Fiscal Folly

 Last week, the Senate passed the 2011 budget to the tune of N4.972 trillion (US$32 billion), increasing the Federal Government’s (FG) spending by 18% over the President’s initial proposal three months ago. In its current form, the 2011 budget represents a 4.4% contraction in total FG spending from N5.2 trillion 2010, however it is a far cry from the President’s initial reduction of 18% to N4.2 trillion. In his comments after the passing the 2011 budget, Senate President David Mark noted that while the 2011 budget was being processed by the National Assembly the Presidency presented a request for an additional N312 billion in funding to be  added to the previous budget to account for errors in estimates for Ministries, Departments and Agencies (MDAs).

Of the proposed aggregate expenditure of N4.97 trillion, the sum of N4.03 trillion is being allocated to spending in Ministries, Departments and Agencies (MDAs), N445 billion is slated for debt service, while N497 billion is earmarked for statutory transfers. Of the total amount set aside for spending by MDA’s, N1.56 trillion is earmarked for capital expenditure while N2.47 trillion is targeted at recurrent expenditure, same as in the proposed budget. On a positive note, the revised budget provides for a 14% increase in capital expenditure YoY as compared to the 27% reduction proposed by the President. As such, the revised budget implies an increase in capital expenditure as a percentage of entire expenditure to 31.8% from 26.3% in 2010.

On the revenue front, the budget revenue projections were predicated on the following key assumptions;

· Oil price benchmark of US$75 per barrel, revised upwards from US$65 per barrel proposed by the President.

· Crude oil production of 2.35 million bpd, 50,000 bpd higher than the President’s budgeted production assumption of 2.3 million bpd.

· Corporate Income Tax (CIT), Value Added Tax (VAT) and Customs Duty projected to increase, 7.8%, 7.8% and 12.5% Y-on-Y respectively to N632.8 billion, N625.24 billion and N450 billion.

For me, the key take away from the budget is the government continued focus on consumption, in spite of recent criticism and promises of greater fiscal responsibly. Though I applaud the Senate for its N560 billion increase of the capital expenditure budget, my view remains that the government is bloating personnel costs and overheads in a budget that should be focused on boosting investment in the long-run competitiveness of Nigeria’s economy. Alarmingly, as part of its budget review, the Senate increased transfers to the National Assembly by 115% to N233 billion. Clearly, the long term implications of extensive growth in non-infrastructure related expenditure appear to be lost on Nigeria’s fiscal administrators.

Overall, I estimate a budget deficit of ~N1.87 trillion, down 13.4% from 2010 but 36% higher than the President’s proposal of ~N1.39 trillion and exceeding the 3% deficit target set under the 2007 Fiscal Responsibility Act for the second straight fiscal year. Although the senate raised the crude oil benchmark to USS75 per barrel, the FG also expects to raise independent revenue from signature bonuses on the sale of oil blocks and on the sale of assets such as the privatization of some aspects of the PHCN, which is already at an advanced stage. I believe the senate’s assumptions on the FG’s ability to increase its funding though privatization and sale of assets may be optimistic at best given the FG’s antecedents. Notably, at H1’10 only N42.4 billion of N300 billion in independent revenue budgeted had been realized.

In my view, the increase in the deficit to ~N1.78 trillion is puzzling when viewed in the context of the FG’s reduction in proposed borrowing for 2011 to N835 billion. I see few alternatives to making up the “unfunded” ~N1 trillion portion of the deficits. Perhaps the FG will give consideration to funding a significant portion of its deficit via dollar denominated debt as domestic borrowing rates are likely to rise going forward and its strengthened balance sheet may temper international borrowing cost especially with rising crude oil prices, increasing crude oil production and growing dollar reserves. However, the expansion still detracts from the signals it has been attempting to send the domestic bond markets about its new inclination towards fiscal consolidation and will likely remove the support bond prices have enjoyed so far this year. I expect to see renewed softness in both primary and secondary bond markets going forward.

Mandela Toyo

Oh Inflation.

Earlier today, the CBN governor announced the decisions of this 75th Monetary policy Committee (MPC) meeting, as expected, the MPC voted 9-3 to resumed monetary tightening citing; fiscal imbalances, rising global commodity prices and currency stability as its primary basis for the hike. In what could be considered a strong policy statement, the MPC increased its benchmark Monetary Policy Rate (MPR) by 100 basis points (bp) to 7.50%. The key decisions made at the meeting include;

·         Raising MPR by 100bps to 7.50%

·         Maintaining the symmetric corridor at ±200 bps MPR, thus bringing the Standing Deposit Rate (SLR) and Standing Lending Rate(SDR) to 5.50% and 9.50% respectively

·         Maintaining the Cash Reserve Ratio (CRR) for banks at 2%.

·         Maintaining the liquidity ratio by at 30%.

