Nigeria
Third Review Under the Policy Support Instrument: Staff Report; Staff Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Nigeria

This paper examines Nigeria’s Third Review Under the Policy Support Instrument. Robust growth, lower inflation, a dramatic decline in debt, and an accumulation of significant reserves are among the notable economic achievements. It will be important to consolidate and institutionalize these gains as the foundations for sustained and improved economic performance. Non-oil growth accelerated and its prospects are promising. Inflation remained in line with the single-digit program target owing to a likely increase in confidence and money demand.

Abstract

This paper examines Nigeria’s Third Review Under the Policy Support Instrument. Robust growth, lower inflation, a dramatic decline in debt, and an accumulation of significant reserves are among the notable economic achievements. It will be important to consolidate and institutionalize these gains as the foundations for sustained and improved economic performance. Non-oil growth accelerated and its prospects are promising. Inflation remained in line with the single-digit program target owing to a likely increase in confidence and money demand.

I. Policy Setting1

1. The accomplishments of the outgoing Obasanjo administration include improved macroeconomic stability and a better policy framework. Robust growth, lower inflation, a significant build up of reserves, and a reduction of external debt are among the notable economic achievements. These developments benefited from favorable external conditions. Broad and ambitious structural reforms led to an improvement in the policy framework and institutions, leaving a strong legacy for the new administration that took office on May 29.

2. The robust growth observed in recent years—supported by improved macroeconomic conditions and structural reforms—is expected to continue in 2007.2 In 2006, solid agriculture and trade growth boosted non-oil sector activity. In 2007, supply-side conditions could improve as several new power plants should stabilize and enhance electricity production, and thus reduce production costs. Following a drop in crude oil production in 2006 due to unrest in the Niger Delta, a rebound is projected to the 2005 levels stemming mainly from production in new off-shore fields. Gas production will increase with the new West African Gas Pipeline.

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Non-oil sector dominates growth…

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

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…boosted by agriculture and with trade and telecommunications leading a shift to services.

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

3. Following the Paris Club debt relief and aided by higher oil prices, the external position strengthened further through efforts to divest external debt and continued increases in international reserves. The London Club par bonds were repaid in late 2006, the liabilities for promissory notes were divested in March 2007, and efforts were made to buy back the oil warrants. Rising investor confidence is reflected in Nigeria’s favorable sovereign ratings and interest rates on private sector external bond issuance.

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High oil revenues and the Paris Club arrangement led to debt reduction and reserve accumulation…

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

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…and favorable international ratings of BB

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

Source: Fitch Ratings; March 12, 2007

4. The immediate policy challenge is to manage the economy through the period of political transition: to preserve the gains of previous years, and provide a sound policy framework as the starting point for the incoming administration. Discussions with the authorities on the third review therefore centered on the following issues:

  • Maintaining a macroeconomic policy setting consistent with stability;

  • Safeguarding wealth through comprehensive asset and liability management; and

  • Consolidating and institutionalizing reforms.

II. Maintaining Macroeconomic Stability

5. Against a background of the strong real and external position, fiscal and monetary policies were more expansionary than programmed in 2006. Growth of the monetary aggregates accelerated owing partly to ineffective monetary policy and a one-time increase in state spending. However, the unanticipated liquidity injection did not translate fully into inflation likely due to rising confidence and money demand. Inflation performance has improved including in relation to program projections. The 2007 macroeconomic program targets a stronger fiscal position and addresses the remaining risk of inflation by targeting monetary growth that is lower than non-oil sector growth.

A. Managing Fiscal Developments

6. The larger-than-projected expansion at the consolidated government level and the change in the composition of spending added to domestic demand in 2006.

  • While the assessment criterion on the federal government fiscal balance was met with a margin, the target on the non-oil primary deficit of the consolidated government was exceeded by 3 percent of non-oil GDP (Table 2a and Table 2c, Text Table 1). The expansion was due to higher-than-projected state and local government (SLG) spending financed by one-off distribution from the excess crude account beyond the oil price fiscal rule, a partial execution of the new explicit fuel subsidy scheme and somewhat higher gas receipts.3, 4 Yet the overall fiscal balance remained well in surplus, enabling further accumulation of oil savings.

