Monday, April 16, 2018 03.58AM / By Bode Agusto
Text of a paper presented by Bode Agusto at the 2018 Vanguard Newspaper’s Annual Economic Discourse held in Lagos, 13 April 2018.
2. Setting the scene
1. The central government – the FGN
2. The State Governments & Local Government Areas (LGAs)
3. Partnering with the private sector
5. The external sector
6. Money and banking
Please let us start by debunking certain myths in our country.
First, “Nigeria is an oil rich country.” False, because oil revenue per person per annum in Nigeria in 2013 when crude oil prices averaged over US$100 per barrel was US$520. In Qatar and Kuwait, it was US$31,000 and US$27,000 per person respectively. Those are the oil rich countries because there isn’t much that anyone can do with US$520 per person per annum.
Second, “Nigeria’s population is a strength.” False, population is only a strength if it is well educated, healthy, the economy has the capacity to provide them with employment and households have enough income to buy goods and services produced by businesses.
Thirdly, “Nigeria’s debt to GDP ratio is below 20%, one of the lowest in the World. Therefore, we are not overleveraged and can continue to borrow to finance infrastructure spending.” Again, false, measuring the level of leverage as a percentage of national income is misleading for a country like Nigeria. This is because the presumption is that a large national income generates a large amount of tax revenues. This is untrue of Nigeria – we don’t pay taxes – therefore debt as a percent of revenue is a more meaningful ratio for us. By this measure, the local currency debts (LCY) of the Federal Government of Nigeria (FGN) is 325% of her revenues. According to Fitch, the ratings agency, the median for countries in Africa and the Middle East is 200%. Interest on loans is 50% of FGN revenues whereas Portugal, a country with a debt to national income ratio of 130%, uses only 11% of her revenues to pay interest on her loans. Of course, we are overleveraged!
Lastly, “Our problems cannot be solved.” Again, false! Of course, they can be solved - with sincerity of purpose and presence of mind. We all know the challenges facing our economy therefore the purpose of this paper is to set out how we can return our country to the path of growth and prosperity.
SETTING THE SCENE
To set the scene, there are five key sectors in every economy:
1. The central government, in our case the FGN, which levies and collects taxes, spends the tax revenue to fulfil the purpose of government and if it is still short can print money to fund her spending. Some of us call this printing of money by a central government legal counterfeiting.
2. The external sector which covers transactions between a country (Nigeria) and the Rest of the World. It covers trade, capital flows and exchange rate policy.
3. The financial sector, largely the banking sector, whose principal role is to take deposits and lend these to businesses to grow output and to households so that they can become homeowners.
4. Businesses, who invest in new machinery & inventories and employ people to grow their output and make profits.
5. Households, who buy the goods and services produced by businesses and decide how much to spend on these goods and services and how much to save.
The finances of the central government are of course managed by the FGN. The central bank regulates the banking sector and usually determines the exchange rate policy. The FGN and the central bank manage trade and investment policies. The first three sectors should help businesses and households to thrive. When they do this well the output of the Nation grows.
There are also three key prices in every economy namely inflation rate, interest rate and the exchange rate. In my opinion, the rate of inflation is the most important amongst the three because it drives both interest rates and exchange rates. The annual rate of inflation is the rate at which the local currency loses purchasing power every year. Margaret Thatcher calls inflation “the unseen robber of those who have saved.”
Knowledgeable investors always take expected inflation into account when making investments – they always want their return on investment to beat expected inflation otherwise they will lose purchasing power.
The long-term rate of inflation is linked irreversibly to exchange rates. For example, between the year 2000 and 2015, the average annual inflation of the Swiss Francs (SWF) was 0.1% while that of the USD was 1.8%. In fact, in each of those years except one, US inflation was higher than the Swiss inflation. This means that, during this period, the USD lost purchasing power faster than the SWF. The USD was thus the weaker of the two currencies. What happened to exchange rates? At the end of 2000, you needed 62 US cents to buy one Swiss Franc (SWF) but by the end of 2015 you needed US1.00.
