Finance plays an increasingly important role in economic growth and development of nations around the world. These roles are in many different forms, they include but not limited to channelling savings towards investment. The level of sophistication of a financial system is important and to a large extent determines the level of overall growth and development of that economy. The financial system contributes to economic growth performance through several mechanisms and channels – mobilising savings, allocating funds to their most productive uses, monitoring productive uses i.e. investments, transferring and sharing risk (see World Bank (2001)). In modern economies, disruptions in the flow of credit from the financial system to businesses within the economy are detrimental to economic growth and can lead to a general slowdown in the level economic activities. This in turn can lead to unemployment; drop in consumer spending, consumer and industrial economic confidence levels, other leading economic indicators and ultimately a general slowdown in the economy.
Capital account liberalisation in many countries and increasing levels of regional integration and globalisation add an international dimension to the flow of investments and capital around the world. These have made the transfer of funds and investment easy and accessible from one country to another. Investments and capital can be transferred around the world with fewer restrictions as barriers are being removed due to increasing impact of globalization.
Since the start of the global financial crisis in 2008, the focus has increasingly been on the roles of the banking sector and the capital market in most economies. The global financial crisis caused a massive flight to safety with investor divesting from currencies, equities markets and other risky assets to the sovereign bond markets which are perceived as safe haven. Investor in major economies divested from perceived risky assets to markets where their investments are relatively safe and guaranteed. This shows one of the significance of sovereign bond market as an investment option for investors in times of crisis and how it can help to minimize the occurrence of such crisis.
According to Arteta (2005), there have been many banking crises over the years in many developing countries which were very costly due to the fact that they tend to obstruct the free operations of financial intermediaries, affecting industries and the real economy. Crises can block the normal flow of credit and loans from banks to firms. The dominance of bank intermediation and the general underdevelopment of capital markets (especially the bond markets) in many developing countries aggravate the susceptibility of the real economy to episodes of banking problems.
It follows that having an additional sources of domestic external finance would allow firms to better withstand episodes of financial distress. By allowing firms to raise funds issuing debt securities, the existence of deep and liquid domestic capital markets would complement the availability of bank finance. By patronising this capital market option, firms would also help to deepen and broaden the market. Well diversified financial systems would lead to more efficient allocation of resources especially capital, where firms can issue bonds in domestic markets. This would enable the firms to ease maturity mismatches in their balance sheets. Thus, bond markets would lessen the effect of waning bank credit flows on firms’ financing requests during periods of banking crises.
Bond market has major importance in any economy but more so in emerging economy where savings and investment opportunities are inadequate. Financial sector development (especially for capital market) starts with the development of a sovereign bond market in many emerging economies. This is common, not only because governments are mostly the biggest domestic borrowers with the best credit ratings but also because of how their actions and inactions affect scope and potential for market development throughout the economy.
There have been significant changes politically, economically and socially in many developing economies particularly in Africa. The financial crises of 1997-1998 (in Asia and Russia) have pointed out how vulnerable economies are when over dependent on foreign capital or banking system (Fabella and Madhur, 2003).
In many emerging economies in Africa, recently there have been changes in organizational and regulatory framework of capital markets. These countries are re-strategizing in order to broaden their capital market and investors base as well as tap into the new sources of funding such as bond markets. (Brownridge, 1998). Currently, the domestic bond markets in most African economies where they exist are narrow and largely undeveloped compared to the banking system and the equity market.
There are many rationales for developing a domestic bond market especially for emerging economies. First, developing a bond market will help the government to finance fiscal deficits which was done previously by forcing local banks to hold government paper, usually to meet demanding reserve and liquidity requirements. Secondly, according to Frankel (1993) in the absence of a bond market it would be difficult to sterilize large long-term capital inflows for infrastructural development. This was a difficult challenge for several central banks during the early 1990s when they had only short-term debt instruments. Sterilization that relies entirely on issuing short-term securities tends to drive up short-term interest rates while bond issuance help to minimise this risk.
Thirdly, to generate a yield curve which could serve as a benchmark for investors and borrowers in the financial markets. This enables the market participants to derive the market interest rate that reflect the opportunity cost of fund at each maturity. Also, Sokoler (2002), bond market increases the competitiveness and efficiency of the financial system, which might have been dominated by few banks before the introduction of bond market.
However, the effectiveness of the bond market as an alternative source of financing depends essentially on there not being a high co-movement between bank lending, bond and equity financing in a domestic setting, and the absence of contagion in the international capital markets more importantly for countries with open accounts.
