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Structural Adjustment in Nigeria: Widespread reform in progress; the challenge ahead

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
September 1987
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Nils Borje Tallroth

The sharp increases in oil revenues in 1973-74 and again in 1979-80 had a pervasive effect on the Nigerian economy. These revenues provided the basis for large increases in public expenditure designed to expand infrastructure and non-oil productive capacity, even as they served the political and social purpose of healing the wounds of the civil war (1967-70). There were also substantial increases in public spending on health, education, and other social services throughout the country.

But notwithstanding some important successes, many public investment projects were undertaken without sufficient attention either to their economic viability or to the capacity of government agencies and public enterprises to implement them. Furthermore, the rapid expansion of construction and urban services that was associated with the increase in public expenditure was accompanied by price and wage increases that severely reduced producer incentives in the non-oil tradeable sectors. Agricultural exports were particularly hard hit, since the exchange rate was allowed to appreciate substantially in order to cheapen costs of imports and to curb inflation. Within a decade, Nigeria became a major food importer, while production of export crops declined substantially, making the country dependent on a volatile international oil market for almost all of its export earnings and most of its federal and state government revenues. In industry, negative real interest rates and rapid wage increases, together with the appreciating exchange rate and the system of tariff protection and import licensing, stimulated the use of imported capital-intensive technology and rapid expansion of consumer goods and assembly-type industries based on imported inputs.

During most of the 1970s, budgetary expenditures exceeded the rapidly rising revenues from oil. Indeed, official data show only a modest surplus even in 1980, despite the spectacular rise in oil earnings that year. When the oil market weakened in the early 1980s-reducing Nigeria’s oil export earnings from $23.4 billion in 1980 to $9.9 billion in 1983-the Government responded slowly. Large external and internal deficits resulted. Foreign exchange reserves were run down even as $6-7 billion of external payment arrears were amassed. Heavy external borrowing from the late 1970s increased outstanding medium- and long-term public debt from less than $1 billion in 1978 to about $12.8 billion in 1983.

In addressing the crisis, the Government resorted to economic austerity, relying heavily on administrative controls and regulations. These reinforced rather than corrected the structural distortions that had been built up earlier. Large across-the-board cuts were made in investment expenditure, leaving projects without sufficient funding for their completion. Current expenditure was also cut but, since the wage bill was protected, falling revenues left insufficient funds for materials, supplies, and maintenance. While the austerity measures brought about a rapid decrease in fiscal and external deficits, they also brought on a serious recession. The downturn was aggravated by drought-induced declines in agricultural production in 1983 and 1984. Severe supply shortages of both imported goods and foodstuffs sharply boosted prices. Together with an inflexible nominal exchange rate policy, this resulted in an appreciation of the exchange rate in real effective terms of more than 80 percent over the period 1980-84.

Policies changed when the new military government came to power in 1985, declaring its intention to move from “austerity alone to austerity with adjustment” and to seek international financial support for its program. Initial reforms, including substantial increases in domestic petroleum prices, were announced in the 1986 budget. The dramatic fall in world oil prices in early 1986 increased the urgency of reform. An ambitious structural adjustment program was adopted in June 1986. The program is supported by a debt rescheduling and external financing package to provide new funds, involving commercial banks, and the Paris Club and other creditors. The World Bank is supporting the program with a Trade Policy and Export Development Loan in the amount of $452 million. The IMF approved in January 1987 a stand-by arrangement of SDR 650 million (about $830 million) in support of the adjustment program, though the Government has declared its intention not to draw on the IMF stand by.

The adjustment program

The Nigeria program has two main components: measures aimed at changing the structure of the economy and policies to support stabilization. While there is considerable interplay between the two, the focus of structural adjustment is on exchange rate and trade reforms, while monetary and fiscal policies are the important instruments of stabilization. The adjustment strategy is based on the assumption that external financing will permit Nigeria to run current account deficits and thereby to achieve higher import levels and growth rates than would otherwise be possible. In the spirit of the Baker Plan, the approach is to allow debt to increase, although at a slower rate than projected export growth, with the result that credit-worthiness would be restored over time. Austerity is still necessary, for the oil price decline of 1986 sharply reduced export revenues. But the strategy allows Nigeria to avoid the further expenditure controls that would have otherwise been needed for a rapid restoration of creditworthiness.

Exchange rate reform. The centerpiece of the adjustment program is the shift to a market-determined foreign exchange rate for trade transactions, through the introduction of an auction system for the allocation of foreign exchange--the second-tier foreign exchange market (SFEM). At the inaugural SFEM auction on September 26, 1986, the value of the naira was discounted by 66 percent, trading vis-a-vis the US dollar at $1 = N4.6 as against the administered rate of $1 = N1.6. Initially held every week, fortnightly auctions have been the rule since April 1987. A shift has also been made to a “Dutch auction” system, whereby buyers pay their bid price, rather than the earlier system where each successful buyer paid only the marginal rate that exhausted the total amount being offered. The official, administered (“first tier”) rate was kept for an interim period, with its use reserved for debt service and payments to international organizations. In accordance with the program, the two rates were unified in July 1987. Overall, the auction is working well and has become a generally accepted part of the economy. These are important achievements for a country that had long resisted outright devaluation.

