Fiscal Vulnerability Index for Nigeria

Culled—Proshare

May 19, 2017/CBN

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Background
The literature on fiscal policy is replete on how it has been confronted with various issues since the last decades especially in the aftermath of the global financial crisis.

Studies in this regards include: debt limit beyond which fiscal solvency is in doubt (Gosh, Kim, Mendoza, Ostry and Qureshi 2011), when sovereign debts turns bad (Scott 2010), increasing public debt (Reinhart and Rogoff), solvency risk exposure (Ciarlone and Trebeschi, 2006), ageing population (Corsetti and Roubini 1996), Since June 2014 for instance, when oil prices began to plummet, it has become obvious that fiscal policy is faced with difficulties in overcoming different external shocks that might occur. In fact, the decline in global oil prices and the severe economic downturn that followed especially for oil exporting countries, suggests vulnerability, however, this assertion to some extent may be counterintuitive.

Hence, the logical challenge and expectation is for us to attempt to proffer a concise discourse of fiscal vulnerability.

Over the years, the plummeting of oil prices has continued to pose economic challenges for many oil-exporting countries including Nigeria. In the past the oil industry which encountered booms and busts has recently faced its deepest downturn beginning from the 1990s, owing to supply glut and weak global demand.

Earnings are down for countries that have made record receipts from taxes and royalties in recent years, leading to sharp cut in investments, exploration and production. Several thousands of oil workers have lost their jobs, and manufacturing of drilling and production equipment has fallen sharply.

The recent decline in crude oil prices created severe economic consequences for most oil exporting countries particularly, Nigeria because of its overly dependence on crude oil exports. The development requires greater fiscal flexibility in view of the fact the current decline is unconnected to the conventional factors like geopolitics and natural occurrences.

Rather, the current decline is technologically- induced following the discovery of shale gas. The greater fiscal flexibility envisaged is one that has the capacity to provide instant response whenever there is a shock(s) like the current one that could affect fiscal solvency.

Empirical evidence indicates that fiscal policy has been confronted with numerous difficulties since the 20007/2008 global financial and economic crisis which has weakened its capacity to react to shocks and thus, increased its vulnerability. For Nigeria, the low oil prices has led to a sharp decline in government revenue and worsening of government finances. As a result, public debts are likely to rise and expected to increase more.

Fiscal problems in the country have manifested in the form of reduced Federal Accounts and Allocation Committee (FAAC) distribution, reduced external reserves and in fact, pressure in the The literature on fiscal policy is replete on how it has been confronted with various issues since the last decades especially in the aftermath of the global financial crisis.

Studies in this regards include: debt limit beyond which fiscal solvency is in doubt (Gosh, Kim, Mendoza, Ostry and Qureshi 2011), when sovereign debts turns bad (Scott 2010), increasing public debt (Reinhart and Rogoff), solvency risk exposure (Ciarlone and Trebeschi, 2006), ageing population (Corsetti and Roubini 1996), Since June 2014 for instance, when oil prices began to plummet, it has become obvious that fiscal policy is faced with difficulties in overcoming different external shocks that might occur.

In fact, the decline in global oil prices and the severe economic downturn that followed especially for oil exporting countries, suggests vulnerability, however, this assertion to some extent may be counterintuitive. Hence, the logical challenge and expectation is for us to attempt to proffer a concise discourse of fiscal vulnerability. Over the years, the plummeting of oil prices has continued to pose economic challenges for many oil-exporting countries including Nigeria.

In the past the oil industry which encountered booms and busts has recently faced its deepest downturn beginning from the 1990s, owing to supply glut and weak global demand. Earnings are down for countries that have made record receipts from taxes and royalties in recent years, leading to sharp cut in investments, exploration and production. Several thousands of oil workers have lost their jobs, and manufacturing of drilling and production equipment has fallen sharply.

The recent decline in crude oil prices created severe economic consequences for most oil exporting countries particularly, Nigeria because of its overly dependence on crude oil exports. The development requires greater fiscal flexibility in view of the fact the current decline is unconnected to the conventional factors like geopolitics and natural occurrences.

