Jekwu Ozoemene
Nigeria is headed for a deep depression unless crude oil demand from COVID-19 hit global economy witness a rebound and the Kingdom of Saudi Arabia and Russia back down from their tiff. This particular crash will be markedly different from Nigeria’s 2016 recession.
There is a key to understanding why 2020 will be different.
Busts often telegraph their occurrence based on three factors; the laws of demand and supply, the availability of capital and future expectations. In economic theory, the next economic bust is inevitable because expanding asset classes that come with a boom always lead to a bust. However, busts do not always lead to a recession as their impact can often be mitigated by a local government’s policy response.
By 2014, it was evident that an oil industry bust was fast approaching.
By late 2015, early 2016 I had hypothesized a “catapult effect” in Nigeria, that the country’s attempts to use monetary policy instruments to solve fiscal problems was akin to stretching a catapult beyond its elastic limit and that the whiplash from the ensuing snap could lead to a violent correction.
That correction eventually happened in 2016.
The ensuing recession was not necessarily caused by the crash in oil prices (there had been several asset price crashes that did not lead to recessions) and production disruption by militants, but was a direct result of the country’s poor policy response to the crash.
Post the penultimate Presidential elections in Nigeria, perception by Foreign Investors was that it will take the opposition People’s Democratic Party (PDP) at least 4 years to put its acts together after losing the 2015 Presidential election. So they were willing to take a measured investment approach in Nigeria, keep a foot fully in the door while keeping eyes peeled for policy direction.
Such conditions no longer exist.
If the current recession transits into a depression, Nigeria is unlikely to exit it till 2022/23, towards the expiration of President Muhammadu Buhari’s constitutionally allowed 2 terms of 4 years each. Consequently, investors will rather wait till 2024/25 to understand the views of the next president and political party before further investments in Nigeria can be made. This will further prolong the nation’s ability to exit the depression.
Why we think Nigeria may be headed for a depression.
I will use a couple of anecdotes to illustrate our train of thought;
1. Yesterday, a friend exclaimed that Saudi Arabia and Russia were just being silly to engage in an oil price war.
2. Another opined that neither Saudi Arabia nor Russia can sustain their budgets on US$20 per barrel crude oil.
3. In response to one of my posts on the current oil price war, a stranger commented that there is no need to worry as Nigeria has reduced its budget oil price benchmark from US$57 to US$30 per barrel.
To the friend who believes that Saudi Arabia and Russia are being silly, I asked, “Is OPEC not a cartel?”
We have all gotten used to the existence of OPEC (particularly because it favours Nigeria and other oil-producing nations) that we do not see the abnormality in its acceptance.
The dictionary defines a cartel as “an association of manufacturers or suppliers with the purpose of maintaining prices at a high level and restricting competition”.
Key phrases to note here are “maintaining prices at high levels” and “restricting competition”.
Why does the world have to pay a premium foisted by a cartel for a commodity that can be produced cheaply by few countries who have the requisite comparative advantage?
For the past three years, Saudi Arabia (leading the OPEC cartel) has worked with Russia to prop up global crude oil prices.
Why did they fall out?
Why will they not reconcile, particularly in the face of COVID-19’s impact on global demand?
That takes me to the next anecdote.
To the fellow who opined that neither Saudi Arabia nor Russia can sustain their budgets on US$20 per barrel crude oil, it is key to understand why the two countries are facing off in the first instance.
Riyadh had insisted that Russia agrees to a deal to cut oil supplies by 1.5 million barrels per day (bpd). This was in other to prop up prices to compensate for the impact of the COVID-19 pandemic on global demand as China, the world’s biggest importer of the product, was turning back tankers as the pandemic ground its economy to a halt.
On the other hand, Moscow wanted Riyadh’s support to battle the United States’ high-cost shale producers following sanctions imposed by Washington and targeted at Russia’s oil giant, Rosneft Trading, because of its continued support in selling Venezuela’s oil.
Moscow believes that Saudi Arabia and OPEC are beneficiaries of the sanctions thus support can only come from reduced or at least muted oil prices to hit back at the US.
A simple but almost impossible to resolve political situation led to this face-off.
But then, these two big players can afford to play the crude oil game of thrones.
The IMF believes that Riyadh requires US$83 per barrel oil to balance its budget. Though oil constitutes about 65-70% of the Kingdom’s budget revenues, they have foreign reserves of about US$500 billion and a sovereign wealth fund of about US$320 billion.
