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Country reportsApril 2 2006

Capital markets must grow

Nigeria suffers from severely underdeveloped capital markets, which must grow and deepen if its financial market as a whole is to become more efficient and banks are to thrive.
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In response to new minimum capital requirements, a number of Nigerian banks turned to the local equity market to raise funds. Despite initial fears that the market was not deep enough to absorb the surge in issuance, investors turned out in force. In 2005 alone, banks raised N517.6bn ($4bn), representing 17.8% of the year-end market capitalisation of the Nigerian Stock Exchange (NSE). And without pausing for a breath, Zenith Bank went back to the market in January with a N50bn public offer, which is the biggest in Nigeria’s history. As The Banker went to press, the offer was expected to be oversubscribed.

However, despite the apparent vigour of the NSE, the country’s capital markets are severely underdeveloped. The exchange, which includes bond listings, is no exception. At the end of 2005, the NSE’s market capitalisation was $22.5bn, less than a quarter of gross domestic product (GDP).

In comparison, the market capitalisation of the Cairo and Alexandria Stock Exchange in Egypt was $79.5bn at year-end, 88% of GDP, and the Johannesburg Stock Exchange in South Africa ended the year at $549.3bn, 239% of GDP. In terms of liquidity, the NSE’s turnover ratio (the value of all shares traded as a percentage of market capitalisation) was 12.4%, compared with 73.8% in Egypt and 44.6% in South Africa.

The fixed income market, particularly the bond market, is even less developed and, not surprisingly, the market for derivatives is embryonic.

Functioning, viable capital markets are crucial to the efficient operation of the financial market in its entirety. They are particularly important to the fortunes of banks as a source of Tier 2 capital – long-term funding that permits the creation of more varied and longer-term credit products – as well as for risk mitigation and balance sheet management. Without them, banking sector development will remain severely constrained.

The right direction

Two significant developments are gathering momentum, boding well for the future of capital markets. The first is the implementation of the Pension Reform Act, which essentially privatises pension management and gives the industry new focus. It promises to mobilise substantial long-term savings. The second is an overhaul of the government’s debt management strategy, specifically to change the term profile of public debt out of its concentration in short-term treasury bills to make use of longer tenor bonds instead. The spin-off is the creation of a bond market that until recently was moribund.

In February, 12 pension fund administrators were awarded licences to begin receiving pension fund contributions. Four custodians were also awarded licences. This latest milestone is an important step in the implementation of the Pension Reform Act of 2004, an ambitious plan to transfer pension management to the private sector.

In the past, the state-run National Provident Fund and the Nigeria Social Insurance Trust Fund managed state pensions; private sector pensions were not compulsory and only the fortunate few benefited from schemes arranged by their employers, which were mostly multinationals operating in Nigeria.

The public sector scheme was chaotic and beset with incompetence and corruption. Pension savings were frittered away, either through mismanagement or fraud. Pension payouts were irregular, if they happened at all, and were largely funded out of recurrent fiscal expenditure. In addition to the obvious social welfare consequences, the potentially sizeable annual savings inflows were not efficiently allocated to productive sectors of the economy.

The new scheme makes it compulsory for public sector workers and private sector workers in firms of more than five employees to contribute to a personal retirement savings account. This can be a mix of employee and employer contributions in any ratio so long as it is at least 15% of the employee’s salary. Individuals must then nominate a pension fund administrator to manage their account. The National Pension Commission regulates the industry.

A question of confidence

With memories of the way in which savings of all kinds were squandered or stolen in the past still fresh, it is not surprising that there is a jaundiced attitude towards pension reform in Nigeria. The country’s president, Olusegun Obasanjo, has reiterated the compulsory nature of the scheme to public sector workers and tried to allay fears by issuing a stern warning to administrators of the consequences of funds mismanagement.

Once the scheme is up and running, it is estimated that annual savings inflows could be N300bn-N600bn, growing by 15% a year. The impact of this increase in liquidity annually on Nigeria’s capital market will be significant – in comparison, recapitalisation of the banking sector injected N490bn into the system.

Moves to grow and strengthen the bond market are proceeding at pace. In the first half of this year, the government plans to raise N155bn in the market after successfully tapping the market for N140bn last year. The issuance programme that is under way includes five-year and seven-year tranches – the longest duration instruments yet since the federal government returned to the bond market in 2003.

The government’s motive for accessing the bond market is as much to stimulate the creation of a viable and active local debt market as it is to improve public debt management. It is an imperative to do the latter that is creating conditions to achieve the former.

According to Mansur Muhtar, director-general of Nigeria’s Debt Management Office (DMO), the country’s domestic debt stock totalled N1500bn ($11.6bn) at the end of 2005. In 2003, as much as 62% of domestic public debt was in Nigerian treasury bills, the bulk of which were 91-day instruments. This posed a significant refinancing and roll-over risk, and was an indirect driver of money market volatility and short-term interest rate movements. Beginning in 2003, the DMO commenced a programme to lengthen the maturity of its stock of

T-bills, and by the end of 2005 almost 80% were 182-day and 365-day instruments.

More significantly, the DMO began issuing bonds, first in 2003 with mixed success and again in 2005, following a lot of groundwork to prepare and sensitise the market. Following this, longer dated securities of two years and more are progressively becoming an important part of the domestic debt portfolio, causing the proportion of T-bills in the total domestic debt stock to fall to about 56% in 2005.

Last year, the DMO had a regular monthly issuance programme; plans to extend the tenor of federal government bonds this year to five and seven years extends the yield curve and starts to provide price guidance to corporate issuers.

Market prerequisites

Establishing a viable bond market is part of the government’s economic reform plan but is dependent on a number of variables being in place, only some of which the relevant authorities have direct control over. A basic prerequisite is the necessary legal framework and market infrastructure for bidding, matching and settlement.

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The other basic prerequisite is liquidity, which is a typical chicken-and-egg problem. The government’s issuance programme is the first step towards creating a healthy mix of tradable instruments; for its part, in a clear bid to encourage investment in the market, the Central Bank of Nigeria has redefined ‘liquid assets’ – in which banks need to hold 40% of their assets – to include any approved market instrument with a tenor of up to three years.

The authorities recognise that there is an urgent need for a functioning secondary market, which for the moment is an important missing link. There is agreement on the principles but no clear timeline for their implementation. For some time yet, authorities’ efforts to stimulate the bond market will be hostage to the pace and success of building up an institutional investor base. Unlike equities, there has been little interest shown in the bond market by Nigeria’s investing public. In this respect, the pension reforms are important.

Investor appetite

Despite good intentions, there is one variable that cannot be fast-tracked: investor appetite for longer-dated instruments will remain subdued as long as there is any lingering doubt about the continuity of economic reform and the sustainability of fiscal prudence. Reform only began in earnest at the start of Mr Obasanjo’s second presidential term in 2003; and the formidable finance minister, Ngozi Okonjo-Iweala, is this year presenting only her third budget. Despite reform progress, it is barely a track record. And with persistent concerns that a change of president in 2007 might upset reform momentum, it is not surprising that many investors remain timid.

The central bank, too, has to make its interest rate policy more transparent. Taking a view on long-term interest rates becomes a gamble in the present climate of opaque and unpredictable interest rate decisions. This is compounded by the absence of a secondary market, which precludes trading out of instruments as circumstances change.

Much needs to be done but there is a coherence to the government’s approach: mobilise savings and offer the instruments for investment. It is hoping that the market will take off.

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