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Assessing the Macroeconomic Direction for 2017

Proshare

Wednesday, November 23, 2016 12:29  PM /CardinalStone Research

On September 30, President Buhari submitted the 2017-2019 Medium Term Expenditure Framework (MTEF) and Fiscal Strategy Paper (FSP) to the National Assembly for consideration and approval.

The MTEF comprises baseline assumptions/projections for the 2017 budget as well as a budget peformance report for H1 2016. Following approval from the upper house, amidst reviews and adjustments, the 2017 budget is expected to be submitted in December and signed into law by March 2017.

In this report, we provide some insight into assumptions and baseline projections for the 2017 budget, and provide a forecast of macroeconomic activity in

2017.

2017 Budget – Assumptions & Rationale


Government’s rationale
Given the likelihood of sustained volatility in oil prices – amidst slightly improving global demand, Iran ramping up production to pre-sanction levels and with OPEC’s plan to freeze production yet to materialize – government pegged its oil price benchmark at US$42.5/bbl.

Despite the challenges with oil production which include oil theft, pipeline vandalism and production shut-ins, government pegged its oil production at 2.2 million barrels per day.

Although actual oil production have remained consistently below 2016 budget so far this year (Figure 1), government is optimistic of a gradual uptick given its planned engagement with oil producing communities and renewed efforts towards enacting the Petroleum Industry Bill (PIB).

Although no specific detail was put forth as to the basis for a N290/US$ exchange rate assumption, government stated that it upheld the objective of improving investor confidence by putting forth strategies to ensure a more predictable and market reflective naira-dollar exchange rate.
 

2017 budget - revenue and expenditure highlights


Total capital and recurrent expenditures are 10.2% and 14.8% higher than in 2016
Proposed expenditure for 2017 is about N6.86 trillion (US$22.5 billion), 13.3% higher (in naira terms) than the expenditure presented in 2016 budget. Total capital and recurrent expenditure as percentages of total expenditure is 31.1% and 68.9% respectively.

Capital expenditures exclusive of statutory transfers is 11.2% higher than in 2016 and non-debt recurrent expenditures, which is for payment of salaries and pensions, is 9.3% higher than in 2016.

The key theme around increasing expenditures in 2017 is the need to boost infrastructure spending which is necessary to bail out the economy from recession. Debt service is 39.3% of revenue which is higher than the 35.3% level in 2016’s budget.

Government expects oil and tax revenues to be substantially higher in 2017, while independent revenues will remain subdued
Oil revenues in 2017 are estimated at N1.38 trillion (US$4.5 billion), about 70% higher than the projection in the 2016 budget. The federal government is optimistic that ongoing talks with oil producing communities as well as an expected rebound in oil prices - as OPEC plans to cut production and prop up price, will bode well for the oil market next year.

Non-oil tax revenues are projected to increase marginally by 4%. Customs collections are expected to come in lower because of the effect of recent monetary policies and the introduction of new tax policies including the introduction of Common External Tariff (CET) and the removal of Import Adjustment Tax (IAT).

Company Income Tax (CIT) projections are higher as government doubles efforts on broadening the tax base and improving the overall business climate. According to the MTEF, 700,000 companies were added to the tax base in 2016 and the Federal Inland Revenue Service (FIRS) is projecting a 10% year-on-year improvement in its collection efficiency. Value Added Tax (VAT) is predicated on an estimated national consumption of N80.1 trillion (US$262 billion) in 2017 down from N91.9 trillion (US$301 billion) estimated for 2016.

The VAT rate will be maintained at 5% and VAT collections are projected to increase by 42%. Leakages and weak accountability in government owned enterprises (GOE’s) and other revenue generating agencies, continue to dampen efforts at improving independent revenues.

Although independent revenues were reviewed downwards by about 20%, government expects that some of the reforms which have been ongoing including the Treasury Single Account (TSA) and a stipulation of a maximum cost-to-income ratio of 75% will yield improvements.

Fiscal deficit at 2.5% of nominal GDP
Government’s forecast of gross domestic product (GDP), which largely influences its fiscal deficit position, stands at N108 trillion (US$354 billion) - a 10.3% increase over 2016 forecast and a 15.5% increase over 2015 actual nominal GDP.

Fiscal deficit is 2.5% of GDP, higher than 2.2% in 2016 and safely below the 3% threshold stipulated by the fiscal responsibility act.

Our view – how realistic are the budget assumptions? How large is too large for recurrent spending?

