Easy Money: Time to Create Buffers

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Many Central Banks in both advanced and developing countries are adopting an expansionary monetary policy stance in order to stimulate economic growth. The monetary policy strategies differ in each country. The Federal Open Market Committee (FOMC) of the US Federal Reserve System cut the interest rate in July 2019, the first-rate cut since 2008. The Bank of Japan maintains a negative policy rate (the anchor interest rate). The European Central Bank (ECB) maintains the interest rate at zero. The Bank of England (BoE) maintains the interest rate at 0.75%, which is considered low compared with the historical average of 3.89% between 2006 and 2009. The South African Reserve Bank lowered its interest rate in July 2019. The Central Bank of Nigeria (CBN) also lowered its interest rate in March 2019 and has indicated its preference for a low-interest rate, causing yields on fixed-income securities to drop. These strategies have created easy money (low cost of the fund) in the global financial market and by extension, in Nigeria.

Individuals, companies and governments can now borrow money from local and foreign financial markets cheaper than in the last few months. FSDH Research has observed that many banks and other credit providers in Nigeria have recently begun aggressively pushing credit to their customers. Some companies are also refinancing their existing debt obligations at lower interest rates. The Federal Government of Nigeria (FGN) is also refinancing maturing debt obligations and taking on new debt at cheaper rates because of the low-interest-rate environment. Foreign portfolio investors are aggressively investing in fixed income securities with reasonable yields because of the low-interest rates in advanced countries and the expectation of a further interest rate cut, particularly in the US, before the end of 2019. FSDH Research warns that current developments in the global financial market may change, leading to rising interest rates and possible capital flight, particularly from developing countries. Therefore, companies and countries need to build buffers to protect themselves.

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If the current trade tensions between the US and China subside and the economic growth in the two countries returns to an upward trend, there may not be a need for excessive expansionary monetary policy. Central banks in the US, UK, India, and South Africa increased their interest rates last year, following prospects of a stronger global economic outlook. Developments in the US and China affect the global economy as the two countries account for about 40% of the global economy in terms of Gross Domestic Product (GDP). The US, the Euro Area, China, Japan, the UK and India collectively account for about 69% of the global economy. Therefore, economic and financial market signals in these regions will have a direct impact on the global economy and financial market. If the economic outlook of these regions improves, the low-interest rate may change and there may be capital flight from Nigeria. This could damage the Nigerian economy and financial market unless there are buffers in place to counter the negative implications that may follow.

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The low yield on fixed income securities in Nigeria is already impacting on the total Foreign Portfolio Investment (FPI) through the Investors’ and Exporters’ Foreign Exchange Window (I&E FX window). Between January and July 2019, Nigeria recorded the lowest FPI through the I&E FX window in July, both in absolute number and as a ratio to the total. Although FSDH Research always advocates for Foreign Direct Investment (FDI) because FPI may be regarded as ‘hot money’, FPI, however, does help in a way to increase the stock of foreign exchange in the country. This would help to increase foreign exchange stability and curtail inflationary pressure arising from cost-push effects.

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Companies may wish to issue debt capital at this moment to expand business operations and create additional lines of business that can generate improved earnings for them. In doing this, it may be important to provide FX hedging mechanisms for foreign loans. When the financial market becomes tight again with rising interest rates, companies may then modify their capital structure in favour of equity capital and hopefully, their earnings would have grown in order to eliminate the dilutive effect of increased equity capital of return on equity. The FGN may also take advantage of the current low-interest-rate to access long-term debt and channel it specifically towards building the capacity of the economy to generate more revenue. Investment in infrastructure, security, education, healthcare and other forms of a social safety net would improve the productivity of the country and provide an opportunity for the government to increase future tax revenue. This strategy should increase the stock of foreign exchange in the country and may reduce the inflation rate.

The current low-interest-rate should not be seen as an opportunity for individuals, companies and governments to increase deadweight debt. Otherwise, the consequences could be very grave. On the contrary, the low-interest rate regime should be seen as an opportunity to access long-term funds that can be used to improve the wellbeing of the economy in order to generate increased revenue for all the economic agents. Final words – the low-interest rate will not last forever, so enjoy it while it lasts!

The ratio of FPI to Total Inflow Through I & E FX Window

Sources: www.cbrates.com, FSDH Research Analysis and FMDQ. * upper limit

FSDH Research

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