Text Table 1.

Consolidated Government (non-oil), 2005-07

(Percent of non-oil GDP)

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Sources: Nigerian authorities, and Fund staff estimates and projections.

Estimates domestic demand impact of fiscal stance. Defined as non-oil balance (excluding fuel subsidy) less estimated foreign content of large infrastructure projects and foreign interest.

  • The overall fiscal expansion combined with the underexecution of import-intensive capital spending raised the (proxy) domestic balance beyond projected levels. While identified capital spending increased relative to 2005 as intended, it remained below budget levels for the federal government and the large infrastructure projects.

7. The authorities have reaffirmed their 2007 fiscal program set at the second review, which now involves a reduction of the fiscal impulse. The program envisages a reduction in the non-oil primary deficit of the consolidated government by about 3 percent of non-oil GDP. Capital spending needed to close Nigeria’s infrastructure gap, including the large infrastructure projects with high import content, is expected to grow, while other spending remains contained. The assessment criterion for the federal government balance set at the second review has been reaffirmed by the authorities. Achievement of the consolidated government target hinges on adherence to the oil price fiscal rule by all levels of government; it has been implemented so far in 2007.

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A lower deficit and a shift to import intensive capital spending will reduce domestic demand pressures in 2007.

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

B. Strengthening Monetary Policy Implementation

8. Monetary targets were not met because policy only partially offset the unexpected fiscal stimulus of late-2006.

  • Problems with monetary data impeded effective analysis, thereby limiting the CBN’s ability to respond promptly to changes in liquidity conditions (Box 1). The end-December 2006 accounts have now been reconciled, including the previously-reported inconsistency on international reserves, and the external auditors gave an unqualified audit certification for the 2006 CBN accounts.5

Monetary Statistics

The simultaneous introduction of several new software systems at the CBN in January 2006 resulted in significant accounting errors, difficulties in preparing monetary statistics, and substantial delays in data reporting to the Fund throughout the year. The full extent and interrelationship of the problems became apparent during the external audit of the CBN’s 2006 financial accounts. The Fund provided technical assistance both on accounting and statistics. The CBN has embarked on a comprehensive approach to resolve these issues related to accounting, statistics, and information technology (IT).

  • Uneven implementation of monetary policy led to higher-than-programmed growth of monetary aggregates. With real interest rates remaining negative, reserve money was on average above program targets, and end-quarter corrections were only temporary. Insufficient sterilization of balance of payments inflows, reflecting higher than expected government spending, meant that the end-December reserve money target (assessment criterion) was exceeded (Text Table 2). In addition, reserve money was lowered through a reduction in the cash reserve requirement (CRR)—contrary to the CBN’s Monetary Policy Committee communiqué in February 2006—though the liquidity impact was sterilized with 91-day treasury bills.6 Adjusting for the reduction in the CRR, the reserve money target would have been surpassed by a wider margin. The authorities attribute the sharp rise in reserve money in December 2006 to a surge in currency resulting from demands associated with political campaigns. The surge in currency has been reversed in the first months of 2007 and hence represents a temporary deviation from the program.

  • Allowing the naira to appreciate would have provided scope for greater foreign exchange sales to meet the reserve money target. The naira-U.S. dollar exchange rate has remained stable as a result of the authorities’ intervention policies (Text Figure).

Text Table 2:

Required Mop-up of Government Spending, 2004-071

(Percent of non-oil GDP)

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Sources: Nigerian authorities, and Fund staff estimates and projections.

Staff does not have adequate historical data on liquidity management to directly measure the scale of mop-up. This table uses the non-oil overall balance and the import content of large investment projects to proxy the domestic balance. The proxy for central bank intervention is, thus, the difference between the proxy domestic balance and the change in reserve money. It is indicative because it also captures the impact of the balance of payments, central bank profits, and other factors.

