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A beautiful photo of Cape Town went viral on Nigerian Twitter a couple of months ago, and I found out that a sizeable number of Nigerians believe the country would be better off if it was colonized for longer because nowhere in Nigeria is as beautiful as Cape Town.

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This perspective also came to light in an unexpected conversation with my Uber driver in Abuja, who, without prompting, expressed his belief that British colonial governance should have been extended until the year 2000 and their early departure is the cause of the country’s ills. I happened to be researching how democratization affects economic growth, and this revelation provided an interesting angle and a nice distraction to make me feel like I was actually making progress.

Does Colonization make countries richer?

Implicit in the view that Nigeria would be better off if it gained its independence later is the assumption that South Africa has better infrastructure because it gained independence relatively recently in 1994. Several political scientists have spent much of their careers trying to understand the economic impact of colonial legacies, so the relationship between total years under colonization and per capita income has been studied widely in academia. One such political scientist is Paul Hensel, whose visualizing colonization project was indispensable in my quest for answers.

The correlation between the length of colonization and per capita income is expectedly faint because numerous other factors play a role in shaping a country's economic standing. Nevertheless, the study finds that most countries with higher per capita incomes were colonized for less than 200 years, and the few that were colonized for 400 years, including South Africa, all have low per capita incomes. This doesn't say much because many countries (like Nigeria) that were colonized for less than 200 years also have lower per capita incomes than South Africa. 

What the data fails to capture is the timing of Africa's colonization. 

Colonialism in Africa, beginning predominantly after 1882, allowed colonial powers to disrupt existing political structures without establishing a robust state framework to endure post-independence. David Abernethy identifies this era as the third phase of European colonialism. Unlike most of the continent, South Africa’s colonization commenced earlier, in 1652, marking it as an outlier that experienced the first wave of European expansion along with southeast Asia and the Americas. Furthermore, its climate, more conducive to European settlers, positioned South Africa not only as a site for extraction but also as a place to settle, distinguishing its colonial experience from regions like Nigeria or Congo, where colonial governance focused primarily on exploitation.

Excluding South Africa, the legacy of colonialism on the continent diverges markedly from that of other ex-colonies globally. Spain and Portugal succeeded in wiping out the indigenous regimes and reproducing their own political systems on the soil of the New World. In Singapore, the British not only established a previously non-existent port but also constructed an administrative framework to bolster their influence across Southeast Asia. In India, the British Empire’s most prized possession, the establishment of a British Indian army and civil service laid the foundation for institutions that, bequeathed to the newly independent republic in 1947, continue to function today.

The late onset of colonization in Africa, coupled with the prevalent use of indirect rule, provides little basis to assume that extending such colonization would have enhanced economic development today. Had Africa undergone colonization akin to that of other continents, or if it had been colonized during the initial wave, the outcome might have been different. However, we can’t forget about the associated costs of the first wave of colonization, such as the wiping out of indigenous populations or several decades of crushing apartheid.

Though Paul Hensel’s project might have missed certain nuances, the most interesting aspect of the Visualizing Colonization project was his perspective on the data, shedding light on the underlying biases and notions of political correctness in academia. The foundational hypothesis of the researchers was that prolonged colonization would lead to worse economic conditions due to the extended depletion of resources. This is in contrast to the predominant view of everyday Nigerians that longer periods of colonization would have created better economic outcomes.

Embedded in the notion that South Africa’s lengthier colonization has made it more prosperous is an uncomfortable implication regarding governance and race: white people are better at governing countries. Merely articulating this thought provokes a blend of skepticism and discomfort, highlighting the distastefulness of the hypothesis. This inherent discomfort deters serious scholars from delving into such inquiries, wary of venturing into territory that borders on scientific racism at best or echoes eugenics at worst.

But these views are worth a lot of deliberation because, all around Africa, citizens are becoming increasingly disillusioned with their political systems. In the last three years, there have been six military coups in West Africa, and at least some sections of the population in each country appeared to support the usurpers because they are in search of anything that can deliver the bare-minimum standards of modern political order.

While it seems strange on the surface that people yearn for dictatorship or colonization when their grandfathers struggled bitterly to get rid of it, a quick look at the economic and political situation in most African countries post-democratization makes it seem less so. Nigeria has seen its currency’s value more than halve in the last eight months, the Nigerian state has lost its monopoly of legitimate coercion within its borders while inflation and insecurity threaten to plunge millions of people into famine. 

Five decades after independence, people no longer want to blame colonial legacies for their country’s lack of progress.

While East Asian countries had an advantage in state capacity immediately post-independence, they were in worse positions than many African countries in terms of economic development. Over the same fifty-year period, East Asian countries with similar or worse per capita income levels than their African counterparts became several times richer. This stark contrast has left African citizens weary, questioning the ongoing excuses for their governments’ and societies’ failure to secure economic development. Now, they are asking serious questions about their political systems.

In the visualizing colonization project, Hensel and team stated very casually that the former colonies with higher per capita incomes "all have notable reasons for doing so."

"It's interesting to note that the countries that stand out for having higher current per capita GDPs all have notable reasons for doing so. Qatar, Kuwait, Saudi Arabia, Oman, and Bahrain all have significant oil resources (in fact, I believe Qatar has one of the highest per capita GDPs in the world due to its oil reserves). Singapore and South Korea experienced rapid economic growth as countries among the "Asian Tigers" while post World War II Japan rose in economic strength as an industrial center."

The question most Africans have, living in the most resource-endowed continent in the world, is what are Africa's notable reasons for remaining poor?

Is Democracy the Problem?

While the data is sufficient enough to quickly dispense with the idea that African countries need more colonization, it is a lot less clear whether or not democracy is working as a political system.

 A frequent argument against democracy is that economic growth often requires politically unpopular but mission-critical decisions that might not be taken by people who must seek re-election every few years. Nigeria's fuel subsidy saga is a perfect example. The federal government continued to pay petrol subsidies to the tune of billions of dollars until it ran itself into a fiscal crisis while neglecting education, healthcare, and infrastructure investments because it was the political path of least resistance.

While the drawbacks of authoritarian governments are well known, they can have great economic advantages when led by a competent group of elites. 

Li Kuan Yew's miracle in Singapore is often cited as the best example of the benefits of a benevolent despot. The success of the Chinese communist party, based loosely on Singapore's model, in lifting hundreds of millions of people out of poverty over the last forty years is further proof of the potential economic benefits of autocratic government. Despite some of these successes, the data does not show that autocracies perform better economically than democracies. 

In a 2019 study, Daron Acemoglu, a world-renowned economist from MIT, demonstrated that democratization leads to a roughly 20% increase in per capita GDP over the long term compared to non-democracies. This research, covering 175 countries across five decades from 1960 to 2010, employed econometric models to filter out influences on per capita income other than democratization. Essentially, one of the best economists globally has provided strong evidence that democracy indeed fosters economic growth. 

A valid point is that democracy’s benefits depend on pre-existing conditions of economic and human capital development, and democratization can be economically costly for countries that haven’t scaled these hurdles. In other words, democracy doesn't work in impoverished countries. Richard Posner, the most cited legal scholar of the 20th century, wrote in his 2010 book on the crisis of capitalist democracy:

"Dictatorship will often be optimal for very poor countries. Such countries tend not only to have simple economies but also to lack the cultural and institutional preconditions to democracy."

