Report No. 11983-UNI

NigeriaMacroeconomic Risk Management:Issues and OptionsAugust 9, 1994

Western Africa DepartmentCountry Operations Division

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CURRENCY EQUIVALENTSCurrency unit = naira (N)

Naira/S .$1aaira- (Period averages)-

1986 1.755 0.5701987 4.016 0.2491988 4.537 0.2201989 7.365 0.1361990 8.038 0.1241991 9.909 0.1011992 17.298 0.0581993 21.886 0.046

ABBREVIATIONS AND ACRONYMSABD - Africa and Bilateral Division, FMFALM - Asset/Liability ManagementBIS - Bank for International SettlementsCBN - Central Bank of NigeriaCCFF - Compensatory and Contingency Financing FacilityComSec - Commonwealth SecretariatCS-DRMS - Commonwealth Secretariat Debt Reporting and Management SystemCSF - Copper Stabilization FundDAD - Development Aid Division, FMFDDSR - Debt and debt service reductionDM - Deutsche MarkDMD - Debt Management Division, FMFDRMS - Debt Reporting and Management SystemEAD - Economic Affairs Division, FMFECOWAS - Economic Community of West African StatesECU - European Currency UnitEFIA - External Finance and International Aid DepartmentEMTAP - Economic Management Technical Assistance ProjectFETR - Foreign Exchange and Trade RelationsFEM - Foreign Exchange MarketFMF - Federal Ministry of Finance and Economic DevelopmentFOD - Foreign Operations Department, FMFGDP - Gross Domestic ProductGNY - Gross National IncomeGON - Government of NigeriaIBRD - International Bank for Reconstruction and DevelopmentICM - International Capital Markets Division, FMFIMF - International Monetary FundIPE - International Petroleum ExchangeJOA - Joint Operating AgreementsLC - Letter of CreditLIBOR - London Inter-Bank Offer RateLNG - Liquified Natural GasMdC - Mexicana de CobreMFED - Ministry of Finance Exchange DepartmentMLT - Medium and Long TermMOU - Memorandum of UnderstandingNAPIM - National Petroleum Investment ManagementNEPA - Nigerian Electric Power AuthorityNFW - New Field Wildcat WellsNNPC - Nigerian National Petroleum CorporationNOGDP - Non-Oil Gross Domestic ProductNPC - National Planning CommissionNPV - Net Present ValueNYMEX - New York Mercantile ExchangeOECD - Organization for Economic Cooperation and DevelopmentOPEC - Organization of Petroleum Exporting CountriesPDVESA - Petroleos de VenezuelaPEMEX - Petroleos MexicanosPNG - Papua New GuineaPPG - Public and Publicly GuaranteedSDR - Standard Drawing RightsSFEM - Second-tier Foreign Exchange MarketSGRF - State General Reserve FundSME - Small and Medium EnterprisesSTABEX - Stabilization for ExportersUNDP - United Nations Development ProgramWTI - West Texas Intermediate

FISCAL YEARJanuary 1 - December 31

ABSTRACT

Nigeria's oil sector accounts for more than 90 percent of the country's exports, 80 percent of publicrevenues, and 25 percent of GDP. Broadly, a US$1 increase in the per-barrel oil price increasesNigeria's foreign exchange earnings by about US$650 million-2 percent of GDP-and its publicrevenues by more than US$300 million a year.

Oil prices and revenues are uncertain and subject to large and frequent fluctuations. In the past,Nigerian policymakers tended to assume that oil price increases were permanent and oil pricereductions temporary. This assumption has led to a number of difficulties:

* During oil booms, expenditures have tended to increase with higher revenues, and sinceexpenditure programs are difficult to contain or reduce when booms come to an end,external imbalances and fiscal and monetary disequilibria have been a recurring problem.Given that external-and internal-imbalances cannot be sustained indefinitely, expenditurecuts have been unavoidable, but have been undertaken too late.

* TMe public expenditure program's expanding and contracting with oil revenues haschanneled the fluctuations that characterize oil earnings to the domestic economy-in termsof changes in relative prices and the associated structure of production. This has increasedthe risks faced by investors in non-oil activities, causing private investment to be lower thanit would otherwise be and reducing growth in the non-oil economy.

* Oil boom resources have financed additional, large public expenditure programs thatexceeded the public sector's programming, implementation and management capacity.Many investments did not pay for themselves, in large part because with the large numberof programs, project selection criteria and procedures became very lax during oil booms.

At present, Nigeria faces serious macroeconomic policy issues-not just oil revenue volatility-thatmust be addressed if it is to return to a path of sustainable growth and poverty reduction. Nigerianeeds to promote fiscal transparency and discipline, and to return to market-determined exchangeand interest rates. But managing the country's exposure to oil price volatility-and also to exchangeand interest rate volatility that affects debt service obligations-will also be important in establishingthe foundations for the sustainability of such policies, once adopted.

Techniques are available to manage countries' external exposure. Using these techniques, theNigerian authorities could manage this exposure themselves, or partially transfer its management tothe international financial community, or both.

If the authorities were to manage the external exposure themselves-the self-insurance option-theapproach to be pursued would be to create an oil stabilization fund. A stabilization fund isessentially a spending rule for oil revenues. It is designed so that by saving resources in someperiods, the Government could lessen the need to cut spending in others. By stabilizing expendituresin line with sstainable or 'permanent" income, an oil fund helps stabilize relative prices, the realexchange rate, and the structure of production. If an oil price change turns out to be permanent, awell-designed fund can allow smooth expenditure adjustments-upward or downward. The use ofan oil fund would avoid sudden and traumatic expenditure cuts in the face of a negative shock. Ifa shock is positive, it would allow the government to gradually increase expenditures, with sufficientadvance warning to enhance its own programming, implementation and management capacity. Chileis an example of a developing country that has established a successful stabilization fund-the CopperStabilization Fund.

Oil price and revenue exposure can also be transferred abroad through the use of hedginginstruments, which, for a fee, provide insurance against unanticipated price fluctuations.International markets for some hedging istruments tend to be thin and short-dated-and costly-butthe use of some hedging instruments can become extremely useful, as Mexico's experience suggests.Hedging tools may stabilize a share of revenues in the short run and provide useful information aboutfuture revenues-thus reducing uncertainty and helping governments plan in advance. The volatilitythat cannot be managed with hedging instruments can be managed by an oil stabilization fund.

NIGERIA

MACROECONOMIC RISK MANAGEMENT: ISSUES AND OPTIONS

CONTENTSPage No.

EXECUTIVE SUMMARY ....................................... i

CHAPTER I. NIGERIA'S RISK MANAGEMENT PROBLEM .............. 1A. Overview ............ ............................. 1B. Sources of External Risks in Nigeria ......................... 3

1. The Oil Sector ..................................... 42. Exchange Rates ..................................... 73. Interest Rate ....................................... 94. Terms of Trade and the Evolution of Real Income ............... 9

C. Estimation of Some of Nigeria's External Risk Costs ...... ......... 121. Macroeconomic Costs ................................. 122. Exchange Rate and Interest Rate Costs ...................... 143. Other Costs ....................................... 14

D. Managing External Exposure .............................. 151. The First-Best Solution ................................ 152. Transferring Risk to World Capital Markets ................... 153. Self Insurance ...................................... 204. Complementarity Between Self-Insurance and Transferring Risk

Options .......................................... 235. Transferring Risk to the Private Sector ...................... 24

CHAPTER II. MANAGING THE OIL SECTOR RISK EXPOSURE .... ...... 27A. Introduction ......................................... 27B. Factors Influencing Oil Sector Development ..................... 28

1. Reserves and Production Prospects ......................... 292. Investment Incentives ................................. 30

C. The Oil Sector and The Fiscal Accounts ........ .. ............. 321. Tax Arrangements in Nigeria ............................ 322. Oil Price Risk and Fiscal Revenues ............ ........... 32

D. Conceptual and Practical Elements for the Creation of an Oil StabilizationFund ..................... ........................ 331. Basic Motivation .................................... 332. Conceptual Elements ................................. 333. Institutional Aspects and Practical Experiences ...... ........... 35

This report was prepared by a team led by Santiago Montenegro and comprising ConstantjinClaessens, Sudarshan Gooptu, Mudassar Imran, and Andrew Powell (consultant). Valuableadvice and comments were provided by Ajay Chhibber, Joanne Salop, Jose Sokol, AndresSolimano and members of the World Bank Nigeria economic team. The Nigerian Government,through the Research Department of the Central Bank of Nigeria, provided helpful comments tothe conclusions and the content of the report. Preparation of the report was aided by valuablecomments and collaboration of Preeti Arora.

Contents (contd.) Page No.

4. Potential Problems for the Establishment of an Oil Stabilization Fundin Nigeria ........................................ 39

E. Oil Sector Risk Management: Other Strategies ................... 401. Risk Sharing and Alternative Financing Arrangements ............. 402. Market-Based Risk Management .......................... 403. Diversification Strategies ............................... 43

F. Potential Public Managers of Oil Windfalls and Busts ...... ......... 47G. Policy Recommendations on Oil Price and Other Commodity Risk

Management ................... ..................... 481. Using Externally-Traded, Market-based, Commodity Price-linked Risk

Management Tools ................................... 482. Considering the Basic Elements for the Creation of an Oil Stabilization

Fund ........................................... 493. On Contractual Arrangements and Diversification Strategies .... ..... 50

CHAPTER III. CURRENCY AND INTEREST RISK MANAGEMENT .... .... 53A. Introduction ......................................... 53B. Government of Nigeria's Liabilities .......................... 53

1. Data Availability .................................... 542. Exchange Rate Risk .................................. 543. Interest Rate Risk for the Government ....................... 564. Recommendations On FMF Liability Management .57

C. Central Bank Assets and Liabilities ......... .. ............... 581. Assets .......................................... 582. CBN Liabilities ..................................... 583. Data Availability .................................... 594. Risk Management ................................... 595. Recommendations on Central Bank Reserves and Liabilities

Management ....................................... 60

CHAPTER IV: INSTITUTIONAL AND INFORMATIONAL ISSUES FOREXTERNAL LIABILITY MANAGEMENT ...................... 61A. Introduction ................... ...................... 61B. Institutional and Legal Structure for External liability Management .. ..... 61

1. Legal Framework ................................... 622. Organizational Structure ............................... 63

C. External Liability Management Strategy and Issues ..... .. .......... 661. Overall Strategy .................................... 662. External Debt Data Management .......................... 673. Issuance of Government Guarantees ........................ 694. Foreign Exchange Forward Budget ......................... 705. The Stabilization Account .............................. 70

D. Eternal Debt Service and the Fiscal Budget ....... .. ............ 71E. Conclusions and Recommendations ......... .. ............... 74

APPENDIX I: ESTIMATION OF THE MACROECONOMIC ADJUSTMENTCOSTS OF THE TWO NEGATIVE OIL SHOCKS ................. 77

Contents (contd.) Page No.

APPENDIX II: ESTIMATION OF THE ELASTICITY OF GOVERNMENTOIL REVENUES WITH RESPECT TO THE INTERNATIONAL OIL PRICE 81

APPENDIX III: ORGANIZING FOR DEBT MANAGEMENT: LESSONSFROM INTERNATIONAL EXPERIENCES ...................... 83

REFERENCES .............................................. 87

MAP

FIGURES

1.1: Oil Prices: Bonny Light .................................... 51.2: Nominal Effective Dollar Exchange Rate .......................... 81.3: Currency Composition of PPG Debt ............................. 81.4: Nominal Interest Rates (LIBOR) ............................... 91.5: Share of Variable Rate Debt .................................. 101.6: Terms of Trade ......................................... 101.7: Real Income and Production .................................. 11

3.1: Interest Rates and Export Prices ............................... 56

4.1: Organizational Chart of the Federal Ministry of Finance ................ 644.2: Organizational Chart of the Debt Management Department,

Central Bank of Nigeria .................................... 66

1.1: First Oil Shock: Adjustment Costs ............................. 78I.2: Second Oil Shock: Adjustment Costs ............................ 78

III.1: Organizing for Effective External Debt Management .................. 84

TABLES

1.1: Adjustment, Interest Rate, and Exchange Rate Costs(Nigeria: First Oil Shock 1980-85) ............................. 13

1.2: Adjustment, Interest Rate, and Exchange Rate Costs(Nigeria: Second Oil Shock 1986-90) ........................... 14

2.1: Nigeria: Economic Indicators, 1973-91 .......................... 272.2: Energy Sector Investment by Developing Countries ................... 282.3: Nigerian Crude and Condensate Disposal by Light/Sweet Producers ... ...... 292.4: Forms of Sale of Crude Oil by OPEC, 1985 and 1989 ................. 412.5: Nigeria's Term Buyers, 1991 ................................. 42

3.1: Direction of Trade, Average 1980-91 ............................ 553.2: Central Bank Reserves ..................................... 58

4.1: Summary of Federal Government Finances, 1989-1992 ................. 72

Contents (contd.) Page No.

BOXES

1. Options for Managing Oil Price ............ ................... iv

1.1 Mexico's Oil Hedging Strategy ................................. 171.2 Chile's Hedging Operations with Eurodollars ....................... 171.3 Commodity Swap ........................................ 181.4 Mexicana de Cobre Financing Using a Copper Swap .................. 191.5 Chilean Copper Stabilization Fund ........... ................... 21

2.1 Joint Venture Agreements . .................................. 302.2 Sonatrach's Financing Using Crude Oil Options ..................... 49

EXECUTIVE SUMMARY

A. Nigeria's External Exposure

1. The Nigerian economy is highly dependent on a number of external variables beyond thecontrol of policy makers and domestic agents. Most important among those variables is the priceof oil, which is highly uncertain and determined in fluctuating international markets. With oilaccounting for more than 90 percent of Nigeria's exports, 25 percent of its GDP, and 80 percentof its public revenues, a fairly small price change can have a significant impact. A US$1increase in the oil price in the early 1990s increased Nigeria's foreign exchange earnings by aboutUS$650 million (2 percent of GDP) and its public revenues by US$320 million a year. Largelybecause of changing oil prices, total exports value increased from US$2.1 billion in 1972 toUS$26 billion in 1980 and then bottomed out at US$6 billion in 1987. Nigeria's reliance on oilproduction for income generation clearly has serious implications for its economic policymanagement.

2. Nigeria's exposure to external variables is not limited to oil prices. With its publicexternal debt accounting for 100 percent of GDP, and as a large share of this debt is denominatedin currencies other than the US dollar-and some is interest-variable-the economy is sensitiveto changes in cross-currency exchange rates and interest rates. Adverse movements in theserates, which have become much more volatile during the past two decades, played a major rolein the rapid growth of Nigeria's debt burden during the 1980s.

3. At present, Nigeria faces serious economic problems. To return to a path of sustainablegrowth and of poverty reduction, the country must address a number of critical issues, includingpromoting fiscal transparency and fiscal discipline, and returning to market-determined exchangeand interest rates. But managing the exposure to oil revenues and external debt will also beimportant in establishing the foundations for the sustainability of such policies, once they areadopted.

B. The Costs of External Exposure

4. In the past, policymakers tended to assume that oil price increases were permanent andoil price reductions temporary. Thus, when revenues rose, public expenditures were increased,but were difficult to cancel when revenues dried up. This response to oil price increases hasgenerated several difficulties and costs to the economy:

* Since expenditures have not been cut when oil prices have fallen, either becauseof the belief that the price falls were temporary or because expenditures weredifficult to contain or reduce when booms came to an end, external imbalancesand fiscal and monetary disequilibria-and inflation-have been a recurrentproblem. In the 1970s and early 1980s, the imbalance problem was so severethat, even before oil prices began to fall, a persistent excess of expenditure overrevenues contributed to the growth of Nigeria's large stock of external debt.Given that external-and internal-imbalances cannot be sustained indefinitely,expenditure cuts have been unavoidable, but have been undertaken too late andin too costly a manner.

* The public expenditure program's expanding and contracting with changes in oilrevenues has channelled the fluctuations and uncertainty that plague oil earningsto the domestic economy-in terms of changes in relative prices and theassociated structure of production. For example, during the 1970s and early

Hi

1980s, when oil prices and public revenues were high, Nigeria was subject to theso-called Dutch Disease. This phenomenon occurs when the increased exportrevenues are spent on the domestic economy in general, and on nontradables inparticular. The result is increased relative prices of nontradable goods andwages-and an appreciated real exchange rate. Although this response favors theexpansion of nontradable sectors, such as services and construction, it adverselyaffects the development of tradables other than oil. For example, Nigeria, a netexporter of agricultural products in the early 1970s, became an importer of morethan US$2 billion per year in foodstuffs a decade later. Then oil prices andpublic revenues collapsed and so did the incentives to move resources towardnontradable activities.

If higher oil prices in the 1970s and early 1980s had been permanent, movingresources toward nontradable activities would have been optimal. But the mainproblem with uncertain and highly volatile oil prices-and public revenues-isthat investors cannot predict when the next shock will take place. For the samereason, investors cannot predict the sign of the next oil shock and, consequently,which sector will be favored and which will be adversely affected by it. Thisuncertainty increases the risks in non-oil activities, causing private investment tobe smaller than it would otherwise be and leading to lower growth in the non-oileconomy. In this connection, several World Bank studies (Serven and Solimano,1993) have confirmed that volatile relative prices are one of the main factorslimiting private investment in developing countries.

