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Nigeria Strategy Report H1 2017 (8) - FG Fiscal Expansion: Once Bitten, But Not Shy

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Wednesday, January 18, 2017 10:18 PM / ARM Research

Key Developments in Domestic Economic and Policy Environment 

Today we delve further into the domestic portion of our core strategy document – the  Nigeria Strategy Report. In this piece, we review the fiscal picture over H2 2016 and proffer outlook on same for year 2017.

At N2.2 trillion, federally collected revenue over the first 9 months of 2016 was 25% below budget with annualized receipts of N2.9 trillion at a 5-year low. Given the lower than projected revenues, the FG struggled to implement the N6 trillion expansionary budget as annualizing the 9M 16 actual expenditure places budget implementation for 2016 at a six year low of 78.8%. Owing to the FG’s inability to secure planned foreign borrowings (N900 billion), the deficit was financed largely via local sources with net debt issuances of N851 billion split between bonds (86.7% of total) and NTBs. Overall, despite heightened public expectations about the credibility of the Buhari government to implement the ambitious N6 trillion budget, the revenue disappointment and failure in raising foreign debt undermined the ability of the 2016 budget to be anything but expansionary during a period of economic stagnation. 

Despite the disappointment, President Buhari proposed a larger federal budget for 2017 with aggregate expenditure projected at N7.298 trillion (+20% YoY) while retained revenues is expected to rise at a faster pace (+28% YoY) to N4.94 trillion—translating to proposed fiscal deficit of N2.36 trillion (2.18% of GDP vs 2016: 2.14%). On the spending side, FG proposed to raise recurrent expenditure 13% higher YoY to N5.1 trillion, largely reflecting a 33.1% YoY jump in projected non-debt expenditure to N2.98 trillion with debt service (+18.5% YoY to N1.7 trillion) and statutory transfers (+6.8% YoY to N419 billion) expected to rise more modestly.

FG’s bullish revenue picture is premised on an expected jump (142% YoY to N1.9 trillion) in oil revenue, which more than offset tamer projections for non-oil receipts. Focusing on the oil assumptions, the FGN assumed higher exchange rate (+54% YoY to N305/$) and oil price (+12% YoY to of $42.5/bbl) but left mean oil production flat at 2.2mbpd which does not fully account for the surge in oil receipts. We believe the missing link is the President’s assertion regarding the removal of JV cash call obligations in 2017. Despite the cuts to non-oil receipts, we are more pessimistic on budget assumptions as we believe macroeconomic headwinds, which has resulted in reduced corporate profitability and lower imports, should temper, relative to historical trends, actual receipts. Overall, we estimate fiscal receipts at N4.1 trillion (17% short of budget estimate) in our base case scenario.  

Though our analysis show that fiscal deficit could range between N1.1 trillion and N5.6 trillion, it is more likely to hover around N3.2 trillion—our base case scenario—should FGN implement the N7.2trillion budget. That said, as in 2016, when the FG dithered on budget implementation, our estimate assumes that FG credibility remains intact. Our assumption is hinged on the belief that going into the last year before 2019 politicking comes into view, 2017 is the last chance for the Buhari administration to seek to meet heightened expectations which trailed its 2015 election victory. 

Budget implementation falls to 6 year low as revenue assumptions flounder

At N2.2 trillion, federally collected revenue over the first 9 months of 2016 was 25% below budget with annualized receipts of N2.9 trillion at a 5-year low. Though revenue breakdown has not been provided, the shortfall likely stemmed from both oil and non-oil receipts. Focusing on oil, given higher than projected crude oil prices (+10.1% to $41.85.bbl vs budgeted $38/bbl) and weakness in exchange rate (-30.7% to N257.52/$ vs. assumed N199/$), pressures on oil receipts reflected production shortfalls (-16.6% lower than budget at 1.84mbpd) on the back of renewed attacks on oil installations. On the non-oil leg, we believe aggressive assumptions made in 2016 budget, relative to actual 2015 proceeds, with regards to VAT (+89.4% YoY to N198.2 billion), Taxes (+82.4% to N867.5 billion) and Custom duties (+40.7% to N326.4billion) underpinned the shortfall. Given the lower than projected revenues, the FG struggled to implement the N6 trillion expansionary budget as annualizing the 9M 16 actual expenditure of N3.6 trillion places budget implementation for 2016 at a six year low of 78.8%. Unsurprisingly, aggregate spending remained skewed towards meeting debt and salary obligations with recurrent expenditure accounting for 79% of total spending (vs. 71% proposed in the budget). Whilst CAPEX fell significantly short of budget (-43% on annualized basis), it was nonetheless 50% higher YoY at N904.3 billion. Overall, largely reflecting the cutback in spending, 9M 16 fiscal deficit came it at N1.41 trillion—14.5% lower than pro-rated budget estimate. On an annualized basis, the reading translates to a full year fiscal deficit of N1.88 trillion (1.83% of nominal GDP).