In addition to the auction, SFEM encompasses transactions between authorized dealers and the private sector and an interbank market, which accommodates the recycling of foreign exchange initially purchased from private sources. The latter have become an important source of foreign exchange for the market; data for February 1987 suggest that proceeds from non-oil exports, remittances, invisibles, and capital transfers supplied to the market amounted to almost 50 percent of the auction sales for that month. This is an encouraging development, given the rather insignificant funding from such sources at the beginning of the SFEM.

Trade reform. Virtually all price controls and import licensing were abolished at the start of the SFEM, and the number of items subject to import prohibition was reduced from 74 to 16. Under the program, the Government also abolished the temporary 30 percent import surcharge introduced in January 1986 and adopted an interim import duty and excise schedule. This reduced the dispersion of rates and the trade-weighted average customs duty from 35 percent to 25 percent. Some imports of agricultural and industrial products, which compete with the products of major domestic producers, still bear high nominal rates. Nevertheless, the removal of import licensing has transformed the protection regime, with the devalued exchange rate combined with more uniform and lower tariffs now providing protection for domestic producers. By far the most powerful change in export incentives under the program is the devaluation of the naira, while regulations carried over from the previous era of bureaucratic controls, such as prohibitions and export licensing requirements, have been reduced or removed.

Monetary policy plays a dual role in the adjustment program. For demand management purposes, monetary policy is to remain tight over the program period in order to prevent inflationary pressures from creating excessive demand for foreign exchange. In 1986 the broad money supply (M2) grew by only 2 percent; inflation was only half the level that had been projected in the program, and there was considerable upward pressure on interest rates. Recently, monetary policy has become expansionary. Monetary policy also has a structural component under the program, involving movements toward a more market-oriented financial system designed to facilitate the mobilization of financial savings and to encourage more efficient allocation of financial resources. Recognizing the need to give banks greater flexibility in their credit operations, the Government replaced the earlier extensive use of sector-specific credit targets with a simpler categorization which gives guidelines for the allocation of credits between priority activities for only half of the banks’ lending. This is a further step in the deregulation of the financial system. Interest rate ceilings were also raised, thereby making it more profitable for banks to intermediate savings to potential investors and ensuring resources are devoted to more profitable projects.

Fiscal policy under the program was to combine a restrictive stance with measures to improve efficiency. The program aimed at keeping the federal budget deficit below 4 percent of GDP, with the devaluation facilitating the achievement of this target by sharply increasing the value of external petroleum receipts in naira terms. But in pursuing the fiscal balance target, certain general principles designed to enhance the effectiveness of public spending were to be followed including restraint on the growth of federal wage bill; an increase in material supplies to ensure adequate maintenance of infrastructure; and a reduction in subsidies to economic and quasi-economic parastatals. In the event, fiscal policies and control over public expenditures have proved the most difficult area of the program to implement, and there has been some slippage from the fiscal deficit target. This issue needs to be addressed in order to ensure the smooth implementation of the program, in particular its monetary and price objectives.

Impact

The changes in trade policy and the real exchange rate that accompanied the introduction of SFEM are likely to have their main effects on relative prices. Thus far, the program has had its greatest impact on the price of exports. Prices of import substitutes have risen to a lesser degree, since the effects of SFEM have been partly offset by removal of import restrictions and lower tariffs. The exchange rate and trade policy changes have had less effect on the prices of nontradable goods which, with domestic demand weak, have continued to decline both relatively and absolutely. The profound distortion in the relative price structure that was built into the economy during the oil boom years has now been largely corrected.

There was some concern in Nigeria that the introduction of SFEM, together with the removal of ex-factory price controls, would cause a resumption of high inflation rates. In the event, prices of grains fell sharply in late 1986, following a bumper harvest, and prices of other food products have increased only marginally. Prices of nonfood commodities have shown a mixed pattern, with modest increases for most items, basically because their retail prices largely reflected depreciated values before the introduction of SFEM. Prices for a few highly visible goods, such as automobiles, have risen sharply. But many prices actually fell somewhat during the first three months of SFEM operation, a trend that seems to have continued during the first quarter of 1987.

In agriculture, domestic prices for the principal cash crops-oil palm, cocoa, rubber, cotton, and groundnuts-used to be set by the respective Commodity Boards, which were dismantled in 1986. This move, together with the exchange rate change, greatly improved incentives for most of Nigeria’s traditional cash crops, especially those whose prices had not been artificially supported by export subsidies or import restrictions accompanying the overvalued exchange rate. The immediate supply response has been strong for cocoa-the dominant non-oil export commodity-and rubber, with most existing trees reportedly now back in production. The longer-term supply response is still difficult to gauge; substantial new investment in additional capacity for tree crops with long gestation periods will require confidence in the sustainability of the present incentive framework.