Bond market debt financing is necessary for developmental projects and infrastructures like electricity generation, transmission and distribution, the fuel energy sector, transportation, telecommunication, etc.
1.2 Purpose of the Study
The goal is to provide a detailed review of the progress and prospects for the development of the government bond market in Nigeria with a view to identifying how the market can be broadened and deepened from both the demand and supply sides. The supply side includes the issuers of debt securities like federal government, sub-sovereigns and corporates. The demand side of the market is made up of institutional investors like banks, pension fund administrators, foreign investors, hedge funds and high net worth individuals as well as retail investors. The paper would also examine how the issuers on the supply side can take advantage of the relatively cheap sources of funding in the market against conventional funding methods as well as how the creation of alternative investment options would affect the demand side.
Also, the roles and impacts of financial intermediators who facilitate the smooth operations of the market, and the perceived benefits for them (especially primary dealers) would be examined and finally the benefits for the Nigerian economy should the market be further deepened and broaden.
In an attempt to provide an in-depth, objective and balanced perspective on the development of the Nigeria bond market, this project write-up draws conclusions from the various research papers and information supplied by other authors on the development on bond markets in other emerging market economies.
The main factors behind the recent development of the Nigerian bond market would be explained in details by analysing information and statistics on the market. This involves the analysis of major macro-economic changes in Nigeria, pension reform, changes in debt management strategies, consolidation exercise in the banking industry etc. Statistical information provided in the dissertation have not been tested and are quoted verbatim.
Outline of the Dissertation
An outline of the remaining chapters is presented below:
Chapter 2 reviews relevant literature on the development of bond markets especially the importance which establishes the foundation of the dissertation. The chapter also considers the main factors, trends and forces that have contributed to the development of bond market in other emerging market countries with an in-depth look at Asian and Russian markets.
Chapter 3 takes a detailed look at the timeline of bond market development in Nigeria, structure, regulatory framework, regulators, the main drivers behind the growth of the Nigeria bond market as well as the make-up of the demand and supply sides..
Chapter 4 seeks to identify and adapt the lesson in other parts of the world and concludes with the recommendations for broadening and further development of the Nigerian bond market.
Chapter 5 will again highlights the importance of the study; it concludes with an overview of the recent developments in the Nigeria bond market and considers the new challenges that would emerge going forward.
Literature Review on the development of the bond market.
This chapter reviews the literature on domestic bond market development in several emerging economies. From this review critical success factors that are prerequisite to the development of the domestic bond market will be determined.
Information has been gathered by reviewing reports from government agencies, investment analysts’ reports, reports by the World Bank, the International Monetary Fund, African Development Bank, Asian Development Bank, Bank for International Settlement, the Emerging Markets Committee of the International Organization of Securities Commission and other bond market associations and debt management agencies.
2.2 The Development of bond markets in Emerging Markets
This section examines the challenges and issues concerning domestic bond market development in many emerging markets as well as prerequisites for an efficient, broad and deep domestic bond market. There are several factors to consider.
First, the financial crisis that happened between 1997-1998 reminded most policy makers around the world of the over-reliance of many emerging market economies on their respective domestic banking systems as a source of funding.
Secondly, information on bond markets in emerging markets especially in sub-Saharan Africa is not readily available when compared to other developed markets or even other domestic market segments notably the equity market.
2.3 Rationale for developing a domestic bond market
After the Asian and Russian financial crises of 1997-1998 many researchers have advocated for the development of domestic bond market as an alternative source of financing not only in the crisis-hit countries but for all emerging market economies where obvious shortcomings are prevalent.
The following is a summary of the major arguments put forward:
an alternative source of domestic debt finance
fiscal deficit financing
broadening and deepening of capital markets
efficient risks pricing
aids smooth operation of monetary policy etc.
2.3.1 An alternative source of domestic debt finance
Witherell (2003) argued that bond markets reduce the over-dependence on bank credit for debt financing and that these markets also reduce the susceptibility of the economy to the risk of banking system failure. Banking crisis can have negative and adverse effects on the economy as a whole because firms and industries would find themselves credit constrained and be forced to jettison new investment spending, leading to a drop in aggregate demand through the multiplier effect.
Harewood (2000) also opined that deep and efficient bond market enable firms to gain access to an alternative source of debt financing which could help banks in times of crisis to recapitalise through securitization by issuing bonds backed by non-performing loans.