 Daron Acemoglu’s study includes a focused analysis of whether the impact of democracy varies with a country’s economic development, specifically addressing how democracy fares in nations that are both impoverished and have low education levels. His findings reveal that the economic condition of a country prior to democratization has little statistical significance, suggesting democracy does not adversely affect low-income countries.

Considering the compelling evidence from Acemoglu, it's reasonable to assume that the problem is that African countries don't actually have democracy. European and American observers of voting exercises on the continent have occasionally called them "election-like" events due to the widespread rigging, violence, and electoral malpractice they witnessed. So, if democracy causes growth, Africa hasn't grown because most countries are democratic in name only. 

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But if you exclude the western industrialized countries, the map above shows that African democracies are not much worse than other areas in the world that perform far better economically.

The reality is that It doesn't matter that some African countries are not "truly democratic" because the important distinction is between modern systems operated for the broad public good versus those run on patrimonial lines. Just as patrimonial states can be democratic, modern states too can be autocracies. In a patrimonial state, the government is seen as a personal asset by those in power, used primarily for personal enrichment and the benefit of their immediate circle. Despite having the trappings of democracy—elections, supreme courts, and extensive bureaucracies—these states govern with self-interest, distributing state resources among a tight-knit group of friends, family, and allies.

The Journey to Modernization

To understand why some countries are able to develop modern states where bureaucrats are selected based on merit and govern for the interests of broader society, it is important to outline the three components that make up a modern government:

• The first institution is the state itself. The essence of any state, as Max Weber outlined two centuries ago, lies in its monopoly of legitimate force within its borders. This foundational principle remains relevant because it underscores the fact that states are about concentrating and applying power. States must consolidate power to enforce laws, collect taxes, and maintain order through the imprisonment of lawbreakers. The legitimacy of this power is crucial because it requires everyone to agree that the state has the right to exert that power.

• The second institution is the rule of law, which constrains society's most powerful political actors. This principle hinges on the premise that leaders themselves must adhere to the state’s laws. Without this constraint, the rule of law gives way to rule by law, a scenario prevalent in many of today’s patrimonial states, where laws serve the interests of those in power rather than the collective good.

• The third institution involves mechanisms of accountability, which in contemporary democracies, manifest as free, regular, multi-party elections. The underlying purpose of these processes is to ensure that the government reflects the interests of the broader society rather than serving solely the political elite. This principle of inclusivity is fundamental to the concept of accountability within a democratic framework.

Considering these three institutions together highlights a dynamic tension: the state’s objective to amass power sufficient to exert legitimate force is strained by the rule of law and accountability, which aim to limit that power. Because of the problems faced by western industrialized countries, political order in the modern day focuses too much on the institutions of constraint rather than the institution of power — the state —  which has the ability to exert legitimate force over its territory, grow the economy, and administer services in an impersonal fashion. Before governments can be constrained, they have to have the capacity to do things.

Not only is democracy unnecessary for the purposes of creating this modern state, but it can actually be a hindrance to its development. 

Democracy, as practiced, requires the mobilization of a large number of uneducated, uninformed, and often disinterested people to participate in elections. The easiest way to get these people to vote is to bribe them. Countries that transition to democracy prior to establishing a modern state—one where administrative roles are filled based on impartial criteria like merit, education, or technical expertise—tend to spiral into patterns of patronage and clientelism. 

The United States, democratizing immediately after independence, had a highly clientelistic political system for its first 100+ years of existence.

At the time, 85 percent of Americans lived in rural areas, were involved in agriculture, and had no more than a fourth-grade education. These citizens were induced to come to the polls with Christmas turkeys, bottles of brandy, or get-out-of-jail-free cards. By the time the Republicans replaced the Federalists in government in 1800, presidents were already using their power to place political allies in powerful positions, leading to a state that was limited, inefficient, and plagued by corruption. This sort of patronage and clientelism is often misinterpreted as aberrant political conduct unique to developing nations, attributed to cultural characteristics, largely because of a lack of awareness about similar practices in the early histories of now-developed countries.

The reality is that the political patronage relationship is the default form of human organization.

Throughout time and in all countries, states have had to contend with the tendency of political elites to favor their allies, driven by the deeply ingrained biological principles of kin selection and reciprocal altruism—a trend that persists today. The countries governed by impersonal, merit-based organizations are actually the exceptions, but they have come to be seen as the rule. What we need to understand is how a handful of countries have managed to go against this basic human nature.

The experience of previously clientelistic countries like the United States, Greece, and Italy has led many people to emphasize the importance of sequencing in the process of state formation. Countries should ideally develop an autonomous bureaucracy and a liberal rule of law with well-trained judges and independent courts before introducing democracy. Samuel Huntington, the former director of Harvard’s Center for International Affairs, argued in his book Political Order in Changing Societies that countries were better off making an authoritarian transition to a modern economic and political system because “societies need order before they need democracy”.

Many African countries have managed to establish authoritarian regimes that maintain control via a mix of repression and patronage, but none have succeeded in developing institutionalized bureaucracies governed by clear, well-defined rules akin to the German Rechtsstaat or the Chinese mandarinate system. It is easy to emphasize the importance of sequencing in state formation; however, the actual institutional construction is a much more complicated matter. Under the conditions of a corrupt and/or incompetent dictatorship, what could be the benefit of delaying democratization?

Without the presence of a benevolent despot, countries can look to the only three ways that states have moved from neo-patrimonial  to modern: 

1. Direct colonial inheritance

2. Military competition

3. Getting rich

Historically, war and military competition have been one of the most important forces driving states toward modernization. The looming threat of powerful outsiders threatening the survival of elites necessitated the development of a strong army and the tax collecting abilities needed to finance that army, which both require strong bureacracies. This path to state modernization is so reliable that Edward Luttwak, a noted military analyst and author of a book on coups d’état that ranks among my favorites, actually suggested that we should “give war a chance” in areas like sub-Saharan Africa that are plagued with weak states. While it is true that European countries forged their modern states through nearly endless military competition, no one should wish a similar fate on their own country. Moreover, several formerly patrimonial states, including the US, were able to achieve high-quality government without war, so there are certainly other paths.

The other powerful force apart from direct colonial inheritance that has driven states towards modernization is economic growth or “getting rich”.  In nineteenth-century Britain, the Industrial Revolution created an urban middle class led by industrialists and entrepreneurs that replaced the feudal agrarian society. In pursuit of self-interest, the new British middle class advocated for merit-based standards of advancement in all institutions in order to get their kids into Oxbridge and find employment for them in the civil service. A few decades later, the new middle class in the United States, also created by industrialization, had little stake in the entrenched clientelistic system and was mobilized into interest groups that upturned the existing patrimonial political order.

In both of these cases, economic growth created the foundation for new political coalitions to mobilize against the interests of a political class that had succeeded in co-opting the masses of nonelite voters into the patronage system. The failure of countries like Greece and Italy to fully transition away from clientelism because their middle classes were absorbed into the local patronage networks illustrates that reform is primarily a political process rather than a technical one. Clientelistic systems do not exist because the politicians do not understand how to organize an efficient bureacracy, but because the incumbents benefit from the system. Moving towards a modern bureaucratic system requires not only implementing technical characteristics like educational qualifications and examination requirements but also dislodging the political godfathers who get money and power as well as the patrons who get jobs and favors.

