Monday, March 16, 2020 /06:36 PM / By NOVA Merchant Bank / Header Image Credit: Archival Institute
In our March Economic Insights (See report: COVID-19 Economic Disruption Going Viral?), we estimated the impact of the escalating COVID-19 on Nigeria's fiscal and external balances. We adopted average crude oil price of $59.45/bbl, which was anchored on an expected action by OPEC+ to support price and an end to the pandemic earlier in Q2. The breakdown in OPEC+ negotiations and further escalation of the COVID-19 have further amplified the downside risk for Nigeria. Accordingly, we see a need to reassess the economic cost of the continuous global shock and prolonged rift in the OPEC+ coalition on Nigeria's fiscal and external balances, domestic growth and stability in addition to assuming a more stringent crude oil price for our bear, base and bull scenarios. Further supporting our case is the revision to forecast 2020 average Brent crude price by EIA to $43/barrel in 2020, down from a forecast of $65/barrel in the January (See Report: Saudi Arabi Vs. Russia: Everyone Paying the Price).
In structuring our bull, base and bear case we assumed three key scenarios. For bull case, we assumed a quick resolution of the oil price war (oil price averaging $52.28/barrel) and containment of Covid-19 pandemic without major escalation beyond Q2 2020. On our base case, we assumed protracted oil price war (oil price averaging $45.17/barrel) and the Covid-19 is successfully contained without major escalation beyond Q2. On our bear case, we assess a situation in which COVID-19 escalates beyond Q2 2020, amidst protracted price war with oil price averaging $38.06/barrel.
While we reckon that the OPEC+ rift and COVID-19 are fluid, and could reverse quickly, the scenarios informed our view of the outturn in the event of a reversal. Below are the key revisions across key macroeconomic variables under coverage on our base case:
Current Account: Deficit on the Run as Pressure Mounts
The current account balance recorded a combined deficit of $9.2 billion over the first nine months of 2019, compared to a $4.2 billion surplus over similar period in 2018. The deepening deficit reflects rising non-oil imports â€“ which neutered the trade balance â€“ and further deterioration in services deficit. For context, trade surplus over 9M 19 contracted by 70% YoY to $5.1 billion following surge in imports by 34% YoY to $42 billion (encumbered by Naira stability which resulted in 60% jump in non-oil imports to $34.7 billion, to more than outweigh the 26% decline in oil imports to $6.8 billion). Elsewhere, exports remained largely flat (grew just 0.43% YoY to $47 billion) following 4% YoY decline in oil export which more than outweighs the increase in non-oil exports by 56% YoY to $5.7 billion. Furthermore, the services deficit deepened by 38.7% YoY to $25 billion in 9M 19 following increased personal and business travel expenses coupled with health and education related expenses, and foreign business and professional services.
Intuitively, we reckon that a sustained pressure on oil revenue will result in CBN implementing some administrative measures to limit the scale of imports (especially, nonoil import) and even services demand as witnessed in 2016 prior to the introduction of personal travel and business travel allowances. Irrespective, we model a trade deficit of $6.1 billion (compared to 2019 surplus of $5.9 billion), services deficit of $23.5 billion (compared to 2019 surplus of $31.2 billion), income deficit of $14.3 billion (compared to 2019 surplus of $12.2 billion) and current transfer surplus of $23.9 billion (compared to 2019 surplus of $25.5 billion). Overall, we believe the ongoing global shocks could extend Nigeria current account deficit to eight consecutive quarters, with 2020 deficit of $21.0 billion, exceeding 2019 level of $11.9 billion. On the downside, we note that that the deficit could widen to $24.9 billion and a surplus of $1.7 billion for our bullish scenario.
Recent Gross Reserve Depletion are a Child's Play...
Following spate of FPI repatriation amidst decline in foreign inflows, the Investors and Exporters Window (IEW) recorded a net deficit of $1.54 billion in February (See report: Double Whammy as FPI Hit on Both Sides), compared to surplus of $556 million in January. Accordingly, the CBN became a net seller at the IEW, stepping up its intervention at the window to the tune of $2.0 billion in February, compared to net purchase of $250 million in January. Reflecting the increased sales, the gross external reserve depleted by $1.71 billion. Year to date, the gross external reserve has been depleted to the tune of $2.42 billion to adjusted level of $35.67 billion.