2.3.2 Fiscal deficit financing
Khalid (2007) argued that the benefits of developing domestic bond markets are both macroeconomic and microeconomic in nature. Within the macroeconomic perspective, the primary importance of the government bond market is to provide a channel for the financing of fiscal deficits. This is arguably the most important benefit for emerging market economies with historically large fiscal deficits and the failure of other possible sources of financing the fiscal deficits which are compelling governments to borrow from domestic markets. In addition, several countries both developed and developing have faced the need to finance very large extraordinary and unusual expenditure which are of long-term nature. The finance required for bank restructuring and long-term support for industries have been one recent example in many emerging markets.
2.3.3 Lower cost of borrowing
IOSCO (2002) identified that governments and firms can enjoy lower cost of debt capital in the bank markets compared to high charges and rates offered on bank loans. This is achieved through the process of bank disintermediation which allows direct access to investors, thus removing the “middleman” and related costs. Also, the issuer may tailor its asset and liability profile to minimise the risk of currency and maturity mismatch thus reducing the weighted cost of capital.
2.3.4 Broadening the capital market
Debt market development helps to diversify the capital markets, reducing over-dependence on banks and susceptibility within the banking system which is positive for the entire economy at large. The bond market has provided avenues for financial engineering and innovations which have broaden the financial system in general (Akhtar 2007).
A well-functioning bond market provides with investment options across a wider range of instruments including sovereign, sub-sovereign, corporate bonds and securitized obligations such as mortgage backed securities and collaterized debt obligations. The wide range of investment alternatives allows investors to make optimal asset allocation decisions. This is particularly important for investor like life insurance companies and pension fund administrators because the bond market facilitates better management of the maturity structure of their balance sheets.
2.3.5 Efficient pricing of credit risks
Bond markets create cost-effective and competitive capital markets by generating market yield and interest rates that reflect the opportunity cost of capital at each tenor and maturity. This is necessary for efficient and financing decisions. Herring and Chatusripitak (2000) further stated that without a developed bond market, firms and investors would lack a clear measure of opportunity cost of funds. This may lead to mispricing of funds as was evident in late 1990s in many dynamic Asian economies suggesting that the internal discount rate may have often been too low because returns on investment fell sharply.
IOSCO (2002) suggests banks’ interest rates are not always competitively determined so may not always reflect the true opportunity cost of funds. This is because big banks could always agree to fix rates.
2.3.6 Aids smooth operation of monetary policy
The debt market is increasingly more important for the operation of monetary policy. Monetary policy now relies not only on a well functioning money market but also increasingly on indirect instruments of control like the bond market. Moreover, yields in the long-term bond market show expectations of likely macroeconomic developments and about market reactions to monetary policy moves by market regulators.
2.3.7 Promotion of financial stability
The bond market provides an alternative source of funding to equity and banking financing, this alternative source enhances the stability of the financial market as a whole and efficient allocation of credit. This was evident after the Asian financial crisis the weak banking sector provided an impetus to the development of bond markets in several emerging markets. By diversifying funding sources, firms can adjust their borrowing between the banks and the debt markets (Hameed, 2007).
IOSCO (2002) added that where there is no corporate bond market, a significant ratio of debt funding for corporations would come from the banking sector. By doing this, banks would assume a considerable amount of risk mainly due to the maturity mismatch between liquid short-term liabilities (deposits) and relatively long-term assets (loans). Banks cannot transfer credit risk to depositors.
Herring and Chatusripitak (2000) concluded that in emerging markets where few banks dominate and account for bulk of lending activity, there is a concentration of credit risk with the banking sector. This leads to an increasing level of systemic risk in an economy.
In summary, the existence of a well-functioning bond market ensures that risks are efficiently diversified within the financial system.
2.3.8 Sterilization of large capital inflows
Frankel (1993), for any economy to grow and develop there is a need to sterilise large capital inflows. This was a particularly difficult challenge and difficult for several central banks in emerging economies during the first half of the 1990s. In the absence of well developed bond markets, the central bank has only short-term debt instruments at its disposal in conducting open market operations and raise fund for governments to finance developmental projects. Sterilisation that relies exclusively on issuing paper tends to drive up short-term interest rate and crowding-out effect. This risks biasing the structure of inflows towards the short end. Sterilisation through the sale of bonds reduces such risk.
2.4 Basic prerequisites for successful development of government debt markets
The development of bond markets must be seen as a continuous, progressive and dynamic process in which macroeconomic and political stability are necessary to building an efficient market. Also, the credibility of the government as an issuer of debt securities must be established.