2.2mbpd production depends on tempered militancy activity in Niger Delta
Oil production at 2.2mbpd is largely dependent on the success of ongoing talks with the Niger Delta community. Even then, the assumption is largely optimistic as oil production has consistently underperformed budget estimates in the last 3 years.

Just hours after the federal government had concluded talks with veteran leaders of Niger Delta states early this month, the Trans-Forcados pipeline was vandalized.

The government is between the devil and the deep blue sea given that most of the demands from militants are far reaching and military efforts have been mostly unsuccessful.

Some of the demands included the relocation of administrative and operational headquarters of International Oil Company’s (IOC’s) to the region, inclusive policies that favor the region in the allocation and ownership of oil & gas assets, amongst others.

We think a realistic oil production benchmark for the budget is 1.9mbpd based on average oil production over the last 4 years. A higher oil production is dependent on fresh exploratory activities and increased investments in the oil & gas sector.

The US$42.5/bbl. oil price assumption is prudent and realistic
A planned deal by OPEC to cut output by between 500,000 and 700,000 barrels per day, and expectations of supply/demand rebalancing next year, may lead to a higher realized oil price than the benchmark used in the budget.

The World Bank in October 2016 raised its 2017 oil price forecast to US$55 per barrel from US$53 previously – a 29.4% upside to the budget benchmark.

Therefore, there’s a strong likelihood that realized oil price for 2017 might be higher than the benchmark used in the budget, hence some savings can potentially accrue to the excess crude account assuming the oil production benchmark is met. 

Exchange rate assumption – too optimistic
We believe that the N290/US$ exchange rate assumption is largely impractical given the current state of the foreign exchange market. The over 50% premium of the parallel rate (N460/US$) over the interbank rate (N305/US$), due to the chronic shortage of FX, fuels the incentive for further speculative attacks on the currency. FX scarcity will be prolonged if capital controls continue and the FX market remains tightly managed.

Government expenditures are still mostly recurrent
Although government projects a recurrent non-debt spending of 37% of total expenditure and capital spending (excluding transfers) of 26%, actual recurrent non-debt expenditures, chiefly comprising salary and pension payments, have historically taken up the bulk of total expenditure (over 50%) while actual spend on capital projects (excluding transfers) have accounted for a smaller percent (12.7% in 2015) – see Appendix.

The budget performance so far in 2016 (January to June) shows recurrent non-debt at 61.2% of total expenditure and while capital projects accounted for only 7% of expenditure.

Federal government needs to pay particular attention to its recurrent spending especially given the need to plug an infrastructure deficit necessary to pull the economy out of recession.

There is the case however of a direct transmission on consumption demand and in turn output growth, of sustained employee incomes. The increase in debt service cost is the direct consequence of higher borrowings throughout the course of 2016.

As at October 2016, the federal government had issued about N964.5 billion (US$3.2 billion) worth of bonds, an over 40% increase over the amount issued as at October 2015.

Also, issuances of Treasury Bills have so far been higher than in 2015. From all indications, total domestic borrowings in 2016 will exceed the planned borrowings stipulated in the 2016 budget.

Nominal GPD basis for fiscal deficit is unrealistic
The N108 billion (US$354 billion) nominal GDP projected for 2017, the basis for a 2.5% fiscal deficit, translates to a 3.02% growth in real GDP. We think this is rather too optimistic as the economy is still reeling from the impact of the drastic fall in oil prices.

In fact, widespread expectations for 2016 real output is a contraction of over 1.0% and with no clear direction yet on FX – the biggest culprit behind the country’s woes, a 3% growth may be far-fetched.

To improve output however and ensure wholesome growth, government must focus on investments in infrastructure especially power and transport. In the short term, heavy FX inflows are needed to provide support to the manufacturing sector and ease inflation pressures that have squeezed profit margins for companies in the sector.

Our macroeconomic projections for 2017
A number of macroeconomic outcomes foreseen in 2017, amongst other factors, is largely hinged on the direction of policy for the foreign exchange market. We discuss our macroeconomic projections under 3 scenarios centered on FX – a bull case, a base case and a bear case.



FGN’s external borrowings plans for 2016/2017
The federal government plans to borrow a total of US$30 billion between 2017 and 2019. The borrowing plan includes a US$4.5 million Eurobond program, a US$1 billion budget support facility from the AfDB and yet to be disclosed sums from multilateral agencies including the World Bank, the Japan International Cooperation Agency (JICA) and China’s Exim Bank.

The borrowings are anticipated to shore up FX supply which, if sufficient, can lead the CBN to minimize its tight grip on naira liquidity. Following from this, the ministry of finance recently announced that the country has secured $500 million in investor commitments towards the planned first issue of US$1 billion in Eurobonds and, the board of the AfDB announced its decision to approve US$600 million out of the US$1 billion pledged as budget support facility.