They also have the lowest cost of production in the industry of about US$2.8 – US$3 per barrel, compared to Nigeria’s US$31.60 per barrel.
At US$30 per barrel and a 10% increase in production (Riyadh is targeting an over 20% increase) over the next 6 months, Goldman Sachs believes that Saudi Arabia’s budget deficit (based on a budget oil price benchmark of US$55 per barrel) will increase by US$36 billion.
Our conclusion is that the Kingdom does have the capacity to ride out this price war. Their state agencies have already prepared budget scenarios (with spending cuts across the board) that envisage extreme benchmark Brent crude prices dropping as low as a US$12-US$20 per barrel, with a worst-case scenario play of US$10 per barrel.
What about Russia?
Based on data from Russia’s central bank, as at March 20, 2020, the country’s foreign reserves stood at US$551.2 billion. A day earlier, on March 19, 2020, Russia’s Ministry of Finance announced that the National Welfare Fund was at US$157.2 Billion (11% of GDP).
Russia’s Finance Minister, Anton Siluanov, believes that though the current crisis will create a RUB3 trillion hole in their budget, the shortfall will be fully covered by withdrawals from the NWF.
Analysts estimate that at RUB3 trillion budget deficits due to persistent low oil prices, and without spending cuts from the current budget (running to 2022) or raising taxes, the NWF will compensate for any shortfall for at least four years.
On the other hand, the Finance Minister believes that Russia can sustain 6 to 10 years of US$25-US$30 per barrel oil, the IMF believes that Russia needs oil at US$42 a barrel to balance its budget while the country had a budget surplus last year which it transferred to the NWF.
Meanwhile Nigeria’s foreign reserves stood at US$36.166 Billion as at March 11, 2020 while its Excess Crude Account (ECA) was at US$71.81 Million as at February 2020.
So both Saudi Arabia and Russia appear to be positioned and willing to go to extreme lengths to force their position while Nigeria is extremely disadvantaged.
Now, the fellow who believes that there is no need to worry because Nigeria has reduced its budget oil price benchmark from US$57 per barrel to US$30 per barrel completely misses the point.
At US$20 per barrel, there may be little or no revenue.
In Canada for instance, the price of a barrel of oil fell below the US$5 per barrel cost of shipping it to a refinery, making it more economic for producers to shut down their wells rather than plummet to “negative prices”.
In the same vein, Nigeria has to consider the revenue impact of scenarios where the high production cost of deep-offshore oil rigs are shut-in, while only the lower production cost land rigs are in operation. Also for consideration include an extreme situation where revenue from oil is zero or close to zero (depending on the average cost of production of the land oil rig facilities).
It also goes without saying that in such a dire situation, the only thing that the country can do in order to pay salaries is to devalue its currency.
While the market rate is at N367/US$1, about a week ago, Nigeria’s one-year currency forward recorded its biggest fall in more than 10 years (indicating where the market believes the currency could trade in a year’s time), falling by 11.3% to N515/US$1. Some analysts are forecasting an exchange rate of between N570 to N600/US$1.
In the post-COVID-19 and low oil price emerging world order, any weak or unsustainable fiscal or monetary policy response will severely punish Nigeria.
Those who have regularly followed my writings know that I have never been afraid to stand alone especially as it pertains to my positions on Nigeria’s economy; fiscal and monetary policies.
For context, we will briefly review some of those positions;
Increased External Commercial Debt and Total Debt Service.
By the Fourth Quarter of 2015, Nigeria’s GDP had slowed to 2.11%, a contraction that continued into the fourth quarter of 2016.
Without an overarching fiscal policy direction, very few seemed to be bothered about the country’s increasing external public debt against a significant drop in earnings from crude oil sales.
External debt increases a country’s vulnerability to economic shocks, particularly the commercial part of the county’s external debt which in Nigeria’s case, increased from US$1.5 Billion in June 2015 to US$11.68 Billion as at December 31st 2019, bringing total external debt (Multilateral, Bilateral and Commercial) to US$27.676 Billion by December 31st 2019, from US$10.316 Billion as at June 30th 2015.
The key problem with this is that Commercial debt is less flexible than Multilateral and Bilateral debt in terms of terms renegotiation and much more expensive in terms of cost.
