MONEY MATTERS: The lull before the storm

During the past eighteen months, the interest rates at which households and businesses borrow from banks in Nigeria have crept up riding on the back of higher inflation.

Even though inflation is slowing down, interest rates are yet to fall. This is because most people believe that this is a lull before the real storm.

Recently, the FGN made its fiscal strategy for 2010 public. Revenue projections were based on oil price of $ 50 per barrel and oil production of 2.2 million barrels per day.

Whilst the oil price assumption appears prudent, the production level looks very high. According to OPEC sources, production during the first half of 2009 averaged about 1.7 million barrels per day. Given the situation in the Niger Delta, the business community would like to know where the additional production of half a million barrels will come from. Even if we have the capacity to produce this much, will we have the OPEC quota?

Businessmen need answers to these questions because they are wandering how the FGN will finance her planned spending of over ₦3 trillion in 2010. The large deficit of the current year is being financed, in the main, by running down savings in the ‘excess crude account’. Projections are that these savings will finish or be significantly depleted by the end of this year.

Based on the current level of production and FGN’s projected price of US$ 50 per barrel, the federal government will earn about ₦ 1.3 trillion in 2010. In order to spend ₦3 trillion, government will have to raise additional funds from one or more of the following sources - domestic borrowing, devaluing the Naira and quantitative easing (printing money). All these sources of financing the budget deficit are inflationary therefore interest rates are not responding to the lower inflation reported in the first quarter of the year.

In 2005, Nigeria could balance her budget with US$ 50 per barrel oil today we require US$ 100 per barrel! This means that, unless government cuts her spending or oil price picks up significantly, Nigeria is likely to run large budget deficits for some considerable future period. Some will argue that deficit financing is not necessarily bad but the size of our deficit is too large. We are also using it largely to finance a bloated wage bill and purchase of goods and services for the day to day running of government.

The implication of this for households and businesses is more worrying. Because people expect higher inflation, nominal interest rates will remain high. This means that households and businesses are less able to use debt efficiently. Default rates will rise, banks will foreclose on businesses and more people will lose their jobs. Output will drop and the country could slip into recession.

The banks will then have to write off their bad loans and this will affect profitability and capital adversely. If the problem is severe enough a banking crisis could result.

On the external side, imports will exceed exports, external reserves will be depleted and we shall build up trade arrears which will be added to our national debt. Then we go back to the negotiating table with the IMF and the Paris Club. The Chinese could also feature prominently this time. We would have gone full circle.

The FGN needs to prune down her spending urgently otherwise there will be significant adverse macroeconomic consequences. Government will of course argue this level of spending is required to stimulate the economy and prevent a recession. This is argument is not tenable because the spending of previous years has not resulted in any significant improvement in the quality infrastructure, education and healthcare.

Cutting spending might not be as difficult as it seems, for example, government can cut spending in the power sector simply by opening up the sector to private participation. Even though government spending in this sector will go down, overall spending will go up and the implications for the economy will be positive.

‘The ship of state is sinking!’ When a prominent politician used those words thirty years ago, he was labeled a prophet of doom. I certainly hope I turn out to be wrong this time.