These are however very little compared to the current need for FX. In fact, between June and October the CBN has sold US$4.1 billion in forwards just to clear backlogs, and this is substantially higher than the US$1.6billion anticipated from the Eurobond sale and the AfDB.

There is however an optimistic possibility of an Indian deal worth US$15 billion which will see the country export crude to major refineries in India. Details however remain sketchy and so it is yet to be known what terms will be laid out.

Bull Case – GDP Growth: 2.1% & Headline Inflation: 16.4%
For our optimistic scenario, we assume a fully liberalized FX market with a tight band of N10-N20/US$ between rates at the interbank and parallel markets. In this instance, we foresee a further depreciation of the interbank rate and a consequent knee-jerk reaction of domestic prices especially for items directly impacted on by FX – imported food items and petrol.

We think however that if government successfully secures large inflows from borrowings (and other sources) at the same time that the market is fully floated, rates at the interbank and parallel rates may find an equilibrium around N410-N450/US$. The uptick in domestic prices will therefore be short-lived and coupled with the consequence of a base effect, inflation will ease gradually, ending the year at around 13% - with average inflation for the year projected at 16.4% in this instance.

The positives for the manufacturing sector include an increase in capacity utilization given that production lines earlier closed down due to the difficulty in sourcing FX to pay for inputs, will be put back to work. Other critical sectors such as trade and financial services are also expected to benefit from the increased availability of FX.

Overall, we foresee gross domestic product (GDP) growth of 2.1%. Under this scenario, we also forecast that investor sentiments will improve significantly and translate to significant returns for both the equities and fixed income markets in 2017.

Whilst we acknowledge that a full liberalization of FX market may not be easily desirable in the Nigerian context where economic and political decisions interfere to a large extent, we reiterate that economic decisions taken against market forces only result in very negative consequences in the long run.

Government can take proactive steps to minimize any potential unrests in reaction to a further depreciation of the Naira through palliative measures. Such palliatives could be in form of additional mass transit schemes, hastened efforts towards actualizing the school feeding and graduate employment programs.

We also assume under this scenario that the restiveness in Niger Delta is contained. This will further boosts FX inflows and additionally, guarantee consistency in government revenues.

Base Case – GDP Growth: 0.8% & Headline Inflation: 18.1%
Our base case scenario assumes that government secures only 1 or 2 of its planned borrowings (in Q1’17) without fully floating the FX market. Our expectations are that only about US$2 billion worth of borrowings will be secured without a shift in the current FX stance – US$1 million each from the AfBD and Eurobond issuance.

As has been the trend, these inflows are likely to be spent settling matured and new letters of credit for importers (mostly manufacturers). To the extent that FX demands from manufacturers are fully settled, we think capacity utilization and production growth will be positive albeit subdued in 2017.

We forecast a marginal output growth of 0.8% on bets that the inflows secured through borrowings may not be sufficient for 12 months. Inflation is also expected to moderate under this scenario but only in the quarter when FX inflows are secured (Q1).

We see monthly inflation slow further in Q1, first because of the high base of 2016 and second because rates may stay relatively stable during the period and in March inflation may touch 15%.

However, we think that this will be short-lived particularly if the interbank FX market remains heavily influenced by the CBN.

FX pressures will reemerge once inflows are exhausted and the CBN will resort to its liquidity mop ups to stem speculative pressures. Consequently, interest rates will remain very high and the difficulty in accessing FX for imports of critical input will resurface.

Under this scenario, manufacturing output will be impacted negatively from Q2’17 onwards. Inflation will pick up in Q2’17 as well, ending the year at 20% and averaging 18.1%. FX rates at the parallel market will climb sharply and returns for equities and fixed income will drop further.

If however, government is able to ensure a 2.2mbpd production volume at US$42.5/bbl. expectations are that output growth and inflation moderation may continue into Q2’17.

Bear Case – GDP Growth: -2.0% & Headline Inflation: 21.2%
Following news that potential creditors are demanding a hands-off of the CBN from the interbank FX market and with government adamant at ensuring the market does not depreciate further, there is a chance that this scenario plays out.

With no external borrowings in volumes necessary to sustain a strong improvement in the FX situation, the CBN will deplete its reserves. Under this scenario, we forecast that the economy will contract further by about 2.1% in 2017 and inflation will touch 25.5% and average 21.2% for the year. The issues at stake include social unrest and heightened socio-political tensions.
 

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