## cr1781 - 7. These findings can be applied to explain the relative intensity of the impact of the

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### INTRODUCTION — overview and key takeaways
- Paper examines:
  - the role of lower oil prices in explaining deterioration in Nigeria’s macroeconomic indicators;
  - impact on corporate and financial sector performance; and
  - forward-looking aspects of promoting job-intensive growth and strengthening State and Local Government (SLG) finances.
- Key takeaways:
  - Slump in oil prices contributed to sluggish growth; lack of foreign exchange weakened corporate performance and increased likelihood of non-performing loans.
  - Macroeconomic conditions deteriorated from the slump in oil prices, reflecting weaknesses in pre-shock fundamentals and policies implemented after the shock (examples: delay in implementing the 2016 budget; imposition of foreign exchange restrictions).
  - Foreign exchange inflows are highly correlated with corporate sector performance; declines in services sector performance are more sensitive to FX inflows from autonomous sources.
  - The economic downturn amplified banking sector vulnerabilities more than non-bank financial sector vulnerabilities: higher NPLs and eroded capital.
  - Reducing unemployment requires both higher growth and reforms to increase employment-growth elasticity.
  - Improving SLG resilience requires broad fiscal reforms including fiscal federalism strengthening, budget preparation, expenditure controls, subnational TSA and cash management reforms, fiscal reporting, and IGR administration.

### Explaining the oil price decline impact — cross-country regression findings
- Regression identification uses 2013 fundamentals to explain 2016 real GDP deviation from Fall 2014 WEO forecast.
- Five significant variables in preferred specification:
  - Exchange rate regime flexibility
  - Ratio of non-oil exports to GDP
  - Reserve adequacy (percent of IMF metric)
  - Historical inflation volatility (seven years prior to the shock)
  - Ratio of net government debt to fiscal revenue
- These variables together explain sixty percent of the cross-country variation in real GDP response to the oil shock (R-squared: 0.600 for core sample).
- Estimated coefficients (preferred/core sample) — dependent variable: Percent deviation of actual 2016 real GDP from Fall 2014 WEO forecast:
  - Exchange rate flexibility: 2.078 (standard error (0.883))
  - Non-oil exports (percent of GDP): 0.145 (standard error (0.036))
  - Reserve adequacy (percent of IMF metric): 0.005 (standard error (0.001))
  - Inflation volatility: -0.980 (standard error (0.460))
  - Net government debt (percent of revenue): -0.172 (standard error (0.031))
  - Constant: -7.486 (standard error (1.722))
  - Observations: 26
  - R-squared: 0.600
- Robustness:
  - Variables remain significant when sample expanded to include conflict-affected cases and less oil-dependent countries, though explanatory power falls.
  - Net government debt significant across specifications whether expressed relative to total revenue, non-oil revenue, or GDP.
  - Reserve adequacy metric based on total external debt liabilities; ratio of reserves to imports is an alternative significant measure.

### Nigeria-specific impact decomposition and residual
- Cumulative impact on Nigeria’s real GDP: 15.5 percent (percent deviation of 2016 real GDP from Fall 2014 WEO forecast).
- This was about 8 percentage points more negative than the sample average.
- Contributions of pre-shock fundamentals (relative to sample average):
  - Contribution explained by pre-shock fundamentals for Nigeria: about minus 4 percentage points of real GDP impact.
  - For other Sub-Saharan African oil exporters: minus 2 percentage points.
  - Managed float economies: fundamentals diminished impact by about 4 percentage points.
- Main specific fundamental difference for Nigeria: lower level of non-oil exports.
- Regression residual for Nigeria: negative 4.1 percentage points (indicating additional negative country-specific factors).
- Additional negative contributors identified:
  - Policies after the shock (examples: delay in 2016 budget implementation; imposition of foreign exchange restrictions).
  - Idiosyncratic developments (example: increased oil infrastructure sabotage).

### Policy priorities highlighted (from oil shock analysis)
- Fiscal consolidation to build buffers for oil price fluctuations.
- Build a more substantial reserve cushion.
- Build a track record of price stability to create space for countercyclical monetary policy.
- Allow exchange rate to flexibly adjust to external conditions to reduce transmission to non-oil sector.
- Structural reforms to improve business environment and diversify economy to boost non-oil exports.

### FX inflows and corporate sector performance — data and stylized facts
- Corporate panel: quarterly Orbis data covering 2013 Q3–2016 Q2; sample size: 150 companies (144 firms for corporate stress test sample).
- Corporate performance trends (2011–2016 Q1):
  - EBITDA, EBIT, and net income declined on average.
  - Asset turnover ratio declined.
  - Debt-to-equity ratio peaked in 2013.
  - Interest cover ratio declined from about 85 in 2013 to below 4 in 2015.
  - Profit margin negative on average since 2014.
- FX inflows evolution:
  - FX inflows to the Central Bank of Nigeria declined from $12 billion in 2013Q3 to $4.5 billion in 2016Q2.
  - Other FX inflows to the economy declined from $27 billion in 2013Q3 to $9.5 billion in 2016Q2.
  - By end-2016, FX inflows were only a third of the level observed in 2013.
- Major exchange rate events chronology (2014–2016 Q2):
  - 2014Q3: Oil prices start to decline
  - 2014Q4: 8 percent devaluation
  - 2015Q1: 18 percent devaluation; Dutch Auction System closed
  - 2015Q2: Election; FX restrictions (41 items) introduced
  - 2015Q4: Cabinet appointed
  - 2016Q1: FX sales to Bureau de Change stopped (reintroduced Q3 2016)
  - 2016Q2: 40 percent devaluation; Flexible FX regime introduced

### Empirical model and elasticities
- Model: Autoregressive distributed lag (ADL) estimated in error correction model (ECM) form.
- Dependent variable: firm i sector j time t EBIT (ijt EBIT).
- Key explanatory variable: FX inflows to the economy at time t (t FX) — federation oil revenue to the CBN plus other autonomous inflows.
- Short-run interpretation: sector-specific short-term elasticity of EBIT relative to FX availability (1j α).
- Aggregate short-run result:
  - A 1 percent decline in FX inflows through autonomous sources reduced firms’ operating profits by about 1 percent on average across sectors (short-run elasticity from column (4) in Table 2).

### Sectoral impacts of FX shocks
- Stronger adverse impact in primary sector, food, beverages, chemical, and plastics — these sectors represent about 40 percent of the economy; a one percentage point decline in FX autonomous inflows can reduce earnings by more than one percentage point for these sectors.
- Services sector: almost four-to-one relation between FX inflows from autonomous sources and declines in earnings; services account for 25 percent of GDP.
- Petroleum firms: a one percentage point increase in the market spread associated with a 9.5 percent decline in operating profits.
- FX inflows to the CBN from oil exports matter less for corporate profitability generally, but chemicals, rubber, plastics, and non-metallic products sector are more sensitive to declines in CBN FX inflows (CBN flows coefficients statistically significant only for this sector).

### Conclusion on FX and corporate performance
- Decline in FX inflows adversely affected corporate performance mainly through macroeconomic fluctuations and additionally through declines in non-oil FX inflows.
- Decline in FX inflows to the CBN associated with profit declines for chemicals, rubber, plastics, and non-metallic products.
- Decline in FX inflows through autonomous sources had a pervasive adverse impact, particularly in other services sector.
- Policy implication: actions affecting non-oil FX inflows are important because of their additional adverse effects on firm operating profits.

### Financial sector — size, structure, and vulnerabilities
- Financial sector size driven by banking sector activity: banking sector accounts for 80 percent of total assets.
- Banking sector FX exposure: 45 percent of banks’ loan book is in foreign currency.
- Non-bank financial institutions: assets mainly in local currency; growth driven by new funding.
- Banking system concentration:
  - Size of five largest banks fell from 60 percent of assets in H2 2015 to 43 percent of assets in H1 2016.
  - Herfindhal-Hirschman index: 743 at end-June 2016.
  - Market shares for other 18 banks: 0.3 to 6.4 percent.
- Lending and credit depth:
  - Banks reduced lending; lending relatively flat in 2016 after accounting for FX depreciation.
  - Credit-to-GDP ratio: 15 percent.
- Funding structure:
  - Deposits: about 75 percent of total liabilities.
  - Deposits below one-year maturity: 95 percent of all deposits.
  - Unremunerated demand deposits: 44 percent of deposits.
  - Loan-to-deposit ratio: 130 percent.
  - Financing from alternative sources: $0.6bn in 2016 versus $1.47bn in 2015.
- Asset quality:
  - NPLs doubled from a year ago to about 13 percent of total loans by end-2016.
  - Provisions increased to about 65 percent since end-2015.
  - Manufacturing and energy (power, oil and gas) account for 70 percent of FX loans.
- Capital and solvency:
  - Capital adequacy ratios declined from 17.7 percent in 2015 to 14.8 percent in 2016.
  - Overall solvency ratios in 2016 averaged 16.9 percent after excluding three undercapitalized banks (ratios below 8 percent; these banks account for 5 percent of assets).
  - Solvency ratios range: 3.2 percent for small banks to 15.7 percent for Tier I banks.
- Liquidity and profitability:
  - Liquidity ratios: decreased to 42 percent at end-June 2016 from 48 percent at end-2015; prudential minimal limit: 30 percent.
  - ROE and ROA in 2016: 12.6 and 1.5 percent respectively.
  - Net interest margins declined but remain in line with peers.
- Supervisory actions:
  - Central Bank intervened in one domestic systemically important bank (Skye) by replacing management and injecting liquidity; Skye and two small undercapitalized banks submitted remedial plans.

