Nigeria: Policy Action in a Time of Stagflation

LAGOS, Nigeria, Capital Markets in Africa: The Nigerian economy is currently between a rock and a hard place as policymakers grapple with stagflation i.e. the simultaneous emergence of negative economic growth and high inflation. Inflation has accelerated in 2016, outstripping all expectations to hit a decade-long high of 16.5% in June. GDP growth, meanwhile, turned negative in the first quarter of the year as the economy contracted by 0.36% year-on-year. With a recession looming, the International Monetary Fund (IMF) slashed its 2016 growth forecast for Nigeria to -1.8% (Vetiva estimate: -1.3%), a huge deterioration from the 4.1% growth forecast it set at the start of the year. The confluence of these two threats create a policy conundrum for the Central Bank of Nigeria (CBN) and Federal Government (FG) as they try and reverse the economic malaise.

Supply-side distortions
Runaway inflation has been caused primarily by rigidities in the FX policy that have led to supply-side disruptions throughout the economy. Stringent restrictions on dollar supply for much of the past 16 months pushed up import prices, with imported food inflation at a high of 20% in June. Dollar scarcity further fed into the downstream petroleum market, leading to shortages of petroleum products that spurred higher energy costs; Premium Motor Spirit (Petrol) retailed at a national average of N163 in April against the prescribed price of N87 at that time. The depreciation of the naira as a result of  factors such as the much-vaunted introduction of a flexible FX regime, liberalization of the downstream petroleum market and higher electricity tariffs contributed further to the sharp rise in prices this year. Financial implications have also materialized as spiraling inflation pushed down the real rate of return and exerts upward pressure on government bond yields. 

Economic rut spreads through key sectors
Yet, monetary tightening is likely to further depress a private sector struggling to achieve growth (non-oil sector Q1’16 growth was -0.18%). Industry is suffering from higher costs of energy and raw materials as the power situation in the country continues to suffer from militant attacks on oil & gas infrastructure.

Meanwhile, consumption remains sluggish as high inflation is accompanied by volatile earnings, with a number of states failing to pay workers consistently in 2016.

Furthermore, unemployment is on a similar upward trend – Q1’16 unemployment rose to 12.1% from 10.4% in Q4’15 whilst Q1’16 underemployment rose to 19.1% from 18.7% in Q4’15. These higher numbers depict an economy failing to create enough jobs to accommodate an expanding labour force.

The finance sector is creaking under the strain. Banks’ significant exposure to Oil & Gas firms, who continue to struggle in an unforgiving oil market, and the NGN/USD rate (about 45% of bank loans in the country are foreign currency-denominated) have tightened liquidity at a time when they need to recapitalize due to the naira depreciation. Particularly, lending appetite has been tepid as banks have run to safe assets like government bonds. The sector is in better shape than in the last crisis (2008/9) but remains hamstrung by legacy debt from previous boom era.

The economic situation is further complicated by a sharp decline in government revenues during the year. The primary driver has been lower oil production as resurgent militancy in the oil producing Niger Delta region has adversely affected production levels. According to the NNPC, oil production slumped to a 2-decade low of 1.6 million bpd in June. Borrowing becomes key in this situation but international appetite remains weak despite roadshows conducted by the CBN Governor and Minister of Finance.

A tonic of guns and spending
So far, fiscal response has been slow in the face of severe challenges to the Nigerian economy. Opacity and controversy over altered capital spending items led to delays in the budget before it was finally passed in May but implementation of the many infrastructure and welfare projects outlined in the budget is yet to really kick off. Welfare policies targeted at the very poor will be an important cushion in the current economic climate but urgency is tempered by the need to ensure efficacy and avoid the leakages that plagued previous welfare schemes. On infrastructure, it could be a case of too little too late this year as the fiscal lag and bureaucratic process mean that economic effects of spending are unlikely to manifest until 2017. Furthermore, deficit financing becomes more important in the longer term as the 2016 budget estimated a deficit of N2.2 trillion even before recent revenue shortfalls.

A quicker fix could be addressing the present state of insecurity gripping the nation. So far, the Government has been unconvincing in its efforts to rein in marauding Fulani Herdsmen in the Middle-Belt and South-West. Agriculture, one of the cornerstones of the FG’s economic policy, can only thrive in conditions of security and output has already taken a hit, with Q1’16 growth in the sector at 3.09%, the lowest since 2013. The return of militancy in the Niger Delta is a more acute problem. The previous amnesty program, criticized for creating perverse incentives and rewarding violence, had been successful at maintaining peace within the region albeit unsustainably. The FG is likely to adopt a different, less lenient approach to tackling the insurgency. A protracted conflict in the Niger Delta would be disastrous for oil production, Nigeria’s fortunes and investor confidence.

Monetary policy and stagflation
The awkward choices confronting the nation’s policymakers is best reflected in the monetary policy situation. Following a 200 bps Monetary Policy Rate (MPR) cut to 11% at the end of 2015, the MPC raised the rate to 12% in March and then to 14% in July, citing the limited pass-through effect of the rate cut to the real economy, the growing threat of inflation and the need to sustain the recent free-float currency policy. Yet, tighter monetary policy has been impotent in the face of cost-push inflation. Now the MPC is between a rock and a hard place – if it loosens, it needs to ensure that the effects feed through to real economy but there is the risk of a bigger currency rout and squeezing bank margins.

If it tightens, it might just choke the economy even further and put more pressure on bond yields and counteract the effects of expected fiscal stimulus.

The genesis of this dilemma can be partly traced to the botched handling of foreign exchange policy. Until recently, the CBN kept a firm grip on the NGN/USD rate. Following the oil price decline and falling foreign currency reserves, the central bank sharply cut dollar supply in the official market.

Compounded by dollar illiquidity and worsening macro picture, capital flows reversed sharply and a wide spread emerged between the parallel market and official rates – close to 100% as at February. The recent shift to a floating exchange rate regime and introduction of naira settled futures-trading (to discourage frontloading) has exposed the wretched state of the market. Trading volumes in the spot market remain small even as the CBN demonstrates its willingness to let the naira freely float. Attracting investors to an illiquid market is a hard sell as pressure on the naira persists. Wooing investors with dollars is critical in the short run as dollar earnings from oil sales bottom out. To do this, the CBN must convince market participants that it is willing to let the naira freely trade above 300 NGN/USD mark, an important psychological breach. The final weeks of July give credence to this view as the NGN/USD fell more than 10% in just 5 trading sessions. Barring further CBN intervention, it is likely the NGN/USD will trade above 300 for the rest of the year. Longer term, there is a need to diversify FX earnings to stimulate liquidity in the FX market.

2016: Lessons learned?
Whereas it took fiscal policy half the year to kick off, the CBN tried a cocktail of initiatives before succumbing to pressure to float the naira. Without a doubt, the impotency of current policy has accelerated Nigeria’s descent to stagflation. Now, no easy remedies exist. Tackling negative growth must be priority. To do this, easing the pressure on the naira by attracting investors (to boost supply) will be crucial, perhaps necessitating the need to keep monetary policy tight. Meanwhile, the budget still holds the promise of a substantial fiscal multiplier – if it is implemented efficiently. Following a string of questionable policy choices, precision is required to turn the economy around.

Contributor Profile
Mr. Pabina Yinkere is Head of Research at Vetiva Capital Management, a Lagos based investment bank. He possesses vast experience in investment analysis and market research. Pabina’s valuation and investment strategy supports over N40 billion (USD 125 million) Assets Under Management and a broad clientele base of domestic and international investors.

This article features in the September edition of INTO AFRICA Magazine, which focuses on reviews of Africa’s economies in the first half of 2016.