Owing to the FG’s inability to secure planned foreign borrowings (N900 billion), the deficit was financed largely via local sources with net debt issuances of N851 billion split between bonds (86.7% of total) and NTBs. Furthermore, as in 2015, when CBN financing of N616 billion helped plug 40% of the deficit, the apex bank provided additional N345 billion in overdraft financing. Overall, despite heightened public expectations about the credibility of the Buhari government to implement the ambitious N6 trillion budget, the revenue disappointment and failure in raising foreign debt undermined the ability of the 2016 budget to be anything but expansionary during a period of economic stagnation.

Figure 1: Trend in Budget implementation and FG’s retained revenue



States find financial succor in FG’s arms

For state governments, the dire fiscal revenue conditions bit harder as oil receipts led to a 30.3% YoY decline in FAAC allocations to N1.1 trillion over the first ten months of the year. Annualizing, the FAAC allocation comes to only 22% of cumulative state government budget for 2016. Furthermore, IGR likely fared worse in an environment of recessionary economic conditions and rising unemployment picture. Given the tight fiscal picture and rising interest rate environment, local debt markets were not receptive to sub-national bond issues even as a number of states restructured their bond payments. In a bid to shore up State Government (SG) finances but more importantly instil fiscal discipline, the FG provided budget support loans to states conditional on commitments to implement a 22-point Fiscal Sustainability Plan aimed at promoting accountability & transparency, managing cost, increasing public revenue, and facilitating sustainable debt management. Thus far, 35 states have committed to the program with N220.5 billion loans granted which together with a N153.01 billion cash refund to 14 states for over-deduction of debt service between 1995 and 2002 helped states meet (92% vs. 77% without FG’s support) most of their recurrent spending plans.

Figure 2: State Revenue as a percentage of recurrent revenue


FG re-attempts economic reflation with even more bluster

On the 14th of December, President Buhari presented the proposed federal budget for 2017 to the National Assembly. In the budget proposition, aggregate expenditure is projected at N7.298 trillion (+20% YoY) while retained revenues is expected to rise at a faster pace (+28% YoY) to N4.94 trillion—translating to proposed fiscal deficit of N2.36 trillion (2.18% of GDP vs 2016: 2.14%). On the spending side, FG proposed to raise recurrent expenditure 13.0% higher YoY to N5.1 trillion largely reflecting a 33.1% YoY jump in projected non-debt expenditure to N2.98 trillion, whilst debt service (+18.5% YoY to N1.7 trillion) and statutory transfers (+6.8% YoY to N419 billion) are expected to rise more modestly. Breakdown of the non-debt expenditure reveals flat movement in Personnel cost (N1.8 trillion) which questions the acclaimed monthly savings of N180 billion from elimination of ghost workers, restricted travel costs, reduced board members’ sitting allowances etc. Also, included in the non-debt expenditure is a N500 billion Special Intervention programme (unchanged from prior year), which amongst other things would provide loans for traders and artisan, a Conditional Cash Transfer to poor families, a bigger Niger Delta Amnesty Programme of N65 billion (over two-fold YoY) as well as N45 billion for the rehabilitation of North East.