What I am Reading

Books:

The World for Sale: Money, Power and the Traders who Barter the Earth’s Resources

I thoroughly enjoyed reading this book by Javier Blas and Jack Farchy. I was acutely aware of how important global shipping and commodities trading are to the economy, but I didn’t have a clue how any of it worked. I tore through this book in less than a day and came out and learnt about the people and companies that run perhaps the most powerful global industry.

Aliko Dangote's Sugar company has nearly quadrupled in price this year. 

Last month, he announced a merger between his three Agro-Allied businesses, and each listed entity's price doubled in the month since the announcement. Studying what will probably be the most significant corporate action of 2023 and investors' reactions to it will yield important lessons for anyone curious about the Nigerian equities market, M&A deals, or the games that billionaires play.

As an investor over the last six years, I have seen how corporate actions have been an important catalyst for value realization. Considering that the complete terms of the deal haven't been disclosed to the market, it's possible that investors have been too busy making money to weigh the full financial implications of their positions. I searched for clues in each company's financial statements to find out what the market could be pricing in - and to answer three main questions I'd want to know as a shareholder:

• Why is Aliko Dangote merging his companies?

• Why is the market reacting so positively to the announcement?

• How attractive are the offer terms to each involved party? 

Merger Rationale

There's a lot of speculation that Aliko Dangote is merging his companies to bolster his position as the wealthiest man in Africa on the Forbes Billionaires list and to one-up his long-term rival, Abdulsamad Rabiu.

Mergers, however, are time-consuming projects that involve exorbitant fees to corporate lawyers and investment bankers and should only be undertaken with good reasons. But there is evidence that suggests that Forbes magazine and his petty rivalry could have played a role:

1. The announcement comes after a 30% loss in Aliko's net worth due to the devaluation of the naira.

2. The merger will put Dangote Foods in a similar position to BUA Foods regarding revenues and outstanding shares.

3. Nigerian billionaires are fond of holding 80%+ of the shares outstanding in their companies to keep prices high.

While this makes for exciting market gossip, this merger is likely happening simply because there is a financial incentive to do so. 

Higher share prices mean that Dangote can access more money through credit facilities based on the value of his businesses. If combining three of his companies can increase their total value, he stands to benefit from a higher net worth and more options for managing liquidity - a vital concern after he sunk billions of dollars into his petroleum refinery. 

BUA Foods plays an essential role in achieving this, but it has little to do with their perceived rivalry. 

They are creating an entity that matches BUA Foods in financial metrics because Abdulsamad's food company trades at an average 16.8x earnings multiple. Prior to the recent appreciation, Dangote Sugar and NASCON had historical average earnings multiples around 7x and 11.2x, respectively. The idea is that the market will value a combined Dangote Foods similarly to BUA Foods.

These businesses had been severely undervalued for a long time, leaving enormous amounts of value to be unlocked. 

The head of research at Coronation Merchant Bank said three years ago: 

Within the Dangote group of companies are two specialized food producers, NASCON and Dangote Sugar, that have not only produced RoEs well in excess of our target of 20.53% but that have actually improved their RoEs in recent years. The result, unfortunately, has been total shareholder returns below our benchmark return. This is a case of unjust treatment by the market, quite likely a case of investors not paying attention to fairly small and not-very-liquid stocks.

I like this excerpt because it shows how the market can be wrong for over a decade and explains an inefficiency that will always exist in securities markets that savvy value investors can exploit.

How institutional investors operate is a significant determinant of securities prices, and the nature of their operations can create inefficiencies in places that are too small for them to pay attention to.

A merger of Dangote's three companies would create an entity large enough for institutions to invest in and research analysts to justify writing about - two factors that will likely lead to further expansion in multiples.

On the actual business side of things, some potential synergies may arise from combining the companies. However, it is hard to know what they are or what their magnitude will be until the explanatory statements by the financial advisers are published. In any case, most evidence points to this being primarily a multiples expansion play rather than a synergetic one. 

Understanding The Transaction Structure

The transaction is set up as an internal restructuring to be executed through a scheme of merger. 

 The three businesses will be combined with Dangote Sugar Refinery as the surviving entity. The expectation is that the new company will be called Dangote Foods to reflect the addition of the Rice and Salt companies. Transactions like this are lengthy affairs that involve courts, regulators, and government agencies and last up to 3-6 months. The process might be accelerated because certain legal exemptions on internal restructurings could mean the merger falls outside the Federal Competition & Consumer Protection Commission's (FCCPC) purview.

As part of the deal process, A 60-80 page scheme of merger document prepared by Dangote's investment bankers will be presented to shareholders for consideration. The document will provide the necessary information for investors to make an informed decision, and it will contain the following:

• Timeline for Key Events 

• Letters from the Chairmen of each company's board of directors

• Explanatory statements by the financial advisers

• Valuation based on:

  •     Historical Market Price Analysis;

  •     Net Asset Value

  •     Comparable Trading Multiples Analysis;

  •     Comparable Precedent Transaction Multiples Analysis; and

  •     Discounted Cash Flow Analysis.

• Pro-forma financials of the surviving entity

With the scheme of merger documents, it's easier to know critical variables like the privately-held Dangote Rice's value and the surviving entity's listing price. 

Yet, investors have bought heavily into the involved companies, presumably based on only the announcement of partial merger terms and publicly available financial information.

The scheme consideration below shows that Dangote Foods will comprise the three companies in the ratio of 70%:14%:16% (DSR:NASCON:DRL). 

Investors with 100,000 units of NASCON will receive 91,667 shares of Dangote Sugar. In comparison, the shareholders of Dangote Rice (mostly Aliko Dangote himself) will receive 1,400,000 shares of Dangote Sugar for every 100,000 units in Dangote Rice.

Scheme Consideration

Eleven (11) ordinary shares of 50 Kobo each in DSR, credited as fully paid-up shares, for every Twelve (12) NASCON shares of 50 Kobo each, which totals 2,428,651,847 new ordinary shares of DSR; and

Fourteen (14) ordinary shares of 50 Kobo each in DSR, credited as fully paid-up shares, for every One (1) ordinary shares of N1.00 Kobo each in DRL share, which totals 2,775,792,508 new ordinary shares of Dangote Sugar Refinery.

The issuance of new shares could dilute existing shareholders in Dangote Sugar, and at current prices, the exchange ratios appear less favorable for investors in NASCON. The listing price of the surviving entity is an indispensable input needed to make judgments about whether or not the offer will sufficiently compensate investors.

Price is What You Pay, Value is What You Get.

As of March 2023, Dangote Sugar was trading at 17 Naira per share, a market capitalization of N205bn. 

At that time, the business had just released it’s annual report where it posted N400bn in revenues, N80bn in levered free cash flows, and a 142% rise in net profits to N54bn in 2022. Its return on equity averaged 23% over the last five years. Their business model gives them strong pricing power as 95% of their sales are to distributors or manufacturers of confectioneries. This model gave them the ability to increase their average selling price by 33% while also growing unit volumes by double digits.

I did a discounted cash flow analysis using simple historical averages of the company’s following metrics:

• Revenue growth

• EBITDA margins

• Capital Expenditures as % of revenues

• Depreciation & amortization as a % of revenues.