### Prudential regulations (selected)
- Solvency:
  - CAR (National Authorization banks): 10% of Risk-Weighted Assets.
  - CAR (International Authorization banks): 15% of Risk-Weighted Assets.
  - Undercapitalized banks of <2%: take over management/revoke license.
- Provisioning:
  - Sub-standard: 10% of outstanding balance.
  - Doubtful: 50% of outstanding balance.
  - Lost: 100% of outstanding balance.
  - General (performing loans): 2% of total outstanding balance.
- Liquidity and reserve:
  - Liquidity Ratio (excluding CRR): 30% of Total Assets.
  - Cash Reserve Ratio (CRR): currently 22.5%.
- Concentration and exposures:
  - Single Obligor Limit: 20% of Equity.
  - Exposure to any single group/related borrowers: 10% of Total Credit Portfolio.
  - Limit on Largest Aggregate Exposure: 8% of Equity.
  - Exposure to any industry >20% of credit: risk weighting of 150%.
- Exchange rate related:
  - Net Open Position: 10% of Equity (down from 20%).
  - FX Borrowing: 125% of Equity (up from 95%).
  - Since August 2015, banks instructed to avoid FX loans to borrowers with no FX revenue; 2014 measures require natural hedges for FX exposure.

### Outlook and risks for banking sector
- Historical NPL recovery time: on average 5 to 6 years to return to normal; after 2009 crisis NPLs returned to normal in three years due to AMCON interventions (limited fiscal space for similar action now).
- Oil and gas exposure:
  - Oil and gas account for 30 percent of banks’ loan books.
  - 14 percent of loans in oil and gas sector are non-performing.
  - Sabotage and lower oil prices reduce revenues and repayment capacity.
- Exchange rate risk:
  - About 45 percent of loans and 40 percent of NPLs are in foreign currency.
  - A further depreciation of the naira by 50 percent would increase NPLs net of provisions relative to capital by 12 percentage points (from 28 to 40 percent) (See Chapter 2).
- Capital needs under scenario:
  - Staff estimate: NPLs would have to increase to 27 percent for CARs to fall below 10 percent.
  - Under that scenario, banking sector would need a capital injection of N352 billion (about 0.33 percent of GDP).
- Concentration breaches:
  - Naira depreciation caused passive breach of single obligor exposure limit (20% of equity) and aggregate large exposure (eight times equity).
  - Regulatory forbearance applied; banks required to submit plans to return to prudential thresholds.

### Banking stress tests (CBN sensitivity results)
- CBN sensitivity analysis:
  - A 50% increase in NPLs: small banks become insolvent with CARs at -9.8 percent; industry CAR reduced by 1.5 percent to 13.2 percent.
  - A 200% increase in NPLs: industry CAR reduced to 8 percent.
  - If provision of five biggest obligors’ credit facilities increased to 100%: industry CAR reduced to 6.3 percent.

### Corporate sector vulnerability stress tests — methodology and scenarios
- Corporate sample: individual firm data from Orbis; sample size: 144 firms; firms’ reported total outstanding liabilities: $7.3 billion (about 9 percent of IMF staff estimate of outstanding corporate debt).
- Two debt-at-risk definitions: Interest Coverage Ratio (ICR) and Debt to Gross Income (DGI).
- Scenarios applied to corporate sector debt:
  - Baseline:
    - Exchange Rate: 55 percent devaluation (USD/NGN 197 to 305)
    - Interest Rate: +200 basis points
    - Net Income: -5 percent
  - Adverse:
    - Exchange Rate: USD/NGN 197 to 400 (further depreciation)
    - Interest Rate: additional +100 bps (total +300 bps)
    - Net Income: -10 percent
  - Extreme:
    - Exchange Rate: depreciation to USD/NGN 600
    - Interest Rate: +400 bps
    - Net Income: -20 percent
- Assumptions:
  - Implied increase in aggregate NPLs assumes banking sector holds same percentage of debt-at-risk as sample with 15 percent probability of default.
  - Implied loss rate assumes loss given default of 45 percent (optimistic; World Bank suggests 70 percent for Nigeria).
  - Risk weighting assumes 100 percent.
  - Multiplier of 4.4 on change in CAR for impact on credit growth (based on preliminary empirical work).

### Corporate stress test quantitative results (selected Table 1 values)
- Current claims on private sector (N billions): 13,074 (End 2015 and for Baseline, Adverse, Extreme scenarios).
- Aggregate NPLs (N billions): End 2015 484; Baseline 666; Adverse 1,021; Extreme 3,874.
- Implied NPL Ratio (percent): End 2015 4.0; Baseline 5.1; Adverse 7.8; Extreme 29.6.
- Implied increase in aggregate NPLs (percent): Baseline 28; Adverse 83; Extreme 525.
- Implied loss rate (percent): Baseline 3.6; Adverse 4.6; Extreme 11.4.
- Implied loss (N billions): Baseline 472; Adverse 596; Extreme 1,488.
- Implied capital (N billions): End 2015 2,945; Baseline 2,473; Adverse 2,349; Extreme 1,4357
- CAR (percent): End 2015 16.6; Baseline 14.4; Adverse 13.7; Extreme 9.0.
- Impact on CAR (percentage points): Baseline (2.3); Adverse (2.9); Extreme (7.7).
- Impact on credit growth (percentage points) using multiplier 4.4 on change in CAR: Baseline (10.1); Adverse (12.8); Extreme (33.7).
- Credit growth (implied) (percent): End 2015 5.3; Baseline (4.75); Adverse (7.49); Extreme (28.38).

### Corporate stress test conclusions and implications
- Under extreme adverse scenario (exchange rate to N/$600 and interest +400 bps):
  - NPLs rising by 26 percent would cause CAR to fall by 8 percentage points (staff narrative).
  - Banks would remain resilient under scenario given initial capital buffers, though credit contraction could be severe.
  - Using multiplier of 4.4, credit to private sector could contract by as much as 34 percentage points in extreme scenario.
  - Corporate debt at risk could amount to $11.6 billion and number of firms with debt-at-risk could double to 29.

### Policy recommendations for banks and supervisors
- Address undercapitalized banks:
  - Capital raising, buyouts and/or mergers; existing shareholders to sustain losses balanced against restoring confidence.
- Resolve NPLs:
  - Encourage divestment of NPLs and restructure viable borrowers.
- Strengthen monitoring and supervision:
  - Strict enforcement of prudential measures on FX and concentration risks; consider further tightening.
  - Intrusive and conservative supervision approach.

### Non-bank financial sector — state and policy advice
- Non-bank sector less affected by downturn; pension funds, insurance, and managed funds remain healthy despite asset price declines.
- Pension sector:
  - On track to meet strategic objective of capturing 30 percent of working population under CPS.
  - Pension Reform Act 2014 expands CPS coverage (applicable to organizations with more than three employees; earlier Act: 15).
  - Significant portion of pension assets held in government paper; investment in government securities approaching upper limit of 80 percent.
- Insurance sector:
  - Corporates account for 80 percent of insurance coverage; individual penetration low.
  - Assets invested mostly in short-term instruments and equities or held as bank deposits with no exposure to government securities.
  - Sector expected to triple by 2020 with premium income growing by 18 percent per annum.
- Managed funds:
  - Net market value marginally lower over 2016; “Fixed Income” represents about a third held as government bonds; exposure to government declined by half a billion Naira (from 8 billion to 7.5 billion).
- Policy recommendations:
  - Review regulations and enhance monitoring as sector develops.
  - For pensions nearing 80 percent government securities limit: introduce regulatory measures to limit liquidity and interest rate risks, consider relaxing exchange rate risk.
  - Insurance: continue move to risk-based regulation; build regulator capacity; prepare to adopt Solvency II.

### Reform initiatives, business environment and job creation
- ERGP goals for 2017 include improving port efficiency, single customs window, automating business start-up processes, and simplifying procurement.
- Subnational heterogeneity:
  - 2014 subnational Doing Business study shows wide variation across states; adopting best practices from top states could substantially improve national rankings.
- Impact of business environment on employment elasticity:
  - Historical employment-growth elasticity for Nigeria: 0.43.
  - Freedom in business regulations (scale 0 to 10): Nigeria 4.71; other large Sub-Saharan African 6.23; Nigeria gap: 1.52.
  - Cross-country impact of one point improvement in business regulations on elasticity: 0.17.
  - Employment-growth elasticity with reforms could rise to 0.69 (calculation using A plus D times E in source).
- Unemployment implications:
  - Applying historical elasticity to staff baseline: unemployment rate would increase from current 13 percent to over 20 percent by 2020.
  - Adjustment scenario plus reforms raising elasticity to 0.69 would place unemployment on a downward path once recovery occurs.
- Policy takeaway: higher growth alone insufficient; reforms to business environment critical for job-intensive growth.