Rather, the current decline is technologically- induced following the discovery of shale gas. The greater fiscal flexibility envisaged is one that has the capacity to provide instant response whenever there is a shock(s) like the current one that could affect fiscal solvency. Empirical evidence indicates that fiscal policy has been confronted with numerous difficulties since the 20007/2008 global financial and economic crisis which has weakened its capacity to react to shocks and thus, increased its vulnerability.

For Nigeria, the low oil prices has led to a sharp decline in government revenue and worsening of government finances. As a result, public debts are likely to rise and expected to increase more. Fiscal problems in the country have manifested in the form of reduced Federal Accounts and Allocation Committee (FAAC) distribution, reduced external reserves and in fact, pressure in the the past few years, Nigeria has witnessed a considerable increase in government indebtedness despite the crude oil gains.

These developments may be associated with the issue of poor fiscal policies as exhibited by the government‟s inability to save during windfalls. Evidence revealed substantial increase in government spending in past years, as states government sought for continuous agitation for sharing from the Excess Crude account (ECA). Government debt profile has increased significantly after the debt pardon in 2005.

It substantially rose from about N4.2 billion to N12.1 billion in the second quarter of 2015, thereby increasing the debt service and debt to GDP ratio. In the recent time as the oil receipts decreased as a result of the global oil price, government spending have been negatively affected, thus financing the budget becomes a constraint.

Over the years, there have been revenue deficits driven largely by oil prices collapse, with negative implications attendance to the stable provision of government services. It is thus crucial to have in place a fiscal framework to monitor public finance risks. The existence of a well-entrenched fiscal rules and medium-term framework can be a source of great support because it can facilitate unimpeded access to borrowing at favorable conditions.

It also has the potential to provide control over expenditure during a budget cycle as well provide the latitude to be able to respond to shocks. Recurring and persistent fiscal imbalances, which have plagued the Nigerian economy, usually lead to high levels of government debt, sovereign debt rollover and eventually, indebtedness. The foregoing highlights the significance of developing indices to measure fiscal vulnerabilities to cater for unexpected fiscal shocks and their attendant effects on the Nigeria economy.

Blanchard (1990) identified four sets of questions that fiscal indicators can help answer:

  1. What part of the changes in fiscal position is due to changes in the economic environment and what part is due to policy
  2. Can the government sustain its current course of fiscal policy, or will the government have to adjust taxes or spending?

iii. What is the effect of fiscal policy on economic activity: effects on relative prices- labour or the price of capital?

  1. What is the macroeconomic impact of fiscal policy, through deficit and debt finance?

It is against this background that, this study contributes to the literature on fiscal monitoring framework, the core objective of developing a fiscal vulnerability indicator. The paper aims to develop index (indicators/indices) for measuring fiscal vulnerability in Nigeria.

In specific terms, the paper analyzes the current state of fiscal developments in Nigeria and identifies basic fiscal variables to cater for unexpected fiscal shocks and their attendant effects on the Nigeria economy. In the longrun, the study aims to develop fiscal vulnerability forecasting model for tracking fiscal conditions and to guide monetary policy implementation.

While, we posit that there is no single indicator that can proffer solutions to all these questions, our attempt in this study is to design fiscal indicators in line with the peculiarities of the Nigerian environment. In terms of output, we develop a set of indicators and apply them to explain fiscal policy in Nigeria.

In addition, the indicator is expected to provide early warning signals on rollover problems, as well as provide avenues for policy makers to adjust policies when confronted with signs of fiscal vulnerabilities or extreme fiscal stress.

Following this introduction, the rest of the paper is organized as follows. Section 2 presents the conceptual framework. Section 3 discusses some country experiences, while section 4 provides some stylized facts on fiscal developments in Nigeria. Section 5 looks at the methodology and results. We conclude the paper in Section 6.

Conceptual Framework
Fiscal vulnerability depicts a government‟s exposure to the possibility of not achieving its broad fiscal policy objectives. Its main concern is with the occurrence of unexpected fiscal policy challenges and the capacity of the government to handle them.

When addressing fiscal vulnerabilities, the first risk that comes to mind is “sovereign debt risk” and how much damage it could cause to the economy in the absence of fiscal adjustments. Frequent fiscal imbalances could lead to high levels of government debt, sovereign debt rollover and ultimately, insolvency.