I used a discount rate of 19%-20% and assumed that revenues in perpetuity would grow just below the historical nominal GDP growth rate of 13%.

With these assumptions, Dangote Sugar’s equity value is somewhere between N570bn-N815bn. At the market capitalization of N205bn, the company's shares were trading at a significant discount to even conservative estimates of its intrinsic value and should have been on every value investor's radar.

Prior to the merger announcement, the company published its June 2023 results where it reported a net loss of N30bn caused by the devaluation of the naira. The shares immediately dropped 10%. However, if you exclude the unusual expense, its normalized LTM earnings were over N7 per share. The company was effectively trading at 3.8x earnings at its price of N27 in June. If you apply its historical multiple of 7x, then it should have been trading at N50 per share.

A similar analysis of NASCON‘s equity value yields a fair value estimate of N130bn (N50/share) with a range of N110bn-N160bn.

Because 84% of the new entity will comprise the two publicly listed companies, we can make some assumptions about Dangote Rice using the exchange ratio to arrive at a reasonable guess for the intrinsic value of Dangote Foods.

If we assume the exchange ratios were calculated based on each company's intrinsic value, Dangote Rice's implied equity value is somewhere between N125 and N180 billion. Summing up the numbers for each company means that Dangote Foods' intrinsic value could be between N815bn - N1.16trn or N48-N67 per share.

As we have already seen, however, a company's intrinsic value can differ significantly from its stock price.

Security prices are often determined by events and how investors react to those events, which is primarily a function of how the events stack up against investors' expectations. 

The main event in this case will be the listing price of Dangote Foods after the technical suspension that will be placed on it towards the end of the merger process and how it stacks up to the market’s expectations

We could estimate pro-forma financial statements for the new entity and then conduct a relative valuation to get a sense of what multiples the market could apply, but the lack of critical information will not make the results meaningful.

There are also investment bankers working late somewhere on the island who have been paid lots of money to do this -- so I would rather wait for their explanatory statements.

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What I am reading

Books:

Formation: The Making of Nigeria from Jihad to Amalgamation

I enjoyed this fascinating book about Nigeria’s pre-colonial history. It gave me deeper understanding of the nature of political power in Nigeria through it’s explanation of succession practices in the various pre-colonial empires that existed at the time.

Articles:

• How China’s Economic Slowdown will Impact Sub-Saharan Africa

Nigeria exports about 5% of GDP to China every year, so a potential slowdown in China could have a serious effect on the economy and markets.

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Last month, an American travel writer published his Notes on Nigeria after visiting four cities in the country. Many Nigerians reacted on social media with shame, disdain, or outright anger as he brought to light some of the harsh realities that many of us have grown to ignore or take for granted. It’s not often that people see their country from the lens of an outsider, especially considering that Nigeria isn’t much of a tourist hot spot.

Some were quick to rush to Nigeria’s defense, pointing out that open defecation and urination also happens in America, which I know all too well writing this from downtown Los Angeles. But that happens here because of drug use and untreated mental illness, not a lack of proper sanitation infrastructure.

Matt Lakeman’s observations were particularly jarring because they had a raw honesty that our collective consciousness had long been evading. It made me think about one of the questions that led me to pursue economics for my undergraduate studies: Why do people have to live like this in any country, let alone a “resource-rich” one? How does such wealth produce such poverty?

Matt gets close to what I think is the root of the issue:

Nigeria earned $350 billion in oil revenues from 1970-2000, but average yearly income somehow went down from $1,113 to $1,084 over the same period. It has been two decades since then, and Nigeria now has 130 million people living in poverty, and there is still no definitive answer to the mystery of the resource curse. I think the notion of incentives gets lost in conversations about Nigeria’s failings, both on the ground and in academia (albeit for different reasons).

The fact that many countries with the most ‘natural wealth’ are some of the poorest in the world seems like one of those ironic tragedies in life; curses disguised as blessings, such as how lottery winners are more likely to declare bankruptcy than the average American.

Both of these phenomena are shockingly pervasive. The resource curse has struck famously in Venezuela, Russia, Angola, and Congo-Kinshasa, while some studies have shown that anywhere from 30%-70% of lottery winners eventually declare bankruptcy.

Yet, neither of these are natural laws. Countries with natural resources aren’t doomed to failure, and not every lottery winner goes broke. The chart below compares oil earnings per citizen to how corrupt the country is perceived to be, and it shows that there is a positive trend but still many outliers. In other words, having oil can certainly cause corruption, but it doesn’t always.

So why do some resource-rich countries turn out like Norway, Qatar, or Botswana instead of Venezuela, Angola, or Nigeria?

I read a lot of excellent academic papers that dealt with this question, like this one that provided the scatterplot above by Paasha Mahdavi, a political science professor at UCSB. His research shows that countries are more susceptible to corruption when the oil industry is regulated by state-owned oil companies instead of government ministries. These types of studies are insightful and are based on agency theory, which focuses on incentives. Still, the methodological approach fails to give meaningful answers to what I see as such a human problem.

When thinking about these abstractions of politics, corruption, and regulatory institutions, it’s easy to forget that it’s all just about normal people. It’s about people in different countries who choose to behave in the same ways when they are in charge of countries that can dig money out of the ground. The advanced econometrics used in academia can sometimes obscure how the consequence of those behaviours is human suffering, but Matt’s perspective as an outsider brings it front and center:

It just doesn’t feel like you’re grappling with the same question of why people choose to behave in certain ways when the theoretical explanations in academia are using things like Markov-chain Monte Carlo methods just to show that countries can have a little corruption or a lot, irrespective of oil wealth.

If you ask the average citizen the cause of Nigeria’s problems, they would tell you it’s corruption or bad leaders. Economists and other analysts would cite weak institutions or an elite consensus on rent-seeking. But these problems are first or even second-order consequences of misaligned incentives.

Looking through the lens of incentives feels like a more natural explanation for why countries end up like this. Politicians are primarily concerned with getting and keeping political power, while everyday people focus on their welfare. This holds across all types of governance, from the most liberal democracies to the strictest dictatorships. Rulers utilize the wealth generated by the state to reward those who help them retain political power. This can range from bribing key figures and offering cash for votes to more subtly granting subsidies or forgiving debt held by their supporters.

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Politicians in countries that rely on revenue from taxing wages and profits need these wages and profits to increase if they want to generate more money to reward supporters and secure political power. Therefore, they take actions that will increase wages and profits, driven by their selfish interests. They are like bees that pollinate all the flowers in the garden in their greedy search for sweet nectar despite not actually caring about the reproduction of plants.

When the state's wealth is tied to the productivity of the people, the leader’s interest in maintaining political power aligns (coincidentally in many cases) with the people’s interest in their own welfare. After all, a healthy, educated, and well-fed population is not just a happy one but also a productive one.

However, governments of countries with vast natural resources can secure the money needed to stay in power without much input from the citizens. So, they have little incentive to invest in increasing the productivity of the people. If the bees suddenly had a giant pot of nectar beside their nests, they wouldn’t venture out to deal with those pesky flowers. This would leave the garden in chaos when the neglected flowers fail to reproduce, and the nectar eventually runs out.