Figure 3: Breakdown of recurrent expenditure (N’trillions)


Elsewhere, unfazed by the poor implementation of its 2016 budget, the FG increased its planned capital expenditure by 39.4% YoY to N2.24 trillion, which boosted capex contribution of overall spending by 149bps YoY to 30.7%. Akin to 2016, the breakdowns reveal an infrastructure tilt with prioritization of Power, Works, and Housing, as well as Transportation, which jointly constitutes 48% of planned capital expenditure for 2017. Focus on transport reflects increased counterpart funding for construction of the Lagos-Kano, Calabar-Lagos, Ajaokuta-Itakpe-Warri and Kaduna-Abuja railway projects which are to be funded using Chinese loans. Whilst government’s desire to reduce the country’s huge infrastructure deficit seem laudable, absence of confirmed external financing arrangements as well as possible revenue shortfall could result in poor implementation as with prior budgets.

Removal of JV cash calls underpin sanguine oil revenue projections

FG’s bullish revenue picture is premised on an expected jump (142% YoY to N1.9 trillion) in oil revenue, which more than offset tamer projections for non-oil receipts. Focusing on the oil assumptions, the FGN assumed higher exchange rate (+54% YoY to N305/$) and oil price (+12% YoY to of $42.5/bbl) but left mean oil production flat at 2.2mbpd which does not fully account for the surge in oil receipts. We believe the missing link is the President’s assertion regarding the removal of JV cash call obligations1 in 2017. As was later announced by Ministry of Petroleum Resources, an alternative funding structure, under which JV fields would fund operations as an independent entity allowing for cost recovery, would come into effect in 2017 removing the need for budgeted JV cash calls. According to the NNPC, the proposed funding structure would result in $2 billion, providing a boost to fiscal revenues.

Furthermore, the Ministry of Petroleum resources announced that it had reached an agreement with IOCs to repay outstanding JV debt obligations, estimated at $6.8billion, over five years via incremental production from each JV oil field. Whilst details about the deal are still sketchy, the removal of the JV cash calls help offset concerns over the static production estimates. On this item, despite increased amnesty payments and more conciliatory tone by the FG, which raises cause for optimism, we think the yet uncertain security situation limits prospects for quick rebound in production above mean 2016 levels of 1.8mbpd and forecast same in 2017. Incorporating the removal of JV cash calls, assuming mean oil prices (+29.4% to $55/bbl), in line with our views about oil prices, and expectation for further naira depreciation (average: +14.8% to N350/$), we project oil revenues 26.3% higher than FG’s estimate at N2.5trillion.

Figure 4: Fiscal Revenue projections (N’trillions)

 



But non-oil revenues remain aggressive relative to macro realities and trend levels

Elsewhere, though the disappointment in 2016 drove cutback in non-oil (-6% YoY to N1.37 trillion) and independent (-46.3% YoY to N808 billion) revenue projections, these are cushioned by the impact of higher recoveries2 (+61.2% YoY to N565.1 billion) on other revenue which is projected to surge nine-fold YoY to N776 billion.

Despite the cuts to non-oil receipts, we are more pessimistic on budget assumptions on account of several factors. First, non-oil projections continue to remain above trend levels and we believe macroeconomic headwinds which has resulted in reduced corporate profitability and lower imports should temper, relative to historical trends, receipts from Companies Income Tax (CIT), Value Added Tax (VAT) as well as Customs and Excise Duties. Consequently, we project 2017 non-oil revenue at N825 billion, which is 39.7% short of budget.

Figure 5: Trend in FG independent and non-oil revenue (N’ billion)


On recoveries, whilst budgeted amount represents only 19% of assets repossessed from corrupt government officials thus far3, we note that most of the recovered loot are illiquid (96% of the retrievals are tied up as real estate property). Thus, unless more cash recoveries are made, we do not think the legal system would allow quick conversion of recovered assets into cash form for budget implementation4.

Accordingly, we project N454 billion reflecting recoveries of N243 billion (current cash recoveries of N145 billion and expected partial receipt of Abacha loot from Switzerland of N98 billion). Overall, we estimate fiscal receipts at N4.1 trillion (17% short of budget estimate) in our base case scenario.