In our maiden Economic Insight (See report: Temporary or Sustained Relief at the IEW?), we had modelled a scenario of prolonged lower crude oil prices for the rest of H1 2020, with year average of $59.45/barrel (which reflects possible actions by OPEC+ to support price and a possible end to the pandemic earlier in Q2). Also, coupled with a possible escalation of the rate of repatriation, we estimated that the gross reserve could decline to as low as $32.3 billion at the end of the year. Adjusting our bonny light price forecast (with forecast Brent price adjusted for average 2019 Brent-Bonny spread) while leaving production unchanged at 2.05mbpd, we now expect oil inflow to the CBN to decline to $11.55 billion over 2020, compared to $16.02 billion in 2019.
Also, we expect the global risk-off sentiment and the dwindling reserves to limit the rate of portfolio inflows, even as more funds exit the economy. Accordingly, we see limited avenue for CBN to shore up the reserve with our model suggesting the reserve could decline further to $26.73 billion at the end of the year. On the downside, we note that it could deplete to $25.38 billion and $28.11 billion for our bullish scenario. Irrespective, Eurobond issuance will provide a $3.30 billion upside to the varying scenarios. While the worsening reserve picture begs the question of when the foreign exchange rate will reflect fundamentals, we believe the apex bank would first adopt some administrative measures, roll out further unorthodox policies or reversal of some of the policies implemented in 2019 to curb further dwindling of the reserves before necessarily succumbing to adjusting the FX rates. On our fundamental based purchasing power parity, we believe the Naira is 12% overvalued, and a likely adjustment could see the exchange rate weaken to ~N405/1$.
On the Eurobond Issuance, while average FGN Eurobond yields expanded 47bps MoM in February, the escalation of Covid-19 and expectation of stimulus measures by monetary authorities in advanced economies resulted in increased demand, with yields contracting 30bps compared to the end of the month. With the fall-out of OPEC+ deal and mounting pressure on the FGN, investors dumped FGN Eurobonds with yields now higher on average by 308bps compared to February month end. While we do not rule out the ability of the FGN to issue the proposed $3.3 billion Eurobond, we believe it will come at a significant cost or could result in a delay till when market conditions are more favorable. For context, the January 2021 $500 million Eurobond, which is expected to be refinanced now trades at 8.47%, compared to yield at issuance of 7% and February close of 3.27%.
Dwindling Fiscal Revenue - History Repeating?
In our NOVA Economic Outlook (NEO) H1 2020, we had dissected the 2020 fiscal act and our estimate of FGN revenue, and expenditure over 2020. Our estimate was based on average crude oil price of $60.51/barrel over 2020, while we also adjusted expected revenues from other sources. As a result, we guided to FGN revenue of N4.18 trillion, and assuming a budget implementation rate of 84% we estimated 2020 fiscal deficit at N3.93 trillion on our base case. Also, in our first assessment of the impact of Covid-19 on the fiscal balance, we raised the likely budget deficit to N3.96 trillion.
Beyond actual revenue estimates, we now believe the implementation of the 2020 budget is largely doubtful with the scapegoat being the capital expenditure. Overlaying the revised average bonny light price of $45.17/barrel (adjusted for average 2019 Brent Bonny spread) on our forecast FGN oil revenue, we reckon that oil revenue to the FGN could decline 37% YoY to N1.2 trillion on our base case. While we made downward adjustments to forecast Non-oil revenue, we left independent revenue and other revenue unchanged. Accordingly, we now estimate total 2020 FGN revenue of N3.68 trillion (11% YoY), which overlaid on revised budget implementation of 78% resulted in deficit of N3.87 trillion (+8% YoY). Also, we believe the impact will reverberate across the federating units, with our model suggesting lower revenue to the states and local governments by 12% YoY to N5.37 trillion.
Economic and Price Stability - Clouds Gathering, Downpour Insight?