* The belief that oil booms are permanent encouraged Nigeria to finance largepublic expenditure programs, including a number of investment projects thatproved to be costly mistakes. Even long before oil revenues began to dry up inthe 1980s, it was clear that Nigeria's public sector did not have the capacity toimplement and manage these programs. Many of the projects failed to pay forthemselves. Some projects that might have become viable had high oil pricesbecome permanent, turned into non-viable ones once oil prices fell-whichtriggered new relative prices and a new trade regime. Yet because of non-economic considerations, some of the projects have become irreversible.

* Other macroeconomic costs of external exposure result from capital flight-oftenthe private sector's response to the fear that, once oil revenues fall, unsustainablebudget deficits will bring about increased inflation and higher future taxes.Additional macroeconomic costs are associated with the interactions amongeconomic actors-not least the states and regions of Nigeria-trying toappropriate for themselves the external sector's windfalls.

C. Options for External Shock Management

5. A government can manage external exposure by self-insuring, transferring risk abroad,transferring risk to the private sector, or using a mix of these options. These are summarizedin Box 1.

6. Self-insuring. One option for managing oil shocks is to convert oil reserves into a securefinancial or physical asset, such as US treasury bills. However, the possibility of selling oilreserves is limited by several economic, political, and institutional constraints.

7. Economic uncertainty could also be avoided by reducing oil extraction. But the benefitsof oil production in improving welfare more than offset the costs of economic uncertainty. As

iii

long as the rate of return on the assets that may be acquired with oil revenues exceeds theexpected rate of growth of the real oil price, oil production should be limited only by availableextraction technology. Otherwise it would be more advantageous to keep oil reservesunderground and only sell them when oil prices rise.

8. Taking into consideration Chile's successful experience, Nigeria could create an oilstabilization fund. A stabilization fund is essentially a spending rule for oil revenues, designedso that the government, by saving resources in some periods, lessens the need to cut spendingin others. By stabilizing expenditures, such a fund would contribute to stabilize relative pricesand the real exchange rate. If the oil price change turns out to be rather permanent, a well-designed fund can allow smooth expenditure adjustments-upward or downward. This wouldavoid the need for sudden and traumatic expenditure cuts if negative shocks were to take place.If a positive shock were to take place, a fund would enable the government to gradually increaseexpenditures, with sufficient advance warning in order for it to enhance its own programming,implementation and management capacity. By allowing expenditure adjustments, the fund alsolessens the possibility of it running out of resources when negative shocks become permanent,or of its indefinite growth if permanent shocks become positive. Chile's Copper StabilizationFund has been deemed a critical factor in that country's dramatic economic success.

9. Transferring risk abroad. The Nigerian government could take advantage of possibilitiesin world financial markets to transfer part of its external exposure abroad. During the pastdecade a growing number of financial instruments have emerged in international markets allowinggovernments, corporations, and individuals in developing countries the possibility to reduce theirexposure to currency, interest rate, and commodity price fluctuations-by "selling" such exposureto other agents better able to bear such risks, that is, by "hedging."

10. In Nigeria, neither the government nor the private sector uses these market-basedinstruments to reduce exposure, primarily because of lack of information, lack of awareness ofthe benefits, the complexities of managing a hedging program, and the lack of an adequategovernment institutional and policy framework. Another reason is that markets for the relevanthedging instruments are thin or are not of appropriate maturities-although some markets aregrowing rapidly. At the same time, developing countries' access to these growing internationalfinancial markets has been restricted by lack of creditworthiness. Mexico's recent experience,however, shows that a developing country can successfully participate in these growing markets.

11. Transferring risk to the private sector. The private sector could be allowed increasedparticipation in managing external exposure. This might require transferring to the private sectorownership of the oil sector-through alternative financial and equity arrangements-or windfalls.How far privatization could be advanced depends on political considerations, and assessing thoseconsiderations is beyond the scope of this report.

12. Transferring windfalls to the private sector while maintaining public ownership of the oilsector would likely be cumbersome. During a period of positive shocks, for example, thewindfalls could be transferred to the private sector through lower taxes, direct transfers, andhandouts and by selling windfall foreign exchange, which, under a floating rate regime,appreciates the nominal-and the real-exchange rate. Dutch Disease effects, however, wouldnot be avoided. These transfers would need to be reversed once the oil price fell back from itshigh levels, to prevent the budget deficit from widening. If (unpredicted) negative shocks wereto occur, public expenditure would have to be cut-or the real exchange rate depreciated-because it might not be possible to increase taxation in the short run-let alone to force theprivate sector to transfer resources to the government to sustain a given level of expenditure.

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Box 1: Options for Managing Oil Price Exposure in NigeriaExposure

managementoption Potential benefits Potential problems Country expeniences

1. Business as * None * Continuing pronounced absorption * Nigeriausual fluctuations, relative price changes, and

recurrent balance of payments, fiscal,and monetary imbalances

2. Self-insurance

a) Risk avoidance

Selling oil * Possible avoidance of risk * No markets for oil reserves in * United Statesreserves developing economies

Lowering oil * Possible reduction of risk * Reduced government revenue and * No evidence ofextraction rates * Possible environmental expenditure countries reducing oil

benefits * Loss of competitive advantage and extraction rates to* More oil for future market share reduce external

generations volatility

b) Oil stabilization * By aaving resources in some * Given the Government's lack of a * Chile: Copperfund periods, the Government can positive record managing external Stabilization Fund

lessen the need to cut shocks, risk that the resources of a * Oman: Oilspending in other periods stabilization fund would be squandered Stabilization Fund

* May help stabilize the real ex- * The opportunity cost of keeping * Colombia: Nationalchange rate and the resources in the stabilization fund Coffee Fundmacroeconomy

* Backed by a law, it maycounter political pressurefrom competing groups tospend much of any windfall

c) Economic * May diminish Nigeria's * May take too long * In Indonesia (oil),diversification dependence on the oil sector * Could harm Nigeria's comparative Chile (copper),

and, hence, reduce external advantage in the oil ector if it takes Colombia (coffee),risk exposure place at the expense of this sector and Mexico (oil),

(namely, reducing extraction rates). external commodityexposure significantlyreduced in recentyears

3. Transferringrisk abroad

a) Markets for * The transfers of risk to the * Markets for hedging instruments are thin * Mexico: in 1993 ablehedging world financial community, and incomplete, although some are to hedge up to oneinstruments which is in principle better growing very rapidly. Maturities are not half of oil price expo-

equipped than developing long enough. sureeconomies to manage external * Markets for hedging instruments, even if * Brazil: swaps,risk exposure used to hedge a substantial share of total futures, and options

* Improvement in credit- exports, may not stabilize revenues. * Chile: price bandsworthiness For example, oil futures prices have * Algeria and Kuwait:

* Raising capital been very volatile, almost as volatile as small hedging posi-spot prices. tions using the Brent

* Upfront costs (premiums) to purchase futures marketsoptions can limit use in cash-strappedcountries.

* Existence of 'basis risk' can also limitthe use of futures and options, althoughthese risks can be transferred.

* Government's poor record managingexternal shocks, and the risk that theresources to be hedged would besquandered

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ExpoureeLanagemet

option Potential benefits Potettial problans Country experiences

b) Credit markets * Transfer of some risk to the * Credit markets may be costly, rationed, * Many developingworld financial community or both, economies partici-

* Commercial credit is usually pro- pating in worldcyclical. Other credit lines are available financial marketsonly ex post, after the international

financial crisis of the1980s

4. Transferringrisk to theprivate sector

a) Transferring * A deregulated financial * Complete and even partial privatization * Argentina, Colombia,asset owner- ector, an open capital is contingent on political considerations. Peru, Venezuela:ship, or account, and a predictable Assessing these considerations is beyond publicly owned oilredesigning oil macroeconomic environment the scope of this report. companies partlyexploration may put the private sector in * Even if privatization or new exploration privatized, particu-contracts, or a better position than the pub- contracts are feasible, this option may larly in downstreamboth lic authorities to assess and not reduce public revenue volatility activities

manage external risk, significantly-especially if the privateector does not manage its risks.

b) Transfrring * The private ector may be * Transferring external shocks to the * No evidence ofwindfals while better equipped than the private sctor is extremely difficult: it economies subject tomaintaining Government to manage amounts to endogenizing fiscal policy, external shocks thatpublic external risk exposure. With positive shocks, one or more of transfer windfalls andownership these measures would be needed: taxes busts directly to the

should be lowered, subsidies increased, private ector on aand the real exchange rate appreciated. systematic temporay

* With lower oil prices, these measures basiswould have to be reversed to keep thebudget balanced.

* Even if the private sector is prepared toaccept this endogenous fiscal policy,nmaking it institutionally viable would bevery difficult.

c) Setting a target * With positive shocks, this * This policy would transfer external * No evidence of anyfor the Central policy would tend to sector volatility to the private sector government practicingBank's interns- appreciate the real exchange through real-exchange rate and relative this policy systemati-tional reserves rate. Because the private price movements. callyand elling component of the current * In the event of negative shocks, thiswindfafl re- account of the balance of pay- policy would force the private sector toserves to the ments is in deficit, this policy transfer resources to the public sector.public under a would increase the private * Relative price instability would reducefloating ex- sector's real income and private investmentchange rate would tend to stabilize realregime public revenues.

S. Mizing sef- * The use of an oil stabilization * This combination would encounter the * Chile, Colombia:icnrane and fund and the increasing use of same problema as each of the two countries withrisk trnfer markets for hedging inatiu- options alone, stabilization fundsOptions ments may be the only also using hedging

realistic way to manage marketsNigeria's external oil priceexposure over the short andmedium term.

* The stbilization fund may beused as leverage for financialundertakings, including theuse of markets for hedginginstruments.

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13. MLxing self-insurance and risk-transfer options. A combination of self-insuring activitiesand transferring risk abroad, such as through the use of markets for hedging instruments, maybe the optimal way to deal with a country's external exposure. These general options may becomplementary: expanding the use of each of them may widen the possibilities for using others,and each of these ways for managing risk may address a different critical aspect of externalexposure.

14. In constructing a comprehensive program to manage Nigeria's external exposure and thecosts it generates, it is important to address both oil price uncertainty and oil price instability.A well constructed strategy would be to combine a self-insurance mechanism, such as an oilstabilization fund, with specialized financial instruments, such as hedging instruments. While astrategy of selling oil forward year after year, for example, might allow Nigeria to anticipate theprice it would receive the following year-thus reducing oil price uncertainty-this strategy alonewould not necessarily reduce the volatility of Nigeria's cash flow. The volatility of oil futuresprices has always been pronounced-sometimes almost as high as spot price volatility. Thisvolatility can be best managed by a stabilization fund.

15. Asset and Liability Management. Neither Nigeria's government nor its public enterpriseshas used market-based or self-insurance techniques to manage interest rate and exchange rateexposure-that is, asset and liability exposure. To manage its currency exposure, the FederalMinistry of Finance-when it was borrowing from international markets during the 1980s-couldhave considered using diverse funding sources to achieve a better currency mix of net liabilities.For example, given Nigeria's capacity to generate US dollar-denominated foreign assets-becauseof the dominance of oil in total exports-the authorities could have diversified their borrowingsaway from non-US dollar-denominated loans toward US dollar-denominated loans. AlthoughNigeria is not borrowing from international commercial banking sources currently, it could followthis approach should the opportunity arise.

16. For its stock of outstanding debt, the Ministry of Finance could consider using short-datedcurrency risk management tools (largely forwards). Using longer-dated risk management tools-futures, options, and swaps-will be more complex. Because such work may require institutionalchanges and training, it should be considered a long-term option. To manage its interest raterisks on public debt, the Nigerian government could have increased in the past its share of fixedrate financing to the extent possible. At present, it could use interest rate hedging tools tomanage its short-dated interest rate exposure. Longer-dated interest futures and swaps shouldalso be considered a longer-term option.

17. In the past, the Central Bank of Nigeria could have made better use of its reserves-matching its liabilities-as a tool for risk management. The Central Bank could have alsoimproved the returns to its reserves, its information systems, and staff training. The CentralBank needs to strengthen its capacity to manage external debt-by setting up, or linking to, theCommonwealth Secretariat Debt Reporting and Management System (CS-DRMS), which isalready installed at, and partially utilized by, the Finance Ministry. CS-DRMS can be used tocomputerize the recording and reporting of Nigeria's external payment obligations that are notalready being monitored at the Ministry of Finance-short-term debt, par bonds, and promissorynotes.

18. If efforts to establish effective management of external assets and liabilities are tosucceed, however, an appropriate institutional structure must be in place at the Ministry ofFinance and the Central Bank. Such a structure should be designed to ensure complementarity

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between functional units of the Ministry of Finance and the Central Bank, rather than thecompetition and duplication that currently exist.

CHAPTER I. NIGERIA'S RISK MANAGEMENT PROBLEM

A. Overview

1.1 The Nigerian economy is highly dependent on a number of external variables beyond thecontrol of policy makers and domestic agents. Most important among these variables is the priceof oil, which is uncertain and determined in fluctuating international markets. The oil sectoraccounts for more than 90 percent of the country's exports, 25 percent of its GDP, and 80percent of its public revenue. A US$1 increase in the oil price in the early 1990s increasedNigeria's foreign exchange earnings by approximately US$650 million-2 percent of GDP-andpublic revenues by US$320 million, annually. Largely because of changing oil prices, totalexports, which peaked in 1980 at US$25 billion, declined to a level of US$10.5-12.6 billionduring 1983-85. Once again, in 1986, oil exports lost half their value and fell to aboutUS$6 billion, remaining depressed until the onset of the Gulf War, in the second half of 1990.Nigeria's reliance on oil production for income generation clearly has serious implications for itseconomic policy management.

1.2 Nigeria is also exposed to debt-related risk. With its public external debt accounting for100 percent of GDP, and as a large share of this debt is in currencies other than the US dollar-some debt is also interest-variable-the economy is sensitive to changes in cross-currencyexchange rates and interest rates. Adverse movements in these rates, which have become muchmore volatile in the past decades, played a major role in the rapid growth of Nigeria's debtburden in the 1980s.

1.3 At present, Nigeria faces serious economic problems. To return to a path of sustainablegrowth and of poverty reduction, the country must address a number of critical issues, includingpromoting fiscal transparency and fiscal discipline, and returning to market-determined exchangeand interest rates. But managing the exposure to oil revenues and external debt will also beimportant in establishing the foundations for the sustainability of such policies, once they areadopted.

1.4 In the past, policymakers tended to assume that oil price increases were permanent andoil price reductions transitory. Thus, when revenues rose, public expenditures increased, andsince they usually took on a life of their own, it was very difficult to trim or cancel them whenrevenues dried up. This response to oil price variations has generated several difficulties andcosts to the economy.

1.5 Since expenditure programs have not been cut when oil prices have fallen, either becauseof the belief that the price falls were transitory or because expenditures were difficult to containor reduce when booms came to an end, external imbalances and fiscal and monetarydisequilibria-and inflation-have been a recurring problem. In the 1970s and early 1980s, thisproblem was so severe that, even before oil prices began to fall, a persistent excess ofexpenditures over revenues had opened up, initiating the growth of Nigeria's large stock ofexternal debt. Given that external-and internal-imbalances cannot be maintained indefinitely,expenditure cuts have been unavoidable, but have been undertaken too late or in too costly amanner.

1.6 This oil price uncertainty and instability and the discretionary and erratic public spendingtracking of actual, rather than permanent or sustainable, income transmits and magnifies theexternal uncertainty to relative prices and to the structure of production. For example, in the1970s and early 1980s, when oil prices and public revenues were high, Nigeria, like other large

2

oil and commodity producers, experienced the so-called Dutch Disease. This phenomenon tendsto occur when increased export revenues are spent on the domestic economy, thus raising therelative prices of nontradable goods and wages, namely appreciating the real exchange rate.While this favors the expansion of nontradable sectors, such as services and construction, itcontracts the development of tradables other than oil. As a result, Nigeria, which had been a netexporter of agricultural products in the early 1970s, was importing more than US$2 billion peryear in foodstuffs a decade later. Then oil prices and public revenues collapsed and with themthe incentives to move resources toward nontradable activities. If oil-generated income hadremained relatively high for a significant period, or if the oil-price shocks had been permanent,sooner or later the overall economy would have adjusted to the implied real income stream, andthe subsequent relative price and sectoral resource allocation adjustment would had been optimal.

1.7 But because oil prices are uncertain and highly volatile, the main problem is that investorscannot predict when the next oil shock will occur. For the same reason, investors cannot predictthe sign of the next shock and, consequently, which sector will be favored and which will be hitby it. Given that capital, once installed, is sector specific, and that investors make their decisionsbased on expectations of future relative prices, investors put a risk premium on the return to allinvestment, whether in tradables or nontradables, making the volume of investment lower thanit would otherwise be and resulting in lower growth in the non-oil economy. This, rather thanthe Dutch Disease, is the real problem arising from external sector volatility. A comprehensiveWorld Bank study on investment performance in developing economies concludes that a stableand predictable exchange rate policy-and relative prices-is crucial to promote investment.Actually, this study finds that the variability of the real exchange rate has a stronger and moreadverse effect on capital formation than does its level (Serven and Solimano, 1993).