### Subnational governments (SLGs) — fiscal position, vulnerabilities and federal arrangements
- Fiscal federalism:
  - Constitutional revenue-sharing (FAAC) pooling oil and non-oil revenues; revenue-sharing formulas set by National Assembly and updated every five years per RMAFC.
  - SLGs account for about half of Consolidated Government revenue and expenditure.
- Revenue-sharing specifics (distribution of remaining 87 percent of oil revenue):
  - FG: 48.5 percent
  - EBFs: 4.2 percent
  - SLGs: 47.3 percent
  - Subnational component of SLG allocation: 40 percent distributed equally among states; 60 percent by equity considerations (population, land mass, IGR, school enrollment, hospital beds, rainfall).
- Collection fees deducted before distributions:
  - Customs fees: 7 percent
  - CIT: 4 percent
- VAT allocation:
  - SLGs: 85 percent
  - FG: 14 percent
  - EBFs: 1 percent
- SLG revenue and expenditure trends:
  - In 2015, more than half of distributable revenues went to SLGs.
  - SLG revenue-to-GDP ratio: fell from 8.6 percent in 2011 to 2.7 percent in 2016.
  - Share of oil revenue in SLG revenue: declined from 70 percent in 2011 to 26 percent in 2016.
  - Non-oil revenue (excluding IGR): around 1.6 percent of GDP in 2016; represented 59.2 percent of total SLG revenue in 2016.
  - IGR averaged 0.4 percent of GDP countrywide; Lagos IGR topped 60 percent of total revenue in 2016; across states IGR averaged about 20 percent of revenue in 2016.
  - SLG expenditures: declined from 7.4 percent of GDP in 2011 to 4.5 percent of GDP in 2016.
  - Capital expenditure share of total expenditure: about 41 percent.
  - SLG overall deficit widened to 1.7 percent of GDP in 2016 (from a surplus of 1.2 percent in 2011).
- Subnational debt and arrears:
  - SLG debt-to-GDP increased from 2 percent in 2011 to 5 percent in 2016 (increase of 3 percentage points).
  - External debt rose over 2011-15; Lagos accounts for over 36 percent of SLG external debt.
  - Domestic debt: by 2015 domestic debt was 75 percent of total SLG debt; composition includes salary and pension arrears (10 percent), contractors’ arrears (28 percent), commercial bank loans, and other liabilities.
  - About 15 states issued bonds in last five years; in 2015 seven states raised N61 billion (face value) compared to N15 billion in 2014 for Bauchi State only.
  - Financing pressures have led to deductions from FG allocations via irreversible standing payment orders (ISPOs) and other service payments.
- Macro-fiscal challenges:
  - Formula-based transfers tied to budgeted oil price reduce macro stabilization and weaken SLG incentives for expenditure control and revenue efforts.
  - Revenue-sharing formulas do not account for expenditure capacity; guaranteed transfers raise questions on expenditure quality and governance.
- IGR and budget execution:
  - IGR in 2015: on average 19 percent of total revenue.
  - PAYE main source of SLG revenue; high-performing IGR concentrated in urban centers (Lagos).
  - In 2015, Lagos IGR share of recurrent revenue: over 50 percent; 23 states performed below subnational average of 12 percent.
  - Budget implementation consistently below 80 percent: recurrent spending implementation nearly 100 percent between 2010–2013; capital spending implementation averaged 58 percent.
  - Budget execution skewed toward recurrent spending (salaries, wages, overheads) over capital.
- Data and transparency gaps:
  - In 2015 only 10 states disclosed approved budget information and no state published an actual outturn report.
  - Limited statistical information available for SLGs.

### Coordination, Fiscal Sustainability Plan (FSP) and policy options for SLGs
- Poor policy coordination among tiers amplified shock transmission; adjustments without coordination can lead to duplication or lack of service provision.
- 2016 Fiscal Sustainability Plan (FSP): contract-based 22-point plan conditional on state action plans; aims to rationalize expenditure, increase revenue, improve accountability, debt management, and PFM.
- FSP access conditional on submitting action plans; risk of moral hazard due to prior restructuring and bailouts.
- Contractual fiscal programs can enforce coordination by defining primary surplus and revenue targets, spending and debt limits, reporting requirements, numerical targets and sanctions.
- Policy options and strategies:
  - Depoliticize budgeted oil price via budget rule combining past 5-year average, current year price, and forward-looking 5-year average plus structural primary surplus target.
  - Increase non-oil revenues:
    - VAT reforms: broaden base, allow tax credits for all inputs including capital goods, increase registration threshold with simplified presumptive tax for SMEs, rationalize exemptions, progressively increase VAT rate from 5 to 15 percent over medium term.
    - Expected effect: progressive VAT rate increase and base broadening would increase non-oil revenues by at least 4 percent of GDP for SLGs in the medium term.
    - Reform PAYE and introduce property tax could augment IGR by about 0.5 percent of GDP.
    - Reform of PIT and CIT (rate structure, tax expenditures, incentives) to reduce reliance on oil revenue.
    - Improve tax administration: strengthen Joint Tax Board capacity, establish and enforce minimum standards, monitor state PIT administration.
  - Strengthen coordination mechanisms: medium-term debt targets (commitment to achieve certain debt-to-GDP over next 4–5 years) with annual flexibility for large shocks.
  - Adapt FRL to SLGs: adopt and enforce Fiscal Responsibility Law, Public Procurement Act, introduce enforcement mechanisms and peer reviews.
  - Improve transparency and fiscal reporting: capture off-budget items and consolidate general government revenue, expenditure and financing across three tiers; implement international accounting standards.
  - Extend Treasury Single Account (TSA) to States with phased plan, IT-based FMIS, accounting changes; Kaduna State TSA Implementation Manual (2016) cited as guide.
  - Strengthen cash flow forecasting and management tools.
  - Capacity building: long-term revenue forecasts, medium-term budgeting, public investment quality, stabilization fund management; near-term: transition to programmatic budgeting and capture committed multiannual liabilities.
- FSP selected items and dates (examples):
  - Publish audited annual financial statements within 6 months of financial year end — State Government Dec 2016.
  - Introduction and compliance with IPSAS — State Government Ongoing.
  - Publish State budget online annually — State Government Mar 2017.
  - Publish budget implementation performance report online quarterly — State Government Mar 2017.
  - Develop standard IPSAS compliant software to be offered to states — Federal Government Dec 2016.
  - Set realistic targets to improve IGR and ratio of capital to recurrent expenditure — State Government Sep 2016.
  - Implement centralized TSA in each State — State Government Dec 2016.
  - Quarterly financial reconciliation meetings between Federal and State Governments — State/Federal Government Sep 2016.
  - Share company database with FIRS to improve VAT and PAYE collection — State/Federal Government July 2016.
  - Introduce immediate issue of VAT/WHT certificates on payment of invoices — State/Federal Government July 2016.
  - Review all revenue related laws and update rates/tariffs — Local/State/Federal Government Mar 2017.
  - Set limits on personnel expenditure share of budget — State Government Dec 2016.
  - Biometric capture of States’ civil servants to eliminate payroll fraud — State Government Dec 2016.
  - Establish Efficiency unit — State Government Dec 2016.
  - Create fixed asset and liability register — State/Federal Government Jun 2017.
  - Establish Capital Development Fund and domesticate Fiscal Responsibility Act — State Government Dec 2016 / Jun 2017.
  - Attain and maintain a credit rating for each State — State Government Dec 2017.
  - Fast-track Municipal bond guidelines — State/Federal Government Dec 2016.
  - Ensure total liabilities do not exceed 250% of total revenue for preceding year — State/Federal Government Continuous.
  - Monthly debt service deduction not to exceed 40% of average FAAC allocation for preceding 12 months.
  - States encouraged to establish consolidated Debt Service Account funded to minimum of 5% of IGR — State Government Continuous.

### Conclusion and priority reform agenda
- Strong and bold reforms needed to address SLG vulnerabilities and structural challenges highlighted by oil shock.
- Priority reforms:
  - Depoliticize budgeted oil price (budget rule).
  - Comprehensive tax policy reforms (notably VAT reform and progressive increase from 5 to 15 percent).
  - Better reporting of fiscal outcomes and risks.
  - Stronger coordination between levels of government.
  - Adaptation and enforcement of FRL at subnational level.
  - Extension of TSA and PFM improvements.
  - Capacity building at SLG level.

*Italicized: IMF staff summary based on the provided chapter content.*

### INTRODUCTION _________________________________________________________________________ 4

### INTRODUCTION

### Overview
- This Selected Issues Paper contains five chapters examining:
  - the role of lower oil prices in explaining the deterioration in Nigeria’s recent macroeconomic indicators;
  - the impact on corporate and financial sector performance; and
  - forward-looking aspects of promoting job-intensive growth and strengthening State and Local Government finances.
- The slump in oil prices contributed to sluggish growth; the lack of foreign exchange weakened corporate performance, increasing the likelihood of non-performing loans.
- Structural reforms to improve the business environment can have a positive impact on growth, while fiscal reforms would help strengthen finances of sub-national governments.

