonds to encourage inflows and protect the naira.
The central bank’s stock of open-market operation (OMO) bills has risen to N17.4 trillion ($48 billion) from N11.3 trillion in 2017, according to BusinessDay’s estimates.
That’s a 54 percent jump in 2 years.
About $16bn of the OMO securities are held by foreigners, many of which are carry traders enticed by yields of about 13 percent.
“To attract foreign investors, the Central Bank of Nigeria is paying high-interest rates on these certificates,” Moody’s analysts Samar Maziad and Marie Diron said in a statement. “This policy is very costly, and has a consequent impact on the yields of other government financing instruments.”
The CBN has stopped publishing its annual report since 2018, however, the most recently available public data shows the extent of the cost of its liquidity management.
The CBN’s interest expense (interest payable on any borrowings – bonds, loans, convertible debt or lines of credit) jumped significantly by 192.8 percent to N1.3 trillion in the financial year ended December 2017 compared to N459.3 billion recorded in the corresponding year of 2016, according to data from the banks 2017 annual report seen by BusinessDay.
The rise in the interest expense was as a result of increased OMO auctions carried out by the CBN in the review period.
The draft annual report showed that the average monthly OMO issuance stood at N945.5 trillion in 2017 from N654.9trillion in 2016 and the average yield also increased to 19.43 percent in 2017 as against 14.60 percent, feeding directly into the higher interest expenses.
The strategy has worked in terms of keeping the naira stable, a key aim of both President Muhammadu Buhari and CBN Governor Godwin Emefiele, who recently barred everyone except foreign investors and banks from playing in the primary and secondary OMO markets.
The Naira has barely budged against the dollar this year and is Africa’s best-performing major currency after the Egyptian pound.
Societe Generale a French multinational investment bank, says the trade, which has returned investors almost 30 percent in dollar terms so far in 2019, will not lose its appeal soon.
The French bank forecasts that the naira will essentially trade flat next year, slipping only around 1 percent to N365 per dollar by the end of 2020.
“Nigerian fixed income has provided excellent returns and attracted large portfolio inflows over the past couple of years,” SocGen analysts said last week. “We expect this to continue.”
That will be great news for foreign investors, but for the rest of the domestic economy there’s a nagging feeling that just like it did for Citi’s Chuck Prince, the music may end abruptly, and an unwind of the carry trade by offshore investors will lead to Nigeria’s second recession or financial crises in a decade.

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