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Medium-Hot Money: Cardoso’s FPI playbook show glimmers of hope

At first, it seemed simple – ditch the subsidy and float the Naira. Pundits and analysts, including myself admittedly, predicted that it would take a few quarters for the Naira to settle at its true value, estimated to be around N650-850.

Unfortunately, there was a catch: over a decade of unconventional monetary policy, which aimed to maintain the illusion of a strong Naira by manipulating legitimate demand out of the official window, had created foundational distortions in the FX market.

We were left with three opaque FX markets – the official, the parallel, and the P2P – each with its own quirks, all operating without an effective price discovery mechanism.

Above all, we found ourselves in a conundrum – how do you fix a market where artificial scarcity was driving intense demand, sending the currency into a death spiral? If you continued to peg, the cost would likely rise exponentially from the $17 billions of 2022.

Fewer businesses and citizens would be able to access that rate as dollar liquidity in the official window continued to decline, and backlogs would grow. The intensity would have been amplified by the dollar rally of Q3 2023. You simply didn’t have the funds for it.

If you stopped pegging, however, your vulnerable economy risked exposure to challenging global economic headwinds as commodity prices soared.

Worse still, those who profited from the window of arbitrage you were trying to close would bite back, capitalizing on an unprecedented wave of speculative demand as citizens and businesses attempted to hedge against soaring inflation.

We found ourselves grappling with declining production in the manufacturing sector as businesses, unable to access FX for their machinery and other inputs, dropped like flies.

The Form Ms and Form Qs piled up with no answers. Simultaneously, the behemoth of the subsidy regime tied down the vast majority of our dollar earnings from crude, while years of underinvestment in the sector systematically eroded our capacity to meet oil production targets.

It seemed we had nowhere to turn to get the necessary liquidity to rejuvenate our hobbling FX market while the Naira remained in decline.

Foreign investment and capital importation have been on everyone’s lips; the hope is that they will save us. However, since the substantial Foreign Direct Investment promised during the president’s unofficial investment tour hasn’t quite kept pace with the announcements and MoUs, many are warming to the possibility of Foreign Portfolio Investors.

The trouble, though, lies in understanding not just how to attract it but how to retain it. Overlapping geopolitical and climate crises put a squeeze on global capital flows in 2023; controlling for flows with European conduit economies, FDI flows fell by 18%.

This contraction was felt most acutely in the developing world. In Africa, FDI flows fell by 1%, but crucial infrastructure-driving project finance deals fell by a third.

So, we’re scrambling for a piece of a smaller pie, and the tumultuous geopolitical realities have resulted in risk-averse investors.

Grain prices are breathing down our necks as climate change ravages global production capacity. Citizens are hungry, without the wages to absorb the inflation, resulting in substantial contractions in wider consumption.

Businesses are undercapitalized, faced with a choice between eye-watering local interest rates and the implicit interest rate on foreign loans due to rapid depreciation. Not an ideal environment for an economy in transition.

Businesses are undercapitalized, faced with a choice between eye-watering local interest rates and the implicit interest rate on foreign loans due to rapid depreciation. Not an ideal environment for an economy in transition.

A look at our capital importation data in Q3 2023 reveals a year-on-year decline across all sectors, with a quarter-on-quarter decline in all but one: money markets.

My initial suspicion that, in addition to bringing remittance flows into the official market, Foreign Portfolio Investment (FPI) would be the centerpiece of CBN’s plan to stabilize the Naira was confirmed in the CBN Governor’s interview with Arise News.

Cardoso sought to assuage fears, refuting the idea that all FPI was hot money, arguing that a good FPI portfolio includes a broad spectrum of investors.

This unassuming aside was followed up by a 19% 365-day treasury bill bonanza later in the week. As the Honourable Minister for Finance and Coordinating Minister for the Economy, Mr Wale Edun, pointed out in an interview at the World Economic Forum, bringing in foreign investment means that “the direction of interest rates, in the short term, naturally is upwards.”

At a point in Nigeria’s history, FPI was a rising tide that lifted (and sank) all boats, but today, the data suggests a more complicated picture.