1.8 Nigeria's experience points to other related problems. In the 1970s and in the early1980s, high oil prices and high public revenues helped finance large public expenditure programs.Many investments did not pay for themselves. Project selection criteria and procedures were lax,nor did Nigeria have adequate implementation capacity to manage sudden bursts of investmentexpenditure. In this sense, Nigeria's observed public investment inefficiency problems arecritically linked to the economy's high external risk exposure. Attempts to reform the publicsector and to reorient public investment to activities and assets with the highest returns, includingforeign assets, would be incomplete without the parallel introduction of a framework withadequate tools to manage the economy's high external risk exposure.

1.9 Nigeria's high external risk exposure has also affected the financial sector. Major shocksemanating from oil revenue fluctuations have created an environment in which financial marketsin Nigeria have fluctuated widely and unpredictably. The poor quality of the banks' portfoliomight be partly due to the macroeconomic swings caused by public expenditure adjustments tooil shocks. Sudden relative price movements, such as real exchange rate appreciations ordepreciations, affect the solvency of firms whose prices are negatively affected by external shocksand, by extension, the solvency of the financial institutions they deal with. Actions to reform andrehabilitate the Nigerian financial sector may be inadequate unless full account is taken of thestress that the external shocks and the lack of external risk management instruments have placedon the sector in the past.

1.10 Broadly speaking, countries with publicly-owned resource sectors have four ways tomanage their external risk exposure: a) self insurance; b) transfer of risk to world financialmarkets; c) transfer of risk to the private sector; and d) a mix of approaches. In principle,transferring risk abroad should be the best way for managing external exposure for a developingeconomy. A developing economy does not have a comparative advantage in bearing price risk,

3

while international financial markets are generally better equipped to do so. In practice, acombination of self-insuring activities and transferring risk abroad, such as through the use ofmarkets for hedging instruments, may be the optimal way to deal with a country's externalexposure. These general options may be complementary: expanding the use of each of themmay widen the possibilities for using others, and each of these options may address a differentcritical aspect of external exposure.

1.11 Generally speaking, well-designed self-insurance strategies increase the country'sinternational creditworthiness and, consequently, improve access to international financialmarkets, including the market for hedging instruments. Wider and deeper use of financialmarkets, in turn, may provide additional resources to diversify the economy away from oil,which may further increase the economy's credibility abroad, expand its ability to borrow, andreduce the costs of participating in the markets for hedging instruments. From a differentperspective, while market-based hedging instruments are ideal for reducing the economy'suncertainty over a variable such as the oil price, the establishment of an oil stabilization fund or,if possible, the use of credit markets can be critical means to reduce exposure to the instabilityof the oil price. In other words, in the construction of a comprehensive program to manageNigeria's external exposure, it is critical to distinguish between two concepts: oil priceuncertainty and oil price instability or volatility. While the strategy of, for example, selling oilforward year after year may allow a country such as Nigeria to know the price it would receivein the following year and, hence, make better budgetary plans, this in itself would not necessarilyreduce Nigeria's cash flow volatility. It is a well-known fact that, save exceptional periods, oilfuture price volatility has been almost as pronounced as spot price volatility.

1.12 Some of this volatility, however, could, in principle, be partially managed by accessingworld lending markets. Unfortunately, Nigeria's access to lending markets is limited, particularlywhen it has been needed most. International commercial lending to developing countries hastended to be procyclical. And contingent borrowing facilities, such as the Compensatory andContingency Financing Facility of the International Monetary Fund and the EuropeanCommunity's Stabilization for Exports (STABEX), are accessible only on an ex post basis.Moreover, Nigeria does not qualify for these facilities because they do not cover oil. So, forNigeria, an oil stabilization fund may be a rational choice for addressing oil price volatility.

1.13 This chapter discusses a number of possibilities that the Nigerian Government mayconsider for managing the economy's external exposure. The approach followed is that apragmatic use of self-insurance mechanisms, such as an oil stabilization fund, specialized financialinstruments, and integrated asset liability management techniques may be optimally combined toaddress the country's overwhelming external exposure and the costs so generated. Section Bhighlights the principal sources of external risks for Nigeria. Section C estimates some of thedirect macroeconomic adjustment costs faced by Nigeria during the 1980s as well as the costsincurred due to exchange rate and interest rate volatility. Finally, Section D discusses theprinciples and market-based options available for reducing exposure to these risks, compared withmore traditional options.

B. Sources of External Risks in Nigeria

1.14 Nigeria is exposed to a variety of risks, some arising from changes in the structure of thedomestic economy, others from changes in the international economic environment at large,particularly in countries with whom Nigeria has economic relations. Some of these risks arecompletely exogenous to Nigeria, others arise from-or are influenced by-domestic actions,public or private. Of these different types of risks, a large proportion will need to be managed

4

through the use of appropriate public policies, as no direct instruments are available to managethese risks-e.g., the effect on Nigeria's trade flows of changes in the growth performance ofOECD countries. But those risks arising from international market factors, i.e., currency,interest, and commodity risks, can to a large extent be managed directly by Nigeria.

1.15 While the country as a whole is subject to a number of external risks, these risks are notevenly distributed among different economic actors. Institutional arrangements, such as taxpolicies or the contractual relationship between the Government of Nigeria and the oil companies,affect agents' relative risk exposure accordingly.

1. The Oil Sector

a. Oil Price Risks

1.16 Figure 1.1 plots international prices for Nigeria's oil during 1986-91. A pattern of largefluctuations in prices is evident, especially since Nigeria started to sell at non-posted prices. Theprice fluctuated between a low of US$11.5/bbl and US$40.9/bbl over the period 1988:02-1992:07, while the mean price over this period was US$19.6/bbl. The volatility (standarddeviation) of the Bonny Light price over this more recent period was US$5/bbl or 38 percent,which is very high compared with most other internationally traded commodities. Largefluctuations in the oil price resulted ex ante in large risks to the Nigerian economy, owing to itshigh dependence on oil exports. Oil exports amount to about 90 percent of total exports. Netliquified natural gas (LNG) exports, which are expected to account for about 5 percent over theperiod 2000-05, also represent an exposure to energy prices, as the LNG price will (in part) beindexed to the international oil price. The exposure to risks associated with oil and LNG are toa large extent incurred by the public sector, either in the form of variable tax revenues fromforeign companies or through the sales of Nigeria's oil share (through the Nigerian NationalPetroleum Corporation, NNPC). Other primary commodities exports are relatively minor, onlycocoa represents a significant exposure (currently about 1 percent of total net exports). Thisexposure is-since the abolishment of the marketing boards in 1986-incurred by the privatesector in different forms, and represents less of a direct public management issue.

1.17 Furthermore, the relative dependence on oil has increased over the past five years. Theshare of oil exports in GDP has risen by about 20 percentage points and the relative and absoluteamount of oil price exposure has thus increased. For example, a US$1 movement in the priceof oil implies a change in gross export receipts of about US$650 million. Production-sharingarrangements will, in the future, reduce somewhat the balance of payments and fiscal impact ofoil price movements, since the Government receives only a share of the oil output. However,absolute exposures and possible effects on Nigeria's fiscal situation remain large for theforeseeable future.

1.18 The recent dramatic turn of events in the former Soviet Union and the impact of yetuncertain environmental policies has widened the range of oil market uncertainty. For example,in 1993 this was reflected in a wide range of the price forecast-between US$10/bbl andUS$231bbl for 1995, within a 70 percent confidence interval. The market also remainssusceptible, perhaps increasingly so, to supply disruptions since future oil supplies will beincreasingly concentrated in a few countries in the Middle East-witness the impact of the recent(1990-91) Middle East crisis on volatility in the international oil market. Oil price volatilityimplied by the market prices of crude oil options on futures increased to between 40 percent and70 percent over the August-December 1990 period, and reached over 100 percent following theoutbreak of hostilities in mid-January 1991. Prior to the Middle East crisis in July 1990,

5

volatility was 20-22 percent.' The uncertainties in oil price expectations and Nigeria's very highexposure to oil price shocks underpin the need to manage these price risks effectively in orderto achieve the optimal utilization of receipts from oil sales. Nigeria needs this type of riskmanagement much more, for example, than the Middle East oil producers, because it has limitedproduction capacity to increase output and exports to offset revenue losses due to a decline in oilprices; also, Nigeria's low per capita income level means that the welfare impact of the oil priceuncertainty is much greater.

Oil Prices: Bonny Light, 1986-1992(US Dollars per Barrel)

4 4

-42-

40

39

36

34

32

30

28

26

24

22

20

.16

~14

1996 1967 1999 1999 1990 1991 1992

Bo-ny LIght

Figure 1.1

1.19 The oil sector generates at least two additional sources of risks for the Nigerian publicsector and for fiscal revenues. The first is the risk derived from the contractual relationshipbetween the Nigerian Government and foreign oil companies regarding exploration andproduction costs as well as tax policy. Chapter II discusses these issues at length and assessesways of changing some of these contractual relations that may affect the relative amount of riskshouldered by the Federal Government.

1.20 Second, there are risks related to management of the domestic petrol price and, inparticular, the price at which the Governmnent sells oil to NNPC for domestic consumption. Outof a total production of slightly below 2 million bbl/d, Nigeria devotes about 300,000 bbl/d fordomestic consumption. To date, the Nigerian authorities have delinked the domestic price fromvariations in the world price that Nigeria receives from its oil exports. The most visible problemin domestic oil pricing has been the egregious distortion of the oil transfer price, namely, theprice that NNPC pays for each barrel to the Government, which in turn naturally distorts alldownstream prices. In early 1993, this price was set at N20, while the cost of oil operations wasabout N 120 and the international parity level was estimated at about N500. In early 1994, giventhe financial difficulties faced by NNPC, the oil transfer price had in practice fallen to zero. In

Implied volatilities were calculated by minimizing the mean squared sum of errors between the theoreticaloption value of all outstanding puts and calls (for all strike prices and all maturities) at a particular date andthe observed market price with respect to the volatility used in the theoretical option price formula.

6

terms of the risk involved, the present pricing policy forces the Government to assume theimplied risk.

b. Oil Price Volatility and Public Policy

1.21 A crucial aspect of Nigeria's economic structure is that the vast majority of the oil outputis in government hands. Revenue from oil accounts for about 80 percent of governmentrevenues. Hence, it is likely that volatility in oil revenues in general feeds through to highvolatility in government revenues.

1.22 As shown in Chapter II, other factors also add to the volatility of government oilrevenues. Given that marginal tax rates on oil revenues increase with higher oil prices (i.e., thetax rate is a convex function of oil income), government tax revenue from oil is even morevolatile than general oil revenue. The structure of the tax system determines the volatility offiscal revenues of the Government as a function of the volatility of the oil revenues.

1.23 Highly uncertain government revenues will have a number of detrimental effects. Theseare reviewed below.

1.24 First, uncertain revenues make budgetary planning extremely difficult. If governmentsundertake rather rigid development plans infrequently and if investment decisions are irreversibleand have sizeable recurrent expenditures associated with them, a highly uncertain revenue streamcan make ex post mistakes in planning decisions both very likely and very costly. It has beenargued that certain large investment projects in Nigeria have had ex post low rates of return andhave been inappropriate requiring very large and costly financing.2 These types of mistakes arein line with the experiences of other commodity-dependent countries.3 Further, the anticipationof such costly investment mistakes implies that the optimal degree of public investment will bereduced.

1.25 Second, the uncertainty attached to government revenue can affect the behavior of theprivate sector and, hence, the economy more generally. For example, the Government has asignificant effect on the economy and affects relative prices through many channels. If relativeprices in the economy are more volatile, due to changes in government behavior as a result ofvolatile revenues, private investment will suffer.

1.26 Third, uncertain government revenue may also affect private sector asset holdings-between domestic and foreign assets-which, in turn, may be extremely costly and affect relativeprices. These costs stem from the strategic interactions between the Government and the privatesector. If private agents find that the government's expenditure plans are inconsistent with therevenue at the current price level, the price level may rise to balance the Government's books.In other words, the Government may default on its real commitments through inflation. One wayof thinking about this default on real commitments is that there is a fixed exchange rate and theGovernment devalues in order to balance its fiscal accounts. In these circumstances, theuncertainty attached to revenues could have serious welfare effects. The greater the uncertaintyof the revenue stream, the more the private sector will be forced to hold foreign assets-for agiven level of government expenditure-to hedge against potential crises in the governmentaccounts. This, in turn, implies that if there is a crisis and a devaluation, the situation will be

2 See for example Bevan ct al (1992).

See for example Powell (1991) on Zambia.

7

worse than if government revenues were less uncertain and private sector holdings of domesticassets were higher. There is a severe macroeconomic cost to increased uncertainty, and a verylarge incentive for the Government to find ways to reduce revenue volatility.

1.27 Fourth, given that oil also accounts for the vast majority of exports, this implies that theGovernment is itself the largest natural supplier of foreign exchange to the foreign exchangemarket. This in itself makes the volatility of oil revenue a question for public policy. How muchUS dollar income from oil the Government decides to save in the form of foreign exchange andhow much is presented to the budget in the form of domestic currency in a particular period willdetermine, to a large extent, the supply of foreign exchange. Thus, a saving rule for foreignexchange is also a rule that will affect the nominal exchange rate. The risk management programshould be analyzed in terms of its effects on the exchange rate as well as on the governmentbudget. This point is discussed further below.

1.28 Fifth, a rather different type of reason why revenue volatility is a public policy concernof relevance to Nigeria revolves around the political economy of government expenditure and theperils of collective choice. The focus here is on the federal structure of Nigeria. In times ofhigh oil revenues, political actors and pressure groups, not least the Nigerian states, lobby forincreased federal funds transfers from the extra revenue. If it is known that an oil boom islargely temporary-as demonstrated by the 1990 Middle East crisis-and that the best course ofaction for the country as a whole is to save the vast majority of windfalls in the form of foreignassets (thus avoiding the adjustment costs and the Dutch Disease effects described above), therewill be high costs associated with lobbying for these central windfall funds.

1.29 There are strong reasons for concluding that the problem of volatile oil revenue is aconcern for public policy. To get over these problems, a rule might be optimally used toconstrain behavior. A stabilization fund, for example, could be thought of as a type ofconstitutional rule that constrains the behavior of agents lobbying for the proceeds of oilrevenues. Given the correct design of such a rule, the optimal savings decision (or at least onecloser to it) might be made, as opposed to the inefficient solution of different states lobbying forwindfall revenues.

2. Exchange Rates

1.30 Figure 1.2 plots the nominal effective US dollar exchange rate for the period 1977-92.4As is clear from this figure, exchange rate volatility, which increased after the movement tofloating exchange rates in the early 1970s, did not decline in the 1980s. Since Nigeria has asignificant non-US dollar debt stock (about 62 percent of debt is non-US dollar as of 1991, ofwhich the German deutsche mark has the largest share [15.9 percent, see Figure 1.3]), its debtservice in US dollar terms is sensitive to cross-currency exchange rates (most notably DMIUSdollar and yen/US dollar). About 10.8 percent (US$3.3 billion at end 1991) of outstanding publicand publicly guaranteed (PPG) debt is in the form of mixed currency loans.5 The exposure hasincreased, as the share of non-US dollar debt has increased steadily since 1985 (by about 8percentage points). Although a significant part of the increase in non-US dollar debt can beexplained by the decline of the value of the US dollar since 1985-which increased the share of

' The index of the USS effective exchange rate is the weighted average USS exchange rate against all othercurrencies that are trading partners with the US. The weights used to create the index are the IMF weights.

5 Note that much of the "Mixed" Currency debt (IBRD, ADB, and some SDR) is non-US dollar debt. Forexample, about two thirds of IBRD debt is non-US dollar.

8

non-US dollar debt when total debt is measured in US dollars-a large part of the increase is dueto the increased borrowings in non-US dollar currencies. For instance, US dollar grossdisbursements declined as a percentage of total new commitments from 40 percent in 1980 to33 percent in 1985. Since then, the US dollar share of new borrowings has further declined andwas about 28 percent in 1991.