### Key takeaways
- Macroeconomic conditions deteriorated from the slump in oil prices, reflecting weaknesses in pre-shock fundamentals. The impact was larger than fundamentals alone would have suggested, with the outsized impact likely reflecting policies implemented after the shock (the delay in implementing the 2016 budget and the imposition of foreign exchange restrictions), as well as other idiosyncratic developments (increased occurrence of oil infrastructure sabotage).
- Foreign exchange inflows are highly correlated with corporate sector performance, with declines in performance in the services sector more sensitive to FX inflows from autonomous sources.
- The economic downturn amplified vulnerabilities in the banking sector more than in the non-bank financial sector, increasing nonperforming loans and eroding capital. This reflects the higher exposure of the banking system’s balance sheet to corporates, whose performance was impacted by foreign exchange issues.
- Reducing unemployment in Nigeria will require both higher growth and reforms to strengthen the business environment. Higher growth alone is insufficient and needs to be accompanied by reforms that can increase the employment-growth elasticity.
- Improving SLG’s resilience to shocks requires broad fiscal reforms, including strengthening the fiscal federalism framework. Key areas of focus include the budget preparation process, expenditure controls, subnational treasury single accounts and cash management reforms, fiscal reporting, and internally-generated revenue administration.

### Explaining the impact of the oil price decline on Nigeria
- The chapter examines the degree to which economic fundamentals at the time of the recent oil price decline explain the intensity of its impact on the Nigerian economy.
- A cross-country regression finds that countries with a stronger fiscal position, higher international reserves, a more diversified export base, a history of price stability, and a flexible exchange rate regime weathered the shock better.
- These factors explain about half of the outsized impact of the shock on Nigeria. In addition, the slowdown in Nigeria was larger than can be explained by fundamentals alone, suggesting that country-specific factors also played a role.

### Stylized facts and scope
- Before the shock, projections were for continued robust economic growth of about 7 percent per year.
- After the oil shock, growth slowed sharply in 2015 and the economy experienced an outright contraction in 2016.
- Non-oil sectors, which account for almost 90 percent of the total economy, also slowed sharply.
- The analysis compares real GDP in 2016 with the projection from the Fall 2014 World Economic Outlook (WEO) for a sample of 26 countries with substantial oil exports.
- Nigeria’s 2013 level of oil exports was 17.6 percent of GDP.
- In 2013, oil accounted for over 95 percent of exports and three-quarters of government revenue, though oil GDP was less than 13 percent of overall GDP.

### Cross-country regression approach
- Identification uses each country’s fundamentals at the time of the shock (2013 values) to explain the magnitude of the impact of the oil shock on real GDP.
- Indicators tested as proxies included:
  - Macroeconomic policy space: overall balance, primary balance, non-oil balance, gap between the primary balance and its debt-stabilizing level, net debt to GDP, overall revenue, non-oil revenue, output gap, inflation rate, historical volatility of inflation, exchange rate regime flexibility, level of reserves (relative to the IMF-standard reserve adequacy metric).
  - External factors: revisions to partner country growth, non-oil terms of trade, non-oil current account balance, level of external liabilities, level of external assets.
  - Oil dependence and economic diversification: share of oil output, ratios of oil exports and oil-related fiscal revenue to GDP, share of non-oil output, ratios of non-oil exports and non-oil fiscal revenue to GDP.
  - Structural flexibility: business environment and governance indicators, ratios of private credit and broad money to GDP.

### Empirical findings
- Five variables were significant in the preferred specification: exchange rate regime flexibility, the ratio of non-oil exports to GDP, reserve adequacy, historical inflation volatility (over the seven years prior to the shock), and the ratio of net government debt to fiscal revenue.
- Together these variables explain sixty percent of the cross-country variation in real GDP in response to the oil shock.

### Estimated coefficients (Table 1 excerpt)
- Dependent variable: Percent deviation of actual 2016 real GDP from Fall 2014 WEO forecast.
- Core sample / Including conflict cases / All oil exporters (columns)
  - Exchange rate flexibility: 2.078** / 3.083* / 2.516* (standard errors (0.883)(1.590)(1.413))
  - Non-oil exports (percent of GDP): 0.145*** / 0.135** / 0.145*** (standard errors (0.036)(0.055)(0.053))
  - Reserve adequacy (percent of IMF metric): 0.005*** / 0.008** / 0.006** (standard errors (0.001)(0.004)(0.003))
  - Inflation volatility: -0.980** / -1.150*** / -0.980* (standard errors (0.460)(0.384)(0.496))
  - Net government debt (percent of revenue): -0.172*** / -0.197*** / -0.138* (standard errors (0.031)(0.068)(0.070))
  - Constant: -7.486*** / -7.053*** / -6.820** (standard errors (1.722)(2.199)(2.512))
  - Observations: 26 / 30 / 42
  - R-squared: 0.600 / 0.438 / 0.370
- Notes: Heteroskedasticity and autocorrelation robust standard errors in parentheses; ***, **, * next to a number indicate statistical significance at 1, 5 and 10 percent, respectively.

### Interpretation and robustness
- The same variables remained significant when the sample was expanded to include conflict-affected cases and to a range of less oil-dependent countries, though they explain a lower fraction of growth developments in those expanded groups.
- Net government debt—whether expressed as a share of total revenue, non-oil revenue, or GDP—was strongly significant across specifications.
- The reserve adequacy metric was calculated using total external debt liabilities; the ratio of reserves to imports was statistically significant in place of the reserve adequacy metric.

*Source: INTRODUCTION, Selected Issues Paper (Nigeria), IMF staff calculations.*

### 7. These findings can be applied to explain the relative intensity of the impact of the

### cr1781 - 7. These findings can be applied to explain the relative intensity of the impact of the

### Findings on the oil shock impact
- The cumulative impact on Nigeria’s real GDP was 15.5 percent (percent deviation of 2016 real GDP from Fall 2014 WEO forecast).
- This impact was about 8 percentage points more negative than the sample average.
- Approximately 4 points of the additional negative impact can be explained by Nigeria’s lower-than-average fundamentals.

### Contributions of pre-shock fundamentals (relative to sample average)
- Contribution explained by pre-shock fundamentals for Nigeria: about minus 4 percentage points of real GDP impact.
- For other Sub-Saharan African oil exporters, contribution of pre-shock fundamentals: minus 2 percentage points.
- Managed float economies entered the shock with relatively sound fundamentals that diminished the impact on real GDP by about 4 percentage points.
- Main specific fundamental difference for Nigeria: lower level of non-oil exports.
- Other fundamentals (exchange rate regime flexibility, net-debt-to-revenue ratio, reserve adequacy) contributed similarly for Nigeria and other Sub-Saharan African oil exporters.

### Regression residual and additional factors
- Regression residual for Nigeria: negative 4.1 percentage points.
- Average residuals of other Sub-Saharan African oil exporters and managed float economies: close to zero, on average.
- Negative residual for Nigeria suggests additional negative contributions from:
  - Policies in the wake of the shock (examples given: delay in implementing the 2016 budget; imposition of foreign exchange restrictions).
  - Idiosyncratic developments since the shock (example given: increased occurrence of oil infrastructure sabotage in Nigeria).

### Policy priorities highlighted
- Fiscal consolidation to build buffers for oil price fluctuations.
- Building a more substantial reserve cushion.
- Building a track record of price stability to create space for countercyclical monetary policy.
- Allowing the exchange rate to flexibly adjust to external conditions to reduce transmission of oil shocks to the non-oil sector.
- Structural reforms to improve the business environment to diversify the economy and boost non-oil exports (see Chapter 4 in source).

### Foreign exchange (FX) and corporate performance: overview
- Chapter focus: relationship between FX liquidity and corporate sector performance using panel data from 2013 Q3 to 2016 Q2.
- Quarterly Orbis data used cover 2013 Q3–2016 Q2 and do not cover all sectors.
- Corporate sector sample: 150 companies across a wide range of industries and sizes.

### Corporate sector performance trends (2011–2016 Q1)
- Earnings declined on average: EBITDA, EBIT, and net income all declined.
- Asset turnover ratio (operating revenues / total assets) declined.
- Debt-to-equity ratio peaked in 2013.
- Interest cover ratio (EBITDA / interest paid) declined from about 85 in 2013 to below 4 in 2015.
- Profit margin had been negative on average since 2014.
- Quarterly dynamics: firms tend to have highest income in the last quarter, but not in Q4 2015; sectoral recovery patterns varied (e.g., wholesale and retail did not recover to 2014Q3 level; machinery and equipment and chemical sectors recovered before falling sharply in 2016Q1).

### FX inflows evolution and exchange rate events
- By end-2016, FX inflows were only a third of the level observed in 2013.
- FX inflows to the Central Bank of Nigeria declined from $12 billion in 2013Q3 to $4.5 billion in 2016Q2.
- Other FX inflows to the economy declined from $27 billion in 2013Q3 to $9.5 billion in 2016Q2.
- Three major devaluations occurred during the period; parallel market depreciation followed introduction of FX restrictions (including on CBN sales to Bureau de Change in January 2016).

