A good mix in the DMO’s debt strategy
The Debt Management Office (DMO) has created ripples in domestic financial markets with the release of its medium-term strategy 2012-15. Attention focused on the statement that an appropriate mix of public domestic and external debt was 60/40. The mix at the end of 2012 was 87/13, leading some market participants to fear that the transition would be rapid and that naira FGN paper would become a rare commodity. We stress that the strategy is medium-term and welcome it.
The DMO’s thinking can be explained by the rising burden of domestic debt service and by the cost differential in favour of external borrowing, which the strategy document estimated as high as 800 basis points (bps). Interest payments on domestic and external debt cost N322bn and N59bn, respectively, in 2008, and are projected at N543bn and N48bn in the 2013 budget.
As for the cost differential, the estimate of 800bps represents the approximate difference between the yield on Nigeria’s maiden Eurobond and on FGN bonds of similar tenor. We should point out that the differential will shrink once monetary policy in the leading developed markets is tightened. In the US this process could even start towards the end of this year, according to some analysis of the latest minutes from the Federal Open Market Committee. Frontier markets such as Nigeria have been among the main beneficiaries of the wall of cheap money.
We identify three grounds for caution in increasing external borrowing: that the economy does not generate adequate foreign exchange to service the debt, that interest rates could spiral (often for reasons over which the Nigerian monetary authorities have little, if any, influence), and that the cost of debt service is vulnerable to a sharp fall in the naira exchange rate. On the first point, we have no concerns, given Nigeria’s status as a leading oil exporter. The balance of payments for 2012 shows inflows of US$97bn from the export of goods alone.
Interest rates could spiral on any floating-rate external borrowings. However, Nigeria has access to multilateral and bilateral funding at below-market rates. The differential of 800bps widens when we compare a loan from, for example, the African Development Bank, with a naira-denominated FGN bond. Indeed, the DMO’s data for March 2013 shows that 80 per cent of the FGN’s external debt burden of just US$6.7bn, which includes the loans of state governments, was contracted on such a basis. If we look ahead, we do not see a substantial change in this ratio. The proposed second Eurobond (of US$1bn) has the headlines but concessional finance will account for the lion’s share of the ceiling of US$7.3bn for new external borrowing which the House of Representatives has set for 2013-14. We are still comfortable with the risk of spiralling foreign-currency interest rates when we acknowledge that concessional finance will become more expensive once the lenders classify Nigeria as a middle-income borrower.
The most serious of our three grounds for caution is the exchange-rate risk. The CBN has been able to hold the line since the collapse of the oil price in Q4 2008 and the ensuing downward adjustment of the rate. The FGN could reverse the decline in oil sector investment by securing the passage of the Petroleum Industry Bill. However, it is powerless to counter the impact of hydraulic fracturing (fracking) or indeed global demand for oil. The exchange-rate risk is mitigated by our observations above on the second point (external interest rates).
The 60/40 mix is appropriate in our view. The ratios for end-2011 for Kenya and Ghana were 54/46 and 50/50, respectively. In both cases the grounds for caution are more potent than with Nigeria. The progress towards 60/40 will be gradual. On the external side, drawings under the US$7.3bn ceiling will be in stages, subject both to the negotiation of the individual loan agreements and to the go-ahead of the National Assembly. On the domestic side, new issuance by the DMO and CBN will not come to a halt. A smooth running debt market requires a steady flow of new paper. Nigeria’s inclusion in the JP Morgan and Barclays government bond indices would quickly be reviewed without it. The new supply from the DMO in H2 2013 was already set to slow without the new strategy: the 2013 budget projects domestic borrowing (net) at N528bn and the DMO raised N500bn (gross) from the sale of FGN bonds in the first five months of the year.
The DMO’s strategy does not carry any risk that Nigeria again becomes an international pariah for failure to meet its external debt obligations. The sovereign fell off the investor radar screen due to a fiscal and political combination of “can’t pay” and “won’t pay” from the 1980s through to the Paris Club agreement of 2005. Macroeconomic and sectoral reforms have transformed its ability to pay, while its policy stance developed over the past decade assumes its willingness. Nigeria is now integrated in global financial markets. It stands to benefit from greater visibility in international capital markets and can live comfortably with the consequences.
GREGORY KRONSTEN
Head, Macro Economic and Fixed Income Research, FBN Capital