Nominal Effective Dol lar Exchange RateNIglrs 1977-1992, C1985=100)

120

110

90

930

70

50

50 1 I I1977 1979 1991 1993 1995 1997 1999 1991

Figure 1.2

Currency Compos ition of PPG DebtNIQ6aIa: 1985-1991

50

40

20

10

1995 1895 1987 1999 1999 1990 1991

US Do I I are Gar-an Mark Japansee Yen French FrancLUK Pound Sterl n = MI.ea Cur-ency

Figure 1.3

9

3. Interest Rate

1.31 Figure 1.4 plots the nominal interest rate most relevant for Nigeria from 1965 to 1992(i.e., US$ LIBOR).6 As can be observed, nominal interest rates have experienced largefluctuations. It can also be seen from Figure 1.4 that there have been a few periods oftranquillity. Today, Nigeria's debt service is less sensitive to international interest rates than itwas in the past, as a significant amount of commercial bank debt has either been bought back orconverted to fixed interest rate bonds. The share of variable rate debt in Nigeria's total long-termdebt has also dropped by 3 percentage points since 1989, from 34.7 percent in 1989 to 31.8percent in 1991 (see Figure 1.5). Still, including short-term debt-which is rolled over at currentinterest rates-the share of variable-rate debt stands at 34 percent. In absolute terms, the interestexposure is large; a 1 percent change in international interest rates implies a change in debtservice (short term and medium to long term combined) of about US$100 million a year. SinceNigeria's external debt structure may have to increase its reliance on commercial financing asofficial sources will gradually reduce their support and as financing needs (for the oil sector)remain large, exposure to interest risk can be expected to increase significantly.

Nominal Interest Rates CLIBORD1955- 1992

20

19

10

14

15

15

14

.E10

a

4

3 1S,7519701950 1990 iIs

Figure 1.4

4. Terms of Trade and the Evolution of Real Income

1.32 This section shows the effects of changing world oil prices on Nigeria's terms of tradeand real income since the early 1970s.7 World oil prices began to improve in 1973. As a

X The nominal rate is the London interbank offer rate (LIBOR) on six-month US dollar deposits (periodaverages in percent per annum) on which much Nigeria's commercial bank debt used to be indexed.

7 A more complete assessment of the main economic events of the period is presented in Montenegro, S.(1993) 'Nigeria: The Legacy of the Oil Boom and Policy Options for External Shocks Management,' andWorld Bank (1994), 'Nigeria-Structural Adjustment Program: Policies, Implementation, and Impact,' ReportNo. 13053-UNI.

10

Share of Variable Rate DebtNlera: - Ie1935- 1991

so

55

so

9 45

40

35

30

25

20 1985 1995 1987 1998 1989 1990 1991

Figure 1.5

TERMS OF TRADENIGERIA: 1971-1991

290

270 -

250-250-240-

230-220 -

210 -

200-190

180

170

1SO

150

140

120

110

100

s08070

¶971 >719l73 |191 5 |19177 |19179 ;1981 1983 |¶9185 1987 198 19819

19 2 19 4 19 6 19 9 1990 1992 1984 198b 1999 1990

0 TE._S OF T_RADE

Figure 1.6

consequence, the terms of trade increased by 142 percent between 1972 and 1974 (the first oilshock). After remaining relatively constant through 1979 (with 1987 = 100, the indexes for 1974and 1979 were 149 and 161, respectively); the terms of trade doubled from the 1976 level by1981 (the second oil shock). The terms of trade in 1981 were 325 percent above their 1972level. Although both the real oil price and the terms of trade started to fall in 1982, in historicalterms, both indicators remained relatively high until 1985. In 1986, the real price of oilplummeted and so did the terms of trade. By that year, the terms of trade had lost 65 percentof their 1980 level (Figure 1.6).

11

REAL INCOME AND PRODUCTIONNIGERIA: 1971-1991

220

210 -

200-

190

190

170

150 0

140

130 G

-J 120-

110

100

90

70 -19V75 ISO1955 iso

C GDY + GOP

Figure 1.7

1.33 Not surprisingly, these terms of trade variations were partly responsible for theextraordinary real income fluctuations over the period 1971-91 (Figure 1.7).' While real incomeincreased by more than 200 percent between 1972 and 1980, by 1983 real income had lost almost60 percent of its 1980 (peak) level. After a modest recovery in 1984-85, real income returnedto its low 1983 levels in 1986-87. This period was followed by an expansion initially led byproduction rather than by the terms of trade (1988-89), and in 1990 by the windfall due to the1990 Middle East crisis. A simple regression analysis indicates that the elasticity of real incomewith respect to the terms of trade is as high as 0.47.9 In other words, this figure indicates that,based on past experience, a 10 percent increase (reduction) of the terms of trade would cause anincrease (decline) of 4.7 percent in real national income. This significantly high figure onlystresses the sensitivity of real national income to fluctuations in the real oil price. In the case ofNigeria, this sensitivity is critically extended to the public sector and through the public sectorto the whole economy. Given that expectations are erratic and considering that in boomingperiods they usually err on the positive side, relative price improvements tend to overshootexpenditure, particularly investment, which normally takes a life of its own and cannot bereversed, or can be reversed only too late and too painfully. This seems to be the lesson to belearned from the oil shocks of the. 1970s and 1980s.

' The difference between GDY and GDP is given by the term, x[(Px/Pm)-1l], where x records total realexports (at 1987 prices). Px is the overall export deflator and Pm is the import deflator.

9 The rsults of the regression of Ln(GDY) on Ln(TT(terms of trade)) ar: a=9.45 (0.13); b=0.47 (0.065);R squared =0.73; Number of observations =21. The results of the regession of Ln(GDY) on Ln(oil price)are: a=11.8 (0.13); b=0.24 (0.033); R squared=0.73 and number of observations=21. 'a' records theconstant term; 'b" indicates the coefficient of the independent variable. The numbers in parenthesis are thestandard errors of the coefficients.

12

C. Estimation of Some of Nigeria's External Risk Costs

1.34 Adverse external shocks arising from the above-mentioned factors require large balanceof payments adjustments, which carry with them adverse repercussions in the form of dramaticabsorption contractions, reduced perceptions of Nigeria's creditworthiness in internationalfinancial markets, the need to adjust and reallocate factors of production, and in general moredifficult economic management. Even though much of the effect of an external shock iscontemporaneous-the immediate cash flow effect-and limited to the relevant sector of theeconomy, a shock can exert significant adverse effects across the domestic economy and overtime. The "Dutch (or Nigerian) Disease" effects of a booming commodity sector show that evenbeneficial terms of trade movements can, over the long run, have negative effects for othersectors of the economy, often led by an appreciating real exchange rate.10

1.35 This section discusses the direct effects of the external shocks during the 1980s. Eventhough it is very difficult to quantify exactly what the adverse effects are, beyond those of theimmediate loss in export revenues and increase in debt service, it is clear that the low non-oilGDP growth rate in Nigeria throughout the 1980s stems in part from the difficulty in adjustingfactors of production across the whole economy in response to positive as well as negative oilprice shocks. Good management of external risks should, therefore, result in significant gainsto Nigeria.

1. Macroeconomic Costs

1.36 Macroeconomic costs are those costs incurred by economies which, faced with liquidityconstraints, have to adjust expenditure to current income changes. When real income declines,expenditure has to contract for the economy to return to balance of payments equilibrium. Ofcourse, expenditure may not decline enough to equilibrate the balance of payments if someexternal financing is available either in the form of new resources or via increasing arrears orrescheduling arrangements. But, even in these cases, costs are incurred as adjustment is simplypostponed to some future date when external debt has to be repaid. It is useful to distinguishbetween the so-called efficient costs and the inefficient costs. Efficient costs, or primary costs,are unavoidable adjustment costs any economy has to face in order to return to balance ofpayments equilibrium when no external resources are available. If all of the economy's outputwere tradable this would be the only adjustment cost. However, a significant share of aneconomy's activity is usually nontradable. This means that as absorption is reduced, part of theexpenditure reduction falls on nontradables and, consequently, does not improve the balance ofpayments directly. If the economy shows price and/or wage rigidities, as absorption adjusts,output and unemployment may fail to remain at full employment levels. This adjustment cost,called secondary adjustment cost, is clearly inefficient and should be distinguished from theprimary adjustment costs.

1.37 Even if primary costs are efficient, they are still costs and are usually very damaging,particularly if, as in the case of Nigeria, external revenues mainly accrue to the public sector.Many types of public investment decisions, which are usually irreversible, require a highcomponent of recurrent revenues. In these circumstances, when the Government runs out ofresources to maintain the financing of such projects, this results in additional adjustment costs.

10 Also, especially when there are long lags in adjusting factors of production, uncertainty will tend to dtecrinvestment and production. Economies heavily dependent on a single commodity, therefore, often havedifficulty in diversifying into other commodities as the uncertainty about the pricc of the predominantcommodity tends to introduce exchange rate uncertainty, which deters investment.

13

These are unplanned costs due to negative external shocks and the presence of liquidityconstraints.

1.38 Tables 1.1 and 1.2 record primary and secondary costs for the Nigerian economy in the1980s (See Appendix 1 for a detailed explanation of the methodology employed). This exercisedistinguishes between two external shocks. For the first oil shock, 1980 is taken as the baseyear. In that year, oil exports peaked at US$26 billion, only to collapse to a level that oscillatedbetween US$10.4 and US$12.6 in 1983-85. The second oil shock exercise takes 1985 as the baseyear. Between 1985 and 1986, oil exports fell again by half to about US$6 billion and remainedat that depressed level until the outbreak of the Middle East crisis.

Table 1.1: Adjustment, Interest Rate, and Exchange Rate Costs(Nigeria: First Oil Shock 1980-85)

(As a Percentage of Trend Non-oil GDP Unless Otherwise Stated)

1981 1982 1983 1984 1985

A. MACROECONOMIC COSTS (1+2) 28.0 58.3 75.5 73.3 62.71. Primary Costs 23.5 55.5 64.2 52.7 48.82. Secondary costs 4.5 2.8 11.3 20.6 13.9

B. ACTUAL ADJUSTMENT -27.5 -7.7 18.4 45.6 45.8C. EXCESS ADJUSTMENT (B-A) -55.5 -66.0 -57.1 -27.7 -16.9D. INTEREST RATE ADJUSTMENT (USS MILL)' -55 -391 46 -152 39E. EXCHANGE RATE ADJUSTMENT (USS MILL)b -354 -520 -512 -503 799P. TOTAL (D+E) (USS MILL) -409 -911 -466 -655 838G. PERCENTAGE OF NON-OIL GDP (F/NOGDP) -0.59 -1.37 -0.61 -0.73 1.07H. TOTAL COSTS AS % OF NOGDP (B+G) -28.09 -9.07 17.79 44.87 46.87

Sources: A-C: Appendix 1, D-F: World Bank Staff Estimates.

Measures the increase in debt stock due to interest rate changes relative to 1980.i Measures the increase in debt stock due to exchange rate changes relative to 1980.

1.39 During the first oil shock, the unavoidable contraction was on average about 50 percentof non-oil GDP in 1982-85. Total adjustment costs reached the dramatic figure of more than 70percent of non-oil GDP in 1983-84, as non-oil GDP departed significantly from its trend, peakingat 20 percent in 1984. Equally striking, actual absorption adjustment was consistently below totaladjustment costs, thus indicating that Nigeria's net debt accumulation increased throughout theperiod. In 1981-82, actual absorption was even above its trend (by 30 percent in 1981), whichhelps explain why during these two years secondary costs or the so-called inefficient adjustmentwas relatively low.

1.40 During the second oil shock, total adjustment costs are practically determined by primarycosts as non-oil GDP grew around its trend level of 5 percent in 1985-90. Total adjustment costsstood at the dramatic figure of 70 percent of non-oil GDP in 1986-88, while actual absorptioncontraction remained at about 40 percent below trend in 1987-90. Although total costs fellmarkedly in 1989-90, they remained above actual absorption contraction, which shows, oncemore, the macroeconomic fundamentals behind Nigeria's explosive debt accumulation in the1980s-namely, a significant gap between total absorption and national income.

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Table 1.2: Adjustment, Interest Rate, and Exchange Rate Costs(Nigeria: Second Oil Shock 1986-90)

(As a Percentage of Trend Non-oil GDP Unless Otherwise Stated)

1986 1987 1988 1989 1990

A. MACROECONOMIC COSTS (1+2) 70.4 70.4 67.6 55.0 39.71. Primary Costs 69.8 68.1 70.2 56.7 41.0

2. Secondary Costs 0.6 2.3 -2.6 -1.8 -1.3

B. ACTUAL ADJUSTMENT 23.4 69.4 36.9 37.3 35.6

C. EXCESS ADJUSTMENT (B-A) -47.0 -1.0 -30.7 -17.7 -4.1

D. INTEREST RATE ADJUSTMENT (USS MILLr -65.0 43.0 100.0 -71.0 -55.0

E. EXCHANGE RATE ADJUSTMENT (USS MILL)b 2282 5001 -2775 411 3849

F. TOTAL (D+E) (USS Mill) 2217 5044 -2675 340 3794

G. PERCENTAGE OF NON-OIL GDP (F/NOGDP) 6.42 24.89 -11.34 1.55 16.02

H. TOTAL COSTS AS % OF NOGDP (B+G) 29.82 94.29 25.56 38.83 51.62

Sources: A-C: Appendix 1, D-F: World Bank Staff estimates.

Increase in debt stock due to interest rate changes relative to 1985.' Increase in debt stock due to exchange rate changes relative to 1985.

2. Exchange Rate and Interest Rate Costs

1.41 In the 1980s, Nigeria also faced significant exchange rate and interest rate costs. In theearly 1980s, world interest rates increased dramatically (see Figure 1.4), and so did the cost ofservicing external debt. Similarly, the effective exchange rate of the US dollar against all othercurrencies that are trading partners with the US appreciated during the first half of the 1980s.In the second half of the decade, while interest rates steadily fell, the US dollar reversed theprevious appreciation and ended the decade at a level even lower than at the start of the early1980s.

1.42 Assessing the stock of Nigeria's debt at 1980 exchange and interest rates, the US dollarappreciation and falling interest rates actually reduced the stock of Nigeria's external debt bymore than US$1.6 billion through 1985 (Table 1.1). However, if 1985 is taken as the base year,a falling US dollar vis-a-vis the currencies of other Nigerian creditors increased Nigerian externaldebt by US$9.2 billion between 1985 and 1991 (Table 1.2). Interest rate effects actuallydiminished the total stock by US$0.5 billion in the same period. The combined effect is, then,a net increase of US$8.7 billion.

3. Other Costs

1.43 As mentioned above, there are other costs generated by external uncertainty. Whenpublic spending tracks current rather than permanent or sustainable revenues, the oil price,exchange rate, and interest rate uncertainty spills over the whole economy, affecting relativeprices in all sectors. Private investment is particularly negatively affected. In economies subjectto severe external shocks, such as Nigeria, it is impossible for investors to determine ex antewhether a shock is transitory or permanent in nature or whether it will be positive or negative.Considering, for the sake of brevity the second case only, this implies that, knowing that theauthorities will adjust expenditure more or less in line with income variations, investors cannotdetermine which sector will be favored-namely, tradables or nontradables. Given that capital

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is sector-specific once installed, investors put a risk premium on the return to investment, makinginvestment lower than it would be otherwise and causing lower growth in the non-oil economy.This is another cost that would have to be incorporated into the analysis. This report does notestimate this type of external uncertainty.

1.44 Microeconomic costs would ideally have to be added to all the macroeconomic costsdiscussed above. Microeconomic costs have generally been considered as those costs stemmingdirectly from risk aversion or instability aversion or, in other words, from the idea that a smoothconsumption stream is preferred to an unstable or an uncertain one. Depending on a number ofassumptions, these costs may amount to several percentage points of GDP in a country such asNigeria. Again, this report does not estimate this type of risk cost.

D. Managing External Exposure

1.45 Countries with publicly owned resource sectors, such as Nigeria, have four generalmethods available to reduce their large external exposure and, consequently, their associatedcosts: transfer risk to the international financial community, self-insure, transfer risk to theprivate sector, and a mix of these. This section treats these options along with the problems fortheir implementation.

1. The First-Best Solution

1.46 The first-best solution to the problem of volatile oil revenues for a developing countryand indeed for Nigeria might be to simply sell oil reserves and acquire a non-risk asset." Theproblem with this strategy is that the market would probably not exist. The Government wouldhave to commit itself never to renationalize, and it is difficult to see how this might be done ina credible fashion. Any potential purchaser would be concerned that the Government wouldrenationalize in the future. There is a problem of inconsistency that makes the markets in suchtransactions disappear.

2. Transferring Risk to World Capital Markets

a. Main Techniques

1.47 If the sale of oil reserves is not possible as an option for dealing with oil sector externalexposure, a second-best solution is to hedge or, in other words, pass the risks on to somebodyelse. To date, private and public entities in Nigeria have rarely used the (well-developed)international contingent financing markets to reduce their exposures to external risk. Riskmanagement instruments allow a transfer of risk to the international financial markets at termsthat are attractive to Nigeria. They allow Nigeria to change its existing risk profile, to mitigaterisks, and to correct possible mismatches in its asset-liability structure. Why is such transfer ofrisk, or hedging, attractive? The essential argument rests on the notion that Nigeria is much lesseconomically diversified than most developed countries. In relative terms, an external shockaffects Nigeria more and creates proportionately greater output losses than in other, more

" The idea would be to exchange a non-risk asset-such as US Treasury Bonds-for oil reserves.