The exchange rate adjustment and accompanying measures to liberalize trade have led to far-reaching changes in the incentive structure for industry. Previously, the Nigerian industrial sector had expanded largely in the direction of import substitution, influenced by the overvalued exchange rate which discouraged export production, and the tight limitations on actual imports. The program has reduced the previous bias against export activities. Incentives for producers of import substitutes, taken as a group, have been left broadly unchanged, although the exchange rate and trade liberalization measures have tended to affect individual producers in different ways, depending on the changes in tariffs and the share of local inputs in overall production costs. Broadly speaking, trade liberalization lowers the prices of imported final products, while depreciation of the exchange rate tends to raise them, as well as prices for imported inputs. For a given depreciation of the exchange rate and tariff reduction, the net effect on profitability of producing import substitutes will depend on the share of labor in production costs, since, in the short run at least, labor costs will not be directly affected by the exchange rate change. Hence, the larger the labor and local raw material share, the larger will be the increase in profitability.

Survey results tend to confirm these expectations. The more efficient local resource-based activities in manufacturing have felt a strong boost to their competitiveness. Import-dependent, assembly-type industries, on the other hand, have seen their costs escalate because of SFEM, while their competition from imports has increased, as a result of the freeing up of trade together with reductions in tariffs, and demand for their products fallen as a result of the recession that accompanied the drop in oil revenues. Some have closed down plants, adding to the unemployment problem. Most of the problems in manufacturing are in large, highly visible, urban-based firms which were developed behind protective tariff walls but were not, and will never be, efficient users of Nigeria’s scarce resources. In fact, an inevitable outcome of a structural adjustment program designed to reorient production along the lines of comparative advantage is the restructuring or closing of such activities. The expansionary effects on industry of SFEM are likely—at least initially—to come from small companies based on local resources. These companies have limited visibility so far, particularly as the previous trade and exchange rate regime discouraged the development of a viable industrial export sector.

Notwithstanding serious transitional problems for some groups, the broad social impact of the adjustment program appears positive, particularly when seen in terms of the evolution of policy from “austerity alone to austerity with structural adjustment.” The decline in economic activity that preceded the adjustment program increased unemployment and reduced per capita income. Without the program, the recession was projected to continue and even worsen, given developments in oil prices. By contrast, the large price boost that the adjustment program has given to exportables, and in particular the labor-intensive tree crops, has raised the demand for labor. This should help to forestall further increases in overall unemployment. As the effects of the program become more broadly felt, unemployment should begin to fall. Although the labor market adjustment process on the whole seems to be working, there is a transitional problem of mismatches between skills and job openings-the unemployed are school leavers and those with advanced training, while the jobs being created are for relatively unskilled rural workers.

Conclusions

While the response to the adjustment program in many areas has already been favorable, the domestic political situation is not an easy one, with the effects of continuing austerity and collapsing oil export revenues on imports and production partially obscuring the program’s positive effects. Still, it is essential for Nigeria to persevere with present policies, for the recovery depends on availability of imports and, in turn, on export revenues and access to foreign financing. While oil revenues depend on factors that Nigeria can do little to influence, development of non-oil exports depends on the implementation of the adjustment program. The supply response to the improved incentives depends very much on entrepreneurs’ confidence in a continuation of present policies. Moreover, should the Government lapse in its pursuit of reform and return to the previous policy regime of controls, external financing would be less forthcoming. The challenge ahead is to implement the remaining parts of the program and to maintain the reform momentum, thereby establishing the program’s credibility in private markets.

Nigeria’s prospects for growing out of the debt crisis are good. Assuming continued implementation of the program, Nigeria’s debt crisis should subside over the medium term, as oil and non-oil exports grow. But until then, Nigeria will face a foreign borrowing constraint. This constraint, in turn, will limit the investment response to the structural adjustment program’s changed incentive framework and constrain per capita income growth, particularly given the effects of desert encroachment and deteriorating soil fertility on agricultural prospects.

The Nigerian experience illustrates the importance of keeping public sector spending within “permanent income.” This precept is difficult to implement for countries that depend, like Nigeria, on exports of a single commodity for the bulk of their foreign exchange. Indeed, if oil prices were to rise again dramatically, there would be pressures to use the proceeds for improving standards of living. However, these pressures should be accommodated only to the extent that increased revenues and spending are sustainable. With spending kept in check, painful austerity measures would not be required when prices decline again. This would also prevent the real exchange rate from appreciating unduly during periods of temporary increases in export revenues, thus avoiding costly shifts in the structure of production that would ultimately need to be reversed. This approach would also preclude foreign borrowing to finance consumption or investment in non-economic projects, which-while apparently affordable when oil prices are high-are not affordable from the perspective of permanent income.

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