Economic intuition postulates that the price of a commodity is determined by the market forces of demand and supply in a free economic system. Notwithstanding this economic postulation, it is logical to know the factors that inspire the movements of demand and supply. The readily available response is PRICE, although not all the time that price directly determines the demand and supply. For example, in the primary and secondary segments of the capital markets, the price of equity is largely determined by a collection of micro factors which include management and product quality, ownership structure, research and development, book value (B/V) of the firm, dividend per share (DPS), earnings per share (EPS), price earning ratio (P/E ratio) and dividend cover (DC). Similarly, there are macro factors that incorporate all the systematic (or undiversifiable) fundamentals such as politics, interest rate, inflation rate, exchange rate, unemployment and regulations. Generally, both the micro and macro factors fundamentally affect demand and supply,
thereby shaping the investors’ psychology of the capital markets. Interestingly, the price factor is indirectly present in all the above quantitative and not the qualitative factors; as such, price unilaterally cannot influence the demand and supply. In reality, there are several factors that constitute ‘market forces’, entwine with and influence ‘price’ of demand and supply in the capital markets.
Consequently, this article focuses on the effects of a particular factor, the exchange rate. More precisely, the subsequent discussion is on how the naira devaluation affects the Nigerian capital markets.
Effects on the Nigerian capital markets
A currency exchange rate denotes the value of one currency with respect to another. Most exchange rate quotations are with respect to the US dollar. Under a fixed exchange rate system, such as in China, the government determines the devaluation and revaluation of its currency. In a floating exchange rate regime or managed float, such as in the United States and Nigeria, market forces determine currency depreciation or appreciation. Recently, the Central Bank of Nigeria CBN) depreciated the naira value against the US dollar and, unsurprisingly, such a monetary policy has been having domino effects on the capital markets performance. So, how and why has the naira depreciation been affecting the capital markets?
Fixed income securities
Generally, the naira exchange rate depreciation pushes up the domestic inflation through higher import prices. Investors would require higher returns to compensate for the inflation and the CBN may raise interest rates to fight off inflation, thereby pushing up interest rates even more. Considering the logical inverse relationship between the ‘existing’ fixed income securities’ prices and interest rates, naira depreciation will result in the price crash of the fixed income securities and, consequently, increases the risk of fixed income securities like bonds and treasury bills (TBs). Expectedly, as the interest rate increases, investors will be averse to investing in the ‘existing’ bonds and treasury bills that pay lower than the new rate. In the opposite, investors will have preference for the ‘new’ issues whose prices factor in the new and higher rate. Hence, the crash in the fixed income securities markets will only be applicable to the ‘existing’ instruments issued prior to the naira depreciation and its associated inflation rate increase, while there will be a bullish market for the new instruments under the new higher rate post the naira depreciation and inflation rate upsurge. Additionally, there is usually a capital flight from the capital markets to the money markets to capitalise on the new and higher rate in the money markets. Certainly, this often causes price crash and enhances the investors’ negative sentiments in the capital markets.
Certainly, a strong naira can actually hurt the profits of the Nigerian companies when translating foreign income. On the contrary, a depreciated or weak naira increases the exchange rate for the foreign currency-denominated sales and profits. Interestingly, a depreciated naira will boost the Nigerian exporters’ trade and profits as the Nigerian products become more price competitive in overseas markets. Ideally, the domino effect of the increase in corporate profits is the bullish markets. However, because import prices rise and lead to inflation, naira depreciation can only lead to bearish markets in the short run as the inflation impacts negatively on corporate profits and share prices. Any perspective to naira depreciation resulting in the bearish capital markets stems from two sources. One, the upsurge in interest rate from the increased inflation often encourages investors to divest from the capital markets. Two, the risk-averse foreign investors are at a disadvantage and are hesitant investing in inflation-ridden capital market jurisdictions where investments usually become riskier and more expensive. These ills often prompt investors to demand for higher risk premium, that is, higher returns compensating for the higher risk. Further, foreign investors suffer from low translation value of the naira vis-a-vis their home (foreign) currency. So, it is typical of the foreign investors to divest from the local capital markets of a depreciated currency.
The contagion effects of the naira depreciation on mutual funds are quite similar to the effects on the individual investment assets discussed above.
Dr OLUWATOBI OYEFESO
… is the group chief executive officer, Morewits Financial Market Institute & Morewits Consulting Limited, Abuja