At the time, I had also argued that those who insist that Nigeria still had room to borrow due to a low Debt to GDP ratio erred in judgement, as the appropriate metric should be the Debt Service to Government Revenue ratio.
This is a given, as only about 30% of the country’s GDP impacts government revenue and by extension, the revenue’s available to service debt.
The CBN’s Ways and Means Advances to the Federal Government of Nigeria (FGN)
In the past, we have argued that rather than borrowing, the Federal Government should focus on mobilizing private, non-debt, investment capital with which to build infrastructure and industrialize the economy. Particularly when about US$15 trillion of government bonds worldwide (25% of the market) was trading at negative yields, with governments essentially getting paid to borrow money, as people become increasingly desperate for a safe haven for their wealth. Essentially, zero risk guarantees and assurance of FX liquidity on exit due date should attract such investments.
We are however aware that such structures require innovation, skill, fiscal policy credibility and to some extant fiscal puritanism in the light of Nigeria’s lean revenue streams, sovereign risk rating and deal structuring competences.
Late last week, a leader of Nigeria’s ruling APC, Bola Ahmed Tinubu allegedly advised the Federal Government to print more Naira notes to save the economy from collapse.
Such a request is not far-fetched as the CBN has a mandate to create “Ways and Means” fiscal disbursements out of nothing (aka Helicopter Money, Quantitative Easing, Printing Money etc) on behalf of the Federal Government.
The CBN’s Monetary, Credit, Foreign Trade and Exchange Policy Guidelines For Fiscal Years (Monetary Policy Circular No. 41) 2016/2017 stipulates that “Ways and Means Advances shall continue to be available to the Federal Government, to finance deficits in its budgetary operations to a maximum of 5% of the previous year’s actual collected revenue. Such advances shall be liquidated as soon as possible, and shall in any event be repayable at the end of the year in which it was granted”.
In fact, one of the touted key benefits of the Treasury Single Account (TSA) was the “elimination/reduction of FGN’s access to Ways and Means Advances which involves printing of high powered money with its attendant inflationary impacts”.
The reverse has been the case in practice.
From available records of the CBN, Net Ways and Means claims against the FGN (CBN’s Claims on Federal Government less the Federal Government’s Deposit with the CBN) was positive from January 2015 until December 2016 when it closed in a negative position of N109.159 Billion (recall that the Ways and Means policy stipulates that such advances shall be repayable at the end of the year it was granted). It has progressively increased over time, closing December 2017 in a debit position of N441.663 Billion, December 2018 in debit of N342.214 Billion and December 2019 with a drawn position of N5.051 Trillion. This is way above the CBN policy stipulated maximum Ways and Means of 5% of the previous financial year’s N3.9 Trillion actual collected revenue which should have been N195 Billion.
So Bola Ahmed Tinubu was late to the party.
The CBN has long exceeded its limit for printing more money for the FGN in Geometric Progression. In fact, some analysts believe that the FGN has turned the CBN into its piggy bank. Consequently, printing more money (Ways and Means advances) by the CBN at this time will require more Rube Golberg system of controls to mop up the ensuing excess liquidity. Even at that, the market will still adjust the exchange and deposit rates to reflect the increase in volume of currency.
Nigeria’s Foreign Reserves and Savings Buffer
A country’s foreign reserves is important as it enables payment for its imports and servicing repayment of its debt. Consequently, any funds captured as foreign reserves that is not available to pay for import or repay FX denominated debt is encumbered and does not serve the true purpose of reserves.
This is why analysts insist on determining what portion of a country’s foreign reserves is unencumbered; which is, the stated reserves less Foreign Portfolio Investments (hot money because portfolio inflows may support reserves but are susceptible to a sudden stop driven by global and/or domestic factors), less Swaps, less short to medium term FX debt obligations (like Eurobonds etc), less FX contractual obligations like IATA payments, oil industry JV Cash Calls etc.
This is where it gets interesting.
While there was zero foreign portfolio investment in OMO bills from January 2015 to November 2017, by December 2017 the CBN had about US$8.157 Billion (N2.488 Trillion) worth which progressively grew, peaked at US$21.044 Billion (N6.41 Trillion) in June 2019, before it settled at US$17.47 Billion (N5.33 Trillion) in December 2019. Consequently, to determine Nigeria’s unencumbered foreign reserves at the respective dates, one will need to back out these figures.