The same principle applies to the Nigerian Naira vis-à-vis the USD. During the same period, average annual inflation in Nigeria was 11.2% while US inflation was 1.8% and the Nigerian Naira of course depreciated against the USD. A key takeaway is that anyone who promises stable exchange rates without explaining how he/she will deal with the difference in inflation cannot deliver on this promise in the long term.
Nigeria is an oil exporting nation, therefore, we shall add a fourth key price to these three – the price of crude oil.
Finally, I am not a fan of the current political structure. I believe it is too expensive and gives too much responsibility to and concentrates too much resource at the center. However, I believe that it is unlikely that we make significant changes to it in the near term. I have therefore assumed that the current structure is what we are going to use to implement the reforms I have outlined in this paper.
Now let’s delve into the work proper.
In my opinion, Nigeria’s biggest problem is uncontrolled population growth.
Let us put things into context. Every year, we add 5 million people to our population. This is roughly the size of Liberia or Montenegro. According to www.populationpyramid.net, in 1960, the population of the UK was 52 million while that of Nigeria was 46 million, by 2015 the UK was 62 million while Nigeria was 185 million and by 2070, Nigeria will be 550 million while the UK will be only 80 million! This means that over a period of 110 years, Nigeria will add over 500 million to her population whilst the UK would add only 30 million and the UK was coming from a higher base. This is frightening!
The wealth of a nation is measured by the output of the nation (e.g. number of tubers of yam produced) divided by the number of people going to eat yam.
Today, we are growing the number of people going to eat yam faster than we are producing tubers of yam. This reminds me of the Yoruba adage “Plenty children, plenty poverty.” The distribution of these tubers of yam (wealth) is also heavily skewed in favor of the rich. What should we do?
Population control must enter our political agenda irrespective of religious beliefs. Before we enact policies, we should study what China, India and Singapore have done in this respect and tweak to reflect the realities of our environment.
The least we must do is to encourage families to just replace themselves by having a maximum of two children. There must also be incentives to encourage people to comply and penalties for those who fail to comply.
GOVERNMENT – THE CENTRAL GOVERNMENT – THE FGN
What should we expect from the government?
1. To levy and collect taxes from all of us.
2. To use her tax revenues to:
a. Secure life and property
b. Act as an independent regulator of businesses
c. Improve infrastructure
d. Help the poor and weak in society to access basic services
3. To maintain very sound financial condition and therefore borrow at very low interest rates.
The current situation is that non-oil taxes collected by all the three tiers of government represent about 4% of national income. In Ghana, Kenya and South Africa they are 16%, 17% and 24% respectively of national income. Tax rates in these four countries are not materially different except for VAT of 5% in Nigeria which is less than half of what obtains in these other countries.
According to OECD Revenue Statistics, tax revenue averages 34% of national income in these rich countries of the World. This makes me conclude that we can boost tax revenues significantly in Nigeria simply by improving tax compliance.
The federation account receives less than =N=10 trillion annually which is less than 10% of national income. This translates to about =N=50,000 per person per annum and Nigerian voters believe than this is enough to provide free education, free healthcare and indeed free everything for them! The joke is on us – we voters.
Currently, the FGN earns about =N=4 trillion every year, spends =N=2 trillion or 50% of her revenues on interest payments and another =N=2.5 trillion or 62.5% on salaries and unfunded pensions. This means that obligatory spending is more than 100% of her revenues! This severely constrains the ability of the FGN to spend significant sums on social services and infrastructure. Capital expenditure by all the three tiers of government in Nigeria during the last five years was 2.2% of national income. In Ghana, Ivory Coast and Kenya, capital spending was 4%, 5% and 6% of their respective national income. Even the little spending that we do is spread over many projects and we rarely complete anyone of them.