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diversified countries. Therefore, it is efficient to transfer risk to international markets indeveloped countries."2

1.48 It is important to recognize, however, that it cannot be expected that risk managementwill lead to consistently lower debt-service payments, higher export prices or, conversely, lowerimport prices. Risk management effects a tradeoff between the assurance of moderate andpredictable current cost against future factor price movements, which could produce either largewindfalls or equally large losses. Risk management is an insurance tool, involving some costsof foregoing windfall gains when external shocks are positive, but acquiring protection againstdownside losses. Whether the use of risk management tools has avoided losses or gains to theeconomy depends on the (ex post) trend in international factor prices, which cannot beanticipated. Risk management thus provides an opportunity to reduce the likelihood and effectsof external shocks, which will have positive benefits to the economy. It also enables governmentsto put overall economic management on a more secure basis, as it reduces the possibility ofunanticipated deviations from initial projections in important economic variables. This impliesthat policymakers need to be clear on the objectives of risk management, and that they should setappropriate targets for risk managers.

1.49 Market-based financial instruments offer several advantages. Financial instruments areable to hedge (i.e., smooth) exposures without requiring either substantial resources (e.g.,subsidies, reserves, or finance needed for stockpiling), or the introduction of price distortions;in addition, such market instruments always involve the shifting of risk externally, i.e., permitthe bearing of price risk at the lowest cost by, for example, consumers or speculators in industrialcountries. Because the risk is borne by the party most able to do so, these instruments will carrythe same expected costs for Nigeria as traditional, commercial financing. Costs could even belower, owing to the increase in Nigeria's creditworthiness resulting from a better match betweendebt obligations and the ability to service debt.

1.50 Some developing countries also hedge risks through use of traditional short-dated (i.e.,roughly one-year maturity), exchange-traded instruments, such as forwards, options, andigtures-as illustrated above (Box 1.1) by Mexico's recent oil hedging operations and Chile'shedging of its variable rate debt (see Box 1.2). Short-dated instruments replace spot priceuncertainty by fixed or minimum prices over the life of the contract and, as (long-dated) futuresprices tend to be less volatile than spot prices, result in a more stable income stream. Inprinciple, the short-dated instruments are available to almost all developing countries. In somecases, hedging in the short-dated forward markets has also been routinely undertaken for manyyears. For instance, Ghana and Cote d'Ivoire have consistently sold forward at a significantfraction of their next year's cocoa exports at a fixed price.

1.51 Long-dated (up to 20-year maturity) instruments, namely, swaps and long-dated options,permit longer-term and more comprehensive risk management. These nonstandard contracts,tailor-made instruments, trade in the "over-the-counter" market made by commercial banks andother financial institutions. The instruments are essentially composed of just two new buildingblocks: swaps and options features, which can be combined with loans and bonds in a varietyof ways. A swap is a contract between two parties to exchange a series of future cashflowswhose amounts are based, on the one hand, on known current prices and, on the other, on aseries of unknown future prices. In effect, such a swap is a series of forward contracts,

12 In addition, the Nigerian economy is less able to profit from speculating on movements in internationalfactors (interest rates, exchange rates, commodity prices), because of its lack of specialized skills, lack ofinformation, and lack of financial resources to carry risk.

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Box 1.1: Mexico's Oil Hedging Strategy

In late 1990 and during the first half of 1991, Mexico used financial risk management toolsto protect its earnings from crude oil exports (which average about 1.3 million barrels a day) againsta price drop. The strategy covered a significant part of its export earnings over this period. Mexicobought put options at different exercise prices, engaged in selling oil futures, and used short-dated(up to one year maturity) oil swaps to hedge its oil price risk. Buying put options guarantees aminimum price; and oil futures contracts and swaps guarantee the seller-and the buyer-a specifiedprice at some future date. By using these contracts, Mexico effectively insured some minimum priceof its main export over the near future. In addition, Mexico established a special contingency fundto protect against a trend decline in oil prices.

Mexico's overall strategy was to ensure that it received at least US$17 a barrel, the priceused as the basis for its 1991 budget. (Mexican oil sells at a US$34 discount compared with mostof its crudes.) As explained by the finance ministry, participation in the futures markets served toreassure investors that, regardless of oil price movements, the economic program and the budgetwould be sustained. The strategy was quite successful for Mexico since oil prices fell significantlyin early 1991. Not only did Mexico achieve more certainty ex ante about its oil earnings, but it alsoprofited ex post as the gains from having ensured a minimum price exceeded the initial costs ofbuying the put options.

Box 1.2: Chile's Hedging Operations with Eurodollars

To manage the risk of its variable interest rate debt with commercial banks, in 1988 Chile'sCentral Bank carried out short-term hedging operations with Eurodollar futures contracts on theInternational Monetary Market of the Chicago Mercantile Exchange. As of December 1987, about83 percent of Chile's total US$18 billion medium- and long-term debt consisted of variable-rateloans-of which US$13.8 billion was owed to commercial banks and mostly tied to the six-monthLIBOR. After the October 1987 stock market crash, the future of the US economy and interest ratedevelopments were particularly uncertain.

To hedge against the one-year interest rate on the US$1.5 billion debt, approximately 6,000contracts or US$6 billion worth of three-month Eurodollar futures contracts was necessary (becauseEurodollar contracts are three months, hedging annual payments on every US$1 million debt requiredUS$4 million Eurodollar futures [or four contracts], since the period covered is four times longer).The sale of futures contracts was spread over more than three weeks and the effective LIBORachieved was 7.3 percent. The LIBOR would have been as high as 7.8 percent without the hedging.The Central Bank is said to have carried out similar hedging operations in 1990.

extending to long-dated maturities. Thus, swaps allow one of the parties to fix the price to bereceived or paid for long periods in the future. Swaps involve credit risk to both parties of thecontract since, depending on the prevailing market price being above or below the predeterminedprice, one party owes or is due the net amount.

1.52 A commodity swap is described schematically in Box 1.3. Other commodity-linkedinstruments are commodity indexed loans (or bonds)-where the interest or principal due varies(proportionally) with a commodity price. Long-Term Options are contracts that give the ownerthe right to buy (if a call option), or to sell (if a put option) a fixed quantity of the commodityat a fixed price on (or before) a specified date. They allow for price insurance by guaranteeinga minimum price for exports (by buying put options) or a maximum price for imports (by buyingcall options).

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1.53 Longer-dated interest and currency swaps and options markets have been in existencesince the early 1980s and now represent very liquid and efficient markets. Since the late 1980s,the longer-dated commodity-linked instrument market has developed. These instruments havebeen used regularly in the mineral and energy sector in industrial countries. Investments in goldmining in developed and developing countries are often financed with gold loans. The marketfor energy swaps is estimated to be at least US$25 billion per annum. According to estimatesfrom the Bank for International Settlements, the total notional amount of the commodity indexedswap and option market is between US$40 and US$50 billion.

b. Limitations of Market-Based Hedging Instruments

1.54 Despite the increasing range and depth of market-based hedging instruments, the use ofthese instruments by entities in developing countries has to date been limited, primarily becauseof three factors.

Box 1.3: Commodity Swap

Oil- --------------- Intermediating 11111110- Oil| Producer |- | Bank |- Consumer

_~m Denotes cash flow based on future morket prices._0- Denotes cosh flow based on known prices.

The diagram' above shows a simplified case of a commodity swap, in which theintermediating bank executes offsetting swaps with an oil producer and consumer, thus intermediatingthe credit risk.2 The producer agrees to exchange cash flows with the bank as follows. Semi-annually over the period of the swap contract, which might be five years and based on a notionalamount of 10 million barrels of oil per annum, i.e., 5 million barrels at each semi-annual paymentdate, the producer pays the future market price and receives a fixed market price, say US$21. Thus,if the future market price were US$25 per barrel, the producer would make a net payment to thebank of US$20 million; if the future price were US$18 per barrel, the producer would receive a netpayment from the bank of US$15 million. The consumer executes an exactly opposite contract withthe bank, undertaking to pay at a fixed price and receive at a future market price. The net effect isthat when the producer sells 5 million barrels of oil semi-annually to the consumer at the futuremarket price, in accordance with normal market practice, both producer and consumer have in effectlocked in a fixed price of US$21 through a series of forward contracts.

The chart depicts a simplified case in which the folowing features are omitted: presence of a syndicate ofbanks; presence of an offshore escrow account; and presence of multiple consumers.

2 The cash flows passing through the intermediating bank would not quite offset each other exactly, thusallowing the bank to make a return for bearing the credit risk.

1.55 The cost of these transactions (e.g., usual transaction fees, significant upfront premiums,margin calls, etc., as well as the personnel and information costs of monitoring andimplementing) in a market-based hedging program is relatively low. It is usually no more, andoften less, than those associated with straight borrowing instruments. Unfortunately, developingcountries' access to international financial markets has proven to be extremely restricted.International lending to developing economies has tended to be procyclical, meaning thatcountries have been unable to borrow precisely when foreign resources were most needed. Othersources of credit, such as contingent borrowing facilities (e.g., the IMF's Compensatory and

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Contingency Financing Facility (CCFF) and the European Community's STABEX) are onlyaccessible on an ex post basis.

1.56 Access to markets is lacking for many developing countries, because of creditworthinessconstraints (that would require some form of credit assurance). Most over-the-counter and otherhedging instruments involve the participation of international banks as key intermediariesguaranteeing the transaction, and the banks require creditworthiness and exposure assessments.However, the creditworthiness constraints can be exaggerated. Two factors potentially reducethe constraints: (i) exposure on hedging transactions counted toward total country exposure ofa bank are a function of the degree of risk involved in the transaction and also its maturity, whichtypically means that the exposure is a small proportion (e.g., 20 percent) of the face-value of thetransaction; and with exposures declining rapidly over the contract period; and (ii) there are nowmany specialist banks in the US and Europe that provide intermediary services, and that oftenhave very limited exposure to developing countries such as Nigeria.

1.57 Usually the key consideration in the minds of policymakers is the complexities involvedin the management of hedging operations and the possibilities of "opportunity losses' arising fromhedging activities. Market-based hedges require careful and continuous monitoring by skilledpersonnel capable of dealing with the markets on a continuous basis and, even though the hedgingservices can to some extent be purchased from various financial institutions, the evaluation oftheir quality and cost requires considerable knowledge of market instruments and techniques.However, technical assistance from different sources, especially the World Bank's financialoperations complex, are providing increasing support to these efforts. Simultaneously, entitiesin developing countries are starting successfully to enter into increasingly complextransactions.'3 An example of a complex copper swap associated with new financing, theMexicana de Cobre transaction, is described in Box 1.4.

Box 1.4: Mexicana de Cobre Financing Using a Copper Swap

Mexicana de Cobre (MdC), a copper mining subsidiary of Grupo Mexico, obtained someinnovative financing in 1989. In addition to a conventional loan of $210 million syndicated forMdC, a copper swap was arranged with the same maturity and payment dates as the loan, so as tohedge MdC's export earnings to a European purchaser. As a result of the swap, MdC was able toassure creditors that it had sufficient funds to service and repay the loan, regardless of fluctuationsin the price of copper over the loan life. Further security was provided by an "offshore' escrowaccount (i.e., an escrow account located outside of Mexico), into which the European purchaser ofthe copper deposited payments according to its purchase contract with MdC. The first charges onthe escrow account were the net payments under the debt service on the loan and the swap, aheadof any remittances to MdC. The elimination of the copper price risks through the swap and thesecurity afforded by the escrow account were the basis of financing at an interest rate favorable toMdC. Effectively, MdC shifted financing costs from periods of low copper prices to periods of highcopper prices and, thus, increased its creditworthiness.

1.58 Another standard objection to the use of market-based hedging instruments is that theyrarely go out to the desired maturities and are rarely liquid enough to be useful to a largecommodity exporter. Markets for long-term hedging instruments for many commodities forwhich developing countries have large exposures are still very limited. In the case of tropical

is lhe new LNG projects in Nigeria contain some hedging components, as the prices are adjusted with a lag.

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commodities, markets for long-term instruments are nonexistent. Furthermore, the volume ofsome countries' production of certain commodities is significantly large compared with the sizeof the markets for some hedging instruments. In these circumstances, countries trying to hedgea sizeable fraction of their risk could affect the cost of hedging, which eventually could makethese operations extremely expensive. The nonexistence of markets that go far enough out intime is critical in that, from a macroeconomic perspective, one of the main problems is to reducethe volatility associated with the largest share of the stock of the country's wealth, namely, thepresent value of future oil income streams. In the present situation, access to current marketswould only reduce the uncertainty over a few months, thus representing a small fraction of thetotal stock of wealth. As indicated in Box 1. 1, the Mexican hedging experience and the currentvolume in hedging contracts indicates that oil may be an exception to this objection. This volumewill, however, be largely in short maturities.

3. Self Insurance

1.59 In principle, transferring risk to the international financial markets should be the bestalternative for managing external exposure for a developing economy. A developing countrydoes not have a comparative advantage in bearing price risk, while international financial marketsare at large much better equipped to do so. However, for practical purposes and because of someof the limitations of market-based hedging instruments presented in the previous section,developing countries, including Nigeria, might have other risk-management and smoothingmechanisms: (a) avoiding risk; (b) hedging as a self insurance alternative; (c) participating ininternational commodity stabilizing schemes; (d) building up foreign exchange reserves or foreignfinancial assets; (e) insulating the domestic economy, or sectors of it, through domestic pricestabilization schemes and other means; and (f) through diversification. From past experience,however, it has become clear that, compared with market-based financial instruments, some ofthese mechanisms suffer from a number of shortcomings.

a. Avoiding Risk

1.60 Oil price uncertainty would be avoided if it would be possible to convert oil reserves intoa secure financial asset such as US treasury bills (the first-best solution). Uncertainty would alsobe avoided if oil extraction was reduced, but so would the opportunities for improving welfare,as the benefits of oil production more than offset the costs of the associated uncertainty. Theopportunity cost of leaving oil underground, namely the return on the assets that may bepotentially exchanged for the extracted oil, would be higher than the costs of uncertainty.Furthermore, to the extent that the growth of the real oil price remains below the rate of returnon alternative assets, oil production should be limited only by available extraction technology.Otherwise, it would be more advantageous to keep oil reserves underground and sell only whenoil prices increase.

b. Self Insurance Hedging

1.61 This is perhaps the most extensively used type of self-insuring mechanisms bycorporations, financial institutions, and several countries' Central Banks. Generally, the idea isto use part of the institution's assets to match the structure of its liabilities as a way to reduceinterest rate and exchange rate exposures of its liabilities, and/or vice versa. Chapter III indicatesseveral alternatives the CBN may utilize to successfully self-insure asset and liability risks viathese sort of strategies.

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c. International Commodity Agreements

1.62 Attempts to stabilize international commodity prices through international agreementshave proved inviable or counterproductive. These agreements have encountered seriousdifficulties, because the intervention price has not been set consistent with long-run supply anddemand and because of enforcement difficulties (evasion by parties to the agreement, and "freeriding" by third parties). Currently, only one formal agreement (covering natural rubber) is ineffect. The informal agreement on oil (Organization of Petroleum Exporting Countries, OPEC)-in which Nigeria participates-has also failed to prevent large price (and quantity) changes overtime. As the supply and demand conditions in the oil market will likely become more marketdriven, the stabilization effects of OPEC will remain limited.

d. Commodity Stabilization Funds

1.63 The limited access to international financial markets, the incompleteness of the commoditylinked hedging markets and/or the lack of knowledge about these markets, have usually been thearguments inducing some countries to rely on commodity stabilization funds to manage theirexternal exposure. During periods of high commodity prices and, hence, high external revenues,the country would accumulate external assets, which it would draw down in periods of lowcommodity prices. Accumulating foreign assets during times of advantageous terms of trade(used, for example, by the Mineral Resources Stabilization Fund in Papua New Guinea, and theCopper Stabilization Fund [CSF] in Chile [described in Box 1.5]), is essentially a self-insurancemechanism, and certainly implies some costs for a country with limited access to foreign savings.

Box 1.5: Chilean Copper Stabilization Fund

The Chilean Copper Stabilization Fund (CSF) was set up in 1985 as part of the ChileanGovemment's structural adjustment program with the Bank. The CSF aims to stabilize exportrevenues by using foreign exchange reserves to absorb cyclical variations in revenues, i.e., itpromotes the role of precautionary savings. Under the CSF agreement, the Chilean Governmentdeposits surplus revenues from the parastatal copper producer to the general budget with the CentralBank; it can withdraw these funds in case of a shortfall in export revenues. A price band is definedaround a reference price and when the actual price is above the reference price band, the schememandates a deposit of a proportion of the excess revenues (and, correspondingly, when the actualprice is below the reference band, a withdrawal can be made). Surplus funds are viewed asintemational reserves. As copper prices remained high in the late 1980s and surpluses grew, theaccumulated reserves were used in 1989 to buy back part of Chile's extemal debt and to deal withan unexpected fall in export eamings (the "poisoned grapes" crisis).