But while the temptation of the nectar pot has led many a bee astray, some have managed to resist its allure. The gardens of Norway and Qatar are far from chaotic, despite the presence of their own nectar pots in the form of vast oil reserves. In fact, they might be the richest gardens in the world, depending on who you ask. Like all people, I believe the political elite in countries like Norway and Qatar behave in ways that maximize their interests, rather than being inherently better or more altruistic. But they designed or inherited systems where individuals acting in their own interest are incentivized to behave in ways that benefit society as a whole.

If Norwegians and Qataris are equally incentive driven as everyone else, there must be a reason why they made different choices. The disparities should be explained by the political and economic systems that allocate each country’s vast resources, as these systems dictate how people choose to behave because they outline how money is earned and how political power is acquired.

Norway was an unexceptional fishing nation with per capita income on par with Nigeria’s before they struck oil in the 1960s. Qatar was an even more unremarkable fishing nation, yet, its discovery of oil and natural gas transformed its desolate patch of land in the Arabian peninsula into one of the wealthiest places on the planet.

Norway is a vibrant social democracy, while the Al-Thani family has ruled Qatar as an absolute monarchy since the late 18th century. The political systems of these two countries are polar opposites, but they have equally delivered stupendous wealth to their citizens. The key difference is that both of these countries had established the stable, valued and recurring patterns of behavior known as institutions before they discovered their natural resources.

Thinking about institutions this way is important because they are not just laws on pieces of paper, which most countries have tons of, but particularly the norms and behaviors that are ingrained in society that make it costly for people to deviate from accepted practices.

In other words, while the system itself is important, the strength of those institutions at the time of discovery appears to be a more important signal. So the answer to the question of why some resource-rich countries are poor is that they found the resources too early in the process of state-building. In a way, it’s like how lottery winners are more likely to go bankrupt if they are 18 than if they are 60.

With this framework, it can certainly be argued that Nigeria was doomed from the start, especially given its colonial legacies. However, it has been 60 years since independence and other former colonies have created immense wealth for their people. We must come to accept that our leaders make the wrong choices because our systems don’t incentivize them to make the right ones, and fail to punish the wrong ones. The process of state-building evolves organically over time, but as we embark on the long and arduous journey, we need to place more focus on how our systems encourage real people to behave.

P.S

I am constantly trying to improve my information diet. I’m adding a short section at the end of these letters to share some cool books, videos and articles I’ve come across. Feel free to respond to this with anything you think I might be interested in :)

What I am reading

Books:

• Political Order and Political Decay, by Francis Fukuyama

• Why Bad Behavior is Almost Always Good Politics, by Bruce Bueno De Mesquita and Alastair Smith.

• Buffet: The making of an American Capitalist, by Roger Lowenstein

Articles:

• Attracting Investors: Lessons for Nigeria from Asia’s 1997 crisis

What I am watching

While many citizens don’t care about manifestos having been traumatized by false promises, these documents can actually give useful insight into the general ideological leanings of the parties. Although politics in Nigeria generally lacks ideology, there are stark differences in the positions of the manifestos on Inflation management, government spending & debt, exchange rate policy and international trade. It is no secret that Nigeria is at an important economic crossroads, so understanding these policy differences is paramount for investors, businesspeople and responsible citizens.

Let me preface by saying that there is nothing any of the three frontrunners can do to avoid economic pain in the short term - the country’s fate has already been sealed in that regard. These documents can only hope to outline the necessary adjustments to change the direction of our economy in the medium to long term. Below is a summary of each candidates policy stances:

Inflation Management

Inflation in Nigeria is at the highest level in two decades and the Naira has lost over 90% of its value since the present administration took office. The source of these economic issues is the first point of disagreement between the two manifestos, and it sets the tone for the policies they each go on to propose.

The APC manifesto claims that our inflation problems stem from global supply and production constraints outside the control of the government their party currently controls. The problem is that these so-called global constraints stem from this year’s war in Ukraine and lingering lockdowns in China. Yet, Nigeria has been in economic turmoil for six years, long before either situation materialized.

In contrast to APC, the Labour Party manifesto suggests that our inflation and the resulting problems are because of anomalies caused by government actions. The manifesto takes the time to outline the cause of every macroeconomic problem we face, generally echoing the consensus of economic experts both at home and abroad.

Government Spending & Debt

The news coming out of Accra this week is a perfect example of the dangers of reckless government spending and should serve as a cautionary tale for Nigerians. In case you missed it, Ghana has announced that it will default on its debt; effectively wiping out a large percentage of bank assets in the country and triggering one of the largest wealth destruction events in the history of the region. Events like these are generally spaced out because when times are good, you can keep borrowing more to service debts without having to reduce spending.

What has happened to Ghana, and is happening to Nigeria, is that the avenues for borrowing to pay back old borrowings have become too expensive and effectively closed.  When this happens, governments can either reduce spending and pay back in hard money, which is economically painful because one man’s spending is another man’s income, or they can print money to keep spending and inflate away the debt; at the cost of high inflation and destruction of the currency. Today, Nigeria spends 116 Kobo servicing debt out of every 100 Kobo it earns, and the central bank has printed over 20 trillion Naira out of thin air, indicating that we are already headed in Ghana’s direction at best and Venezuela’s direction at worst.

As evidenced by the Buhari administration’s consistent fiscal deficits and further buttressed by the Tinubu manifesto: APC believes that you can spend your way to prosperity. Not only does the Tinubu manifesto propose even more spending, but it also explicitly states a desire to suspend the limits on government spending and money printing. This is shocking and, quite frankly, terrifying. These limits, codified in the CBN Act (and repeatedly broken by Buhari and Emefiele), exist for very good reasons. If the government does not reign in its spending; inflation will accelerate, the Naira will continue falling, and the country will be at an intolerably high risk of hyperinflation. This is a categorical fact.

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Perhaps even more shocking and terrifying is that the APC is aware of these effects but believes that they have the knowledge to determine the level of spending that won’t make inflation too high. Do you trust any government, let alone APC, to be able to make that calculation accurately? Even with an unlimited budget financed by money printing, their bright idea is to hire millions more Nigerians to work for the government, thereby enlarging the state and incurring recurrent liabilities. Nigerians need less government, not more and both the Labour Party and PDP agree.

On the opposite end of the spectrum, the Labor party has proposed a zero-based national budget and outlined exactly where they will make the budget cuts. While the proposed changes may not successfully balance our budget, it is precisely the direction the government must head to if it is to have a chance of avoiding outright collapse. One potential source of savings would be derived from implementing the Oronsaye report, which could see over 100 government parastatals abolished or merged.

The bulk of the proposed savings, of course, will come from removal of the notorious fuel subsidy which would cost the government N6 trillion if it ran for the whole year. The APC manifesto also suggests a phased removal of the subsidy, but why would that be a priority for a government without spending limits?

Exchange Rate Management

Despite describing the exchange rate as ‘the most evocative monetary issue of the day’ and accurately describing the problem with our multiple exchange rate system, the APC manifesto has nothing more to say about it other than “we will work with the CBN and financial sector to review and optimize it”. The stated goal of a stronger naira is not only unrealistic but also terrible for domestic conditions. When this goal is considered in the context of their proposed government spending, it becomes a cheap lie.

Labour Party explicitly states that they will abolish the multiple exchange rate regime. While the manifesto avoids the dirty ‘devalue’ word, that will certainly be the result of abolishing the system. Such a devaluation will surely be painful, but the benefits far outweigh the costs as dollars will become available for all Nigerians at the true market price. For the broader economy, a sharply depreciated naira will make it possible to offer a positive total return on the currency at a lower interest rate while also benefiting our trade balance.