Because of the high level of obligatory spending, the FGN borrows Naira and USD to fund infrastructure spending. At the end of 2017, FGN’s LCY debt was =N= 13 trillion or US$ 36 billion at current exchange rate. In 2006 when Nigeria repaid US$ 32 billion Paris Club debts, Naira debts were under =N=2 trillion.
We have replaced Paris Club Debt with Abuja Club debts, the principal holders of these debts are the banking system, the pension funds and foreign private investors. They do not forgive debts and they charge high nominal interest rates because they want to beat inflation!
The finances of the FGN are broken! We need to fix it, if we don’t, the FGN will not be able to fulfil the purpose of government set out above. This is, in my opinion, the second most important challenge that Nigeria has.
How do we fix the finances of the FGN? We need a government that will do unpopular things – control population, cut costs, enforce tax compliance and relinquish government control over infrastructure spending.
To fix the finances of the FGN we need to do four things:
1. Generate more non-oil tax revenue
2. Reduce costs, principally interest payments and the wage bill
3. Grow infrastructure spending in a manner that will not increase debt significantly
4. Shift more responsibilities from the FGN to the States
To improve tax compliance and consequently tax revenues, the government has embarked upon a Voluntary Assets & Income Declaration Scheme (VAIDS). In my opinion, the bulk of the benefits of this Scheme will go to the States and not the FGN. This is because the greatest tax evaders are individuals and the relevant tax authorities for the administration of Personal Income Tax in Nigeria are the States.
The major federally collectible non-oil taxes are VAT, Companies’ Income Tax (CIT) and Import Taxes. States and Local Governments receive 85% of VAT and import taxes are contingent upon ability to find USD to fund imports. With weak crude oil prices, the supply of USD is short. CIT is contingent upon profits, the economy is struggling and corporate profits have suffered. Some might argue that small and medium-sized companies pay little or no taxes, “Let’s go after them”. A recent research showed that, in the UK, 1% of companies pay 80% of corporation tax. In my opinion, the concentration in Nigeria might be higher. I believe that the top 1% of companies in Nigeria are largely compliant with respect to CIT. This means VAIDS is unlikely to generate significant additional sustainable revenue for the FGN.
Although improved compliance will improve FGN revenues as well, she still needs to cut her costs. In a country of 200 million people, is it fair that over 60% of FGN revenues is paid to about one million public servants as salaries? The FGN needs to reduce the number of her employees. This should be done by offering employees early retirement on fair financial terms and the severance pay should be made promptly. Nigeria can borrow to fund this onetime payment. If enough people do not take the offer, it should be made obligatory. This should not have any significant adverse impact on the economy if the retirement benefits are paid promptly and most of the retirees employ the funds to generate economic activity. A lower wage bill should also improve the capacity of the FGN to spend on infrastructure and generate economic activity.
The FGN should also sell down some of her oil and gas assets and use the proceeds to partner with the private sector to:
1. Link every state capital to Abuja and our ports by modern rail
2. Improve the capacity and efficiency of the National Grid
3. Reduce the local currency debt burden
The railway sector should be unbundled into infrastructure and rolling stock. Investment in both railways and electric power sectors should be done in partnership with the private sector and the state governments with the private sector investors as majority shareholders. Government should regulate these industries ensuring there is fair trading. In agreeing tariffs, government should negotiate subsidies for the poor and weak in society whilst ensuring that tariffs allow efficient players to cover their costs of capital. Subsidies provided in this way will not blow big holes in the national budget. Minimum equity capital requirements should also be set for players in these industries.
In summary, the focus of our fiscal reforms should be on improving tax compliance (particularly PIT), reducing the rate of CIT and increasing the rate & base of VAT. These revenue initiatives should be complemented by cost cutting and growing infrastructure spending in two principal areas – railways and the national grid.
GOVERNMENT – THE STATES OF THE FEDERATION & LGAs
According to the Office of Management & Budget in the USA, personal income tax has averaged over 45% of fiscal receipts during the past 50 years. In 2017, it was US$1.9 trillion or 49% of total receipts. In the USA, tax revenue averages about 26% of national income which means that personal income tax is 18% of the same base.