There is need to develop indices that can gauge fiscal vulnerabilities in order to be able to absorb unexpected fiscal shocks and their attendant effects on the economy.

Two basic concerns that feature prominently in the theoretical literature on fiscal vulnerability are the determination of the thresholds or limits for public debt and the choice of appropriate fiscal variables to estimate rollover risks and fiscal vulnerabilities.

Prudential Limits on Public Debt
In the analysis of fiscal consolidation and fiscal vulnerability, the need to recommend limits on public debt to GDP ratio is of fundamental importance in view of its crucial role.

Following rigorous and time-tested methodologies, the International Monetary Fund (IMF) has in times past, established benchmarks that policy makers and studies have widely received and referred.

Although, the Fund has not officially endorsed some of these benchmarks, they are not doubt robust enough to guide analysis on fiscal policy and in proposing prudential limits on public debt to GDP ratios.

Thus, while a debt-to-GDP ratio of 60 per cent has often been quoted as a prudential limit for developed countries, a debt-to-GDP ratio of 40 per cent has been suggested for developing emerging economies.

Thus, crossing these limits has the capacity to threaten fiscal sustainability. Remedial measures like fiscal adjustment as often times suggested to countries that are in the breach in order to enable them to reach the required suggested public debt-to-GDP ratios within a given period.

In the follow up to the preparation for the economic and monetary union and the eventual formation of the euro zone, European countries agreed on a 60 per cent debt-to-GDP ratio among a handful of targets during the early 1990s. There was no indication of optimality; it was the median debt-to-GDP ratio.

An issue that is worthy of note is the rising tendency for countries to want to accept these thresholds as “optimal” in the specific sense that crossing these thresholds poses threats to public debt sustainability.

This may not necessarily be so as some literature have often emphasized that a debt 8 ratio above the suggested threshold (60 or 40 per cent) is by any means necessarily implying a crisis. It was also suggested that there is an 80 percent probability of not having a crisis (even when the debt ratio exceeds 60 or 40 percent of GDP.

The IMF (2010) has even suggested that the public debt limit, is not an absolute and immutable barrier, nor should the limit be interpreted as being the optimal level of public debt. As Domar (1944), argued “the problem of the burden of debt is essentially a problem of achieving a growing national income”.

The principle underlying this argument is that, higher fiscal deficits can only enhance purchasing power and do not wield any mounting pressure on interest rates or inflation, nor do they cause large current account deficits in an economy that has spare capacity or unemployment.

As has been argued in the literature, this is consistent with the IMF‟s global macroeconomic model, which assigns a dual role to fiscal policy, which is namely that of smoothing out business cycles in the short run; and meeting targets for debt sustainability in the longrun.

Another claim in the literature is the theory that higher public debt today would be repaid by higher tax in the future. Domar (1944) posted a contrary view when he inferred that, “the problem of the burden of debt is essentially a problem of achieving a growing national income”.

In addition, Domar (1993) suggested that, “the proper solution of the debt problem lies not in tying ourselves into a financial strait-jacket, but in achieving faster growth of the GNP”. We could interpret Domar‟s arguments to mean that, the debt need not be repaid as long as the interest on the debt is less than the annual increase in nominal GDP. This is because; the debt will be a shrinking fraction of GDP.

Basic Fiscal Vulnerability Variables  
Baldacci, McHugh, and Petrova (2011) underscored some key fiscal indicators, to estimate rollover risks and fiscal vulnerabilities. The indicators, which were grouped into three pillars, include basic fiscal variables; long-term trends; and asset and liability management.

A number of fiscal variables have been found to be theoretically useful as univariate leading indicators for signaling crises on an annual basis. The literature has identified some indicators like short-term debt, foreign currency debt, and various deficit measures as the best indicators.

These indicators have performed as well as the best (annual) leading indicators in other Early Warning Signal (EWS) studies. For instance, the deficit and financing variables are perceived to have capacity to send clear signals of impending crisis as was demonstrated during the crises in in Bulgaria, Pakistan, Russia, Ukraine, Brazil, and Ecuador in the late 1990s.

