In fulfilment of monetary policy authority’s aspiration for a single digit interest rate environment, the sovereign yield curve continues to trend lower, with yields on Federal Government Bonds hitting decade low.
Across all tenors, including the 30-year maturity, yields on FGN Bonds are at single digit. This new interest rate environment reinforces the confidence of the Central Bank of Nigeria (CBN), under the leadership of Governor Godwin Emefiele, on the effectiveness of unorthodox measures in easing the cost of capital for businesses.
Quoting the CBN Governor, at his inaugural press briefing in June 2014, he emphasised, “we shall pursue a gradual reduction in interest rates. A comparison of selected macroeconomic aggregates from some emerging market countries including South Africa, Brazil, India, China, Turkey, and Malaysia indicate that Nigeria has one of the highest T-bill rates. Such high rates create a perverse incentive for commercial banks to simply buy virtually risk-free government bonds rather than lend to the real sector”.
Economists and policy analysts globally are encouraging governments and corporates to take advantage of low interest rate environment to finance infrastructure and real sector expansion, particularly in developing markets, where sustainable growth will be dependent on the concerted ability of government and private sector to bridge the huge infrastructure gaps.
The CBN has over the past year reiterated this perception and responded with a number of administrative policy measures, including the prescription of a minimum loan-to-deposit ratio of 60 percent (subsequently increased to 65 percent) for banks, with continuous implementation of its strict penalty for non-compliance, in the form of extra-ordinary cash reserve requirement.
In reinforcing its support to the CBN and renewed accommodative and pro-growth stance, the monetary policy committee (MPC) lowered the benchmark rate by 100 basis points to 12.5 percent at its meeting held in May 2020, citing the need to stimulate credit, crate jobs and reflate the economy against the risks occasioned by the COVID-19 pandemic.
Interestingly, the federal government, which has been the single largest borrower in the country with about N15 trillion debt obligation in the domestic market, is perhaps the biggest beneficiary of the current low interest rate environment.
Notably, the lower interest rate affords the government the opportunity to fund the 2020 budget deficit, which is some 49.7 percent of projected expenditure and 3.7 percent of GDP, at a relatively lower cost.
Importantly, the government would be able to refinance maturing and perhaps existing debt obligations at lower interest rate, thereby reducing the debt service burden and mitigate the lingering concern of fiscal cliff. With a debt service burden, defined as debt service cost to actual revenue estimated at 99 percent in the first quarter of the year, the lower interest rate may improve the fiscal position of the federal government, particularly as COVID-19 pandemic, lower oil price and latent macro challenges may undermine Nigeria’s revenue generation prospect over the near term.
As the sovereign yield curve declines, lending rates are easing, as reflected in the steady ease of the prime lending rate to 14.7 percent in May 2020. More so, yields on corporate bonds have come off the peak levels, as investors seek higher yield alternative debt notes to the single-digit FGN Bonds and treasury bills. Investment grade rated corporate bonds are trading at a tight premium to FGN benchmarks.
For instance, the Infra-Credit backed GEL Utility Bond, rated “Aaa” by Agusto, with approximately 14-year term-to-maturity trades at 9.58 percent, a significant 557 basis points yield tightening when compared to the yield of 15.15 percent at issue in August 2019.
Will rising inflation rate be the showstopper? Orthodox economics, founded mainly in monetary theories such as the Mundell-Fleming model or “impossible trinity”, established a strong nexus amongst three core macroeconomic variables; inflation, exchange rate and interest rate, with each being a prominent tool for taming or managing the others.
Implicitly referencing the cause-effect relationship amongst the three variables, Governor Emefiele in reviewing the Nigerian macros at its inaugural presentation on assuming office in June 2014 noted, “owing to the tight monetary policy of the Bank coupled with improved food harvest, inflation moderated to a six-year low of 7.9 percent at end-April 2014. Debt-to-GDP ratio fell to 11 percent, while foreign exchange reserves stood at $37.15 billion as at 27th May 2014”.
This assertion succinctly describes how monetary policy tightening, manifested through high interest rate can help rein-in inflationary pressures and attract foreign capital, which is requisite for shoring up external reserves and ultimately stabilising the local currency, Naira.
As the era of high yield fades, fund managers may have to explore alternative assets in corporate debt and private equities by working with reputable intermediaries, capable of de-risking otherwise non- investable assets.
This is particularly important, as the current dynamics where pension funds, the largest institutional asset manager, with over N10.8 trillion funds under management, depend mainly on government paper is unsustainable.
Notably, the pension fund industry currently has over two third exposure to FGN securities, thus creating a monopoly market for the federal government, another major factor why it may be justifiably easier for the government to sustain the negative real rate environment.
Therefore, fund managers may have to seek new investable assets in the real sector, particularly in critical sectors like agriculture, telecommunications, power, industrials, utility and energy, where the higher multiplier effect of private sector investments on the economy may help stimulate inclusive growth, sustainable job creation, mitigation of social vices and ultimately increase per capita income, pension remittance and broader fund flow in the Nigerian economy.
It has been well established, globally and indeed Nigeria, that the velocity of every Naira spent in the private sector is multiples of that of government spending, thereby reinforcing the case for increased private sector investment in the economy.
Interestingly, asset managers in peer emerging markets have successfully influenced fiscal behaviour through direct investments in infrastructure, thus limiting the public sector’s role to the creation of a conducive environment, whilst also reducing the attractiveness of politics through non-production backed funding. More so, well-structured infrastructure projects and businesses with strong governance have proven to sustainably generate positive real returns.
Hence, the call on pension funds, insurance firms, traditional asset managers, family offices and unconventional money managers to channel savings into development-oriented sectors, with investable opportunities, just as contemporary peers in other emerging markets.
Interestingly, the local debt capital market is fast-evolving with novel structures that provide relevant mitigants, yield upside and exciting governance worth exploring.
