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Merrill Lynch insists Nigeria needs fiscal buffers against shocks

Merrill Lynch

Nigeria will have to efficiently manage her oil wealth so as to grow fiscal buffers to be able to withstand external shocks, says a BofA Merrill Lynch Global Research report of the Bank of America Merrill Lynch, a global corporate and investment division of the bank  with specialties in mergers and acquisitions, equity and debt capital markets research, among others.

According to the report which made direct correlation between oil and GDP, naira and foreign reserves, while non-oil economy continues to drive the country’s Gross Domestic Product (GDP) growth, due to reforms, oil receipts are crucial to finance the growth and pay for the capital and service imports that they require.

Making reference to the latest 3Q economic report from the National Bureau of Statistics, which showed that the non oil sector grew by 7.95% in real terms, versus the oil sector’s 0.53% contraction, the report said, “We expect this trend to continue, given the sustainability of reforms made, particularly in agriculture, and the declining oil production profile due to oil theft.”

Also, the report observed that oil price is the key driver of international investor sentiment toward the country and as such, “A stronger oil price tends to correspond to a stronger naira and higher reserves. Given the economy’s import dependence, a stable exchange rate is key to ensuring double digit inflation does not return.”

Merrill Lynch

Expecting a gradual decline in oil revenue for the next two years, the report assumes  a “current account surplus of 6.0% in 2014 and 5.7% in 2015, as we expect only a gradual decline in oil revenues over the next two years.

“Our commodities team expects Brent to average $105/bbl in 2014, 4% lower than current spot. The possible return of output from Libya and Iran could send oil down to $95/bbl, but with limited OPEC spare capacity, we do not anticipate Brent would fall sustainably below $90/bbl.”

Consequently, the report said that while Nigeria can manage a moderate oil price shock in terms of price, extreme and sustained decline in the price of oil could wipe away what remains of the Excess Crude Account (ECA), leaving the country vulnerable to external shocks.

The report, ‘Nigeria in Focus, Oil in focus again’, said, “Our scenario analysis shows that a moderate decline in the oil price is manageable but could accelerate the tightening cycle in Nigeria. However, an extreme oil shock highlights the vulnerability of key macro indicators and the inability of the Excess Crude Account to act as a sufficient buffer.”

The report further acknowledges that oil revenues are a contentious issue in Nigeria, as they make up 75 percent of government revenues and 95 percent of the country’s foreign exchange earnings, noting however that the ECA  is down to just $2.5bn, compared to $11.5bn at the end of December 2012.

“We analyse Nigeria’s resilience to a moderate (10%) and an extreme (40%) decline in the average oil price. Though a moderate oil shock is manageable, an extreme and sustained shock could wipe out the ECA entirely and cause severe deterioration in key economic indicators. Our base case remains that oil falls only slightly in 2014 to average $105/bbl,” the report said.

The ECA, it said, holds the oil earnings accruing to the government over and above her $77.5 for the 2014 budget , stressing that at $95 per barrel, the report assumes that  the reference budget price of $77.5 would still stand with the deficit remaining  at 2.9 percent, but with less accrual to the ECA. The development would necessitate the Central Bank of Nigeria (CBN) accelerating its monetary policy stance to retain portfolio flows and shore up the naira which has been under pressure.

However, the analysts which predict 100 basis points hike in the Monetary Policy Rate (MPR) from the present 12 to 13 percent this year, said that in an extreme oil shock $60 per barrel  could lead government to issue “around $15bn of debt to maintain planned spending because the $2.5bn currently available in the ECA  would be wiped out, despite lower fuel subsidy payments.”

Painting a gloomy picture in the extreme position, the report said “This would leave the government debt to GDP ratio at 29%, versus the Debt Management Office’s (DMO) 25% threshold and the IMF’s 40% “rule of thumb” limit. The fiscal deficit would also shoot up to over 6%, compared to the annual ceiling of 3%.

“GDP would contract by 3.6% and NGN/USD would average 213. An oil shock of this magnitude is likely to be due to some global economic shock.  We would expect the CBN and the government to react with accommodative policy, as seen in 2008 when government spending increased, the MPR was cut and reserves fell by 15%. However, reserves are now 30% lower than in mid  2008, implying a potentially more dramatic depreciation of the naira.

“Clearly, oil falling to $60 for an entire year is an extreme scenario and not one that we expect. However, the fast deterioration of key macro indicators in that event suggests Nigeria needs a stronger fiscal buffer. In the event of an extreme oil shock, the ECA would not be sufficient to cushion the economy.”

By:  John Omachonu