Even if we assume that personal income tax rates in Nigeria are half of that in the USA, it means that potential personal income tax revenue in Nigeria is about =N=10 trillion, currently we collect less than one trillion. Nigerians, wake up, if you don’t pay taxes services are not going to improve! Who gets a dividend warrant without buying shares in the company?
This means that our State governments are still scratching the surface with respect to revenue generation from personal income tax. For example, Lagos State, the local champion, has a population of 20 million, 8 million taxpayers and annual tax revenue of NGN300 billion. This translates to NGN37,500 per person per annum. According to the Lagos State Internal Revenue Service, 932 people pay more than =N=10 million in PIT annually and only 210 people pay more than =N=20million. The annual income of residents of Lagos State is =N=30 trillion and the State collects only 1% of this sum as taxes. This, in my opinion, is serious underperformance.
In addition to improving compliance on PIT, States can levy and collect property tax and they will benefit significantly from an expansion of the base and an increase in the rate of VAT.
States also need to cut their costs so that they can place less reliance on borrowing to fund infrastructure.
If they can boost revenues, cut costs and partner with the private sector States can surely
• improve intra-city roads
• 1mprove outcomes from spending on education
• police their States better; and
• buy health insurance for the poor and weak
In managing their financial affairs, the benchmark for every government (state or federal) should be that obligatory spending (payroll & unfunded pensions, interest payments, and statutory transfers) not exceed 50% of revenues. This ensures that there will be free cash flow for infrastructure spending and if governments partner with the private sector in this respect they will be able to spend even more on infrastructure without contracting debts.
GOVERNMENT – PARTNERING WITH THE PRIVATE SECTOR
How should this partnership work? It should be based on three pillars namely
Government should divide infrastructure projects into two buckets and allocate a percentage of their capital spending to each. The two buckets are:
1. Projects with strong economics and strong social impact; and
2. Projects with weak economics but strong social impact.
They will then identify projects with strong economics and strong social impact (e.g. the Lagos State Light Rail Project) and prepare these projects for private sector participation. Secondly, they will provide their equity contributions and identify local investors, international development agencies and foreign businesses who will invest with them. Finally, they will agree with their partners on how each project will be governed and honor these agreements. If practical, I always recommend a company incorporated under the Companies & Allied Matters Act as the vehicle for doing business because it triggers certain corporate governance rules – annual accounts, independent audits, tax returns and accountability to the shareholders at annual meeting.
On every project, government should be a minority shareholder.
Government can then focus on spending the remaining percentage of their budget on projects with weak economics but strong social impact. This way government can do more infrastructure spending without incurring significant debts.
THE EXTERNAL SECTOR
What should we expect from the government?
1. NGN/USD exchange rate that reflects purchasing power parity
2. Policies that will improve the competitiveness of goods produced in Nigeria and will encourage the Rest of the World to trade with Nigeria
3. Policies that will encourage foreigners to set up businesses in Nigeria, employ Nigerians, use locally produced raw materials because they are available and competitively priced, ensure fair trading and allow investors to repatriate their profits
Successive managers of our economy have been obsessed with providing Nigerians with a stable NGN/USD exchange rate. However, they make little or no efforts to reduce the 10% difference in the long-term rate of inflation between the two currencies. They of course fail woefully. What then happens in reality is that, as long as our central bank has a few dollars in reserves, they use them to shore up exchange rates. When they are short of USD, mostly when crude oil prices fall, they are forced to allow large devaluations. This was how NGN/USD exchange rates moved from 1:1 to 4:1 to 10:1 to 22:1 to 80:1 to 120:1 to 150:1 to 200:1 and to 360:1 in our lifetime.
