Heads Up on Nigeria’s Economy as major adjustments keep fiscal house together...just for now

Proshare

Wednesday, July 29, 2015 14:42 PM / ARM Research


Today ARM delves further into the domestic portion of their core strategy document – the  Nigeria Strategy Report. In this piece, they review the fiscal picture over H1 2015 and proffer outlook on same for the current year.


Depressed oil price exposes Nigeria’s vulnerabilities
Gross federally collected revenues fell to multi-year lows of N2.4 trillion (-28% YoY) over the first 4 months of 2015 on the back of softer oil receipts. Deviating from recent norms where weak oil output had been the drag on oil proceeds, low oil prices was the main culprit over this period. Nonetheless, the impact of oil price which averaged $55.28/bbl (Jan – April), 50% lower than the corresponding period in 2014, was compounded by 3% YoY shrinkage in oil output to 2.1mbpd, plunging oil proceeds to a 5 year low of N1.5 trillion (-40% YoY). On the other hand, driven by record high FGN independent revenue (FIR) in excess of N290 billion in April 2015 (April 2014: N21.6 billion), non-oil receipts rose 21% YoY to ~N1 trillion year through April, even as company income taxes softened (-9%) to N214 billion. Although breakdown of the components of FIR are unavailable, based on ~90% of this FIR being accrued to the FG, we believe the jump could be early outcome of the recent drive by FG to enforce the policy which requires MDAs to remit 25% of gross revenue. Accordingly, though the fiscal challenges dragged FG’s FAAC allocation 22% lower YoY, cumulative Federal government revenues stayed flat YoY at N1.2 trillion through April 2015, buoyed by FIR. Interestingly, the FG posted a budget surplus of N106 billion over the period by responding to the deteriorating fiscal position with a 25% YoY cut in expenditure. The cut largely emanated from non-statutory recurrent expenditure, which is N300 billion lower (-26% YoY), and statutory allocation—N40 billion below 2014 levels. On the former, despite no major report of unpaid salaries at the Federal level, the non recurrent expenditure which barely covers budgeted personnel expenses suggest MDAs experienced delayed salary payment.  Incidentally, the capex spend trails corresponding period last year by only 9%, but after averaging N45 billion monthly in Q1 15, the sharp plunge in capex to N4 billion in April suggests our prognosis, as set out in our H1 15 report, that capex budget is set to suffer under current conditions could yet pan out.

 

Figure 1: Federal government expenditure (N billion)


 

ISPO deductions compound states’ weak IGR
Although there is limited timely information on states’ financials, media reports that half of the 36 states owe salaries hints at precarious fiscal position of a number of states. In our view, this is primarily reflective of weak IGR which funds less than 10% of states’ expenditure—a risky state of affairs we highlighted in our last report—but compounded by stable irrevocable standing payment order (ISPO) deductions on debt obligations. In Lagos state for instance, high IGR to expenditure ratio (2014: 56%) masked significantly low net statutory allocation of N600 million in April after a N2 billion ISPO deduction. On the other hand, although a similar ISPO deduction trimmed Osun state’s net statutory allocation by 41% YoY to N841 million that same month, weak IGR to expenditure ratio (2014: 4%) meant there was little alternative boost to offset the relatively small deduction, exposing the state’s financial vulnerability.  As an immediate measure, the FG has agreed to the distribution of part of the Excess Crude Account, but long-term, ramping up IGR appears the only way to go.


Figure 2: Financial metrics of select states


Is the approved 2015 budget nearer reality?
With crude oil prices hovering around multiyear lows, and fast fading prospects of a sharp rebound in the near-term, the FG revised key assumptions in the earlier version of the 2015 budget to better reflect current environment. The downward revision in the crude oil price benchmark to $52/bbl ($65/bbl previously) trimmed revenue expectations, but importantly, widened projected deficit to N1.1 trillion, which in our view is more realistic than N755 billion in the earlier proposal and in line with the N1 – N1.2 trillion expectations outlined in our Q1 15 Strategy update. Similar to prior budgets, the 2015 deficit is set to be financed via traditional sources; borrowing (80%), ECA (10%) and other sources, including sale of FGN signature bonus and sale of properties. However, in a slight deviation from the recent tack, where borrowing was largely domestic, 25% of 2015 borrowing is expected to be foreign-sourced, in form of $2billion budget support from the World Bank and African Development Bank. Although the FG links the move to a deliberate attempt not to crowd out the private sector from the debt market, we believe it is a reflection of FG’s sensitivity to high interest rates domestically, with average interest rate on FGN debt at 12% as at year end 2014. To buttress this point, the H1 15 refinancing of the N535 billion 2015 4% FGN bond that matured in April, at an average marginal rate of 15%, adds roughly N60 billion to estimated 2015 debt service. On other sources of funding, although the $2.6 billion in the ECA should cover its 10% share of the projected deficit, soft oil prices, which diminish the odds of the oil field licensing round occurring, likely eliminates signature bonuses as a credible income source. In any case, these bonuses have been absent in the last few budgets.