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Reserve money was above program…

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

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…as was broad money…

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

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…resulting in looser monetary conditions, a stable exchange rate, and lower yields.

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

9. The inflation consequence of the growth in monetary aggregates was likely muted by an unexpected pick-up in money demand. Credit to the private sector, including long-term investment in the oil sector with limited domestic demand impact, explains about two-thirds of the broad money increase in mid-2006. Nevertheless, core inflation (excluding food and energy) accelerated somewhat in the last quarter of 2006. This increase was broad based, suggesting that it may have been related to the mid-2006 surge of liquidity. However, the subsequent decline in inflation in 2007 indicates that those inflationary pressures have diminished. This could be explained by a pick-up in money demand owing to a significant reduction in headline inflation and reemerging confidence in the financial system following the consolidation of the banking sector.

10. Against this background, the 2007 monetary program targets the CBN’s single-digit inflation objective by reversing in part the acceleration in broad money. Broad money is targeted to grow by about 12 percent, which is below nominal non-oil GDP growth. Inflation developments will nonetheless need to be monitored closely. If money demand in 2007 turns out to be lower than projected or the impact of the monetary surge in mid-2006 is yet to be felt, monetary policy would have to be tightened to contain inflationary pressures. CBN’s sterilization efforts should support the reserve money target by focusing on foreign exchange sales that would also allow sufficient domestic credit growth to the private sector and import growth consistent with the projected real appreciation. Greater flexibility in line with market conditions in the nominal exchange rate (compared to the current practice) and the nominal interest rates is essential.

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Confidence and money demand increased as average headline inflation fell.

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

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This was largely driven by low food inflation…

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

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… as core inflation was broad based in late 2006, with 50 percent of core-urban commodities registering inflation in double digits.

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

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Sterilization through foreign exchange sales should encourage external adjustment—a faster real appreciation and further import growth.

Citation: IMF Staff Country Reports 2007, 263; 10.5089/9781451829020.002.A001

11. To improve the implementation of monetary policy, the CBN has introduced the following measures.

  • Outstanding monetary data problems are being addressed. External advisors are assisting the CBN with IT issues and the Fund is providing technical assistance on accounting and monetary statistics. Regular data submissions of monthly data to the Fund have resumed.

  • The monetary decision-making process is being strengthened, including through internal reorganization of the CBN. Liquidity management is being improved through effective operations of the fiscal and liquidity assessment groups, which should provide timely information on liquidity injections. The Fund’s peripatetic expert and long-term advisor are assisting the process.

  • Intra-month interest rate volatility should be reduced as a result of the new standing facility (end-June 2007 assessment criterion observed well ahead of schedule).

III. Safeguarding Wealth Through Asset and Liability Management

12. Nigeria significantly reinforced the management of its oil wealth in recent years. The oil price fiscal rule that limits the use of oil revenues and participation in the EITI were critical reforms for improving macroeconomic conditions and management of oil revenues. The approval of the Fiscal Responsibility and NEITI Bills by both houses of the parliament (and now awaiting harmonization) are welcome steps toward institutionalizing these reforms. In addition, setting the oil price fiscal rule consistent with macroeconomic stability, its possible expansion to natural gas, and plans to pursue fiscal responsibility bills for states are recognized by the outgoing administration as near-term priorities.

13. A key challenge going forward is to develop and implement guidelines on the use of Nigeria’s oil savings. A recent stakeholder workshop on Oil Savings and the Infrastructure Gap recommended clarifying the principles guiding the use of the oil savings as well as improving cost-benefit analysis and budget management to ensure high quality of spending, especially for joint federal and state large infrastructure projects (Box 2). These reforms will have to be advanced by the incoming administration.

Key Issues Raised by the Workshop on Oil Savings and the Infrastructure Gap1

Improve the institutional framework for managing the oil savings

  • Strengthen the oil price fiscal rule by defining the budget oil price in line with macroeconomic stability and extend it to natural gas.

  • Define the objective of the oil savings “excess crude” account (stabilization and/or savings), governance arrangements, draw-down rules, and ensure transparent implementation.