In fact, in the IMF’s April 2019 Article IV Report for Nigeria, the CBN acknowledged and defended the dual role of its OMOs in both attracting portfolio investment and managing liquidity and saw special OMOs as necessary to keep costs of liquidity management in check.
The IMF also noted that net inflows (liabilities to non-residents) fell below 1.0 per cent of GDP in 2014-16, before increasing in 2017-18 largely driven by strong net portfolio inflows coming through the IEFX window.
Within the same period, the CBN spent N2.114 Trillion to mop up excess liquidity in the banking system in 2018, up by 42% from N1.489 Trillion in 2017 (total CBN Bills offered, subscribed and sold at the OMO auctions increased to N34.6Trillion, N24.916 Trillion and N22.350 Trillion compared with N13.76 Trillion, N12.345 Trillion, and N11.346 Trillion respectively, in 2017).
Banking Sector Non Performing Loans (NPLs)
Nigerian Tier 2 banks operating with weaker capital buffers have always been vulnerable while the Tier 1 banks are said to be better capitalized. However, the industry is still struggling under the strain of acquisition loans granted power investors during the privatization of power assets (which earned the FGN US$3.2 Billion / N1.15 Trillion as generation and distribution companies were sold for US$1.7 Billion and US$1.5 Billion respectively). These assets were supposedly bought with 30% equity while a 70% debt component was provided mostly by local banks (according to the NBS data, total lending to this sector stood at N683.93bn as at the end of April 2019). It is however quite probable that a lot of the equity portion is also sitting as loans on the balance sheets of local banks.
We cannot also ignore that before the crash and at the peak of the oil price boom of US$115 per barrel in 2014, Nigerian banks gave loans to indigenous oil prospecting companies to purchase assets of the International Oil Companies like Shell, Chevron and Total.
Oil and gas companies accounted for nearly 30.02% of all banking-sector loans in the third quarter of 2019, and their borrowing accounts for 24% of all non-performing loans in Nigeria (this was before the current crash in oil prices). By end of June 2019, loans to the oil and gas sector of the nation’s banking system stood at N4.39 Trillion.
The vulnerability of Nigeria’s oil and gas sector loan portfolio to US$20 per barrel oil can only be imagined, exacerbated by a lack of demand, and the disappearance of the illusion of liquidity that typically follows a recession.
The Current Global Recession
In a paper I present at the Chartered Institute of Bankers of Nigeria (CIBN) Rivers State Branch 2018 Annual Bankers’ Dinner on December 18, 2018, titled “Boom and Bust – Preparing our Industry and Customers for the Next Financial Crisis” I argued that we may not know the time, however, what we know for sure is that the next financial crisis is coming as soon as late 2019 and wondered if Nigeria was ready.
To appreciate what needs to be done to mitigate the fallouts of this crisis, we must take lessons from events pre and post the 2008 Global Financial Crisis (GFC).
It is important to note that the roots of the 2008 GFC precede the crash of Lehman Brothers. It can be found in a combination of speculative activity in the financial markets, focusing particularly on property transactions – especially in the USA and Western Europe – and the availability of cheap credit.
Since that crisis, not much was done both international and locally for the much required financial and labour markets reforms to tax systems, fertility patterns, and education policy reforms.
The result is that the massive liquidity that central banks across the world injected into their systems during and after the crisis was not efficiently allocated.
With the current crisis, it is this level of unprecedented debt binging and quantitative easing from regulators that will make intervention by local central banks and federal governments extremely difficult.
There are three stages required for a regulator to catalyse recovering from a financial crisis; admit the losses, decide who should bear them, and fight the ensuing downturn—as quickly as possible. “Delay allows problems to fester on bank balance sheets, increasing the ultimate cost of bailing out the financial system. This was the mistake Europe made and the United States avoided”.
It is extremely important to acknowledge the extent of the problem and determine how much wealth was destroyed. This may be difficult where banks may not be open to revealing the true state of their delinquent assets to avoid aggressive write-downs but should be evident when increasingly large balance sheets are yielding compressed Net Interest Margins and are relying on derivatives to make up for the shortfall on their income lines.
The regulator may also conveniently look the other way, especially for Systemically Important Banks (SIB) as properly flagging the true state of these delinquent assets would mean that the attendant loan loss provisions must be taken, capital written down and losses must be allocated to taxpayers, a step a lot of regulators may be reluctant to take.