Chronology of key events (2014–2016 Q2)
- 2014Q3: Oil prices start to decline
- 2014Q4: 8 percent devaluation
- 2015Q1: 18 percent devaluation; Dutch Auction System closed
- 2015Q2: Election; FX restrictions (41 items) introduced
- 2015Q4: Cabinet appointed
- 2016Q1: FX sales to Bureau de Change stopped (these were reintroduced in Q3 2016)
- 2016Q2: 40 percent devaluation; Flexible FX regime introduced

### Empirical model and interpretation
- Autoregressive distributed lag (ADL) model estimated in error correction model (ECM) form.
- Dependent variable: EBIT of firm i in sector j at time t (ijt EBIT).
- Key explanatory variable: FX inflows to the economy at time t (t FX), including federation oil revenue to the CBN plus other autonomous inflows.
- Sector-specific short-term elasticity of EBIT relative to FX availability interpreted as 1j α .
- Sector-specific long-term elasticity interpreted as (α4 α3 α2 /1) formula as shown in source.

### Empirical results: aggregate and sectoral
- Short-run result (column (4) in Table 2): a 1 percent decline in FX inflows through autonomous sources reduced firms’ operating profits by about 1 percent on average across sectors.
- FX inflows to the economy are highly correlated with corporate sector performance, mostly through macroeconomic fluctuations.
- Regression caveat noted: results for equations 1 to 3 either suffer from omitted variable bias or multicollinearity.

Sectoral impacts (highlights from Table 3 and text)
- Stronger adverse impact in primary sector, food, beverages, chemical, and plastics. These sectors represent about 40 percent of the economy; a one percentage point decline in FX autonomous inflows can reduce earnings by more than one percentage point for these sectors.
- Services sector: almost four-to-one relation between FX inflows from autonomous sources and declines in earnings; services account for 25 percent of GDP.
- Market spread sensitivity: petroleum firms show sensitivity, with a one percentage point increase in the spread associated with a 9.5 percent decline in firms’ operating profits.
- FX inflows from oil exports to the CBN matter less for corporate profitability in general, but chemicals, rubber, plastics, and non-metallic products sector appear more sensitive to declines in CBN FX inflows (coefficients on CBN flows statistically significant only for this sector).

### Conclusion on FX and corporate performance
- Decline in FX inflows adversely affected corporate performance mostly through macroeconomic fluctuations and additionally through declines in non-oil FX inflows.
- Decline in FX inflows to the CBN was associated with declines in operating profits for firms in chemicals, rubber, plastics, and non-metallic products sectors.
- Decline in FX inflows through autonomous sources had a more pervasive adverse impact on operating profits, particularly in the other services sector.
- Evidence underscores the importance of policy actions affecting non-oil FX inflows given their additional adverse effects on firm operating profits.

### Financial sector developments and vulnerabilities (summary)
- Economic downturn increased banking sector vulnerabilities.
- Outlook points to higher NPLs and eroding capital.
- Stress test results show that a depreciating exchange rate and interest rate increases would adversely impact capital adequacy ratios (CARs), although these would remain above Basel II prudential norms.
- Non-bank financial institutions have been less impacted by the current economic downturn.

*International Monetary Fund — content from chapter/section provided in source PDF.*

### 1. The size of the financial sector of Nigeria is driven by activity in the banking sector,

### 1. The size of the financial sector of Nigeria is driven by activity in the banking sector

### Overview
- Banking sector accounts for 80 percent of total assets.
- 45 percent of banks’ loan book is in foreign currency.
- Growth in non-bank financial institutions, whose assets are mainly in local currency, was driven primarily by new funding.

### Banking Sector — Recent Developments
- The banking system is oligopolistic:
  - Size of the five largest banks fell from 60 percent of assets in the second half of 2015 to 43 percent of assets in the first half of 2016.
  - Herfindhal-Hirschman index was 743 at end-June 2016.
  - Market shares for the other 18 banks ranged from 0.3 to 6.4 percent.
- Lending and credit depth:
  - Banks reduced lending; lending remained relatively flat in 2016 after accounting for the impact of foreign exchange depreciation.
  - Credit-to-GDP ratio is 15 percent.
- Funding structure:
  - Deposits are about 75 percent of total liabilities.
  - Deposits below one-year maturity represent 95 percent of all deposits.
  - 44 percent of deposits are unremunerated demand deposits.
  - Loan-to-deposit ratio at 130 percent.
  - Financing from alternative sources was $0.6bn in 2016 versus $1.47bn in 2015.

### Banking Sector Vulnerabilities and Resilience
- Asset quality:
  - Non-performing loans (NPLs) doubled from a year ago to about 13 percent of total loans by end-2016.
  - Provisions increased to about 65 percent since end-2015.
  - NPLs net of provisions relative to capital remain relatively high.
  - Manufacturing and the energy sector (power, oil and gas) account for 70 percent of FX loans.
- Capital and solvency:
  - Capital adequacy ratios declined from 17.7 percent in 2015 to 14.8 percent in 2016.
  - Overall solvency ratios in 2016 would have averaged 16.9 percent after excluding three undercapitalized banks (which have ratios below 8 percent and account for 5 percent of assets).
  - Solvency ratios ranged from 3.2 percent for small banks to 15.7 percent for Tier I banks.
- Liquidity and profitability:
  - Liquidity ratios decreased to 42 percent at end-June 2016 from 48 percent at end-2015; prudential minimal limit is 30 percent.
  - Return on Equity (ROE) and Return on Assets (ROA) were 12.6 and 1.5 percent in 2016 respectively.
  - Net interest margins declined but remain in line with peers.
- Specific supervisory action:
  - Central bank intervened in one domestic systemically important bank (Skye) by replacing management and injecting liquidity; Skye and two small undercapitalized banks submitted remedial plans for recapitalization.

### Major Prudential Regulations and Measures Adopted Since 2010 (selected provisions)
- Solvency:
  - Capital Adequacy Ratio (Banks with National Authorization): 10% of Risk-Weighted Assets.
  - Capital Adequacy Ratio (Banks with International Authorization): 15% of Risk-Weighted Assets.
  - Undercapitalized Banks of <2%: Take over management/revoke banking license.
- Provisioning:
  - Sub-standard: 10% of the outstanding balance.
  - Doubtful: 50% of the outstanding balance.
  - Lost: 100% of outstanding balance.
  - General (performing loans): 2% of total outstanding balance.
- Liquidity:
  - Liquidity Ratio (excluding Cash Reserve Ratio): 30% of Total Assets.
  - Illiquid Banks of less than 50% prescribed amount: Change management/board.
  - Note: Cash Reserve Ratio (CRR) is currently 22.5%.
- Concentration and exposures:
  - Single Obligor Limit: 20% of Equity.
  - Exposure Limit to Any Single Group/Related Borrowers: 10% of Total Credit Portfolio.
  - Limit on Largest Aggregate Exposure: 8% of Equity.
  - Exposure to any industry within a sector >20% of credit: Risk weighting of 150%.
- Exchange rate:
  - Net Open Position: 10% of Equity (down from 20%).
  - FX Borrowing: 125% of Equity (up from 95%).
  - Natural hedge and FX loans to customers with FX revenue required.
- Notes:
  - Recent revisions indicated in 2016/17 for exchange rate related measures.

### Outlook and Risks
- NPL dynamics:
  - On average, it takes 5 to 6 years for NPLs to return to their normal level.
  - After the 2009 crisis, NPLs in Nigeria returned to normal in three years due to AMCON interventions; fiscal space for a similar action is limited now.
- Key factors affecting future NPLs:
  - Developments in the oil and gas sector:
    - Oil and gas account for 30 percent of banks’ loan books.
    - 14 percent of loans in the oil and gas sector are non-performing.
    - Sabotage of oil infrastructure and lower oil prices reduce revenues and repayment capacity.
  - Developments in the power sector:
    - Non-payments by electricity distribution companies increase NPLs; reform including cost-reflective tariffs is essential.
  - Exchange rate risk:
    - About 45 percent of loans and 40 percent of NPLs are in foreign currency.
    - A further depreciation of the naira by 50 percent would increase NPLs net of provisions to capital by 12 percentage point (from 28 to 40 percent) (See Chapter 2).
- Capital needs under scenarios:
  - Staff estimate: NPLs would have to increase to 27 percent for CARs to fall below 10 percent.
  - Under that scenario, the banking sector would need a capital injection of N352 billion (about 0.33 percent of GDP).

### Concentration, Exchange Risk and Regulatory Response
- Concentration risk:
  - Naira depreciation caused a passive breach of concentration risk thresholds (single obligor exposure limit of 20 percent of equity and eight times equity on aggregate large exposure).
  - Regulatory forbearance currently applied; regulator has demanded banks submit proposals to return to prudential thresholds.
- Exchange rate prudential adjustments:
  - Regulator eased FX borrowing limit from 95 to 125 percent of equity.
  - Regulator lowered FX Net Open Position (NOP) from 20 to 10 percent of equity.
  - Since August 2015, banks instructed to avoid extending FX loans to borrowers with no FX revenue.
  - 2014 measures require natural hedges for FX exposure (matching interest rate terms of financing with lending).