Results from the event studies suggested that deficits are significantly higher, on average, in the two years prior to currency and 9 debt crises than in non-crisis periods. Thus, indicating that fiscal variables could indeed trigger financial sector crises in view of the strong relationship that exist between them and banking crises as well as currency and debt crises. In Coratelli (2011), a sovereign risk can manifest in a number of ways; it could take the form of a roll over crisis, which varies in intensity, ranging from a surge in interest rates to open default on public debt.

It may also arise from a situation whereby risk of instability is not looming but there is a presence of increasing government and deficit, thereby negatively affecting economic growth. Next is the rollover risk, which defines the risk that is associated with the refinancing of debt. Countries are exposed to rollover risk when a matured debt is rolled over into a new debt.

Thus, the country could be forced to refinance its debt at a higher rate and incur more interest charges if interest rates rise adversely in the future. When assessing rollover risk, the variables to focus on include: public debt stock, current and estimated primary fiscal balances, differential between interest rate on public debt and the GDP growth rate and the growth-adjusted interest rate on public debt (Escolano, 2010, Baldacci, McHugh, and Petrova (2011).

To measure public debt, literature identifies the debt to GDP ratio as an appropriate proxy, because it accounts for not only public liabilities but also the assets which could be used to pay back the debt as and when due. When the debt ratio is on the increase government finds it more difficult to generate surpluses to offset the debt. A higher debt ratio also connotes a history of fiscal indiscipline, complicating the task of government to efficiently managing the debt scenario (Jędrzejowicz and Koziński, 2012).

The public debt to GDP ratio can then be compared to the widely accepted benchmark levels (e.g. 40 per cent of GDP for emerging economies, 60 per cent of GDP for advanced economies and 90 per cent of GDP for the United States and Japan). Therefore, a higher debt level compared to the benchmark would signify a red flag because the government would find it more difficult to adjust to a sustainable level of debt (Hayes, 2011). Other variables to consider when measuring fiscal vulnerabilities according to Hemming et al (2003) include financial market indicators such as the spread on long-term public external debt.

This variable provides the necessary information on risk of debt default, which is useful in fiscal vulnerability analysis. However, financial indicators should be used with caution because they tend 10 not to signal looming crisis on time and there is usually the difficulty of specifying the exact contribution of fiscal elements to the crisis. It is also pertinent to consider variables that address the financing needs of the government when addressing fiscal vulnerabilities.

For instance, a government‟s exposure to a crisis becomes more apparent, if it has needs to raise large sums of money at frequent intervals (Hayes, 2011). It becomes even worse when a country needs to raise the funds in foreign currency, as it would affect the level of external reserves of the country as well as the stability of the exchange rate.

Therefore, variables such as the average duration of government bonds (which depicts the frequency with which the government needs to refinance its debt), the percentage of external debt to the value of exports and the fiscal balance are also considered. The health of a country‟s financial sector is also very important when measuring fiscal vulnerabilities.

As has been observed in the global economy, banking crises and public debt crises usually occur side by side. This is because the balance sheets of banks have the potential to grow even higher than a nation‟s output and peradventure a crisis occurs in the banking system, the bailout provided by government often have negative impacts on government finances.

Therefore, variables such as the capital ratio of the banking sector (which shows the capacity of the banking sector to absorb losses without the need for government support), the proportion of loans to deposits and the percentage of non-performing loans should be explored.

The Value at Risk (VaR) approach, which is commonly used for evaluating risks by private sector businesses, may also be applied to the public sector (Hemming et al, 2003). This approach identifies risks associated with portfolio or balance sheet problems and provides a measure for such risks.

This approach identifies the relevant shocks and areas of exposure thereby arriving at a measure of solvency, which takes into account the highly volatile nature of the macroeconomic and financial environment.

However, some problems have been identified with using the VaR approach, one of the most common is the dearth of comprehensive data on the balance sheet item of the public sector, making it difficult to estimate and make meaningful inferences.

In addition, a standard VaR model makes use of asset prices which are based on a probability distribution; it may therefore, be difficult to incorporate public finance variables in the model which exhibit more of behavioral relationships than random tendencies. 11 Another set of important indicators as highlighted by Jędrzejowicz and Koziński, (2012) and Hayes (2011) are fiscal rules and institutional factors.