World Bank (2001) noted that “the prerequisites for establishing an efficient and deep government domestic currency debt market include a credible and stable government, sound fiscal and monetary policies, effective legal, tax and regulatory infrastructure, smooth and secure settlement arrangements, and a liberalised financial system with competing intermediaries. Where these basics are lacking or very weak, priority should be given to adopting and implementing stable and credible macroeconomic policy framework, reforming and liberalising in different areas”. All these factors point to the creation of an enabling environment.
Domestic as well as foreign investors will be unwilling to purchase government securities, especially medium- and long-term instruments when there are expectations of high inflation, large devaluations, or high risks of default like Greece recently. It is important that governments work toward macroeconomic policy framework that promotes credible commitment to prudent and sustainable fiscal policies and stable monetary conditions. Such actions will cut government funding costs over the medium to long term, as the risk premium embedded in rates and yields on government securities drop.
Inflationary expectations will have impact on longer-term nominal government securities yields and affect not only government borrowing costs, but also, in countries with unstable monetary and fiscal environment, the government’s ability to extend the yield curve beyond very short maturities. Thus a credible commitment from government to contain inflation is crucial for government securities market development.
The ability to attract foreign investors to a country’s debt market is to a large extent determined by the exchange rate and capital account policies of the country. Foreign investors have a major role to play in the development of government debt markets and in hastening development of the necessary infrastructure by injecting new competition into otherwise dull markets. Foreign investors will compare the yield on domestic debt with those of international markets. They will consider the default risk and the risk of exchange rate volatility. Exchange rate, capital account policies when combined with monetary and fiscal policies can affect each of these risks, and inappropriate policies can result in increased interest rate and exchange rate volatility. Such volatility impedes development of government securities issues with long maturities and can harm secondary market liquidity when there are no derivatives or complementary markets that investors can use to hedge against the risk of price movements.
The soundness of the banking system also has important implications for development of the government debt market. Investor concerns about the health and soundness of the banking system will negatively affect the ability of the government to roll over or issue new debt. Furthermore, lack of financially healthy intermediaries will cause secondary market illiquidity and inefficiency. A banking system in crisis will further impede development of a government debt market and cause significant liquidity shortages. This is because important associated markets such as those for interbank and repurchase agreement transactions are unlikely to function properly.
Although the challenges involved in providing the necessary macroeconomic and financial framework are enormous, these should not deter authorities. This is because the potential benefits to the government and the economy are considerable. In its role as both regulator and primary issuer, the government is a central player in the debt market. The central bank, in implementing monetary policy, will also influence market structure and inevitably market development. Given the involvement of several government agencies and entities in the process of market development, they should interact with the private sector and other market participants as this may be a useful tool to spearhead market development efforts.
Harwood (2000) adds that “Market participants need to evaluate the critical success factors to determine which ones constrain their market’s growth and how to deal with them. Market development will be accelerated if regulators who are interested in market development work closely with market participants to identify problems and solutions with other regulators to persuade them to address problems and solutions and with other regulators to persuade them to address problems under their control.”
Although, there is no one size fits all framework to build a market, emerging markets should try to learn from one another’s experiences for guidance on how to develop from “emerging” to “emerged” and on what works best in what type of environment.
Harwood (2000) concludes that participation in the market cannot be forced, but it can be encouraged by an enabling environment. It can also be discouraged by “unabling” environment.
2.5 Government securities issuance strategy and market access
The process of debt issuance is an important factor in debt market development. For the market to develop, transparency and credibility of the process must be built although they take time.
A market-oriented government funding strategy is an essential foundation for the growth and development of a debt market. The strategy involves the adherence to basic market principles of broad market access and transparency, a commitment to finance budget deficits through the market, and a proactive and continuous approach in developing the necessary regulatory framework to support market development.
World Bank (2001,a), “governments need to improve market access and transparency by providing high-quality information about debt structure, funding needs and debt management strategies to market participants and public at large. They must solicit investors’ views on the current strategy and plans for change. In this way, the government will better understand the source of demand for its instruments and have the ability to act to remove barriers obstructing investment in them.”
World Bank (2001,b) further states that “a sound and prudent debt management operation is also central to the government’s credibility as an issuer”. Having clear debt management objectives, proper coordination between debt management objectives, prudent risk management and effective institutional frameworks are essential components of sound debt management.
As part of developing and maintaining a well-functioning government securities market, authorities will have to provide clear and timely information about the structure and nature of fiscal deficits and public debt as well as other Treasury operations. The information also include but not limited to amortization schedule, issuing calendar, description of outstanding securities, schedule for buybacks or re-openings where relevant, and Treasury cash balances.