This playbook is risky, but the potential upside is the glimmer of hope we need, and the CBN might just be able to create the breathing space for the fiscal team to address underlying dysfunctions in the economy.

Hot money is often considered a sensitive term in central bank circles due to its association with high vulnerability, leading to potential instability and disastrous consequences.

But what exactly is ‘hot money’? It refers to large amounts of capital that move across borders, aiming to gain short-term profits from exchange rate or interest rate shifts.

Countries in economic turmoil, with undervalued currencies or high-interest yields, are prime targets. The challenge arises when the foreign exchange (FX) market is liquid, and there are no minimum terms for holding investments; this money can swiftly leave, causing another economic crisis. The anxiety about hot money stems from this unpredictability.

One significant way hot money flows is through Foreign Portfolio Investment (FPI), unlike direct investments in things like factories, FPI can be withdrawn during economic turmoil. Nigeria’s capital markets lack a sophisticated derivatives component, making us particularly vulnerable, especially in our equity, bond markets, and money market instruments.

Investors could acquire stocks, money market instruments, and bonds, then sell as soon as our currency appreciates, intending to repatriate their proceeds, adding strain to our already fragile recovery.

I maintain that NGX’s bull run in the second half of 2023 being driven predominantly by domestic capital is a positive development. It indicates that the circulating naira is being utilized effectively, invested in Nigerian companies.

Portfolio investment doesn’t always uphold its reputation. The landscape of our financial market underwent a significant transformation before the 2008 global financial crash.

Foreign Direct Investment (FDI), primarily fueled by the oil and gas sector, overshadowed Foreign Portfolio Investment (FPI). In December 2007, FDI constituted 71% of total capital importation, while FPI was at a mere 6%. However, as oil prices sharply declined, both FPI and FDI exited, with FPI showing relative resilience.

By December 2008, our fortunes had reversed in each category. FDI accounted for only 6.5% of capital importation, while FPI soared to 52.5%.

Equity-based portfolio investment, with its higher inclination for diversification, could weather the storm. Its exposure to financial contagion could be mitigated, and the ability to perform a quasi-divestment by reorienting portfolios to other sectors within the market allowed some investors to pivot instead of incurring substantial losses.

Confronted with the imperative of maintaining financial stability in the aftermath of the global financial crisis, Sanusi Lamido Sanusi devised a strategy to boost capital importation.

Despite Nigeria’s limited direct exposure to the global financial system and our underdeveloped financial institutions, the crash in oil prices induced by the global context had a significant impact on our economic prospects.

While oil constitutes only a fraction of Nigeria’s GDP, it holds crucial importance for financial stability as it contributes the majority of government revenues and the overwhelming majority of our foreign exchange (FX).

Even with the recovery of oil prices, the reserves utilized to manage the economic crisis were not replenished due to fiscal recklessness. As Mr. Cardoso remarked, “[the CBN] don’t produce FX; we rely on what comes in.” In the face of occasional outright hostility from the fiscal side, marked by calls to amend the CBN act, SLS embarked on leveraging the available monetary tools to ensure an influx of more FX.

As part of his strategy to garner international credibility for his monetary reforms, Sanusi Lamido Sanusi (SLS) implemented various measures, including the effort to list Nigerian bonds on JP Morgan’s Bond Index.

A crucial step in this process involved eliminating the one-year minimum term for foreign investors, a move undertaken in 2011 that resulted in a substantial influx of dollars. Gross portfolio inflows witnessed a remarkable surge, growing by almost 200% from $4.51 billion in 2011 to $13.4 billion in 2012.

Initially, Foreign Portfolio Investment (FPI) appeared to replace Foreign Direct Investment (FDI) as the new source of foreign exchange. While FPI continued its upward trajectory in 2013, FDI experienced a decline of more than a fifth, amounting to $5.56 billion.

However, it’s worth noting that FPI is challenging to retain unless accompanied by regulatory restrictions on its exit, such as the one-year minimum term for foreigners investing in Federal Government bonds, or within a stable economic environment.

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