  • Develop asset management guidelines.

Strengthen public financial management practices

  • Integrate all spending funded from oil savings into fiscal strategies, budgets, and accounts.

  • Make cost-benefit analysis an integral component of the project selection process.

  • Establish participatory arrangements for the management of joint national and state projects and ensure application of due process standards.

1 Workshop documents are published on http://www.fmf.gov.ng.

14. A comprehensive debt management framework is being prepared to preserve recent gains in debt sustainability. It will provide guidance to policy makers and agencies on the government’s borrowing strategy, procedures, and acceptable terms and conditions of loans. The new government will need to ensure effective implementation of the framework, including at subnational levels.7

IV. Consolidating Structural Reforms

15. Under the PSI, the authorities successfully implemented their ambitious structural reforms (Text Table 3). The reforms, based on the National Economic Empowerment and Development Strategy (NEEDS) focused on increasing the efficiency of the public sector and creating an enabling environment for the private sector. Good progress has been made in reorganizing the government and parastatals; rightsizing the civil service and improving its skill mix; strengthening public financial management, privatizing public enterprises, and removing obstacles for private sector led growth. To ensure policy continuity, government ministries have prepared policy strategy documents for the incoming administration.

Text Table 3:

Main Accomplishments of the Structural Reform Program under the PSI, 2005-071

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Sources: Nigerian authorities and Fund staff.

16. The final steps in completing several structural measures were delayed in the last few months, despite the good progress in implementation of most cases (Table 8). One structural assessment criterion for the third review was observed on time, while five criteria were delayed (Text Table 4). Of the structural benchmarks for December 2006 and March 2007 four were observed, one was observed with a delay, and two were delayed. Most of the delayed measures are well advanced and the authorities are pressing ahead to complete them on a revised timetable. At the same time, one assessment criterion and two structural benchmarks for June 2007 have already been completed.

Text Table 4:

Nigeria: Structural Assessment Criteria for the 3rd Review

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Sources: Nigerian authorities, and Fund staff assessment.

17. The substantive completion of a major banking sector consolidation allows the CBN to move forward with measures to enhance financial stability and development. Next steps include strengthening banking supervision and carrying out a financial stability diagnostic. Fund technical assistance will support supervision of banking groups on a consolidated basis. The CBN is also developing a medium-to-long-term financial sector strategy (FSS 2020) with Fund and Bank input.

18. NEEDS 2 for 2008-11—under preparation—will provide a draft policy strategy for the new administration. NEEDS 2 will be based on wide-ranging consultations, and a review of the current NEEDS (see progress report and JSAN (forthcoming)). It can also draw on the benchmarking exercise of the state-level strategies (the SEEDS), the federal government Medium Term Sector Strategies (MTSS) prepared for the 2007 budget, and the performance reports on MDG-related spending financed from Paris Club debt relief.

V. PSI Issues

19. To monitor Nigeria’s performance under the PSI, the following quantitative and structural assessment criteria and quantitative benchmarks are being proposed through end-June 2007.

  • The assessment criterion on the non-oil primary balance of the federal government set at the second review is reconfirmed. While significant spending slippages took place in the SLGs, broadening the coverage of the assessment criterion in not envisaged because the federal government has no control over SLG spending.

  • The reserve money and net foreign assets targets are revised in light of new information for 2006 and new oil price projections.

  • All structural assessment criteria and structural benchmarks set at the second review remain valid.

20. The staff recommends the following waivers of nonobservance in order to complete the third PSI review. Waivers are recommended for the nonobservance of five structural assessment criteria and two quantitative assessment criteria on reserve money and nonconcessional external borrowing (Text Table 4). Regarding the latter, a nonconcessional loan of $200 million was contracted in January 2006 to finance a communication satellite. This loan (0.2 percent of GDP) represents a small deviation from the program and does not substantially weaken Nigeria’s debt sustainability. The supplier’s contract was signed in 2004 and the satellite was launched in May 2007.