1.64 Commodity stabilization funds are usually justified in a negative way, namely, bypointing to the incompleteness of markets for hedging instruments or the presence of liquidityconstraints. Sub-section iv) discusses the complementary nature of stabilization funds and creditand hedging markets. Furthermore, the report argues in Chapter II that if macroeconomic costsare costs worth avoiding by economic policy, a stabilization fund should be a critical componentof such a policy.

e. Domestic Price Stabilization Schemes

1.65 Domestic price stabilization schemes, which attempt to minimize the impact ofinternational price fluctuations by stabilizing either domestic (local currency) prices or export

22

revenues (or import expenditures), have been little used in Nigeria in recent years since theabolition of the marketing boards."' Since, for many of these schemes, actual objectives havedeviated considerably from stated objectives and domestic prices have adjusted too slowly tointernational prices-as in the case of cocoa in Nigeria-the schemes have not successfullyprovided price stability over long periods. The favorable supply response in some commoditysectors to the abolition of the boards in Nigeria has further underlined the inherent disadvantagesof these schemes.

f. Diversification

1.66 Diversification can, over time, be an effective means of risk reduction. Diversificationinvolves an apparent economic dilemma. While Nigeria needs to diversify its economy awayfrom oil, it also has a clear comparative advantage in oil production (extraction). To the extentthat the real growth rates of oil prices remain lower than rates of return on alternative assets, itwill be optimal for Nigeria to extract as much oil as possible. Of course, this policy is optimalprovided that a significant fraction of national income is saved and allocated to future income-generating assets in order to sustain the standards of living when extraction rates start to diminish.This means that diversification should not take place at the expense of the oil sector (namely,reducing extraction rates), but rather by encouraging growth in other sectors, particularlytradables other than oil, at faster rates than in the oil sector. The critical issue is that the oilsector enjoys a sector-specific input, namely, oil reserves, which cannot be employed in theproduction of other goods or other services. In these circumstances, transferring other resources,such as labor and capital, away from the oil sector to other sectors of the economy would reduce,at the margin, productivity and national income. From the perspective of the oil sector itself,its further development does not require significant amounts of labor resources as oil is a capital-intensive sector. Although capital is certainly relatively scarce within Nigeria, it is accessible toforeign oil companies, which could easily borrow in world financial markets. This means thatthe development of the oil sector would not necessarily crowd out other sectors' expansion.

1.67 Of course, a minimum policy for expanding tradables other than oil at rates faster thanthe oil sector would require a set of fiscal and monetary policies that maintained a competitivereal exchange rate and reduced its volatility, particularly expected future exchange rate volatility.In a country permanently subject to large terms of trade variations, such as Nigeria, this couldbe possible only given the existence of a framework to cushion external shocks, such as an oilstabilization fund and the extensive use of the markets for hedging instruments. It is clear thatthe more diversified the economy, the less is its external risk exposure, and the greater itscreditworthiness vis-a-vis the international financial community.

1.68 Diversification should be pursued via general macroeconomic policies aimed atmaintaining a stable and competitive real exchange rate, not through picking "winners," namely,subsidizing some specific non-oil sectors. Of course, affirmative action may be directed at liftingthe barriers that non-oil exporters currently face in Nigeria. For example, cassava exports arecurrently prohibited while there appear to be good possibilities for this commodity withoutnegatively affecting Nigeria's self sufficiency in this commodity. Similar barriers are faced byexporters of beans and grains and their derivatives. While export diversification has adisadvantage in that it can take a longer time to be achieved, Nigeria may pursue this moreactively and should remove unnecessary barriers. Activities such as the creation of exportprocessing zones and other export-promoting schemes may help in promoting diversification.

14 Examples of price stabilization schemes include stabilization of wool prices in Australia and of agriculturalprices (cocoa, coffee, cotton, and copra) in CMte d'lvoire and Papua New Guinea.

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4. Complementarity Between Self-Insurance and Transferring Risk Options

1.69 Self-insurance and transfer of risk are complementary in two general senses: a) deeperself-insurance options may widen the possibilities for transferring risk, and vice versa; and b)each of these ways for managing risk may address a different critical aspect of external exposure.A good way to explain these complementarities is through some examples.

1.70 Well-considered self-insurance mechanisms may increase the country's internationalcreditworthiness and, consequently, permit easier access to world financial markets, including themarkets for hedging instruments. A well-managed oil stabilization fund, for example, may beused as collateral for a number of alternative financial undertakings, such as the use of market-based hedging instruments. The Nigerian National Petroleum Company (NNPC) could, forexample, either issue oil bonds or simply borrow to obtain resources to finance investmentprojects. The size of the bond issue or of the borrowed resources may be equal to a certainfraction of the amount of the stabilization fund. The fact that Nigeria produces oil, a globallytraded commodity, may ensure that Nigeria could service its external obligations, at least to someextent, in physical oil payments. To guarantee performance, the bond issue or the externalborrowing may be complemented with a swap arrangement with maturities and payment datesidentical to those of the bond or the loan. Both the presence of the oil stabilization fund and theswap arrangement may induce more favorable borrowing terms, such as higher bond prices orlower interest rates and longer maturity structures.

1.71 If the use of the oil stabilization fund is successful in macroeconomic terms, so thatNigeria ends up with a more stable macroeconomic environment, this in itself would enhance theinternational financial community's confidence in Nigeria's economy, which should lead to lowerpremium rates and easier access to financial markets including the markets for hedginginstruments.

1.72 Furthermore, to the extent that the oil fund-induced macroeconomic stability leads to astable real exchange rate and a more diversified economy, the country's external exposure mayfall, which may further increase creditworthiness and, consequently, expand its ability to borrowabroad while reducing the costs of participating in the markets for hedging instruments.

1.73 There are many other possibilities. Suppose that a stabilization fund is kept as foreignexchange reserves at the Central Bank and that oil-hedging operations are also carried out by theCentral Bank. Now suppose that Nigeria sold a percentage of its oil forward using exchange-traded futures contracts. Note that when oil prices fall, margins will be received on the futurespositions and withdrawals from the fund may be required. When oil prices rise and when marginpayments are required, funds are deposited into the stabilization fund. The payments in and outof the fund could be viewed as being financed in part by the margin receipts and margin calls onthe futures position. At the same time, the brokers effecting the actual futures trading willprobably feel more confident in allowing a greater degree of futures market activity knowing thata stabilization fund exists which to some extent might guarantee margin calls.

1.74 The second-perhaps most important-type of complementarity between self-insuranceand transferring-risk options may be illustrated by looking at the effects of hedging on thevariability of cash flows. This is easy to see in the case of a futures market.

1.75 For some periods, oil futures prices have tended to reflect the spot price plus the interestrate and storage charge (in other words, during some periods futures prices have tended to beequal to spot prices plus a full carry). If these latter components do not vary too much, futures

24

prices would tend to follow spot prices fairly closely and, in particular, the variance of futuresprices would be roughly the same as the variance of spot prices. Empirical evidence suggeststhat this may be true for some commodities that are continuously stocked. In practice, futuresprice variability for oil does tend to be lower than the variance of spot prices, although it tendsto converge to a significantly high level. For example, Claessens and van Wijnbergen (1993)record that over the period July 1986 through July 1990 the volatility of futures prices quoted onthe New York Mercantile Exchange fell steadily from 28.5 percent for two-month maturitycontracts and tended to converge to 22 percent for 10-month maturity contracts. The periodduring the Middle East crisis was a significant exception to this trend. During that period,futures prices were agreed at substantial discounts from spot prices, reflecting a perceivedtemporary supply disruption. However, this was fairly exceptional. Therefore, if the strategyof simply selling forward is repeated year after year, hedging will do little to stabilize Nigeria'scash flow, since in general the variance of futures prices will still be significantly high, althoughlower than the variance of spot prices.

1.76 This, of course, does not mean that hedging is irrelevant. The important difference isthat in any one year Nigeria would know the price that would be received for oil in the followingyear. Economic theory has a hard time explaining what the benefit of futures trading is in thiscontext. This is because in standard economic theory there is no distinction between instabilityand uncertainty. Futures trading precisely reduces uncertainty, but may not reduce instability.Credit markets would, then, be one of the ideal means of addressing this known volatility.Unfortunately for Nigeria and for many other developing economies, access to financial marketshas been severely limited in the past, particularly at times when they have been most needed.As stressed above, international commercial lending to developing countries has tended to beprocyclical. Other sources of credit, such as contingent borrowing facilities, the IMF'sCompensatory and Contingency Financing Facility (CCFF), and the European Community'sSTABEX, are only accessible on an expost basis. Moreover, Nigeria does not qualify for accessto these facilities: oil is not eligible to be covered. An oil stabilization fund, then, may berationally utilized to address oil price instability. Again, while the hedging program would bedirected at reducing oil price uncertainty, the stabilization program would be directed atdiminishing volatility and at collateralizing financial undertakings, including market-based hedgingoperations. Thus, the two programs complement each other.

5. Transferring Risk to the Private Sector

1.77 While Nigeria as a whole is exposed to external oil risk, such exposure is not evenlyshared by the public and the private sector, the latter being the domestic or the foreign privatesector operating in Nigeria. Institutional and contractual arrangements between the public andprivate agents determine these relative external exposure shares. The private sector might havea higher participation in the management of external exposure. This might imply some transferof ownership to the private sector via alternative financial and equity arrangements, or bytransferring windfalls to the private sector.

1.78 The transfer of windfalls to the private sector, while keeping public ownership of the oilsector, may be very cumbersome to implement. During positive shocks, for example, thewindfalls may be transferred to the private sector through lower taxes or direct transfers, orhandouts; real exchange rate appreciations; or even helicopter money-drops. These measureswould have to be reversed once the oil price falls back from its high levels; otherwise, the budgetdeficit would widen. If unpredicted negative shocks occurred, public expenditure would have tobe cut (or the real exchange rate depreciated) since it might not be possible to increase taxation

25

in the short run, let alone force the private sector to transfer resources to the Government tosustain a given level of expenditure.

1.79 These measures would be very difficult to implement since the private sector would resistpaying higher taxes, or getting fewer subsides, especially if, as expected, it regarded fiscal policychanges as permanent rather than transitory. Even in the unlikely event that the private sectoris prepared to accept such endogenous fiscal policy, making such policy operationally andinstitutionally viable would be very challenging, if not impossible, for a developing economy.Therefore, this option for managing external exposure should not be pursued.

1.80 The extent to which the privatization process can be advanced is contingent on politicalconsiderations, an assessment of which is beyond the scope of this report. However, Chapter IIwill discuss at length oil exploration and exploitation contracts between the Nigerian Governmentand the oil companies as well as tax policy. Its policy in this area has made the NigerianGovernment more exposed to external risk than the oil companies. Similarly, the managementof the domestic petrol price, more precisely the price at which the Government sells crude oil toNNPC for downstream activities (approximately 300,000 bbl/d), has so far implied theassumption of oil price risk on an additional one sixth of total oil production by the FederalGovernment. In fact, the Government is not only assuming this risk, at the moment it is alsomassively subsidizing domestic petrol consumption.

1.81 Finally, for several years the Nigerian Government followed an exchange rate policy that,despite attempts to establish a foreign exchange market, tended to target the nominal exchangerate and adjust the level of international reserves endogenously. To the extent that the FederalGovernment received a substantial share of its revenues in foreign exchange (US dollars) and tothe extent that the Government ran its own US dollar-denominated current account in a structuralsurplus, naira-denominated public revenues were highly and positively correlated with oil exports.In other words, the Government's high external exposure has not been independent from theprevailing exchange rate regime.

1.82 Could a different exchange rate regime help reduce the Government's external exposure?It certainly could. Assuming, for example, that the Government's own tradable current accountremains in a structural surplus position for the foreseeable future, a foreign exchange regimetargeting the level of reserves while fully floating the nominal exchange rate may make naira-denominated public revenue more stable, thus shifting a larger external exposure to the privatesector. In times of positive external shocks the naira would tend to appreciate, while in timesof falling oil prices the naira would tend to depreciate. Exchange rate appreciations will transferresources to the private sector (and to the rest of the world if the overall current account is in asurplus position), while exchange rate depreciations will tax the private sector (and transferresources from the rest of the world). If this policy is coupled with complementary policies, suchas opening up the capital account, the private sector may be better placed vis-a-vis theGovernment to handle external shocks by using foreign financial asset acquisitions and sales asa smoothing device, should it wish to do so."5

1.83 This report argues that, if implemented, this type of solution would produce massiverelative price and real exchange rate fluctuations, which would severely hit private investment

s This option is presented in Bevan, et al., (1992). The authors of this study are highly skeptical of smoothingmechanisms, such as past attempted stabilization accounts. This report argues that these accounts are farfrom being real stabilization funds. In practical terms, these accounts have been no more than ratherconfusing accounting devices with no clear objectives.

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and preclude the expansion of tradables other than oil. This option for managing externalexposure runs counter to a number of studies showing a critical negative relationship between thevolatility of the real exchange rate and private investment behavior in developing economies(Serven and Solimano, 1993).

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CHAPTER II. MANAGING THE OIL SECTOR RISK EXPOSURE

A. Introduction

2.1 One the central messages of Chapter I is that the performance of the Nigerian economyis inextricably linked with the performance of its oil sector. The oil sector accounts for roughly95 percent of total foreign exchange earnings and more than 80 percent of the revenue base ofthe Government. Thus, the capacity of the Government to support the process of economicdevelopment depends crucially on revenues from the oil sector.

2.2 Data from national accounts show a strong relationship between mracroeconomicperformance and events in the petroleum market. The Nigerian economy experienced robust realincome growth in the 1970s during the oil boom period, but it contracted when oil pricesweakened (Table 2.1). The boom period was characterized by sharp improvements in the balanceof trade, increases in public sector investments, and foreign borrowing. The increasedavailability of foreign credit via monetary effects on the balance of payments reinforced theexpansionary impact of the oil boom. The post-boom period witnessed a sharp contraction of theNigerian economy, with internal and external imbalances. Increased foreign borrowing duringthe boom period, facilitated by the willingness of international creditors to lend on expectationsthat the oil price increase was permanent, resulted in a large debt overhang (see Table 2.1). Poorquality public sector investments made during the boom period failed to enhance the productivecapacity of the economy. Despite the high dependence on oil revenues to finance public sectorprojects, reinvestments in the energy sector remained low. Public sector investment in the energysector was among the lowest of the developing countries during the early 1980s (Table 2.1).

Table 2.1: Nigeria: Economic Indicators, 1973-91(US$ Millions)

1973 1980 1986 1991

GDP (market prices) 12,768 84,378 41,600 34,151Current account balance -8 4,478 -4,383 805External debe neg. 8,934 23,473 34,497Memo:

Intemational crude oil prices (S/bbl)b 11.2 30.5 13.6 17.3Oil exports as share of GDP (%) 22.7 29.9 11.42 25.4Oil exports as share of export revenues (X) 83.1 96.1 94.1 96.5

Total debt stock.i OPEC crude basket. Nigerian crude oil averaged about Sl/bbl higher than the OPEC crude basket

because of the quality differential.

Source: Central Bank of Nigeria; Federal Office of Statistics; World Bank (AF4CO and IEC).

2.3 This chapter centers on managing the economy's oil sector risk exposure. It has threeaims. First, the chapter presents the key factors that influence the development of the Nigerianoil sector, with a primary focus on the role of multinational oil companies. Second, it discussesthe links between the oil sector and the fiscal accounts, stressing the sensitivities of fiscalrevenues to world oil prices as well as the fiscal regimes that affect foreign participation in oil-related activities. Third, the chapter presents a number of options for the management of the oilprice risk in order to reduce the exposure of government revenues so that government

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Table 2.2: Energy Sector Investment by Developing Countries(Annual Energy Investment as a Percentage of Total Public Investment during the Early

1980s)

10-20 20-30 30-40 Over 50Benin Botswana Ecuador ArgentinaEgypt China India BrazilGhana Costa Rica Pakistan Colombia

Jamaica Liberia Philippines KoreaMorocco Nepal Turkey MexicoNigeriaSudan

Portugal

Source: Kumar (1983); Kumar and Panic (1983).

expenditures can be placed on a sounder footing. Finally, it ends with a number of policyrecommendations on the risk management of oil and other commodities in order to improve theoverall performance of Nigeria's oil sector and of the economy at large.

B. Factors Influencing Oil Sector Development

2.4 With real oil price growth rates expected to be lower in the foreseeable future thanexpected returns on alternative assets, an optimal oil policy for Nigeria would be as follows:(a) given available world-wide technology, extract as much oil as possible; and (b) invest theproceeds of oil revenues on assets yielding the highest rates of return. Given the uncertaintyregarding the future price of petroleum, Nigeria is faced with a choice involving contingencyinvestment programs to increase production capacity that maximize the net present value ofincome streams generated through oil exports and through taxation and royalties. In essence, itboils down to an intertemporal choice problem which involves increasing investments to developoil production capacity in the future at the expense of current consumption. The developmentof the oil sector, in turn, depends on the following: (a) the (geological) resource base; (b) accessto capital and technology for exploration and development; and (c) contractual, legal, and fiscalarrangements with international operators.