### Banking Stress Tests and Corporate Sector Linkages
- Sensitivity stress tests by the Central Bank indicate industry-level resilience under extreme shocks:
  - CBN sensitivity analysis indicates:
    - A 50% increase in NPLs will see small banks become insolvent with CARs at -9.8 percent while the industry CAR will be reduced by 1.5 percent to 13.2 percent.
    - A 200 percent increase in NPLs will reduce overall banking sector capital adequacy ratio to 8 percent.
    - Based on updated CBN information, if the provision of the five biggest obligors’ credit facilities were to increase to 100%, the industry’s CAR would be reduced to 6.3 percent.
- Corporate sector exposure:
  - Corporate sector accounts for 75 percent of the loan book.
  - Total corporate debt outstanding amounted to $85 billion in 2015.
  - Funding from capital markets accounted for $1.75 billion, down from $2.3 billion in 2015.
  - Syndicated loans and bank financing remain substantial sources of corporate market-based financing.

*Prepared by Miriam Tamene, Mika Saito and Marwa Ibrahim.*

### 13. Corporate Sector vulnerability stress tests complement the stress tests by looking at the

### 13. Corporate Sector vulnerability stress tests complement the stress tests by looking at the

### Corporate Sector Stress Test Results
- The level of non-performing loans (NPLs) is estimated by applying Moody’s estimated probability of default of 15 percent for companies with Interest Coverage Ratio less than 1.5.
- Under the extreme adverse scenario—exchange rate increasing from N/$197 to N/$600 and interest rate up by an additional 400 basis points (see Table 1 and Figure 6):
  - NPLs rising by 26 percent, which would cause the capital adequacy ratio to fall by 8 percentage points.
  - Given initial capital buffers, banks would remain resilient under this scenario.
  - Using preliminary staff analysis which indicates that for each 1 percentage point change in capital adequacy ratio annual credit growth contracts by 4.4 percentage points, this would lead to credit to the private sector contracting by as much as 34 percentage points.
  - Corporate Sector debt at risk would in that case amount to $11.6 billion, with the number of firms with debt-at-risk doubling to 29.

### Methodology (Box 2)
- Data
  - Individual corporate financial data from Orbis; sample size: 144 firms.
  - Firms’ total outstanding liabilities amounted to $7.3 billion, about 9 percent of the IMF staff estimate of outstanding debt.
  - Two definitions used to analyze debt at risk:
    - Interest Coverage Ratio (ICR): net income as a ratio of interest expense.
    - Debt to Gross Income (DGI) ratio introduced to complement ICR because net income data was lacking for many firms.
      - Of the $7.3 billion liabilities reported by firms, $0.411 billion was excluded from the ICR, compared to $0.05 billion under DGI.
  - Debt-at-risk, using both definitions, has gradually declined.
- Scenarios (three applied to corporate sector debt to assess impact on banks’ balance sheet)
  - Baseline scenario:
    - Exchange Rate: 55 percent devaluation (shift from USD/NGN 197 to 305).
    - Interest Rate: +200 basis points.
    - Net Income: -5 percent.
    - Note: baseline incorporates 200 basis points increase in interest rates in line with increase in policy rate, and 55 percent devaluation.
  - Adverse scenario:
    - Exchange Rate shift from USD/NGN 197 to 400 (further depreciation).
    - Interest Rate: an additional 100 bps increase (up 300 bps).
    - Net Income: -10 percent.
  - Extreme scenario:
    - Exchange Rate: depreciation to USD/NGN 600.
    - Interest Rate: +400 bps (twice the level of the increase under the baseline scenario).
    - Net Income: -20 percent.
  - Interest rate risk scenario is only applicable for the ICR measure.

### Key Quantitative Results (Table 1 — Nigeria: Impact of Corporate Sector Stress Scenario on Banking Sector, 2015)
- Current claims on private sector (N billions): 13,074 (End 2015 and for Baseline, Adverse, Extreme scenarios).
- Implied increase in aggregate NPLs (N billions): Baseline 182; Adverse 537; Extreme 3,229.
- Aggregate NPLs (N billions): End 2015 484; Baseline 666; Adverse 1,021; Extreme 3,874.
- Implied NPL Ratio (percent): End 2015 4.0; Baseline 5.1; Adverse 7.8; Extreme 29.6.
- Implied increase in aggregate NPLs (percent): Baseline 28; Adverse 83; Extreme 525.
- Implied loss rate (percent): Baseline 3.6; Adverse 4.6; Extreme 11.4.
- Implied loss (N billions): Baseline 472; Adverse 596; Extreme 1,488.
- Implied capital (N billions): End 2015 2,945; Baseline 2,473; Adverse 2,349; Extreme 1,4357
- Implied risk weighted assets (N billions): End 2015 17,695; Baseline 17,223; Adverse 17,098; Extreme 16,206.
- CAR (percent): End 2015 16.6; Baseline 14.4; Adverse 13.7; Extreme 9.0.
- Impact on CAR (percentage points): Baseline (2.3); Adverse (2.9); Extreme (7.7).
- Impact on credit growth (percentage points) using multiplier of 4.4 on change in CAR: Baseline (10.1); Adverse (12.8); Extreme (33.7).
- Credit growth (implied) (percent): End 2015 5.3; Baseline (4.75); Adverse (7.49); Extreme (28.38).

- Notes and assumptions from Table 1:
  - Scenarios summary (Baseline / Adverse / Extreme):
    - Exchange Rate: -55% / -103% / -205%
    - Interest Rate: +200bps / +300bps / +400bps
    - Net Income: -5% / -10% / -20%
  - Implied increase in aggregate NPLs assumes banking sector holds same percentage of debt-at-risk as in corporate sector sample, with a 15 percent probability of default.
  - Implied loss rate assumes a 45 percent loss given default (optimistic assumption; World Bank suggests 70 percent for Nigeria).
  - Risk weighting assumes 100 percent risk weighting.
  - Multiplier of 4.4 on change in CAR based on preliminary empirical work applying Bernanke and Lown (1991) approach on a sample of 2,317 banks across emerging market countries for the period 2001 to 2014.

### Policy Recommendations (for banks)
- Address undercapitalized banks to restore confidence:
  - Capital raising should be pursued, though challenging under current market climate.
  - Buyout and/or merger with other banks; existing shareholders will sustain losses (diluted shares and/or value of their shares), balanced against broader benefit of restoring market confidence.
- Dealing with non-performing loans to kick-start bank lending:
  - NPLs constrain banks’ balance sheet by depressing CAR and profitability.
  - Banks should be encouraged to divest non-performing loans and restructure those that will become viable.
- Strengthen monitoring and supervision:
  - Strict enforcement of existing prudential measures on FX and concentration risks, and consider further tightening of these measures.
  - Undertake an intrusive and conservative approach to supervision.

### Non-Banking Financial Sector Findings and Recommendations
- Overall state and trends:
  - The non-bank financial sector has been less affected by the economic downturn; pension funds, insurance companies, and managed funds remain healthy despite a decline in asset market prices.
- Pension sector:
  - Has grown considerably in membership and asset size over the past decade.
  - Industry is on track to meet strategic objective of capturing 30 percent of the working population under the Contributory Pension Scheme (CPS).
  - Pension Reform Act 2014: CPS applicable for organizations with employees of more than three (compared to 15 under the earlier Act of 2004); organizations with less than three employees and self-employed persons are also entitled to participate.
  - A significant portion of pension funds’ assets is held in government paper; investment in government securities is approaching the upper limit of 80 percent as fund managers rebalance towards less risky assets.
- Insurance sector:
  - Growth has been modest; mandatory requirements in motor, oil, gas and aviation sectors, plus life insurance for companies with 5 or more employees, support development.
  - Individual penetration is relatively low; corporates account for 80 percent of insurance coverage.
  - Assets invested mostly in short-term instruments and equities, or held as bank deposits, with no exposure to government securities.
  - Introduction of new insurance products (e.g., Micro and Islamic insurance such as Takaful) expected to boost growth; sector expected to triple by 2020 with premium income growing by 18 percent per annum.
- Managed funds and fund managers:
  - Net market value of investments marginally lower over 2016, in line with decline in stock and bond markets.
  - “Fixed Income” represented about a third held as investment in government bonds; exposure to government declined slightly by half a billion Naira (from 8 billion to 7.5 billion), largely due to market value changes.
- Policy recommendations for non-bank sector:
  - Review regulations and enhance monitoring as the sector develops.
  - As pension funds approach the upper limit on investment in government bonds:
    - Introduce regulatory measures to limit their liquidity and interest rate risks.
    - Consider relaxing exchange rate risk.
  - Insurance sector:
    - Continue move towards risk-based regulation, maintain close monitoring, and build capacity of the regulator as the industry grows.
    - Prepare to adopt Solvency II, building on work done to date.

*Source: IMF staff calculations; Orbis; IMF Financial Soundness Indicators.*

### 9. A number of reform initiatives are already underway. Specific goals for 2017 set out in the

### 9. A number of reform initiatives are already underway. Specific goals for 2017 set out in the

### Reform initiatives and federal plans
- ERGP goals for 2017 involve:
  - improving port efficiency;
  - streamlining administrative procedures for the entry and exit of people and goods, including through creation of a single customs window;
  - simplifying, clarifying, and automating processes for starting, formalizing, and operating businesses;
  - simplifying government procurement processes.
- The FG plans to stimulate industrial activity through targeted Special Economic Zones with dedicated road, water, power, and technological infrastructure to support productivity.