·         extending its guarantees for all inter-bank transactions, all commercial bank foreign credit lines and all pension funds placements with commercial banks to September 30, 2011

While I anticipated the upward adjustment of the Monetary Policy Rate (MPR) and retention of the symmetric band around, I was surprised by the aggressiveness hike in the MPR and the majority with which the committee reached most of its decisions (9-3). It appears that the MPC was more concerned about the impact of the Fiscal Policy and is on a collision course with the FG. I believe, that in addition to the recently passed budget, the impact of this development on the debt and equity markets will be much more far reaching than I had anticipated. Overall, it buttresses my view that investors are probably better off taking refuge in the money market while monitoring developments elsewhere as the wide range of factors, ranging from AMCON to outlook for government borrowing, that have a bearing on direction of asset prices has made overall outlook a lot murkier. 


Mandela Toyo

Currency Stability; is the CBN out of bullets?

At Monday’s WDAS auction, the Naira weakened further against the U.S. dollar as demand once again outstrip supply. In what appeared to be a renewed attempt to provide support for a declining Naira, the Central Bank of Nigeria (CBN) sold US$400 million at N150.90/US$, short of the $434.56 million demanded, but higher than the $350 million sold at  last Monday's auction. Notably, Monday’s auction was the seventh consecutive auction with demand above $320 million and the highest level of demand since Mid-January. Following Monday’s decline, the Naira fell to an eighteen month low against the US dollar on Tuesday as panic buying appeared to intensify, the naira closed the day at N156.3/US$ in the interbank market.

Some currency market participants have pointed to the impending expiration of the CBN’s guarantee on foreign credit lines of Nigerian banks and the decline in autonomous foreign exchange sales from oil majors (possibly due to concerned about the passage of the Petroleum Industry Bill) as the majors reason behind the recent spike in demand.  I also observed that the recent spike in WDAS demand followed closely after the IMF’s report dated February 17th 2011 which noted in its assessment that the Naira is overvalued and stressed the need for greater exchange rate flexibility to avoid further reserve depletion and to prevent one-way bets in the foreign exchange. While it is difficult to determine the exact impact of aforementioned factors, the recent declines in the value of the Naira have prompted a review of my position on currency stability. 

A cursory examination of the recent spike in WDAS demand indicates an increase in pressure from trade related demand, particularly in the form of increased demand by companies with unconfirmed letters of credit and payments of foreign credit cards. To better understand the fundamentals of this sudden spike in demand and to estimate its direction, I reviewed Nigeria’s quarterly trade statics between 2005 and 2009 to uncover the likely smyces of trade related WDAS dollar demand in the medium term. In summary, Nigeria’s primary imports are machinery and transport equipment (41%), manufactured goods (25%) and Chemicals and Fuels (17%) while Food, Beverages and Tobacco accounts for only 15% of total imports.

Taking a cue from these statistics I focused on inflationary patterns in Nigeria’s major import partners (China (28%), United States (14%), France (10%) and the United Kingdom (9%)) accounting for their exchange rate movements relative to the US dollar, with a view to estimate future price movements. By doing this, I have been able to estimate the medium term trend of fundamental WDAS trade related demand hence adjusting for what could be considered temporary election related shocks. Using a weighted average of consensus Producer Price Index (PPI) estimates of Nigeria’s major trading partners adjusted for exchange rate movements, I estimate price increases of 7.6%  by FY’11 when combined with estimated GDP growth of 7% in 2011 this implies fundamental WDAS trade related demand growth of ~15.13%.

I have also hinged my view on Naira stability primarily on the rate of dollar reserve depletion, which weighs significantly on the CBN’s foreign exchange decisions and on its ability to effectively meet demand at the WDAS. As such, my expectation remains tilted towards the view that the Naira will remain under pressure at the WDAS in H1’11 as it has so far. To estimate reserve accrual I regressed Bonny Light Crude price (US$/b), Oil production (bpd), and quarterly WDAS Sales on Net Reserve Flow (US$). Notably, together these measures explain over 75% of reserve accrual. Based on this model and the conclusion above, I estimated an average reserve accrual of US$1.64 billion in Q1’11, assuming 2.39 million bpd crude oil production, average Bonny Light Crude price of US$110 per barrel and quarterly WDAS Sales of US$ 7.36 billion (i.e. assuming average demand growth of 15.13%), this puts gross reserves at US$34.1 billion at the end of Q1’11.

Several events in the horizon, including further increases in crude oil prices amid improving domestic production could lead to further foreign exchange inflow and higher reserves. In view of the above, my view of the direction of reserve flows is positive and I believe the CBN is well positioned position to defend the Naira. As such, I expect the Apex Bank to widen is support for the Naira going forward in order to avert any speculation even though the Naira/US Dollar rate remains firmly within the -/+ 3% of N150 floating peg band. 

Mandela Toyo