2.5 Since Nigeria is a member of OPEC, the crude oil production ceiling set by OPEC mayalso influence Nigeria's extraction decisions. However, data show that Nigeria's crude oilproduction has been consistently above its quota by 3-5 percent over the period 1982 to mid-1990, although intermittently it has implemented production cuts to support OPEC price targets.Since the 1990 Middle East crisis, Nigerian crude oil production has remained significantly inexcess of its quota. For instance, Nigeria's crude oil output averaged 1.967 mb/d during thefourth quarter of 1992, when its production quota was 1.71 mb/d. It is unlikely that Nigeria willdramatically change its policy with respect to OPEC over the medium run. The issue ofcompetition for market share will likely have a greater influence on Nigeria oil policy. In recentyears, Nigeria has lost market share in its premium US market, mainly owing to the aggressivemarketing strategies pursued by other producers (Table 2.3). For instance, Saudi Arabia isoffering large price discounts to US customers. Marketing strategies that maximize oil exportrevenues should also be a part of Nigeria's overall development strategy.

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1. Reserves and Production Prospects

2.6 Nigeria's recoverable oil reserves are estimated at about 20 billion barrels. At the 1993production levels of about 2.07 mb/d, these reserves are expected to last for about 25 years.Nigeria's crude oil exports stood on average at around 90 percent of total production during theperiod 1987-91. In more recent years, domestic consumption has tended to increase to about 13-15 percent of total production."6 Roughly two thirds of Nigerian crude is light and highlydesired by refiners abroad. Even the heavier crudes, such as Forcados, fetch a premium in theseasonal winter market, because of their desirable properties for producing high-quality middledistillates.

Table 2.3: Nigerian Crude and Condensate Disposal by Light/Sweet Producers('000s of bbl/d)

1987 1988 1989 1990 1991

Production 1,300 1,420 1,670 1,760 1,900

Of which:Via Domestic Refineries 110 130 180 225 225

Exports 1,190 1,290 1,490 1,535 1,675

EC 445 475 525 530 640Scandinavia 10 5 - 10 10USA 530 610 800 785 695Canada 40 45 65 50 50Others 165 155 100 160 280

Exports (Percentage)EC 37 37 35 35 38Scandinavia 1 - - 1 1USA 45 47 54 51 41Canada 3 4 4 3 3Others 14 12 7 10 17

Total 100 100 100 100 100

Source: Petroleum Economics Limited.

2.7 Budgetary cuts announced in 1993 and maintained in 1994 have undermined aggressiveexpansion projects planned in the past by the NNPC. In early 1993, NNPC planed to liftNigeria's crude oil production capacity to 2.5 mb/d (from about 2.0 mb/d in 1992) and toincrease recoverable reserves to 25 billion barrels by the mid-1990s. These goals were based onthe following: (a) promising geology; (b) drilling successes recently achieved, partially as aresult of 3D seismic work; and (c) expectations of larger investments by international oilcompanies in upstream projects. As part of this strategy, the NNPC signed six development jointventure agreements, with a 60 percent stake. The largest was mainly with Shell PetroleumDevelopment Company (Shell 30 percent, Agip 5 percent, and Elf 5 percent). Originally witha 60 percent stake, NNPC reduced its holding in this joint venture to 55 percent in 1993 with aUS$500 million sale of 5 percent to Elf. This joint venture produced about 0.96 mb/d in 1991,roughly half of Nigeria's total production. The second is with Chevron Nigeria (Chevrot 40percent), with an output of 0.31 mb/d. The remaining four joint ventures are formed with Mobil

id Domestic consumption has been estimated in the range 250-300 mb/d. An exact figure is difficult toobtain due to leakages in domestic refineries and smuggling of oil derivatives out of Nigeria.

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(40 percent), Agip and Phillips Petroleum (20 percent each), Elf (40 percent), and Texaco andChevron (20 percent each), producing, roughly 0.270 mb/d, 0.140 mb/d, 0.095 mbtd, and0.060 mb/d, respectively, in 1991 (Box 2.1).

2.8 Shell, the largest producer in Nigeria, planed originally to spend about $1.5 billion a yearin its joint venture exploration and development projects over the period 1993-98 and increasecapacity to 1.3 mb/d (up 30 percent). Mobil, the second largest producer, also announced plansto lift output-to 0.50 mb/d (an increase of 56 percent).

Box 2.1: Joint Venture Agreements

Nigeria legislation allows joint ventures to be set up after the signature of a joint operatingagreement (JOA) between the NNPC, acting on behalf of the Government, and one or more foreigncompanies. The NNPC acquires a stake (currently 60 percent) in all oil mining leases held by thejoint venture. The foreign company, or one of the foreign partners, is the operator. Joint venturesare one of three types of participation open to foreign companies; the other two are production-sharing agreements and service contracts.

2.9 While the targets were technically achievable, budgetary cuts announced in 1993 by theGovernment of 30-40 percent have undermined the expansion plans and postponed the realizationof targets to the late 1990s. Since 1993, NNPC has not been able to follow the expendituregrowth of its joint venture partners. In the face of its financial difficulties, the NNPC asked itsforeign partners to cut their exploration-production (E&P) budgets by 30 percent in 1993 from1992 levels. E&P expenditures fell to approximately US$2.1 billion in 1993 from US$3 billionin 1992. The resultant drop in relation to initial 1993 budgets was about 40 percent. At the endof 1993, NNPC had accumulated arrears with the oil companies estimated at about US$600million.

2.10 The realization of the target capacity of 2.5 mb/d will likely be delayed until 2003-04since the reduced investments likely will reduce capacity in 1994-95. In 1993, capacity reachedslightly less than 2.1 mb/d despite budgetary cuts, because of the lagged effect of investments in1992. The date by which Nigeria will be able to reach its target thus hinges on its own abilityto finance exploration and development activity, and on the investments made by multinationaloil companies. Given Nigeria's cash-strapped situation, the oil production capacity plan willdepend on the degree of multinational oil company participation, which will in turn be influencedby the fiscal and financial incentives Nigeria offers.

2. Investment Incentives

2.11 The fiscal terms offered by producing countries have become a key determinant ofinternational oil companies' decisions on investment in upstream projects in developing countries,especially in the development of marginal fields. Most of Nigeria's oil production comes fromsmall fields producing between 500 and 5,000 barrels per day. Uncertain oil prices, and the viewthat most low-cost, high-reserve discoveries worldwide have already been made, have madecompanies more cautious in making investment decisions. In the 1970s and early 1980s roughly37 billion additional barrels were proved-mainly in developing countries (outside Middle EastOPEC)-in response to the incentive provided by high oil prices. Over the period 1970-81, oilprices (in real terms) increased by about 500 percent. Since then, oil prices have declinedsharply. Crude oil prices (in real terms) are now only about 36 percent of the peak in 1981-82.

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2.12 To attract foreign participation, several oil producers have made significant changes totheir fiscal systems. Producers have improved the financial incentives to foreign operations byreducing the Government's "take" from marginal fields and from deep-water discoveries. Thespecific measures adopted include: (a) abolition or reductions in royalties for new fielddevelopments; (b) removal of the "posted price" system; (c) widening of the 'ring fence" to allowany exploration costs to be offset against income from producing fields; (d) providing companieswith guaranteed after-tax profit margins; (e) revising regulations to avoid tax credit problems withcompanies' home-based tax authorities; and (f) reductions in government shares of oil profit,particularly for "marginal" fields. Nigeria has retained its existing system but has added newincentives for special areas, i.e., for deep-water as well as providing guaranteed after-tax profits.

2.13 The United Kingdom has been most aggressive in improving the investment climate inupstream projects and is now regarded as one of the most favorable regimes in the world forpetroleum exploration. The impact of the changes in the fiscal regime have been mostpronounced there. The United Kingdom allows exploration costs to be offset against incomefrom any producing field, royalties have been abolished for new fields, and additional profits taxallowances have been granted. There is a comparatively low corporate income tax rate (33percent) and fields under 100 million barrels are not required to pay taxes. Thus, despite the UKbeing a mature exploration province and having some of the highest-cost exploration wells,considerable exploration efforts continue to be carried out. Indeed, between 1987 and 1991, 519new field wildcat wells (NFWs) were drilled offshore, as opposed to 506 offshore wells inNigeria, Norway, Angola, Malaysia, and Indonesia combined.

2.14 However, this staggering record has not been achieved without the Government acceptinga much lower take from new fields. In 1986, UK government receipts from taxation formedapproximately 55 percent of total revenues and 95 percent of total cashflow (i.e., total revenueless capital investment, exploration, and operating costs). In 1991, this share declined to 14percent of revenue (and 41 percent of cashflow). In Egypt, a reduction in the Government's takein production-sharing arrangements by about 5 percent (from 80 percent to 75 percent) led to theimmediate decline in government revenues of about 14 percent. Egypt has been engaged inproduction-sharing contracts in its concessions to oil companies since 1973.

2.15 While a reduction in the government take has a short-term impact on governmentrevenues, the investment incentive provided to oil companies could lead to higher production andgreater revenues over the medium/long term. In most developing countries, including Nigeria,given that real oil price growth rates are expected to remain below real rates of return onalternative assets, rapid extraction of the oil resource should continue to be favored provided thattwo related conditions are met: a) overall consumption is smooth and grows at a rate that issustainable during and after the oil era; and b) for this to be possible, the savings/GDP ratioshould be increased to the required level, and those savings should be allocated to income-generating assets. Because high rates of extraction reduce the stock of oil wealth and hencefuture income flows, it is essential to implement a savings policy in parallel with an oil extractionpolicy. In practice, however, some governments have certainly favored higher extraction ratesand higher oil revenues either to maintain or increase unsustainable consumption levels or to goforward with unproductive investment projects. In these conditions, higher extraction rates haveno justification whatsoever.

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C. The Oil Sector and The Fiscal Accounts

1. Tax Arrangements in Nigeria

2.16 To achieve its production target, the Nigerian Government has improved the financialincentives given to international oil companies (outlined in the Memorandum of Understanding,MOU, revised in 1991) engaged in joint-venture exploration projects. These are in the form ofguaranteed profit margins and greater tax relief on large capital investments. In areas wheredevelopment costs exceed US$1.51bbl), the tax allowance and profit margins are US$3.5/bbl andUS$2.5/bbl, respectively. For lower cost projects (i.e., where development costs are less thanUS$1.5/bbl), the tax allowance and profit margins are US$2.5/bbl and US$2.3/bbl, respectively.The margins are calculated after payment of production costs, royalties, and taxes. The royaltytax is currently at 19 percent; the profit tax is currently 85 percent. On the basis of a projectedoil price, tax obligations of the companies are estimated for the year. The MOU contract thenallows for the above-mentioned tax reliefs. The royalties and production costs can, however, bededucted only on the basis of a fixed real price. If the margin falls short of the minimumguaranteed margin, the profit tax is reduced. Taxes are paid on a monthly basis. Areconciliation between taxes due on the basis of actual oil prices and taxes paid over the previous12-month period (on the basis of the projected oil price and costs) occurs at the end of the year.Excess taxes are paid back by the Government and shortfalls in taxes are paid by the companies.

2.17 The incentive differential between high-and low-cost areas is designed to attract foreigncapital for developing high-risk, deep-water tracts. The MOU also provides a bonus ofUS$0.1-0.5/bbl for reserve additions. While the revised MOU offers improved incentives tomultinational oil companies, the large investment requirements to develop the oil industry are notcompletely reflected in the tax regime. Therefore, further fiscal flexibility, and changes in theproduction-sharing arrangements with oil companies, could be critical to the development ofNigeria's oil sector.

2. Oil Price Risk and Fiscal Revenues

2.18 Currently, Nigeria uses joint-ventures for the exploration and production of oil, which,under the Memorandum of Understanding (MOU) contracts, operate with a 60 percent stake forthe country, reduced in 1993 to 55 percent in the case of the Shell-led joint venture. This impliesthat Nigeria provides 60 percent-55 percent in the Shell-led joint venture-of the financingrequired for the joint ventures, in exchange for which it receives the corresponding share of thecrude oil found and produced. After allowing for domestic consumption, the oil is then sold bythe NNPC in the international market. After allowing for NNPC and its subsidiaries' financingneeds, net receipts are transferred to the general budget (via the CBN). This, thus, representsa clear exposure on the part of the Government to oil prices: a US$1 change in the oil pricechanges fiscal revenues through this channel by about US$320 million.

2.19 The profit tax exposes the Government to oil prices in an adverse manner, since taxescannot fall below zero and a minimum margin is guaranteed to the oil companies. Consequently,as oil prices rise, tax receipts rise more than proportionally; and as oil prices fall, tax receiptsfall more than proportionally. As government risk is larger than the economy-wide risk, ineffect, part of the oil prices risk is shifted from the oil companies to the Government throughrevenues which are more variable than exports. This is not in the interest of the Government,especially as Nigeria is much less diversified than the companies, who are in a much betterposition to lay off oil price risks.

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2.20 More precisely, the elasticity of government income derived from taxing the multinationaloil companies is, given present oil prices and actual contractual arrangements, 1.38 according toan estimation presented in Appendix II. This means that if oil prices increase (fall) by 10percent, government revenue raised from the multinational oil companies would increase(diminish) by almost 14 percent. Furthermore, the critical world oil price below which thiselasticity starts increasing above unity is US$23.99. Given that present oil prices are situatedsignificantly lower than this level indicates that for the foreseeable future the NigerianGovernment will absorb higher risk than world oil companies over a significant fraction ofgovernment revenues.

2.21 In general, the joint venture and tax structures lead to a highly leveraged participation ofthe Government in the oil industry. Through its percentual stake, the Government is not onlyexposed to exploration and operation risk, but also to oil price risk. At the same time, theGovernment needs to provide 60 percent of the upfront financing in five joint ventures and 55percent in the Shell-led joint venture. This joint venture structure increases overall risk to theGovernment, as debt payments will need to be serviced independently of the exploration successand the oil price. In the future, the situation will improve as Nigeria will obtain a significant partof its oil revenues (in output) through sharing arrangements with foreign companies. Throughthe sharing agreements Nigeria will be able to transfer all the exploration and operating risk tothe foreign companies and minimize any upfront financing, which will eliminate the negativeeffects of this leverage. Nigeria will also share a larger fraction of oil price risk with the foreigncompanies as its share of output will be only 40 percent instead of 60 percent."

D. Conceptual and Practical Elements for the Creation of an Oil Stabilization Fund

1. Basic Motivation

2.22 Chapter I laid out the complementary nature of market-based hedging techniques and selfinsurance, such as an oil stabilization fund, to manage external risk exposure. While the use ofsome hedging instruments, such as futures trading, may be directed at reducing oil-relateduncertainty, instability reduction may be addressed via the use of an oil stabilization fund and,if available, credit markets. The basic idea behind such a stabilization fund is that by saving oilresources in some periods, the Government can then lessen the need to cut spending in other-periods. This might then (a) stabilize the government budget making overall expenditures moresecure and (b) stabilize the real exchange rate and the macroeconomy as a whole, through theinfluence of the Government on the economy.

2. Conceptual Elements

2.23 An oil stabilization fund is essentially a spending rule for oil revenues. The appropriaterule that should be adopted depends on (a) the objectives of the fund, such as the costs that thefund is designed to avoid; (b) the nature of the process driving income; and (c) whether there areliquidity constraints operating-in other words, whether the balance of the fund is allowed tobecome negative.

17 An alternative method to reduce risks would be for Nigeria to sell some of its current equity stakes underthe MOU contracts to outside investors. This would also raise finance.

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2.24 This section briefly summarizes some of the views expressed by various authors" onthis subject. The traditional approach makes three assumptions: (i) the agents (e.g., government)do not face any liquidity constraints; (ii) there are no macroeconomic costs of adjustment; and(iii) shocks to income are transitory in nature. Under these assumptions, a risk-averse agentwould spend according to permanent income, and transitory shocks to income will be saved (ordissaved if the shock is negative). In this case, a stabilization fund would serve the objective ofstabilizing consumption and, hence, increasing welfare.

2.25 However, if the economy faces a liquidity constraint (but the other assumptions hold),extra precautionary savings would be required to adjust consumption as income changes. Astabilization fund may not be able to serve its purpose. A similar result occurs if the shock toincome is permanent. In this case, if the motive for consumption smoothing relies solely on riskaversion (microeconomic costs), typically there will be no justification for a stabilization fund.The reason is that, if income follows a nonstationary process, all changes in income are expectedto be permanent. Given no costs of adjustment, the agent should then simply adjust to the newpermanent level of income.

2.26 Therefore, the driving process for income is an extremely important determinant of thedesign and of the value of a stabilization fund. Hausmann, Powell, and Rigobon (1991b) (HPR)present results that show that the hypothesis for a nonstationary process for oil prices and for oilincome for Venezuela cannot be rejected. Palaskas, Imran, and Duncan (1993) tend to confirmthis process in their paper. They find that over the period 1950-89 the prices of three energysources, including oil, are nonstationary. This would tend to strengthen the argument againstthe establishment of stabilization funds. However, HPR argue that even if oil income followsa nonstationary process, there remains a strong justification for a stabilization fund for thegovernment of an oil-dependent nation. This justification stems from (a) the fact that there areadjustment costs associated with changes in government expenditure, and (b) from the politicaleconomy effects of the economics of oil-the economics of lobbying.