VI. Staff Appraisal

21. The Nigerian authorities’ reform program has led to a robust macroeconomic performance in recent years. The improved policy framework, strengthened institutions, stronger macroeconomic policies, and major progress with wide-ranging structural reforms have resulted in impressive macroeconomic outcomes—notably strong growth and low inflation—as well as improved investor confidence. These results leave a strong legacy for the incoming government.

22. The more recent slippages in policy implementation are addressed adequately in the 2007 program, thereby minimizing the risks to macroeconomic performance. The fiscal expansion at the consolidated government level in late 2006 resulted from a regrettable deviation from the oil price fiscal rule. In conjunction with the lack of exchange rate flexibility, in contrast to previous commitments, this led to an unanticipated liquidity injection. Nevertheless, this did not result in excessive inflationary pressures, due largely to increased confidence and likely higher money demand. The 2007 monetary program therefore targets single-digit inflation by partly reversing the broad money acceleration. The inflation objective should be supported by the overall fiscal contraction (which hinges on adherence to the oil price fiscal rule). To support this, staff urges the new authorities to commit to and pursue a more flexible exchange rate policy going forward. Inflation will need to be monitored closely and monetary conditions tightened in the event that money demand is not as strong as anticipated or the impact of the monetary surge in mid-2006 is yet to be felt. A number of measures being implemented by the CBN should help improve the effectiveness of monetary policy and preserve the low inflation environment. Significant data problems have persisted. Ensuring good quality of monetary data will be therefore essential. Similarly, the recent delays in completing the final steps of several structural measures, while regrettable, should not distract from the progress achieved in structural areas under the PSI.

23. The main challenge for the new administration will be to maintain the reform momentum and safeguard economic gains of recent years. Efforts should focus on three main areas. First, fiscal policy needs to remain consistent with macroeconomic stability. Reaffirming the political agreement on the use of oil revenues among all levels of government will be important in this regard. Political pressures, including from the states, to spend oil savings are likely to remain considerable. Second, recent efforts to develop and implement the guidelines on the effective use of oil savings and ensure good quality of capital spending need to be continued. Third, structural reforms need to be taken forward. Failure to pursue these reforms could jeopardize the macroeconomic stability and future growth potential, which are important elements in Nigeria’s fight against poverty.

24. The staff recommends completion of the third review under the PSI (with the waivers and modifications described in section V). The completion of this review will support Nigeria’s efforts to entrench macroeconomic stability and pursue ongoing strong structural reforms.

Table 1.

Nigeria: Selected Economic and Financial Indicators, 2004-09

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Sources: Nigerian authorities, and Fund staff estimates and projections.
Table 2a.

Nigeria: Consolidated Government (Cash Basis), 2004-09

(Billions of naira)

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Sources: Nigerian authorities, and Fund staff estimates and projections.

Includes capital contributions to joint venture projects with oil companies for power plants.

Actual cash spending

Table 2b.

Nigeria: Federal Government Budget, 2005-07

(Billions of naira)

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Sources: Nigerian authorities, and Fund staff estimates and projections.

Oil revenue net of cash call payments.

Excluding transfer to the NNPC for cash call payments. Includes fuel subsidy payments to independent marketers.

Table 2c.

Nigeria: Consolidated and Federal Government, 2004-09

(Percent of GDP, unless otherwise specified)

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Sources: Nigerian authorities, and Fund staff estimates and projections.

Excluding oil revenue, cash call payments, and cash interest payments. Projections from 2007 reflect revised nominal GDP.

Excluding the transfers to NNPC for cash call payments.

Table 3a.

Nigeria: Central Bank of Nigeria (CBN) Analytical Quarterly Balance Sheet, 2004-07

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Sources: Nigerian authorities, and Fund staff estimates and projections.

CBN presents long-term liabilities in other items net.

Includes the windfall oil revenue savings by subnational governments and extrabudgetary funds.

States and Local Governments (SLGs).

Table 3b.

Nigeria: Monetary Survey, 2004-07

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Sources: Nigerian authorities, and Fund staff estimates and projections.

Includes the windfall oil revenue savings by subnational governments and extrabudgetary funds.