Although the foregoing suggests the financing of the budget is largely sorted, two developments suggest 2015 deficit is set to exceed even the seemingly more realistic estimates. First, the halving of the 2015 PMS and kerosene subsidy budget to N100 billion and N45 billion appears not to incorporate the changes in dynamics, including the 10% reduction of PMS prices and further naira devaluation in February. Combined, these events have driven subsidy per litre to levels (between N30 and N50) only previously obtainable in periods of high oil price. Our estimates, given current oil price and daily consumption of 45 million litres and 8 million litres for PMS and HHK, implies subsidy bill of ~N850 billion (PMS: N600 billion HHK N150 billion). Another finding that could magnify 2015 budget deficit is the provision for debt service. In particular, high interest rate environment over the last few years have kept actual debt service persistently above budget, with 2014 debt service of N1 trillion about 40% in excess of budget. Admittedly, while this reality underpinned the ramp up in projected 2015 debt service to N954 billion, the continuous substitution of lower cost debt with higher suggests debt service is likely to exceed target this year, as in 2014. Indeed, annualising current run rate of 2015 debt service and adjusting for higher interest rates over H1 15, we expect debt service to exceed budget by at least N100 billion. Plugging both (subsidy and debt service) estimated overshoots into the FG’s template, whilst leaving other assumptions unchanged, implies 2015 budget deficit in excess of N1.4 trillion, excluding the N260billion subsidy arrears.

Figure 3: Federal government annual debt service (N billion)




 

...what import for lofty plans of the new government
The prospects of the budget deficit exceeding projections, even if revenue estimates are met, is set to create all sorts of challenges for the new government as it could mean that a sizeable portion of the campaign “promises” are likely to be deferred. Amongst other initiatives, the new government proposed a range of social welfare programs such as free health care education and safety net for every citizen as well as conditional monthly social security payment of N5,000 for poorest 25 million in Nigeria which, combined, are sure to cost trillions. To put into context, current public health expenditure in Nigeria of ~1% of GDP or ~$5.6 billion (N1.1 trillion) is the lowest amongst select African countries that provide free health care services to citizens. Matching Nigeria’s health care expenditure with average of 3.5% for these African countries (South Africa, Ghana and Libya) and assuming the FG bears approximately half, in line with trend elsewhere, implies an additional $6.4 billion (N1.3 trillion) annual expenditure. Overlaying the foregoing with an estimated ~N1.5 trillion, based on sums to be paid to the 25 million poorest Nigerians, it is easy to see why these promises might remain just that without rapid boost in revenue base and cost curtailment, both of which cannot be achieved without major reforms.


Figure 4: Health expenditure to GDP


Broad based reforms must start with low hanging fruits...but subsidy must go
Although the President is yet to set out his policy thrust, gleaning from media reports, reform of the oil and gas sector, possibly via reorganisation of the NNPC, appears to top the list. This makes sense, particularly at a time where profligacy will be more costly than ever, and after numerous audit reports, by sources ranging from PWC to NEITI and senate committees, indicting the corporation for non-remittance of oil and gas proceeds. However, being established by law, the NNPC cannot be disbanded without legislation. This again brings to the fore the importance of speedy passage of the Petroleum Industry Bill (PIB) that has languished at the legislature for over 7 years. Unfortunately, the importance of the bill diminishes the odds of passage in the current form, as we expect some alteration by the new government which could delay the bill for at least another year. That said, quick fixes abound in the form of better surveillance of water ways and crude infrastructure to reduce crude oil theft as well as halting or capping direct deduction of expenses and capex by NNPC to a certain percentage of revenue. Regarding the latter drive, relating to its discretionary deductions, the NNPC has typically found one form of expense or the other to excuse the numerous instances of under-remittance it has been fingered for. For instance, the last NEITI audit report stated that ~$11.6 billion (N2.3 trillion) NLNG dividend between 2006 and 2011 is yet to be remitted to the Federation Account, to which the NNPC responded that dividends had been utilised to fund gas related projects. Similarly, details of the PWC audit report show that the corporation tied half of the missing $20 billion (N4 trillion) to defrayment of subsidy on regulated petroleum products—another area in need of urgent attention in its own right.  However, subsequent reconciliations have resulted in the corporation having to make one refund or the other, with the current ~N7 billion paid monthly since H1 2012 being a case in point. This clearly indicates something is amiss and highlights the potential impact of capping the ad-hoc deductions which could help the FG free up billions of dollar simply by ensuring proper scrutiny of the NNPC.