2.6 Government securities instruments and yield curve
One of the essential benefits of a well-functioning government securities market is to develop a set of benchmark securities. By concentrating new issues of government securities in a relatively limited number of popular, standard maturities, governments can reduce their issuing cost and boost liquidity in those maturities. Markets, in turn, can use those liquid issues as convenient benchmarks for the pricing of a range of other financial instruments. In addition, spreading the relatively few benchmark issues across a fairly wide range of maturities and tenors is generally regarded as building a “benchmark yield curve”. This can help to facilitate more accurate market pricing of financial instruments across a similar maturity spectrum.
2.7 Investor base for government securities
Governments in many emerging market relied on captive sources of funding whereby financial institutions are required to purchase and hold government securities, often at below-market interest rates. However, this system of raising funds is fast diminishing in many of these countries. Instead, countries are developing a diversified investor base for their government securities. Investors in developed government debt market can range from small-scale retail investor to and foreign institutional investors. A diversified investor base for debt securities is necessary to high liquidity, stable demand and reasonable spread in the market. A heterogeneous investor base with different background, time horizons, expectations, risk preferences, and trading motives ensures active trading, creating high liquidity.
2.7.1 Commercial and Investment Banks
Commercial and investment banks serve as both sales agents’ usually primary dealers and investors in government securities in many developing economies. Banks provide valuable source of demand and liquidity for government securities market by providing two-way quotes for other investors
2.7.2 Contractual savings sector
This group consist of life insurance companies and pension fund administrators contractual. This sector is a major player in the fixed income securities markets, as it provides a stable source of long-term demand. This is because of the long-term nature of funds that the sector controls. The sector’s demand for fixed-interest, low-credit-risk products also provides an important basis on which to develop standardized, securitized products such as mortgage bonds. Pension funds and life insurance companies are usually required to invest a large portion of their assets in so-called gilt-edged assets. This has helped to make this sector prominent in the government securities market.
2.7.3 Collective investment funds
Collective investment funds, such as mutual and hedge funds, unit trust scheme etc can play an important role in the development of the government securities market, especially the shorter-term segments of the market because of the nature of funds that they manage. They offer retail and other investor alternative investment option other than investing in bank products. This helps to induce more competition in this part of the financial sector, and can be a cost-effective way for the government to reach retail investors. These collective investment funds that are established domestically or offshore help to deepen the securities market and should be allowed participate actively in the market..
2.7.4 Retail investors
Retail investors are a source of stable demand to the government securities market which could be crucial in times of high volatility. Demand from retail investors can help to cushion the impact of sales by institutional and foreign investors. In order to develop a diversified investor base for government securities the needs of retail investors should be incorporated into the overall strategy of market development.
2.7.5 Foreign investors
Foreign investors are important source of demand and innovation to national capital markets, including government securities markets. They have received much attention in both mature markets and developing countries because of issues like regulation, capital flight, entry and exit barriers, etc. They have contributed positively to the development of government securities market in several countries through the positive pressure they place on the quality and services of intermediaries and their emphasis on sound, safe and robust market infrastructure.
Foreign investors could be in many forms like emerging markets funds, such as some hedge funds and other specialized closed and open-end country or emerging-market funds. They also include crossover investors, such as pension funds and insurance companies not as dedicated to investing in a particular region or even country, and other more specialized investors like distressed asset funds, private capital fund etc.
2.8 Other bond markets
Various studies have been carried on bond market development in different parts of the world. For example Batten and Fetherston (2003) for Asian countries, Schinasi, Sylla (2001), World Bank and International Monetary Fund (2001), etc. BIS (2002) also reviews the experience of many emerging markets in the development of debt markets.
The research shows to varying degrees the three main factors that delayed the development of bond market in most emerging economies namely: a bank-centered financial system, opaque corporate governance and borrowing in low interest rate currencies. This section will look at the experience of other bond markets both developed and developing; draw reasonable lessons on how emerging markets can deepen and broaden their domestic markets and increase efficiency.
2.8.2 Bond market development in Asia
Murphy, Auster and Dean (2007) note that on July 2, 1997 the Thai baht devalued against the US dollar, the first in a series of collapses that have collectively become known as the Asian financial crisis. The crisis had many causes which highlighted the need to have effectively functioning domestic capital markets. The crisis showed the apparent risk of the absence of diversification with the over-dependence on short maturi
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