Foreign exchange – the uncertainties and its effects on M&A activity in Nigeria

July 2016 | EXPERT BRIEFING | MERGERS & ACQUISITIONS

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There has been some uncertainty regarding the Nigerian currency over the last 18 months and this has resulted in a reduction in the number of mergers & acquisitions (M&As) locally. Prior to this, Nigeria was a leading destination for Africa-bound investments and enjoyed significant growth. This uncertainty around the currency has caused many potential investors to adopt a conservative approach to investments. Recent announcements by the Nigerian government suggest that it may be ready to move from a fixed exchange rate system to a more flexible, market driven, exchange rate, and this has been met with optimism. Though we are yet to see just how this policy will operate, the initiative is nevertheless viewed as positive.

Background

With the country being largely dependent on crude oil production (it is said that oil production accounts for about 70 percent of federal government revenues) Nigeria was, inevitably, badly affected by the global fall in crude oil prices. This fall in oil price exerted such downward pressure on the naira that the Central Bank of Nigeria (CBN) was forced to create and implement a number of policies aimed at increasing its control over the foreign exchange market in order to preserve federal government revenues. The first acts of reform saw the naira devalued twice between November 2014 and February 2015. After that, the CBN sought to protect the currency by pegging it at 197-199 naira per dollar and has maintained this since March 2015. On the parallel market, however, the naira has been trading at more than 300 naira per dollar. The government has spent a significant portion of its foreign reserves supporting this official exchange rate. This has resulted in limited availability of funds in the official foreign exchange market and an expectation that the currency will shortly be devalued, both of which are believed to be responsible for the significant drop in M&A transactions. According to data compiled by Bloomberg, the value of M&A transactions in the first two months of 2016 was about a quarter of the value of transactions within the same period in the previous year.

In pinpointing the hurdles associated with M&A transactions in the volatile foreign exchange market, three main issues have been identified as major sources of concern for investors: (i) business risk; (ii) currency/devaluation risk; and (iii) sourcing of foreign currency for repatriation of profits. Each risk is discussed in turn below.

Business risk

Nigeria is highly import dependent, with many manufacturing companies importing most of the raw materials required for production. The limited availability of foreign currency to fund imports has greatly affected business in the real sector. To compound this, in June 2015, the CBN announced that certain imported goods would no longer be valid for foreign currency sourced in the official foreign exchange market. Such goods were not banned and could still be imported using funds that were not sourced from the official foreign exchange market, although specific CBN approval would be required in those circumstances, resulting in significant delays. There are currently 41 items on this list (which includes cement, rice, steel nails, steel drums, etc.) and the list may be reviewed from time to time by the CBN. It is clear that both foreign and Nigerian investors may henceforth find it difficult to source foreign exchange in order to procure raw materials for manufacturing purposes if their required materials are on the list. Investments into businesses that are highly import dependent appear to have been affected by this.

Currency/devaluation risk

Currency devaluation occurs when the value of a country’s currency is lowered against a fixed exchange rate system and is usually triggered by certain economic conditions. Although a common risk in most cross-border transactions, currency devaluation risk is currently seen as an increased risk in Nigerian transactions due to the current protection of the Nigerian currency by the government. As mentioned, the Nigerian government has been supporting the official exchange rate using its foreign reserves. Both Nigerian and foreign investors believe that this cannot continue indefinitely and anticipate a further devaluation by the CBN. While the option of converting their foreign currency into naira in the parallel market has been an option for some, in order to get the all-important certificate of capital importation (CCI), the conversion must be carried out through the banks at the less favourable fixed exchange rate. The CCI is important because it is the document that gives an investor access to foreign currency in the official foreign exchange market in order to repatriate dividends and proceeds from its investment. Reuters reported that “international investors, dismayed by Nigeria’s decision to delay a naira devaluation they see as long overdue, will hold back from its stock and bond markets”. Investors are unwilling to commit significant investments just before a devaluation, and as a result even some investments that have been agreed have been put on hold pending the predicted devaluation. Bloomberg and Citigroup have attributed a fall in cross-border M&A transactions from the previous year, to this.

While the expected devaluation of the naira may favour foreign investors when they bring foreign capital into the country to make investments, it may not favour them when they seek to repatriate profits or dividends offshore. This is because naira-denominated returns are currently converted at the official rate of exchange which is less than 200 naira to the US dollar, earning them significantly more in foreign currency than it would following a devaluation. This means that a devaluation would result in lower returns in the relevant foreign currency. This ties in with the third risk factor for investors.

Sourcing foreign exchange for repatriation of profit

In order to support the naira, the CBN has had to utilise the nation’s foreign currency reserves. To minimise further depletion of these reserves the CBN has limited the availability of foreign currency which, in turn, has led to a scarcity.

While foreign investors are allowed to convert locally denominated dividends and returns into foreign currency at the official exchange rate, which in those circumstances are more favourable, the scarcity of foreign currency at that rate means that it is often difficult to obtain the required foreign currency in the official foreign exchange market. In practice, this means that investors must wait until funds become available.

Conclusion

The Nigerian government has previously indicated that there was no plan to devalue the naira on the basis that a devaluation was likely to lead to high inflation. There appears, however, to be some thawing of this position and the president has recently announced that a flexible foreign exchange rate regime is to be implemented, which is expected to end the current fixed rate policy. Although it is not clear whether the implementation of a ‘flexible rate’ will take the form of a full devaluation, it is certainly a welcome development for the M&A market as it should ease availability issues and result in a rate that is closer to the ‘real’ rate that exists on the parallel market.

Yinka Edu is a partner, Christine Sijuwade is a senior associate and Kunle Durosinmi-Etti is an associate at Udo Udoma & Belo-Osagie. Ms Edu can be contacted on +234 1 746 7733 or by email: yinka.edu@uubo.org. Ms Sijuwade can be contacted on +234 1 746 7733 or by email: christine.sijuwade@uubo.org. Mr Durosinmi-Etti can be contacted on +234 1 462 2307 10 or by email: kunle.durosinmi-etti@uubo.org.

Yinka Edu, Christine Sijuwade and Kunle Durosinmi-Etti

Udo Udoma & Belo-Osagie