Globally and in the light of present crises faced by many countries, there is an urgent need for a strong commitment to fiscal consolidation while ensuring that the objective of economic growth does not suffer.

One way to promote growth is to build investor‟s confidence in the economy by ensuring that strong legal and political institutions are in place. When such institutions are in place, it becomes less difficult to attract investors and other economic agents to do business in the economy.

Some of the institutional variables include Voice and accountability (which measures the extent of democratic participation in the country, freedom of expression and association as well as the freedom of the media). Others are the level of political stability and absence of terrorism or violence, and the degree of government effectiveness (in terms of the quality of public services, independence of the civil service and the commitment of government to policy implementation).

In addition were the quality of regulation (in terms of financial laws and regulation, and the extent to which taxes are heavy and distorted), rule of law (with respect to the law enforcement agencies, the courts etc.) and level of corruption.

Long-Term Fiscal Trends
These indicators are factors that affect the long-term trends in fiscal variables. They are regarded as very important because fiscal solvency is dependent on the degree to which long-term economic trends exerts pressure on the nation‟s budget.

Apart from the current fiscal position, fiscal solvency also depends on expected future primary balances and current projections of long-term fiscal challenges that could affect the perception of solvency as well as increase the risk of rollover.

Some of the long term factors as identified by Coratelli (2011), include trends in health care and pension expenditure, expenditure to fight global warming, spending to combat resource depletion etc. Demographic trends such as the fertility rate are also important because they have weighty effects on economic activity and the fiscal position of a country.

For example, a low fertility rate below a certain level could lead to a significant decrease in the labor force especially if there are not enough migratory inflows entering the labor force.


Asset and Liability Management

These indicators look at the structure of government‟s assets and liabilities and their exposure to rollover needs. For instance, an economy can be said to have higher exposure to solvency problems if it has higher need to rollover huge amounts of debts in the near term.

Therefore, the lower the financing requirements, the lower will be the risk of fiscal solvency concerns and rollover crisis. Some of the asset and liability management indicators as described by Baldacci, McHugh, and Petrova (2011) are as follows:

  1. a) Gross Financing Needs: This refers to the total stock of maturing public debt. It serves as a good measure of the requirements for government rollover.
  2. b) Share of Short Term Government Debt to Total Public Debt: Typically, countries with a higher need for short-term funds are more exposed to hostile market reactions when the risks of solvency are high. Therefore, in most emerging economies where financial market conditions are not too encouraging, a large stock of short-term debt compared to the total debt signifies a higher exposure to rollover risks and solvency.
  3. c) Ratio of Short Term External Debt to International Reserves: This variable provides insight on the likely amount of foreign currency needed to service short-term foreign currency debts.
  4. d) Share of External Debt, To Total Debt: For most emerging economies, debt cannot be issued in domestic currency like it can in the advanced world because of investors risk averse attitude towards currency risk. This exposes emerging economies to foreign exchange risk. A high level of foreign currency debt raises the possibility of a negative impact on the ability of the government to service its debt, given a series of exchange rate shocks.Country Study/Experiences

Uruguay
Rial and Vicente (2004) in their work on Fiscal Sustainability and Vulnerability in a Small Open Economy found that small emerging economies experiencing recurrent shocks of significant magnitude, could not base its findings on fiscal sustainability but on level of debt.

They rather recommended that, the debt structure, debt maturity, interest rate, Instrument types etc are variables that are considered important. Relying on the risks related to the structure of debt, the work found that, despite the debt to GDP ratio that was low in Uruguay, at the beginning of the 1990s, there was high vulnerability.

The study concluded that, future studies on vulnerability should consider the fact that, increase in component of the country‟s domestic currency in its debt profile, would enable debt sustainability. In addition, suggested was that, about 2 per cent of GDP relative to the endogenous trend would be required in order to return to a sustainable path.

Poland
The worsening fiscal positions of most countries in the aftermath of the global financial crisis encouraged Tomasz Jędrzejowicz and Witold Koziński (year) to assess Poland‟s fiscal vulnerability.