Foreign Trade & Import Substitution Vs. Export Orientation

Unsurprisingly, the differences in ideology also extend to the respective trade policy. Tinubu favours a policy of import substitution, which we currently practice, while Obi seeks a change to an export-oriented policy which is more in line with free trade. While the APC plans to ‘exploit the AfCTA’, their proposals of higher tarriffs and fees are at odds with such plans. APC’s aim with these policies is to import less and export more, which is not a bad goal in and of itself. The issue is that the market distortions created by these policies ultimately end up increasing import dependence, among other intolerable economic costs.

Make no mistake; these distortions are features of this ideology, not bugs. Import substitution has been tried, tested, and failed globally - from the Middle East and North Africa to Latin America. Now it is failing Nigeria again. Venezuela pursued similar import substitution policies with famously horrendous economic results. We have followed the same policies under the current administration and achieved nearly identical results. After seeing the end of the Venezuela movie, should we choose to continue copying their script?

Despite having the largest oil reserves in the world, even bigger than Saudi Arabia, Venezuelan citizens still queue for hours to get petrol. The distortions created by subsidies and price controls made it spectacularly profitable to smuggle petrol over the border to Colombia. Like us, they also overvalued their currency via a dual exchange rate system which increased corruption and arbitrage and led their debts to foreign airlines to grow to the point that the airlines left the country, leaving most citizens stranded to endure the hyperinflationary collapse. Nigeria is really not unique. 

Generally, I wouldn’t say I like bonds. I like to think of myself as an optimist, and ‘optimistic bond investor’ is a bit of an oxymoron. When you buy a bond, your upside is (mostly) fixed, and you can only focus on and try to limit the downside, so skeptics rather than optimists rule in that world. However, I have been paying a lot more attention to bond markets this year because interest rates are rising worldwide, and bonds are the first market to react to interest rate changes. A market is nothing more than a system that conveys information using prices, so it’s an excellent framework for me to learn about what’s happening in the world.

Ghanaian Eurobond prices have fallen nearly 50% this year, pushing the implied yield to almost 30% in USD. Naturally, this piqued my interest (and greed), so I decided to dig into what information these prices were trying to convey. When a country’s bond prices fall so dramatically, it’s likely because investors are skeptical that they will get their money back, and so they sell now to cut their losses. So the market believes that Ghana is likely facing a debt crisis. For investors to accept only half their money now indicates that they think something terrible is happening.

Given that Nigeria is facing its own fiscal crisis, I was curious to compare how Ghana is handling their crisis compared to Nigeria and how that will affect its ability to pay back and, subsequently, the value of the securities. As I will explain in the rest of this article, it appears that the Ghanaian government and the Bank of Ghana are engineering a beautiful deleveraging; meanwhile, Godwin Emefiele is sending Nigeria down a hyperinflationary spiral.

Ghana, like Nigeria, has found itself in this position because of a lack of fiscal discipline, running large budget deficits that spurred a dependency on cheap USD loans (mainly Eurobonds). As interest rates began rising, it became too expensive for the Nigerian and Ghanaian governments to borrow money from the international markets. The issue is further compounded by rising commodity prices, causing expenses to rise while incomes are falling simultaneously. This dynamic creates a gap between the amount of money coming in and the amount of money being spent that the countries must find a way to close.

Balance of payments crises can be analogous to a family or individual facing financial difficulties. If a family’s breadwinner loses their job and has to take a pay cut or faces a significant increase in costs, perhaps due to an illness, it would have a devastating economic effect on the family. To fill the gap between earnings and income, they will either have to reduce their living standards or become heavily indebted - if they can even access the capital. Countries, unlike individuals, have a few more options to deal with such crises. However, with no source of foreign capital, the governments had no choice but to resort to borrowing and printing local currency to buy dollars, devaluing their respective currencies and spiking inflation (~30% in Ghana and 20% in Nigeria) as imports became more expensive.

How countries close this gap between money coming in and money being spent ultimately determines how severe the inflationary deleveraging and currency crisis will be. A deleveraging is a difficult and painful situation, but handling a difficult situation in the best possible way is beautiful. The key to a beautiful deleveraging is balancing all the tools available to close the gap. Countries can achieve the right mix of cutting spending, reducing debt, printing money and redistributing wealth to ease some of the pain.

Ghana, unlike Nigeria, quickly limited their money printing to stay within its legal limits because they understand the long-term effects of money printing. Quite frankly, this alone already constitutes significantly better handling of the crisis - orders of magnitude better. This is because continually printing money to finance external spending has been the cause of every hyperinflation in history. While in some cases, its involuntary, in Nigeria’s case, it is 100% a policy choice.

Even though the Ghanaian Cedi has fallen nearly 40% this year, they are managing their currency much better. Letting the currency decline so quickly in such a big way means that there is still a two-way market for the Cedi, i.e. people are not only selling the currency. The use of monetary policy here is also instrumental in making people willing to hold the currency. The Bank of Ghana jacked up interest rates to 22%, partially compensating people for the risk of devaluation if they hold cedis.

While many will correctly argue that such high interest rates will crash the domestic economy, that is the more favorable result because contracting domestic demand will bring down spending more in line with incomes. On the other hand, the Godwin Emefiele-led CBN has been running (relatively) loose monetary policy, keeping debt-fueled consumption high and putting off domestic pain but further spiking inflation. To continue with the analogy, it is like a family facing economic hardship borrowing money to maintain their standard of living instead of tightening their belts and making cuts where possible and borrowing only for essential, unavoidable expenses. They are merely prolonging and worsening the pain by trying to keep the same standards.

So, everything said and done, can Ghana afford to pay back their loans? And therefore have their bonds been priced too harshly? I would venture to say yes for quite a few reasons. The most important thing to determine is the risk of permanent capital loss. A disorderly default seems unlikely because the future costs of such a default, in higher interest rates and being cut off from international lending markets, are intolerable for most governments.

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Given how they have handled their crisis so far, I find it hard to believe they would go down that path. They have also received $750m in financing from Afrexim bank and a $1bn syndicated cocoa loan to cover imminent maturities and hold the country over while negotiating a bailout from the IMF.

Despite this, some form of debt restructuring seems likely. However, the bonds are trading at 47 cents on the dollar, so even an egregious haircut of 40% would still put buyers of these assets firmly in the money, and investors get to have a say in the restructuring. Of course, this would make the bonds far less profitable.

Given that this is public information and shared knowledge for sophisticated investors, one might wonder why the market would react so harshly. This is where the importance of analyzing who the key players in the market are and what their motivation is. For the most part, retail investors don’t get the opportunity to invest in Eurobonds because they are often issued with a minimum investment requirement of $200,000.

Consequently, the most important players in the market are large institutional investors like fixed income funds, many of whom have strict requirements on the types of securities they are allowed to invest in. As Ghana’s balance of payments worsened, its bonds were relegated to CCC- (Junk bond status) by the rating agencies, which meant that many of these large institutions could no longer hold these bonds. This immediately turns these investors into forced sellers, and if you buy something from someone who has no choice but to sell it often, you can get a fantastic deal.