Unfortunately, the fact that 12 years after the 2008 global financial crisis, some of these toxic assets are still on banks’ balance sheets makes the Nigerian banking sector extremely vulnerable to this current crisis. Look at the five countries in Europe worse hit by the 2008 global financial crisis, while Iceland, Spain and Ireland acknowledged the level of their wealth destruction and wrote down the assets, Italy and Greece refused to bite the bullet as long as possible leading to a heavy drag on both economic systems till date.
Recall that prior to their rescue by the Central Bank of Nigeria, a number of the challenged banks were still paying huge dividends and positioning as big and healthy financial institutions, a charade that was helped by the fact that their audited accounts were routinely approved by both their external auditors and the central bank.
Yet, not one of the external auditors or the principal officers of the regulatory authorities was penalized when these banks had their licences revoked.
We dare say that the extent of the current crisis impact on the Nigerian banking industry may partly depend on if these individuals and /or their protégés are still approving audited accounts of financial institutions in Nigeria today.
In Summary;
• The current face-off between Russia and the Kingdom of Saudi Arabia has major political underlining, which may affect a speedy resolution of the price war.
• Both Saudi Arabia and Russia appear to be positioned and willing to go to extreme lengths to force their position. The same cannot be said for high-cost producers like Nigeria.
• With the knock-on effects of the COVID-19 pandemic and the crude oil price wars, the global economy and Nigeria are in a recession, probably headed into a deep depression.
• There is a high possibility of shut-in of Nigeria’s high production cost offshore oil rigs with the attendant effect on production volumes.
• At current revenue levels, Nigeria’s external debt service and the loan repayment will be a big challenge.
• The crash in crude oil price and depleting foreign reserves will trigger a devaluation of the Naira. An exchange rate of N367/US$1, and one-year currency forward of N515/US$1 already creates an arbitrage opportunity which will self-resolve.
• As at 31st December 2019, the CBN’s Ways and Means Advances to the FGN stood at N5.051 Trillion, way above the policy stipulated maximum Ways and Means of 5% of the previous financial year’s actual collected revenue (which was N3.9 Trillion for 2018). This makes further aggressive Ways and Means Advance difficult without increasing inflationary and exchange rate pressure.
• The economic situation will lead to a deterioration in the risk assets portfolio of Nigeria’s Money Deposit Banks, while the CBN may not have the capacity to step in and rescue them.
• Expect bankruptcies and businesses to struggle. Most impacted will be SMEs due to their lack of accumulated capital buffers to withstand the shocks.
• Expect businesses failures and a spike in an already high unemployment rate.
It is however not all doom and gloom for Nigeria’s economy.
Persistent low crude oil prices will leave the country with no other option than to reset and decentralize its current fiscal structure. If it was ever in doubt before, it is now more evident that Nigeria cannot afford to operate under the current fiscal structure.
What Needs to be Done
• With the oil booms, Nigeria had become a procurement economy so any model to address its fiscal inadequacies that did not have provision to award contracts was unlikely to find a listening ear.
• With oil revenues literally gone, this is the time to get a world-class economist to drive fiscal policy and introduce the much needed bold and audacious financial and labour markets, tax systems, fertility patterns, and education policy reforms. The markets will react positively to the individual’s brand equity, even when he/she is making a mistake. President Muhammadu Buhari has to be prevailed upon to listen to this individual and his / her economic advisory team.
• Fiscal federalism should be deployed to ensure alignment between public expenditure and the different needs of the local and state governments. This way, management is brought home and is very local. Accountability is also significantly enhanced as residents/constituents close to the points of service delivery can hold their immediate local and state elected officials who live in their midst answerable. Local and State governments are also likely to be more efficient, responsible and accountable if they have to generate the revenue they spend. Development and services will be specific to the needs of the locals and expenditure adjusted to what is affordable.
• The FGN’s debt should be consolidated; External debt (Multilateral, Bilateral and Commercial), Domestic Debt, AMCON’s N5.3 Trillion (sunset clause of 2023), Contingent Obligations, Outstanding judgment debts, NNPC and other public agencies’ debt etc.
• With a clear idea of our current debt portfolio, the Finance Ministry should urgently approach the IMF for a bailout, our Multilateral and Bilateral lenders for a restructure, and our foreign commercial lenders for a restructure and repricing if possible.
Other than this, I guess we should all brace for impact.
Dr. Jekwu Ozoemene is the Managing Director and CEO of Lyceum Alliance Limited