In light of our belief that subsidy bill could match 2014 levels, at least, we struggle to see how the new government can sustain the subsidy regime without significantly ramping up borrowings, more so, with the liability likely understated in the budget. Notably, lessons from climes where sustenance of subsidy programmes, even in the face of weak revenue, partly contributed to worse fiscal positions with higher debt to GDP[2] gives a glimpse into probable consequences. While Nigeria still maintains healthy debt ratio, funding such consumption at 14% interest rate could easily drive the ratio to unsustainable levels. In any case, as part of reforms, more countries—including India, Egypt, Ghana and Argentina—in the last few years commenced phased removal of subsidies on petroleum products and that seems the reasonable option at this time. However, after the backlash that trailed the botched attempt to fully deregulate in 2012, we believe, for any removal to be successful, the buy-in of the labour union and larger public is critical, particularly as incessant fuel shortages that commenced weeks to the elections have—persisted and—created a thriving shadow market where PMS sells as high as 3x regulated price.

One other option to ramp up income is via the sale of interests in some oil and gas JV agreements. However, given depressed oil prices, valuations of these interests are likely to be low in the current environment even as bearish outlook for oil prices means there are no guarantee of improvements in the long term, especially considering limited scope for improvement in oil output—which has been flat to lower in more than a decade.  To our mind, pursuing the reform of the oil and gas sector with the required vigour is likely to deliver similar and, importantly, more sustainable benefits to fiscal receipts.

Ordinarily, with Nigeria’s tax to GDP significantly below peer average, the government would look to bolster its tax base at such a time as this. However, a woeful track record of putting national funds to use curtails its wiggle room at the time its needed most. For instance, perhaps the quickest way to improve non-oil revenue is via a hike in VAT to 10% or 15% which by our estimates could see an additional N200 to N300 billion accrue to the FG. However, beyond the usual justification that Nigeria has one of the lowest rates in Africa (5%) there is little justification for the hike going by the quality of service in the country. Furthermore, coming at a time when imported inflation continues to pressure disposable income, there is likely to be strong resistance, similar to 2007. b In the same vein, whilst raising other non-oil taxes hold ample potential to boost revenues, of necessity, it’s likely to remain a medium to long drive which is unlikely to alter the fortunes of the FG over 2015. Nonetheless, measures to broaden and diversify the economic base must commence now such that taxes grow even without an increase in the rate.

Figure 5: Tax to GDP ratio of select countries


Related News from ARM’s Nigeria Strategy Report
1.       Soft Commodities post fledgling resistance on narrower gluts – Jul 27, 2015
2.      Dead Cat Bounce in Nigerian Oil Market?
3.      FPI flows yet to find clear pattern
4.      Softer Commodity prices aggravate Africa's slowing growth...
5.      Stalling US momentum leaves global growth stuck on the runway – July 21, 2015


Disclaimer/Advice to Readers:
While the website is checked for accuracy, we are not liable for any incorrect information included. The details of this publication should not be construed as an investment advice by the author/analyst or the publishers/Proshare. Proshare Limited, its employees and analysts accept no liability for any loss arising from the use of this information. All opinions on this page/site constitute the authors best estimate judgement as of this date and are subject to change without notice. Investors should see the content of this page as one of the factors to consider in making their investment decision. We recommend that you make enquiries based on your own circumstances and, if necessary, take professional advice before entering into transactions. This article is published with the consent of the author(s) for circulation to the online investment community in accordance with the terms of usage. Further enquiries should be directed to the author whose e-mail is ARM Research [research@armsecurities.com.ng]

READ MORE:
Related News
SCROLL TO TOP