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Everyone feels intuitively that the 18-19% number by NBS is nothing but a fantasy. And they’re right. NBS has not updated its basket of goods or their weighting since 2009, which means that they are tracking changes in the price of products that are probably not consumed by the average Nigerian. This economic think-tank estimates the inflation rate to be more like 45%. That seems like a realistic number, but I know personally my basket of goods is inflating at a rate higher than that, and anyone that consumes a lot of diesel is probably in the same boat (but certainly won’t represent average Nigerians).

I think a lot of Nigerians have nursed the thought in the back of their heads that we could be headed towards hyperinflation but with no way of actually knowing. Most people understand what hyperinflation is and can probably tell you that it’s usually caused by printing too much money but without a deeper understanding of how one plays out.

Hyperinflations are almost always the result of prolonged boneheaded policies by governments and central banks. Virtually every hyperinflation has been caused by deficit monetization AKA printing money to pay for excessive government spending. If you have even heard of the words “ways and means” before, you are probably getting sick to your stomach right about now.

Now, every hyperinflation was caused by printing too much money, but not every case of excessive money printing causes hyperinflation. So what causes some cases to spiral and others not to?

Luckily for me; Ray Dalio, the founder of the largest hedge fund in the world, spent a lot of time and effort studying the 27 most severe cases of inflationary deleveragings to map out the archetypal case. If you want a broader understanding of debt crises you can read his research for free here. I’m going to use some of the key metrics he uncovered to map out how severe our inflationary depression has been, and how much we share in common with the cases that spiral into hyperinflations.

Generally speaking, the greater the degree to which these things exist, the greater the degree of the inflationary depression. Nigeria literally ticks every last one of those boxes and surprise surprise we have had a severe inflationary depression for much of the last decade. An “inflationary depression” is just as it sounds; a period of economic depression characterized by high inflation rates and the short story is that they are caused by countries spending more foreign exchange than earn.

Like many of the other cases analyzed by Bridgewater, ours started with a fall in income due to reduced exports and a concurrent decline in capital flows coming into the country. When the oil price crashed circa 2014, the value of our exports dropped meaning we started earning less FX than we were spending, creating downward pressure on the naira and a gap that has to be closed somehow.

I will admit that it puts both politicians and central bankers in a difficult position. They can choose to either:

1. let the currency depreciate

2. increase interest rates or

3. spend down foreign reserves.

These choices all result in bankers getting less economic growth per unit of inflation. Realistically, raising interest rates to fill a balance of payments gap isn’t an option. If the currency is expected to decline 5% in a year, then interest rates would have to go up by 5% to keep it at the same price. So even a very small currency decline means a huge interest rate premium. Increasing interest rates by 5% in a year is enough to crash many economies. Now imagine a 5% currency decline per month, it would mean interest rates increasing by 80% per year, and then remember that the naira depreciated 10% just last week on the parallel market.

This leaves bankers with the choice of either spending down reserves or allowing the currency to depreciate. Most central banks choose to defend their currency and Nigeria is no different. Due to ideology* we also got additional measures like capital controls and import restrictions all to close the FX gap. While Central bankers are happy to spend reserves to defend the currency, most sensible ones will not risk running out of savings, so they will still allow a managed depreciation of the currency which is what we have seen for the IEFX rate in Nigeria.

In all inflationary depressions, currency depreciation translates to more expensive imports, much of which is passed on to consumers, resulting in a sharp rise in inflation. The way policymakers manage the currency decline during these depressions greatly affects how much inflation there is and how it plays out.

A gradual and persistent currency decline causes the market to expect continued currency depreciation, which can encourage people to speculate and send their money abroad, widening the balance of payments gap. A continual devaluation also makes inflation more persistent, feeding an inflation psychology. The CBN in this 2018 study found that “Expected inflation constitutes the most significant predictors of inflation in Nigeria.” Talk about inflation psychology. We’ll come back to why this is particularly bad.

Counterintuitively, it is better to have a large one-off devaluation. This only works when the currency is devalued enough that there are both willing buyers and sellers and there is a positive total return for holding Naira. If the currency falls enough very sharply, people won’t expect more devaluation. The 2016 recession followed the archetypal inflationary depression to a tee. Despite the very large devaluation, other poor policy choices have meant that we haven’t had the sort of recovery you would expect.

Perhaps naively, I always thought there was no theory behind Meffynomics and everything was just being done Jaga Jaga. The reality was shocking and worse. Buhari, and by extension Meffy, believe in and practice import substitution industrialization (ISI). It’s why after escaping a long-term depression by the hem of our garments, the government decided to shut its border during a trade surplus to “stop smuggling” and “boost local production”. Make no mistake; the government budget deficits and current account deficits are features of Import Substitution Industrialization which is part and parcel of the African socialism that their generation of politicians came up on.

The Spiral from a More Transitory Inflationary Depression to Hyperinflation

The research is very clear. The most important characteristic of cases that spiral into hyperinflations is that policymakers don’t close the imbalance between external income, external spending, and debt service, and keep funding external spending over sustained periods by printing lots of money. As of June 2022, the CBN has printed N19 trillion (almost $50bn) to finance Buhari’s government deficits over the last 7 years via the Ways and Means advance.

When continual currency declines lead to persistent inflation, it can become self-reinforcing in a way that nurtures inflation psychology and changes investor behavior. With each successive currency decline, savers and investors, who were burned before, now move to protect their purchasing power. They are quicker to short cash and buy foreign and physical assets. You see this today where many people without USD expenses convert their entire salaries to dollars when possible. The result is currency devaluation that no longer stimulates growth.

Understandably, as inflation gets worse, depositors want to be able to spend their money as fast as possible and put them into real assets. As it continues to worsen, people would be happy to get loans to short cash because it is so profitable to do so. Frighteningly, it seems people are becoming confident enough to take out bank loans to buy dollars at the parallel market rate because the interest rates on the loans are less than the amount of depreciation. Something that I think gets swept under the rug is that as the currency declines, the burden of the debt increases in local currency. Whatever ‘low’ debt to GDP numbers we have can be nearly instantly ramped up by severe depreciation.

It’s easy to see how these forces can create a feedback mechanism that causes inflation and currency declines to escalate until people completely lose faith in the currency and people aren’t willing to hold more than a few days of cash at once. I’m not saying we are destined for hyperinflation especially because some of our metrics are slightly better than the averages in the image above - but of course, averages are misleading and it also assumes that Nigeria’s data is accurate.

Modern capital market theory is a good starting point in building a framework for understanding risk, with some important caveats. Capital Market theory defines risk as volatility because volatility indicates the uncertainty or unreliability of an investment. Volatility, especially in the context of standard deviation or variance, provides objective numbers with historical values that can be used for calculations and financial models, and truly, there is no substitute for these purposes.

As Howard Marks put it, volatility certainly can be a symptom or an indicator of riskiness, or even a specific form of risk. However, it is not the risk most investors are concerned about. Investors don’t seek higher returns because the price of an asset may show big fluctuations, rather, they seek higher returns primarily because they are afraid of losing money [1]. A downward fluctuation does not present an issue as long as the investor can hold on and come out the other side, but a permanent loss can never be undone. So, I will define risk, like many value investors have, as the likelihood of permanent capital loss.