What this means is that when we fix our exchange rate relative to the USD, the Naira price of imported goods rise by 2% (average inflation rate of the major countries we import from) but because domestic prices rise by 12%, locally produced goods become expensive and uncompetitive relative to imports. This is the reason why Nigerians seem to prefer imported goods to locally produced ones – “Human beings are economic agents; they react to incentives!” If our incentive structure makes it cheaper to import toothpick instead of producing them in Nigeria, people will continue to import them.
If our exchange rates better reflect purchasing power parity and we are able to make electricity and railways work, we can improve the competitiveness of domestic production significantly.
In managing exchange rates, a country has three principal policy options namely:
1. Peg to the USD
3. Crawling peg
I recommend that Nigeria adopts the crawling peg option. This means that we start from a NGN/USD rate that is close to market and the CBN then allows the NGN to appreciate or depreciate against the USD by close to the difference in inflation between the two currencies.
I don’t believe that pegging the NGN to the USD is a viable option because we don’t have sufficient reserves to back this up and the 10% difference between NGN inflation and USD inflation makes this option unsustainable in the medium term. Most importantly, it makes domestic production uncompetitive.
I have also not recommended a float because I don’t believe that our government has enough faith in the markets to allow this to operate.
In reality, when a country is a chronic net importer, she borrows from the rest of the World to finance this. A lot of African countries are in this situation – many mouths to feed and domestic production is uncompetitive and unable to keep pace with demand.
For example, Ghana has been a chronic net importer since 2004. When she was granted debt forgiveness under the HeavilyIndebted Poor Country Initiative (HIPC) in 2006 her foreign currency debts fell from a peak of USD8.0 billion in 2003 to USD2.2 billion. Because the chronic net import situation did not change, the FCY debts had grown to USD18.0 billion at the end of 2017!
In my opinion, Nigeria’s strategy on the external side should be to
What do we expect from the CBN?
1. Keep inflation low, in my opinion below 3% p.a., to protect the value of the NGN relative to the major international currencies.
2. Work with the FGN to implement measures that will aid growth when the economy is slowing down and ones that will restrain growth when the economy is growing too rapidly.
3. Ensure that the banking industry is healthy and is able to lend to businesses to grow output and households to create homeowners.
4. Lend to the FGN within statutory limits.
Ideally, central bankers like to implement monetary policy that will deliver growth and employment in a low inflation environment. The reality is that in a country like Nigeria with a fast growing population where aggregate demand outstrips domestic production, it is very difficult to achieve low inflation. Under these circumstances, politicians are always tempted to spend more than they earn and with the aid of central bankers print money to partly fund the spending and fuel inflation.
France has helped Francophone African countries deliver low inflation by guaranteeing their exchange rates in return for removing their power to print money. Although pegging their currencies to the Euro helps Francophone Africa to combat inflation, it constrains the ability of these countries implement measures that will aid growth when the economy is slowing down or restrain it when the economy is growing too rapidly.
The current reality is that the rate of unemployment and underemployment in Nigeria is close to 30%. If we could get most of these people to produce, Nigeria’s output will grow significantly. Economists will say that the potential output of Nigeria is significantly higher than the actual output. I believe that Nigeria needs to prioritize growth and employment above inflation in the short to medium term. If we control our population and grow domestic production significantly, shortages will thin out and inflation will begin to drop.
Our central bank has prioritized price stability over growth and employment. They have chosen to bring down inflation by stabilizing exchange rates. One of the key measures they employ is to make it obligatory for banks in Nigeria to keep 27.5% of the deposits they mobilize at the CBN sterilized and interest-free. This translates to 13% of the total assets of the banking industry. Banks are also obliged to keep 30% of their total assets liquid in order to meet their demand obligations. The annual budget deficit of the FGN averages =N=2-4 trillion and is financed largely by domestic borrowing. Banks like to hold these government securities because they are risk-free, qualify as liquid assets, bear interest at commercial rates and the interest income is exempt from tax whereas interest on loans to businesses and households are subject to tax.
Again, the incentive structure favors lending to the FGN who uses the money to pay salaries and interest on loans instead of lending to businesses to grow the output of the nation.