The Nigerian economy ended 2019 on a stronger note (See report: Q4 19 GDP â€“ Positive Surprise, But Sustainable?) with the economy expected to gain more traction in 2020. However, we believe the ravaging Covid-19 pandemic, could dampen growth over 2020 both in terms of supply chain disruptions (resulting in material downshift of manufacturing activities) and weakness of the external sector. Also, we do not rule out the impact an escalation could have on consumer spending, while a transmission impact on government revenue already suggests fiscal strain which could result in the delay of workers' salaries across the federating units with consequent impact on both trade and manufacturing activities. For us, we believe the key sectors at risk are the manufacturing, construction and trade, which combined accounted for 29% of 2019 GDP.
We had mentioned in our March Economic Insight that given the disruption to industrial activities in China, Japan, USA and the 4 largest economies in the Euro Area (Italy, Germany, France and Spain) â€“ all of which accounted for 48% of Nigeria's total imports in 2019 - could result in a slowdown in the Nigeria manufacturing sector due to limited availability of essential input materials. For the construction sector, we see the forecast fiscal strain on the FG and the federating units resulting in material downslide in the construction sector, similar to 2016. In all, we have cut our GDP growth forecast for 2020, and now look for the economy to decelerate 23bps to 2.03%. Our estimate assumed growth to return in the second half of the year as the effects of the global disruption wanes. Assuming higher than expected escalation of the virus, we estimate growth could weaken much lower to 1.84% YoY, with a bullish estimate of 2.24%.
On price stability, beyond the disruptive impact of a breakup in the supply chain on manufacturing and trade activities, we believe it could also transmit to temporary higher prices due to feedthrough from scarce imported commodities and higher demand for local substitutes. In our H1 2020 NEO we factored the impact of a possible FX depreciation, which coupled with expected higher electricity tariff, VAT increase and persisting border closure informed our expectation of inflationary trend over 2020. However, we stated that the aforementioned triggers will materialize over the second half of the year (especially the electricity tariff hike and currency depreciation).
Notably, our forecast currency movement was minimal at the time, with currency expected to trade within the band of N368-N368/$. Also, recall beyond the imported food impact on inflation over 2016 and 2017, the weakness of the Naira created incentive for local manufacturers to export, already scarce local commodities. In a way, we believe the border closure would to an extent limit the rate of export of local scarce commodities. However, we believe the import disruptions (with China accounting for 25% of imports in 2019) could result in elevated demand for local substitutes and transfer of the excess to other countries could result in higher prices for manufacturers. While we do not doubt its ability to continue to defend the Naira and provide import supplies, the invalid segment of the market will witness significant pressure as demand builds up at the parallel market. Even for the valid imports, we believe the active management of FX allocation could create scarcity and delays in allocation which will inevitably push importers to seek FX at the unofficial segment. In all, while we are yet to fundamentally assess the impact on key components of the Consumer Price Index bucket, we believe an upward adjustment might be necessary as supply disruptions intensifies.
Policy Response: Are Rainy-Day Funds Still Sufficient?
Recall, following the crash in crude oil prices from $99/barrel in 2014 to $53/barrel in 2015, net distributable oil revenue to the federation account declined by 63% YoY to N2.5 trillion and further to N1.4 trillion at the end of 2016 following a further slide in crude oil price to $43.9/barrel. Interestingly, inflow to the FGN over same periods declined at a much lower rate relative to the decline in oil revenue. Specifically, FGN retained revenue only declined 17% YoY in 2015 to N2.8 trillion, and 6% YoY decline to N2.6 trillion in 2016. Most of the supports for revenue over the period stemmed largely from drawdown across several rainy-day funds, including the Excess Crude Account. For context, total outflow from the excess crude account between 2015 and 2016 is estimated at $1.9 billion. To fund the 2020 FGN budget, we incorporated the expected foreign borrowing as approved in the budget and build scenarios on the deficit financing.
In all we believe the fiscal operation is at a more precarious state than the level over 2015-2016, as recent update indicates the excess crude account has been depleted to just $71.8 million. In our view, if the pressure on fiscal revenue as modeled in our base case materializes, we believe fiscal operations across the federating units will be in dire straits.
For monetary policy, while advanced economies have adopted several measures to cushion the effect of the global shocks, we believe the CBN is between a hard place and a rock. After initiating series of growth centric and balance sheet management policies over 2019, we believe the ongoing shocks are about to redirect the apex bank's focus strictly to price and foreign exchange stability. We will continue to study the CBN's actions over the next few weeks and advise appropriately in our March Monetary Policy Preview.
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