### Role of State and Local Governments (SLGs) in the business environment
- Several Doing Business indicators are driven by national policies, while others are a weighted average of conditions in Lagos and Kano, obscuring subnational heterogeneity.
- A 2014 subnational Doing Business study shows wide variation across states:
  - In four of seven indicators surveyed, the best state practice in Nigeria (2014) would already be enough, if adopted nationally, to rank the country 100th place or better.
  - In the other three indicators, adopting existing best practices across all states would still represent a substantial upgrade.
- Implication: Widespread adoption of practices already in place in the most business-friendly states could substantially improve Nigeria’s national business environment.

### Impact of reforms on job creation — evidence and elasticities
- Cross-country evidence (Melina, 2016) finds that for countries with a stronger business environment, the employment intensity of growth is significantly higher.
- Applying those results to Nigeria (using other large Sub-Saharan African countries as benchmark):
  - Historical employment-growth elasticity: 0.43
  - Freedom in business regulations (scale 0 to 10):
    - Nigeria: 4.71
    - Other large Sub-Saharan African: 6.23
    - Nigeria gap (C) minus (B): 1.52
  - Cross-country impact of business regulations on elasticity (one point improvement): 0.17
  - Employment-growth elasticity with reforms (A) plus (D) times (E): 0.69
- Quantitative implication: Reforms over the medium term to strengthen the business environment could raise the elasticity of employment growth to GDP growth to 0.69, from its historical level of 0.43.

### Unemployment scenarios and policy importance
- Applying the historical elasticity to staff’s baseline forecast for real GDP growth implies:
  - The unemployment rate would increase from its current 13 percent to over 20 percent by 2020 under the baseline with historical elasticity.
- Alternative scenarios:
  - Return to 2011–14 average growth, with historical elasticity: unemployment rate would still increase substantially over the medium term.
  - Adjustment scenario (growth follows staff’s adjustment scenario) combined with reforms sufficient to reach the higher employment-GDP growth elasticity (0.69): unemployment would be placed on a downward path once the economy recovers from the current downturn.
- Note on assumptions: Each scenario uses United Nations projections for the working-age population and assumes labor force participation remains at its 2016 share of the working-age population.
- Policy takeaway: Higher economic growth alone is insufficient to reduce unemployment; reforms to the business environment are critical for attaining job-intensive growth.

### Subnational governments: vulnerabilities and challenges — overview
- Chapter focus: reviews subnational fiscal performance and vulnerabilities; discusses policy initiatives; explores options to improve the subnational fiscal framework to cope with future shocks.
- Documents:
  - heavy dependence on oil receipts;
  - mounting debt and financing pressures;
  - fast buildup of arrears.
- Conclusion: Bold reforms and revenue diversification will be essential.

### Fiscal federalism arrangements
- Nigerian fiscal federalism is based on a constitutional revenue-sharing mechanism (FAAC allocation) pooling oil and non-oil revenues.
- Revenue-sharing formulas set by the National Assembly; can be updated every five years following RMAFC recommendations.
- SLGs account for about half of the Consolidated Government in terms of revenue and expenditure (Figure 1).

### Revenue-sharing specifics
- Oil receipts: constitution mandates no less than 13 percent of oil revenue allocated to oil-endowed states.
- Remaining 87 percent of oil revenue allocation:
  - FG: 48.5 percent
  - EBFs: 4.2 percent
  - SLGs: 47.3 percent
- Subnational component distribution: 40 percent distributed equally among states; 60 percent allocated according to equity considerations (population, land mass, internal revenue generation, school enrollment, hospital beds, and rainfall).
- Collection fees deducted before distributions:
  - Customs fees: 7 percent
  - CIT: 4 percent
- VAT allocation:
  - SLGs: 85 percent
  - FG: 14 percent
  - EBFs: 1 percent
- SLGs may impose specific taxes (IGR) including property taxes, PAYE, direct assessment, and road taxes.

### SLG responsibilities
- Constitution sets:
  - exclusive list for FG (national interest, defense, international affairs, elections, roads and railways);
  - joint list for FG and states (electricity, industry, commerce and agriculture, research, statistics, higher education, health, social welfare);
  - joint list for SLGs (primary, adult, and vocational education, health care, agricultural, and non-mineral natural resources);
  - exclusive list for local governments (roads, streets, public facilities, sewage).

### Recent subnational fiscal performance — revenue and expenditure trends
- SLG revenue dependence and trends:
  - In 2015, more than half of distributable revenues went to SLGs.
  - Oil receipts averaged about 66 percent of total SLG revenue during 2011-13 (before 2014 oil price collapse).
  - SLG revenue-to-GDP ratio fell from 8.6 percent in 2011 to 2.7 percent in 2016.
  - Share of oil revenue declined from 70 percent in 2011 to 26 percent in 2016.
  - Non-oil revenue (excluding IGR) was around 1.6 percent of GDP in 2016 and represented 59.2 percent of total SLG revenue in 2016.
  - IGR averaged 0.4 percent of GDP countrywide; Lagos State had IGR topping 60 percent of total revenue in 2016; across states IGR averaged about 20 percent of revenue in 2016.
- SLG expenditures:
  - SLG expenditures declined from 7.4 percent of GDP in 2011 to 4.5 percent of GDP in 2016.
  - Capital expenditure to total expenditure remained about 41 percent.
  - SLG overall deficit widened to 1.7 percent of GDP in 2016 (from a surplus of 1.2 percent in 2011).

### Subnational debt and arrears
- SLG debt-to-GDP increased by 3 percentage points from 2 percent in 2011 to 5 percent in 2016.
- External debt:
  - Rose steadily over 2011-15; increase mostly associated with Lagos State, which accounts for over 36 percent of SLG external debt.
- Domestic debt:
  - By 2015, domestic debt represented 75 percent of total SLG debt.
  - Domestic debt composition included salary and pension arrears (10 percent), contractors’ arrears (28 percent), commercial bank loans, and other liabilities.
  - About 15 states issued bonds in the last five years; in 2015 seven states raised funds from the capital market with total face value of N61 billion (compared to N15 billion in 2014 for Bauchi State only).
- Financing pressures have led to deductions from FG allocations through irreversible standing payment orders (ISPOs) and other service payments.

### Federal government interventions and contingent liabilities
- FG measures:
  - 2015 partial bailout addressing salary arrears of SLGs;
  - restructuring of N576 billion in commercial bank loans to 23 states (about ½ percent of GDP) with longer maturities and lower rates.
  - FG provided a further ½ percent of GDP financial assistance plan for 2016-17 conditional on states implementing a comprehensive 22-point Fiscal Sustainability Program.
- Note: Further contingent liabilities from SLGs could be substantial but have not all been quantified.

### Subnational challenges and structural issues
- Macro-fiscal challenges:
  - Formula-based transfers tied to budgeted oil price do not provide strong macro stabilization and reduce incentives for SLGs to exert expenditure control or raise independent revenue.
  - Guaranteed transfers raise questions on expenditure quality and governance; revenue-sharing formulas do not account for expenditure capacity.
  - Example: an increase in VAT rates would increase SLG revenues potentially leading to inefficient expenditure absent strong governance.
- IGR performance and capacity:
  - In 2015, IGR represented on average about 19 percent of total revenue.
  - Low IGR driven by lack of collection capacity, rural-based economy, and limited subnational incentives.
  - PAYE is the main source of SLG revenue; high-performing IGR concentrated in a few urban centers (Lagos standout).
  - In 2015, Lagos recorded an IGR share of recurrent revenue over 50 percent; 23 states performed below the subnational average of 12 percent.
- Budget execution:
  - Budget implementation consistently below 80 percent.
  - Recurrent spending implementation averaged nearly 100 percent across 36 states between 2010 and 2013; capital spending implementation averaged 58 percent.
  - Budget execution skewed towards recurrent spending (salaries, wages, overheads) over capital.
- Absence of idiosyncratic risk pooling:
  - No evidence of risk pooling among SLGs over 2011-15.
  - Expenditure is heavily determined by all revenues, particularly independently collected revenues.
  - With limited borrowing capacity and weak IGR mobilization, many SLGs rely almost entirely on allocated revenues to finance budgets.

*Italicized: IMF staff summary based on the provided chapter content.*

### 12. Poor policy coordination among all tiers of government hinders the adjustment to

### 12. Poor policy coordination among all tiers of government hinders the adjustment to shocks

### Key findings on coordination and fiscal shock transmission
- Fiscal federalism in Nigeria has not been accompanied by strong inter-governmental coordination, amplifying the effects of fiscal shocks.
- The recent large shock to oil revenue resulted in lower distributable revenues leading to adjustments across different tiers of government; without effective coordinating mechanisms, these adjustments might lead to duplication or lack of provision of certain services or types of expenditure (capital investment) with adverse macroeconomic impacts.
- The recent oil shock brought to the fore vulnerabilities of subnational governments: as oil prices collapsed and economic activity weakened, SLG deficits widened, increasing recourse to debt while adjustment was insufficient.

