Precisely, the naira depreciation will erode the value of the underlying asset(s) forming the mutual funds. In contrast, however, the naira depreciation will create bullishness in the money markets via the increase in the demand and price as investors divest from the capital markets to invest in the money markets. In this case, the mutual funds on money markets instruments will experience market growth.
The impact of the naira depreciation on the returns from assets portfolio, particularly in the case of currency contagion, is best illustrated using an example. Assume that you have invested 10 percent of your portfolio in naira-denominated bonds with a current yield of 5 percent. Now if the naira undergoes a 20 percent depreciation, your net return from these bonds would be -15 percent (5 percent – 20 percent), rather than +5 percent. Certainly, the 20 percent depreciation is a decrease or loss in the value of those bonds. Consequently, the overall return on your portfolio would decrease by 1.5 percent (i.e., 15 percent loss of 10 weight of the assets portfolio). However, assuming that you have a total 40 percent of your portfolio in the Nigerian capital markets assets affected by the naira depreciation, that decreases the assets value by 20 percent. The overall portfolio return would plunge by a very substantial 8 percent (i.e., 20 percent loss of 40 weight of the assets portfolio). Concisely, the value of assets portfolio usually falls lower the higher the quantum (weighting) of each asset in the basket and the higher the currency depreciation rate.
Generally, there are bound to be negative multiplier effects of the naira devaluation on the capital market liquidity. In the simplest form, liquidity connotes an asset’s feature of being easily converted into cash through buying and selling without causing significant upward movement in the price and significant loss in value that may result in low demand and supply. The essential characteristic of a liquid market is regular availability of ready and willing buyers and sellers. The liquidity of an investment asset can be measured by the ‘buying and selling frequency’, which refers to volume. Expectedly, naira devaluation with the associated higher inflation and falling demand resulting from the exit of foreign investors can only result in market bearishness and market illiquidity, respectively. Even, the recent increase in the monetary policy rate and cash reserve ratio is a definite stimulant to market illiquidity. In illiquid capital markets, investments instruments and derivatives contracts become riskier and non-attractive with significant plummeting demand. Put differently, investors will only demand if the efficient market forces and/or regulatory interventions can create enabling environment that guarantees liquidity of the investment assets.
Consistent with the above analysis, our capital markets have become bearish since the announcement of the naira depreciation some weeks ago. Indeed, the capital markets bearishness will be exacerbated by the ongoing political activities and the usual forthcoming ‘January effect’. In fact, the bearishness may continue for as long it takes, especially in the absence of the appropriate regulatory stimulants.
It is interesting, albeit conventional, to know that the CBN monetary policy affects the capital markets. An even more interesting question is, why do these effects occur? Until now, our attention has been on the ‘how’. Without doubt, providing economically intuitive answer to this question will enhance our insight into why monetary policy affects the capital markets and the place of the capital markets in the macroeconomic policy decisions. In brief, an equity (a stock) represents a claim on the current and future dividends (or other cash flows, such as share buybacks) to be paid by a company. So, the following three key factors should affect stock prices. One, news that current or future dividends will be higher should raise stock prices. Two, news that current or future real short-term interest rates will be higher should lower stock prices. This truly depicts the current situation in our capital markets. Three, investors’ concern about risk. Because shares are perceived as relatively risky, investors generally demand a higher average return relative to fixed incomes securities that are perceived to be less risky and safer investment assets. In effect, news that leads investors to demand a higher risk premium on stocks should lower stock prices. On the whole, the CBN monetary policy affects share prices only to the extent that they affect the investor expectations about dividends, short-term real interest rates, or the riskiness of stocks.
As depicted above, the toxic effects of the naira depreciation on the capital markets cannot be over-emphasised, and can only be contained via the appropriate regulatory intervention policies of the Securities and Exchange Commission (SEC). Essentially, the SEC should now add another paradigm to its regulatory responsibility: the regular interventions in the capital markets similar to the CBN’s Monetary Policy Committee (MPC). Effective capital markets regulations should focus on creating the jurisdictions conducive to the uninterrupted supply by the corporate and government medium-to-long term funds seekers on the one hand, and demand by the private and institutional investors on the other. There is need for the SEC’s appropriate stimulant interventions simultaneous with the fiscal policy or monetary policy pronouncements that may be designed to contract the economy with subsequent bearish contagion on the capital markets. This shift in the regulatory paradigm shall form the centrepiece of subsequent articles on the naira depreciation and the capital markets.
Source : BusinessDay