Their work consisted five elements consisting of (i)the medium-term dynamics of public debt (ii); the level of public debt (iii) public debt management and the liquidity position of the government (iv) long term sustainability of public debt;; and (v) fiscal rules and institutions.

Despite the limited fiscal risks in Poland‟s, there is still need to correct fiscal lapses. In Poland, there exists a welldefined fiscal policy anchor, representing a public debt threshold of 60 per cent of GDP, These threshold are established in the public finance act.

Thus, whenever the debt to GDP exceeds the 60 per cent statutory ratio, it is termed as vulnerable. The bridge of this signaled for fiscal consolidation government.

Bulgaria
Brixi, Shatalov, and Zlaoui (2000) established the structure in managing fiscal risk in Bulgaria. They found that, it is the responsibility of the Central Authority to manage their liabilities and other forms of fiscal risk in developing a framework to assess and manage fiscal risk. It was suggested that this could be achieved policy strategy adjustments.

They identified key sources of risk: they are; collection capacities of the social protection institutions, environmental liabilities and investment requirements, and further engagement in off-budget programs.

They proffered that the government’ should limit the risk exposure, yet accommodate investment that are crucial to growth. The country 14 should optimized strategy for liability management, fiscal reserves, and risk mitigation. Other recommendation is to prioritize and place strict limits on the amounts of government obligations.

Belgium, Ireland, Germany, Greece, Spain, France, Italy, Netherlands, Austria, and Portugal
Andreea Stoian (2013) computed the fiscal policy vulnerability of 10 advanced economies in European Union; they are Belgium, Ireland, Germany, Greece, Spain, France, Italy, Netherlands, Austria, and Portugal. He evaluated the primary balance that stabilizes public debt using the public debt equation methodology.

By determining the difference between the current and stabilizing primary balance, the primary gap, which indicated fiscal vulnerability, was computed. With annual data that ranged from 1971 to 2010, he found that a few episodes of more severe fiscal vulnerability occurred after the financial turmoil.

Majority of the analyzed data showed a normal state of fiscal vulnerability induced by not aiming at the stabilization of public debt, rather than government’s failure in achieving the stabilizing the primary balance. According to this study a country’s fiscal policy is determined as “vulnerable” if the government primary balance that stabilizes public debt denoted by Pt* is more than the ration of government current primary balance to GDP at time (t) denoted by Pt .

Review of Fiscal Developments in Nigeria: Some Stylized Facts
There are empirical evidences to support the argument on the existence of a number of different channels through which fiscal policy promotes economic growth and development.

The use of fiscal policy as a major stool for stabilization is paramount in most less developed countries (LDCs). Government fiscal policy actions affect revenue receipts and expenditure and thus provide a measure of government‟s net receipts, its surplus or deficit.

Fiscal policy serves as the government‟s shock absorber in specific areas of development as the government may decide to counterbalance variations that are in private consumption and investment using counter cyclical revenue and expenditure measures.

In this section, using annual time series data of some stylized facts on the impact of fiscal policy, we provide analysis of fiscal policy in terms of government expenditure, tax revenue, debts and debt service.

There were indications of substantial increase in government spending between 2000 -2005. The spending may have been exacerbated by the oil windfall, which resulted in increased government spending with an average of about 21 percent of GDP during that period.

The advent of a civilian government in 1999 and the subsequent reform programs restored fiscal discipline in the system. However, another era of oil windfall (2000 -2004) and the associated regular monetization of foreign exchange receipts for the purpose of distribution to various tiers of government, triggered large increases in government spending.

Thus, government spending jerked up to 19 per cent of GDP. It was 14 per cent in 2000. Ratio of deficit to GDP also rose by 7.5 per cent in 2005, from 0.30 per cent in 2000.

The ratio of deficit to GDP peaked at 12.72 in 2009 owing to increases in extra budgetary outlays. Bearing in mind, the need to enhance transparency and accountability in the sphere of public finance, the Nigerian authorities embraced fiscal consolidation following the implementation of various fiscal stimulus packages by the Federal Government beginning from in 2009 through 2010.

The consolidation was targeted at reviving economic activities, while creating the enabling environment for greater private sector participation in the economy and accelerating sustainable economic growth.

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