Where everyone can agree with academicians is that risk is a bad thing. Much of modern economic and financial theory is based on an underlying assumption that people are naturally risk-averse and, ceteris paribus, they would rather take less risk than more risk. Given this assumption, investors must be enticed with the prospect of higher returns in order to take incremental risks.

If, for example, a group of rational investors are given the choice between a government security that promises 7% per year (with the knowledge that governments can simply print money to pay them back so will not default) and a small startup stock likely to generate the same return, investors will rush to buy the government security (thereby increasing its price and reducing its return) while the latter will be dumped, driving down its price and increasing its potential return. This process is called equilibration and it is the mechanism by which markets adjust relative prices to make returns proportional to risk.

Defining and understanding this process is quite important because while the positive relationship between risk and return is well understood by the average person, that relationship, without an understanding of the mechanism that drives it, can breed fallacies. One such misconception that is particularly common in bull markets is “If you want to make more money, you must take more risk because riskier investments provide higher returns”. reality is that riskier investments must offer the prospect of higher returns in order to attract capital. If riskier investments consistently produced higher returns, they simply would not be riskier. This misplaced reliance on the benefits of risk-bearing has led many investors to some very unpleasant surprises. The process of equilibration and the subsequent positive relationship between risk and return culminates in a familiar capital market line illustrated in Figure 1.1 below.

The capital market line illustrates the positive relationship between risk and return; investments that seem riskier must appear likely to deliver higher returns; otherwise people will not make them. In a rational market, the price of a risky asset will be set low enough that the reward for holding them appears to compensate for the risk sufficiently.

This brings us to the unique situation in the Nigerian capital markets and what I view as a breakdown in the risk-return relationship.

As with many developing countries, inflation remains relatively high and the risks that investors are primarily concerned with avoiding are related to the erosion of their purchasing power. A secondary issue, yet equally important to investors, is protection from currency devaluations in Nigeria. In reality, these two issues are effectively the same due to relative purchasing power parity.

The law of one price dictates that an identical asset or commodity will have the same price globally, regardless of location (assuming a frictionless market). This exists because differences between asset prices in different locations would eventually be eliminated as market equilibrium forces align the asset prices due to the arbitrage opportunity. Exchange rates are designed such that the rate of exchange is equal to the ratio of price levels between two countries. As inflation erodes purchasing power at different rates in different countries, the price levels change and so do the exchange rates.

As inflation in Nigeria is generally higher than the United States, the currency is devalued to maintain parity. This erosion in purchasing power is fairly constant but appears lumpy due to the fixed exchange rate system operated by the Central Bank of Nigeria. The difference in the rate of inflation between the two countries has averaged around 10% per year and changes in the actual exchange rate have roughly matched that over time. This is illustrated below in Figure 1.2 which compares the official exchange rate to the nominal exchange rate calculated using the yearly inflation differential between the US and Nigeria using 2010 as the base year.

In 2010, N1,000,000 was worth approximately $6600 and by the start of the next decade, the same N1,000,000 would only be able to purchase $2500 worth of goods. In other words, for investors to have avoided an erosion of purchasing power and earned a zero US dollar return, their N1,000,000 must have grown to N2,600,000 over 10 years representing a CAGR of 9.99%.

Importantly, Inflation in Nigeria has averaged around 11.9% annually over the last 10 years. In an attempt to beat inflation and earn a positive real return, investors also protect themselves from the risk of devaluation because movements in the exchange rate are correlated with, if not caused by, the difference in inflation between the US and Nigeria as illustrated in Figure 1.2.

Average yields on naira securities such as treasury bills and FGN bonds over the last decade show that investors have demanded an average return that closely matches or beats inflation as the risk-free rate. This is illustrated below in Figure 1.3 tracking the average annual true yield on treasury bills with the rates of inflation. Treasury bills were selected as the proxy for the risk-free rate because they lack reinvestment risk due to being zero-coupon securities, and their yields at auction more closely represent investors' demands.

Given the high rates of inflation and the subsequently high rates of return on risk-free securities, we would expect the capital market line for Nigeria to be shifted upwards but to maintain the same positive relationship between risk and return whereby investors are compensated for bearing incremental risks with incremental returns. Moving up the risk curve to equities, we should expect that equities will offer a significant return over the risk-free rate, otherwise investors would not allocate capital towards them. Yet over the course of the last decade, fixed income and even riskless securities have outperformed the equities market and quite significantly in certain instances.

The extra returns demanded (or that should be demanded) by investors in order to invest in stocks is the equity risk premium. It is fairly common practice to estimate the equity risk premium by analyzing historical data on the market returns of equities compared to the risk-free rate. Given the fact that the returns on risk-free securities exceeded the return on equities in Nigeria over the last ten years, an analysis of historical risk premiums would not yield much insight.

Even if the equity risk premium were not negative, the results generated from historical premiums tend to be overly sensitive to the amount of data used and a 10-year time period would result in standard errors in excess of 6%. The choice of Treasury bills or Government Bonds as the riskless security and whether an arithmetic or geometric average is applied also cause large variations in estimating the equity risk premium.

Due to the challenges associated with historical premiums, we can once again turn to the capital asset pricing model to estimate the equity risk premium. I lean particularly on the work of Aswath Damodaran, a renowned professor of finance at the Stern School of Business at New York University. His estimation method uses the difference in Credit Default Swap (CDS) spreads between the United States and the target country to arrive at a country risk premium that is added to the implied equity risk premium of the S&P500 to come at a total equity risk premium [1]. Applying this method to Nigeria yields an estimated equity risk premium of 10.05%.

Having estimated the equity risk premium above, we can calculate the cost of equity using the capital asset pricing model:

Cost of Equity = Risk-Free Rate + Beta x Equity Risk Premium

For the risk-free rate, we start with the interest rates on long-term FGN bonds but subtract the country default spreads because investors perceive default risk in the Nigerian Government. We arrive at a ratings-based default spread of 4.82% based on Nigeria’s B2 rating by Moody’s[2]. Using these inputs results in a cost of equity of 19.18%, which is how much investors should demand from equities to compensate for the risk.

Naturally, the question that follows is why haven’t Nigerian equities returned enough? The answer seems deceptively simple; the listed companies have a return on equity far below this, so most businesses just are not profitable enough to compensate for the risk of doing business in Nigeria. There are, however, companies that have returned more than the cost of equity (and quite consistently for over a decade). Yet, their total shareholder returns do not meet this benchmark we arrived at in the preceding paragraph. For a company to return, say, 30% on its equity, year after year but not receive a commensurate 30% total shareholder return implies that the market constantly de-rates these companies and is willing to pay less for each Naira of earnings. Naturally, this has led to Nigerian stocks being much cheaper relative to their emerging market peers and relative to the Nigerian market’s own historical valuations.

I didn’t intend for this post to explore the potential reasons why this is the case but rather to prove that there is a breakdown in the risk-return relationship, and it is most likely because our companies are being priced exceptionally harshly. I will also say that investors are people, and people don’t always act rationally. I don’t think it’s surprising that investors are pessimistic when the country has gone through one of the worst economic stretches in its history. However, does it make sense to price its stocks as though the country will never recover? I think not.

[1] Marks, H. (2011). The most important thing. Columbia University Press.

[2] Damodaran, A. (2021). Country risk: Determinants, Measures and implications — the 2021 edition. SSRN Electronic Journal

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