The long-term rate of inflation is about 12% p.a. and the short-term rate is even higher. Banks and pension funds that lend short-term money to the FGN seek to beat inflation. This means that they want to lend to the FGN at inflation plus a premium. This is reflected in the yield on FGN 90-day treasury bills an important benchmark rate in the economy currently about 12%. No other person should be able to borrow for a similar tenor at a lower rate because the FGN can print money to repay! Businesses will therefore borrow for similar tenors at this risk-free rate plus an appropriate risk premium.
Individuals are typically riskier than businesses and if they want to take a tenyear mortgage, an appropriate pricing will be about 25% per annum. Put this on an excel spreadsheet and you will see that the borrower will most likely default. The rich World is therefore obsessed with keeping long-term inflation below 3% so that households can borrow long-term at 5-7% p.a. to own their homes. This is the way they create homeowners; government cannot afford to build subsidized homes for all its poor people.
Today, monetary policy provides short run exchange rate stability but impairs the health of the banking sector by reducing industry profitability through high mandatory non-interest bearing cash reserve requirements. Agusto & Co. Limited estimates that the high CRR and the AMCON levy of 0.5% of total assets reduces that ROA of the banking industry by about 2%. If the CBN were to reduce CRR to 10% and abrogate the AMCON levy, banking industry after-tax ROE will jump from the current level of 14% to about 24%. What these negative regulations mean is that banks are unable to grow their capital by making and retaining profits neither are they able to attract investors because their ROE is less than the yield one year FGN securities. No wonder most listed banks are currently valued below book value and maybe only two or three can successfully raise money from the market. Remember capital is what cushions depositors’ funds against losses.
Monies that banks could have lent to businesses and households are either sitting at the CBN as non-interest bearing cash reserves or have been lent to the FGN because the after tax return on this risk-free investment is higher than what the bank will earn giving risky loans. This is another example of a situation where the incentive system hurts the economy. Government should not exempt interest on government securities from taxation.
The CBN and the FGN are pulling the economy in different directions; the CBN pursues a monetary policy that restrains growth in a weak economy; while the FGN is trying to stimulate growth by “spending her way out of the recession”.
The FGN and the CBN need to work together implementing policies that will promote growth and employment even if this means some inflation in the short to medium-term. This means that we shall allow a weak Naira that will make domestic production more competitive relative to imports. If this is accompanied by electric power and railways it will boost domestic production, reduce our import dependence and ultimately bring down inflation.
How can government help businesses thrive? Government needs to
1. Allow the private sector to own and manage the key sectors of the economy.
2. Allow producers of goods and services to set their prices but they should negotiate subsidies for the poor and weak in the society.
3. Regulate private sector businesses ensuring there is fair trading and service/product quality meets minimum expectation. Government should be independent of these businesses and should not institute price controls.
4. Provide legal and fiscal incentives to industries she wants to grow
5. Encourage (not force) players in these industries to list their shares on the Nigerian Stock Exchange
In my opinion, the key industries that the FGN needs to promote are
1. Oil and Gas
2. Electric Power, and
With respect to oil and gas, the FGN needs to sell down its equity stake in the Joint Ventures, become minority shareholders in these JVs, encourage the shareholders to incorporate them and list these companies on the Nigerian Stock Exchange. This means that the annual report and accounts of these companies will be audited by independent accountants, made public and the directors accountable to shareholders at annual general meetings. This proposed change in ownership structure and vehicle for doing business will
About the Author:
2.The Hard Facts To Rescue The Nigerian Economy - Proshare Apr 05, 2017
3. Beyond Recession, Towards A Resilient Economy - Proshare Jan 20, 2017
4. Can a New Buharinomics Save Nigeria? - Proshare Nov 20, 2015
5. PDF -Soludo on Buharinomics: Lecture Paper - Proshare Nov 19, 2015
6. The Quadrilemma of Buharinomics - Temitope Oshikoya Jun 03, 2015