### Structural challenges
- Disparities across states are not fully addressed:
  - The Federal system endows SLGs with considerable political and fiscal autonomy; regional socioeconomic differences have left SLGs with different needs and fiscal capacities.
  - Revenue-sharing formulas are not based on a definition of a minimum set of public services per capita, irrespective of the state of residence, limiting the framework’s ability to address large disparities across states (for example, most of the North Eastern States have substantially higher than average absolute poverty rates).
  - A large variation in allocation of revenue across states is observed both in terms of revenues (distributable and internally generated) and expenditures.
- Data weaknesses prevent a reliable fiscal assessment of SLGs:
  - In 2015, only 10 states disclosed information on an approved budget and no state published an actual outturn report.
  - Only limited statistical information is available for the SLGs, posing challenges for macro-policy formulation and reliable fiscal assessment of SLGs.

### Empirical associations reported (2011–15)
- Regression/association table (variables and coefficients with standard errors in parentheses):
  - Total Expenditure: 0.843***  (0.084)
  - FAAC Allocation: 0.852***  (0.096)
  - IGR: 1.188***  (0.287)
  - Capital Expenditure: 0.517***  (0.078)
  - FAAC Allocation: 0.495***  (0.088)
  - IGR: 0.923***  (0.241)
  - Recurrent Expenditure: 0.335***  (0.070)
  - FAAC Allocation: 0.366***  (0.077)
  - IGR: 0.280  (0.215)
  - Standard errors in parentheses
  - *** p<0.01, ** p<0.05, * p<0.1

### Subnational bond issuance (selected totals, NGN’ Billion), 2011–2015
- Reported table total values by year: 92, 157, 125.9, 15, 60.95

### Homegrown actions: Fiscal Sustainability Plan (FSP) and contractual approach
- In 2016, the Federal Government launched a contract-based 22-point Fiscal Sustainability Plan (FSP) to help ease SLGs’ financial strains.
- Access to the facility is conditional on States submitting an action plan to implement FSP objectives to rationalize public expenditure, increase government revenue, improve accountability and transparency, debt management, and the overall public financial management system.
- The FSP is a positive step that should be implemented by all states; however, the 2015–17 restructuring and bailouts may have entailed significant moral hazard risks.
- A contractual system (fiscal programs) can help enforce coordination between FG and SLGs by:
  - Defining fiscal programs including primary surplus and revenue targets.
  - Setting limits on spending (e.g., wages, investment) and debt issuances.
  - Ensuring minimum reporting of budget execution and debt levels.
  - Stipulating numerical limits, annual fiscal targets, and sanctions in case of noncompliance.
- A key challenge remains implementation.

### Policy options and strategies
- Depoliticizing oil prices
  - The budgeted oil price is highly volatile and subject to political negotiation, leaving SLGs with limited buffers during adverse shocks.
  - One option: a budget rule using a combination of the past 5-year average oil price, the current year oil price, and forward-looking 5-year average oil-price, together with a structural primary surplus target in percent of non-oil GDP (to be tailored at adoption), subject to pre-announced exceptions.
- Increasing non-oil revenues
  - With 85 percent of VAT receipts allocated to SLGs, reforming the VAT system and raising its rate could provide sufficient resources to fulfill subnational spending mandates.
  - Specific VAT reform measures proposed:
    - Broaden the base (allow tax credits for all inputs including capital goods).
    - Increase the registration threshold with a simplified presumptive tax regime for SMEs.
    - Rationalize exemptions.
    - Progressively increase the VAT rate from 5 to 15 percent over the medium term.
  - Expected quantitative effects:
    - Progressive VAT rate increase and base broadening would increase non-oil revenues by at least 4 percent of GDP for SLGs in the medium term.
    - Reforming income tax (PAYE) and introducing a property tax could augment internally generated revenue of states by about 0.5 percent of GDP.
  - Reforms to PIT and CIT (reviewing rate structure, rationalizing tax expenditures, reviewing incentives, phasing out income tax holidays) would help reduce reliance on oil revenue since close to half of the collected revenue falls to SLGs.
  - Improve tax administration: strengthen Joint Tax Board (JTB) capacity to disseminate best practices and enabling systems; establish and enforce minimum standards; monitor quality of state PIT administration.
- Strengthening coordination mechanisms
  - Develop coordination mechanisms to ensure coherence of fiscal objectives, help fiscal management over the business cycle, and strengthen policy credibility.
  - Use medium-term targets for debt (e.g., commitment to achieve a certain level of debt-to-GDP over the next 4–5 years) to signal commitment to fiscal sustainability while providing annual flexibility; annual targets can be adjusted for large unexpected shocks while maintaining the medium-term commitment.
- Adapt fiscal responsibility law (FRL) to SLGs
  - Despite passage of the FRL at the Federal level and across some states, fiscal sustainability has remained weak for most SLGs.
  - States are at different levels of adopting an FRL; for some the law has been passed but not implemented.
  - An FRL plus the Public Procurement Act are essential for rules and procedures relating to accountability, transparency, and stability.
  - Introduce an enforcement mechanism through effective and periodic comparative analysis of budgeting procedures at the sub-national level; use peer reviews for learning and monitoring outcomes and compliance.
- Improve transparency and fiscal reporting
  - Fiscal reports should capture all off-budget revenues and spending and consolidate general government revenue, expenditure, and financing across all three tiers.
  - Authorities plan to implement international accounting standards to produce consolidated fiscal reports covering all three tiers of government.
- Strengthen public financial management (PFM)
  - Extend a Treasury Single Account (TSA) to States along lines implemented by the FG; implement TSA with careful phasing and a comprehensive plan detailing stages of implementation and required changes to financial regulations, IT-based FMIS, and accounting procedures.
  - Kaduna State TSA Implementation Manual (2016) cited as a useful guide.
  - Develop cash flow forecasting and management tools to leverage TSA benefits.
- Capacity building at SLG level
  - Build capacity for long-term revenue forecasts, establish medium-term budget orientation, implement quality public investment projects, and manage stabilization funds.
  - Near-term priorities: strengthen budget preparation to transition from incremental line-item approach to programmatic approach to facilitate policy costing and effective setting of expenditure ceilings.
  - Capture all committed (multiannual) liabilities in the fiscal framework to identify forward spending pressures and available fiscal space.

### Fiscal Sustainability Plan (selected items and dates)
- Objective 1: Improve Accountability and Transparency
  - Publish audited annual financial statements within 6 months of financial year end. — State Government Dec 2016
  - Introduction and compliance with IPSAS — State Government Ongoing
  - Publish State budget online annually — State Government Mar 2017
  - Publish budget implementation performance report online quarterly — State Government Mar 2017
  - Develop standard IPSAS compliant software to be offered to states — Federal Government Dec 2016
- Objective 2: Increase Public Revenue
  - Set realistic targets to improve independently generated revenue and ratio of capital to recurrent expenditure. — State Government Sep 2016
  - Implement a centralized TSA in each State — State Government Dec 2016
  - Quarterly financial reconciliation meetings between Federal and State Governments to cover VAT, PAYE remittances, refunds on Government projects, Paris Club and other accounts. — State/Federal Government Sep 2016
  - Share the database of companies within each State with the FIRS to improve VAT and PAYE collection. — State/Federal Government July 2016
  - Introduce immediate issue of VAT/WHT certificates on payment of invoices. — State/Federal Government July 2016
  - Review all revenue related laws and update obsolete rates/tariffs. — Local/State/Federal Government Mar 2017
- Objective 3: Rationalize Public Expenditure
  - Set limits on personnel expenditure as a share of total budgeted expenditure. — State Government Dec 2016
  - Biometric capture of all States’ civil servants to eliminate payroll fraud. — State Government Dec 2016
  - Establish Efficiency unit. — State Government Dec 2016
  - Federal Government online price guide to be available for use by States. — State/Federal Government Dec 2016
  - Introduce a system of continuous audit (internal audit). — State/Federal Government Dec 2016
- Objective 4: Improve Public Financial Management
  - Create a fixed asset and liability register. — State/Federal Government Jun 2017
  - Establish a Capital Development Fund to ring-fence capital receipts and adopt accounting policies to ensure capital receipts are applied to capital projects. — State Government Dec 2016
  - Domestication of the Fiscal Responsibility Act (FRA). — State Government Jun 2017
- Objective 5: Sustainable Debt Management
  - Attainment and maintenance of a credit rating by each State of the Federation. — State Government Dec 2017
  - Federal Government to encourage States to access funds from the capital markets for bankable projects through issuance of fast-track Municipal bond guidelines. — State/Federal Government (SEC/DMO) Dec 2016
  - Ensure total liabilities do not exceed 250% of total revenue for preceding year — State/Federal Government Continuous
  - Monthly debt service deduction not to exceed 40% of the average FAAC allocation for the preceding 12 months
  - States encouraged to establish a consolidated Debt Service Account to be funded from the State’s Consolidated Revenue Fund Account to a minimum of 5% of the IGR. — State Government Continuous

### Conclusion and priority reform agenda
- Strong and bold reforms are needed to address SLG vulnerabilities and structural challenges highlighted by the oil shock.
- Priority reforms include: depoliticizing the budgeted oil price, initiating comprehensive tax policy reforms (notably VAT reform and a progressive VAT rate increase from 5 to 15 percent), better reporting of fiscal outcomes and risks, stronger coordination between levels of government, adaptation and enforcement of FRL at the subnational level, extension of TSA and PFM improvements, and capacity building at SLG level.

*Source: IMF staff analysis and Fiscal Sustainability Plan materials as provided in the chapter.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr1781.pdf_