In addition to our base case scenario, we sensitize for other revenue possibilities. Our bull case paints a picture where Niger delta militants accept FG’s peace moves resulting in the return of the country’s mean crude oil production to 2.2mbpd while oil prices rally to $60/bbl on further cut in OPEC production. The improved oil proceeds should drive non-oil revenue moderately higher as oil and gas companies become more profitable whilst recovery of more cash funds from looters boost other revenue. On the other hand, we examine a situation where Nigeria’s onshore facilities are destroyed by the militants leaving the country with average crude oil production of 800kbpd even as average crude oil prices fall to $30/bbl reflecting higher shale oil production as well as OPEC’s decision to ignore its agreement of a production cut.

This scenario also assume that $321 million Abacha loot expected from the Switzerland government does not materialize over the course of the year whilst breakdown in negotiations result in JV cash call deduction. Though our analysis show that fiscal deficit could range between N1.1 trillion and N5.6 trillion, it is more likely to hover around N3.2 trillion—our base case scenario—should FGN implement the N7.2trillion budget. That said as in 2016, when the FG dithered on budget implementation, our estimate reflects the FG credibility remains intact as we think going into the last year before 2019 politicking comes into view, 2017 is the last chance for the Buhari administration to seek to meet heightened expectations which trailed its 2015 election victory.

Table 1: 2017 Federation revenue budget vs. ARM estimates


Increased domestic borrowings in the offing

Focus shifts to projected fiscal deficit, which the FG states would be largely financed through borrowings (98%) with a greater emphasis on local debt (54% of planned debt). Despite its inability to secure external borrowings in 2016, the FG raised its foreign loan projection by 39.3% YoY to N1.254 trillion which we believe reflects a combination of delayed Eurobond issuance from 2016 (now scheduled in Q1 2017),

AfDB budget support loan ($1 billion) as well as some portion of the $30 billion planned external borrowings over next three years. However, with the National assembly stalling on approval of the latter on the back of its apathy towards sizable foreign borrowings, we see the AfDB facility and the already approved $4.5 billion Eurobond issuance program as a more likely source of external borrowings over 2017. Given DMO’s plan for only a $1 billion issue, we believe only strong appetite for Nigerian risk—akin to what trailed Ghana’s $750 million bond in September— could see the FG raise close to double of the amount on offer.

Whilst recent recovery in Brent crude stokes prospect for greater investor willingness to tolerate Nigerian risk, recent upswing in US interest rates and subsisting uncertainty over Brexit fallout implies more tight global financial market conditions. Consequently, we see limited scope for a Nigerian issue north of $2 billion which should result in greater reliance on domestic borrowings for financing the deficit. Importantly, in the wake of recent calls for the CBN to cap its financing of fiscal deficit to regulatory limit of 5% of prior year’s revenue, we expect the apex bank’s statutory lending facility to contract 58.1% YoY to N144.7 billion5 in 2017 by our estimate, leaving the government at the mercy of capital market participants for financing the budget deficit. To estimate potential size of domestic paper issue, we played out different scenarios in the table below. Having obtained board approval for disbursement of the AfDB facility, we assume the item as a given and play out varying scenarios over potential Eurobond issuance.

Furthermore, given our reservations regarding the feasibility of certain revenue lines, our analysis incorporates a projected fiscal deficit of N3.2 trillion rather than N2.4 trillion estimated in the budget.

Table 2: Scenario analysis of 2017 proposed borrowings


Sensitizing over varying scenarios with a base case of a $1billion issue – which is the amount the government sought to obtain in November 2016—we estimate that to finance the budget, the FGN would need to increase net debt issue by 183% YoY to N1.6 trillion. In the event of a failed Eurobond raise, our analysis suggests that at the minimum, net borrowings would rise 219% YoY to a record N1.9 trillion.

Underlying all scenarios, we assume that the FGN seeks to keep its credibility by implementing the 2017 budget and that the CBN does not bridge the limit on monetization of fiscal deficit as per the CBN 2007 act.

Figure 6: Trend in FG net debt issuances


ARM Securities | 1, Mekunwen Road, Off Oyinkan Abayomi Drive, Ikoyi, Lagos, W:www.armsecurities.com.ng | M: 234 (1) 2701653 

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