2.27 The adjustment costs come from two distinct sources. First, the government has a verylarge influence on aggregate spending in the economy, and hence influences the real exchangerate. As argued in Chapter I, real exchange rate fluctuations may be costly to the economy fora number of reasons. Second, they stem from the fact that many types of expenditure decisionsrequire a high component of recurrent expenditures. If the government runs out of resources tomaintain the financing of such projects-hits its liquidity constraint-this results in an additionaltype of adjustment cost. In practice, these costs are likely to be high as the reduction inexpenditures in such circumstances is often arbitrary and subject to a great deal of politicallobbying.

2.28 This discussion motivates two types of adjustment costs. The first may be thought of asstandard costs of adjustmnent, due to the costly movement of resources to accommodate changesin demand and the costs involved with a fluctuating real exchange rate. These adjustment costsoccur given that the change in expenditure is planned in advance. The second type of adjustmentcost is due to the fact that the government cannot borrow and faces a liquidity constraint. Hence,when it runs out of resources it is forced to cut expenditure. This is referred to as default costs.This type of adjustment cost is then unplanned. As discussed in Chapter I, from a purely

is See, e.g., Friedman (1957), who developed the basic framework, and Deaton (1989), Arrau and Clacesens(1991), Hausmann, Powell and Rigobon (1991b) and Palaskas, Imran and Duncan (1993) and Powell (1993)for further developments.

35

economic perspective, this type of adjustment may be termed as efficient in the sense that, givenliquidity constraints, this adjustment is unavoidable.

2.29 It is important to note that risk aversion on the part of the government does not enter intothe story and hence it is a very different approach from that adopted by Deaton (1989). TheDeaton (1989) approach represents a microeconomic-based model of optimal savings andinvestment behavior designed to smooth consumption. An alternative approach, such as the HPRframework, comes from a distinctive macroeconomic perspective which acknowledges that thegovernment has an important influence on the economy and hence is designed more from thestandpoint of macroeconomic stability than an individual optimally choosing savings on the basisof private costs and benefits. This tension between the different objectives of a fund (e.g.,macroeconomic stability versus microeconomic smoothing) has been an important tension inpractice as well as in theory. A brief discussion of the more practical and institutional aspectsis given in the next section.

3. Institutional Aspects and Practical Experiences

2.30 The discussion centers on a set of criteria that should motivate the actual design of thespending rule for oil revenues. These criteria may be valid for a variety of economies, such asthose of Nigeria or Venezuela. This criteria, which is naturally not conclusive, is based on theconceptual considerations just presented and some country experiences. Two examples of thesuccessful implementation of stabilization funds have been in Chile for copper and in Oman foroil. Many of the comments on the practical experience stem from the Chilean case."

* The fund should ease fiscal budgeting and execution. In particular, it must becompatible with the ongoing budgetary process and should permit the approvedbudget to be carried out with the minimum of oil-related revisions.

2.31 The first criterion is an acknowledgement that there is already a budgetary process inplace. For an oil-dependent country, such as Venezuela or Nigeria, in the absence of anystabilization fund, the credibility of the budget will depend on the future development of oilrevenues. The stabilization fund should, as far as possible, permit an approved budget to becarried out. Clearly there is a relationship between the size of the stabilization fund and theprobability that a revision (or default in the language of the model above) is required. Forexample, given an assumed statistical process for oil revenues, it is possible to deduce what levelof fund is required to give a particular probability of revision. The more money in the fund, thelower the revision probability. Indeed, it should be able to actually calculate the revisionprobability. One way of thinking about the required level of money in the fund is to think aboutan acceptable probability of revision.

2.32 However, this should not be the only consideration about the optimal level of the fund.That would be to focus solely on the default type of adjustment costs. Standard adjustment costsand general consumption smoothing will also in general impact on the optimal level of the fund.

* The functioning of the fund should not depend on particular oil price projections.

2.33 The second criterion is based on the view that oil prices follow a stochastic processwhich, if not nonstationary, displays only very weak mean-reverting tendencies. It is, therefore,

19 In particular see Basch and Engel (1991) and World Bank (1992).

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extremely dangerous to place great emphasis on oil price projections for the functioning of astabilization fund over the short to medium term.2' In the limit a rule could be constructed thatwould give no role for oil price predictions at all. However, this might be too strong a position.For example, in periods such as during the Middle East crisis, there was information that thesurge in oil prices was temporary. This information was revealed in the oil futures markets. Oneidea would be to incorporate current oil futures prices in the rule governing stabilization funds.If this is to be achieved it should be done in a non-manipulable fashion.

2.34 This discussion is related to a criticism of the Chilean stabilization fund by Basch andEngel (1991). They argue that in the case of copper, econometric models have some forecastingpower over the near term. However, the current design of the Chilean stabilization fund employsa reference price based solely on past price information, namely, a simple moving average.Savings are made to the fund when the actual price is more than a certain amount above thereference price. Basch and Engel (1991) argue that the rule should also incorporate forecastsfrom an econometric model of copper prices.

2.35 There may be a theoretical rationale for such a proposal with regard to copper.However, this proposal should be weighed against (a) the added complexity of incorporatingeconometric forecasts, (b) the fact that any point forecast used may be subject to a statisticalerror, and (c) that it is difficult to legislate on the type of econometric model that should beemployed to generate the forecast. The last point is serious, in that there is a possibility ofmanipulation of the forecasts for political ends.

2.36 The oil stabilization fund for Oman described in the fourth Five Year Development Plan(1991-95)-Sultanateof Oman (1991)-explicitly uses fixed reference prices. Specifically, if therelevant oil price lies in the region of US$18-20/barrel, 7.5 percent of net oil revenue is to besaved in an emergency fund; if the oil price lies in the region of US$20-22/barrel, 10 percent ofnet oil revenue is saved; and so on, rising to a 100 percent savings rate if the oil price risesabove US$25/barrel.

2.37 It is extremely unlikely that such specific fixed reference prices and savings ratios couldbe justified on theoretical grounds. If this rule was adhered to very strictly and oil prices wereconsistently above say US$20/barrel for a prolonged period, the accumulated savings in the fundwould be very large indeed. However, it is also likely given the history of the Oman stabilizationfund (he State General Reserve Fund-SGRF) that these rules may be revised contingent ondevelopments in the oil market. In other words, although the rule appears fixed in thedevelopment plan, it is certainly not non-negotiable. Indeed, quoting fixed prices in US dollarsper barrel in this fashion probably increases the probability of revisions in the fund rulesubstantially.

2.38 In conclusion, two important points emerge. First, although there may be some benefitin incorporating information other than in past oil prices, it is likely in the case of oil that whatprobably should be done is to use current oil futures prices. Second, fixed prices, such as theOman-style fund, cannot be generated from a model of optimizing agents. Such a route is notrecommnended. However, the rule should be as fixed as possible. This is necessary to avoidmanipulation of the fund. In other words, the rule should be as simple as possible and yet shouldbe appropriate at a very wide range of oil prices.

20 Powell (1992) presents evidence that oil price projections contain about as much forecast error as the actualinstability in oil prices. The implication is that the prediction record would have been roughly the same asif a random walk process had been assumed.

37

* The fund should deal simultaneously with the fiscal and balance of paymentsaspects of oil-income instability and uncertainty.

2.39 The third criterion reveals a tension in the design of stabilization funds that is of boththeoretical and practical importance. As pointed out by The World Bank (1992), the morenarrow objective of fiscal stability and the wider objective of real exchange rate stability may notalways imply the same saving rule. For example, in post-1988 Chile the "savings" from above-trend copper prices were forced by law to form the amortization of internal public debt.Although this satisfies the objective of stabilizing the government's fiscal position, domestic banksmay well increase credit elsewhere in the economy. In turn, this could lead to a downwardpressure on interest rates and, hence, to increased spending; a real exchange rate appreciation;and a trade deficit to match the trade surplus from the positive shock. Hence, although fiscalstability is maintained the stability of the real exchange rate is not.

2.40 For the two objectives to be satisfied simultaneously, the overall rate of spending of theeconomy as a whole must be kept constant in the face of a positive shock. This limits the rangeof assets in which stabilization funds should be kept and strongly suggests that the mostappropriate assets are foreign.

2.41 Furthermore, as argued in HPR, close attention must be paid to the design of thestabilization fund and the exchange rate regime to ensure consistency. Oil revenue impacts onthe balance of payments and on the government accounts. If the government had a floatingexchange rate regime and an exogenous target for international reserves, a positive shock wouldlead to an increase in the availability of US dollars to the foreign exchange market. If thegovernment did not adjust its foreign exchange reserves target, this would imply that anappreciation of the domestic currency would occur if interest rates remained constant. Analternative would be to cut interest rates, but again there would be the effect on aggregatespending. For a negative shock clearly a depreciation would be the result. Hence, with a fixedforeign exchange reserves target, unstable exchange rates and interest rates would result.

2.42 A stabilization fund should then be seen in the context of more general foreign exchangereserve policy. In HPR it is argued that the exchange rate should be managed (fixed or crawling)and that the reserve accumulation should be the endogenous outcome of the optimal spending-saving rule. This also appears to be the view of World Bank (1992), which argues that theChilean stabilization fund

"... must be viewed in the context of the broader issue of the optimal policy ofinternational reserve holdings. In this context, reserves should play the role ofa short-run shock absorber in the face of short-run disturbances... " (p. 47)

2.43 A second issue, related to the tension between the twin objectives of stabilization of thefiscal account and stabilization of the real exchange rate, is related to the size of the fund. Againin the case of Chile, it has been argued that the size of the fund should somehow affect thesavings rule-see Basch and Engel (1991). At present, strictly speaking, this is not the case inChile: if copper prices rise consistently, savings rates remain the same even as the size of thefund grows. It is not at all clear, however, what the precise rule is for dissavings from theChilean fund. In practice, dissavings may well reflect the perceived accumulated savings.

2.44 To a large extent, the optimal size of the fund will reflect the objectives. For thepurposes of ensuring budgetary credibility, the optimal size of the fund is given directly from anassumption on how low is the desired probability of a budgetary revision. However, a wider

38

perspective would also consider the relationship between the size of the fund and the stabilizationof the real exchange rate more generally. A greater size of fund will imply a greater degree ofstabilization and, hence, a lower amount of standard costs of adjustment. Naturally, a greatersize of the fund will also imply fewer busts and, hence, a lower amount of default adjustmentcosts.

2.45 As the size of the fund is increased there is a trade-off. Increased savings in the fund willtend to bring diminishing rewards-e.g., diminished marginal increases in stabilization.Therefore, in an optimal savings rule based on adjustment costs, savings rates are reduced as thesize of the fund increases.

2.46 Notwithstanding the potential conflict in objectives, which could be eliminated by theintroduction of an additional macroeconomic tool (for example monetary policy) in practicestabilization funds can perform the dual role of securing budgetary plans and of reducingmacroeconomic instability. In the case of Chile, it has been argued that the stabilization fund hasto some extent stabilized the real exchange rate and increased the credibility of the budgetaryprocess (see World Bank, 1992). However, macroeconomic stability may have been enhancedby fully sterilizing positive shocks rather than by restricting savings in the fund to amortizedomestic debt, which led, to some extent, to monetary expansion.

2.47 In the case of Oman, the oil revenue stabilization fund was created in January 1980,during the first Five Year Development Plan. In the period 1980-85, very significant funds werebuilt up. The fund was extremely valuable to macroeconomic stability in the period after 1985,when the economy felt the severe shock of the bust in oil prices. The existence of thestabilization fund probably also aided in the credibility of the budgetary process during thisperiod, although probably this was less of an issue in Oman than in other oil-exporting countries.

- The stabilization fund should not affect the oil industry. The idea of the fund isto stabilize fiscal revenues and not oil revenues.

2.48 The fourth criterion is that the fund should not affect the oil industry. The idea here isthat production decisions in the oil industry should reflect technological factors and should begoverned by economic efficiency considerations. There should be a separation from thesetechnical decisions and the financial decisions of the government such as the optimal degree ofsavings.

2.49 In practice, as discussed above, there will be ways in which government financial policywith respect to the oil industry will affect oil industry behavior. The most obvious route isthrough the tax system on oil revenues. There is a clear interaction between the type of taxsystem in operation and the optimal design of a stabilization fund. If the tax system implies thatgovernment fiscal revenue is even more volatile than oil industry revenue, the need for astabilization fund will be even stronger. However, the tax system is such that if fiscal revenuesare in part stabilized anyway, the need for a stabilization fund will be diminished.

2.50 Still, whatever tax system is in place, the stabilization fund should not, in itself, affectthe way in which the oil industry will behave.

* The fund should stabilize the fiscal position of the whole public sector, not justthe Central Government.

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2.51 This criterion states that the unit of analysis should be the whole public sector, includingthe federal and state structures. The analysis of the Chilean experience in World Bank (1992)concludes that perhaps the single most important success of the Chilean stabilization fund is thatit has been a useful device for ensuring a degree of saving in the face of very strong pressuregroups advocating increased expenditures at times of windfall copper receipts. The existence ofthe stabilization fund has ensured that each group sees that another group will not capture anywindfall, and that windfalls will be shared over time.

2.52 The federal structure of Nigeria creates natural units that compete for national funds. Ifone state believes that it will lose its share of windfall oil revenues if it does not lobby for thosefunds, it will embark on costly lobbying efforts. All states may think likewise and, hence, allwill lobby for the windfall receipts. The result will be an inefficient degree of lobbying and aninefficient degree of savings, as the central government will find it very difficult to resist suchpressure from all sides. In Nigeria, as in Chile, a stabilization fund may provide a vital role inresisting such pressure and ensuring a more efficient degree of saving.

2.53 In order for this to be effective, the stabilization fund and payments and disbursementsshould be highly transparent. If not, individual states will fear that the mechanism is not simplytransferring funds from one period to the next, but meeting other purposes. An individual statewill fear that if it does not lobby during this period, then next period there may be less funds tolobby over. The implication is that the less transparent the mechanism, the less it will fulfill therole of a constitutional rule to resist the pressure to increase expenditure with positive oil priceshocks. The stabilization mechanism must then be extremely transparent.

2.54 Transparency is also a vital characteristic if the stabilization fund is used in conjunctionwith a hedging program. As argued above, a stabilization fund may be useful as a type ofguarantee of margin calls on futures-type hedging programs. If this is to work effectively, theremust be good knowledge about the size of the stabilization fund and there must be a belief on thepart of the brokers actually effecting the trades that these sums would actually be used to financesuch margin calls. In short, the stabilization fund must be transparent and the mechanisms bywhich payments and disbursements are made should be well known.

4. Potential Problems for the Establishment of an Oil Stabilization Fund inNigeria

2.55 The establishment of an oil stabilization fund in Nigeria may face several other non-technical obstacles. First, the Nigerian Government has a poor record for managing externalshocks. For this reason, there is the perception among some Nigerians that the accumulatedresources of an oil stabilization fund may be squandered. This may create opposition against thisoption. Second, even if the general public would agree on the need of a stabilization fund, thediscipline expected to be introduced by the fund is also certain to generate opposition from thosesectors that benefit from the current situation. For the same sort of reasons, there may be strongopposition to any plan by the Federal Government to introduce a market-based hedging program.If additional risk management is transferred to the state and local governments-given that theirshare of external windfalls also appears to have been wasted-these tiers of government wouldface the same sort of obstacles trying to implement their hedging programs.

2.56 Third, there is the unfounded perception that a stabilization fund entails an expropriationby the Federal Government of revenues that belong to the state and the local governments. Ifa stabilization fund is created, the revenue shares of the state and local governments may notchange in present-value terms, although their consent will be needed, since the revenue allocation

40

formula may be revised. The resources in the stabilization fund would belong to all tiers ofgovernment. The agency that may manage the fund may not be located at the federal level andwould have in its board, if implemented, representatives from the Federal Government, and thestate and local governments.

E. Oil Sector Risk Management: Other Strategies

1. Risk Sharing and Alternative Financing Arrangements

2.57 Under the terms outlined in the MOU, oil company margins are secured against declinesin oil prices. Therefore, the price risks are borne by the Nigerian Government. Because theguaranteed profit margins are net of taxes, the Government's receipts from taxes are also exposedto an oil-price collapse. Under the present joint-venture arrangement, NNPC is responsible fora 60 percent share of all costs and is, therefore, exposed to higher exploration and developmentcost risks.

2.58 NNPC can reduce its cost and price risks exposure by (a) reducing its stake in the jointventures; (b) moving to production-sharing types of arrangements; and (c) by using its offtakein creative risk management strategies.

2.59 NNPC can reduce its stake by selling equity shares to companies. In addition, thisstrategy would reduce its cash call commitments, which Nigeria has had difficulty in meeting.Alternatively, Nigeria could move to production-sharing arrangements. Nigeria is one of the fewdeveloping countries, where joint-ventures still dominate upstream operations. Under production-sharing arrangements, the full financial burden for upstream activity and price and cost risks areborne by operators. At present, only Ashland Oil is involved in a production-sharingarrangement in Nigeria. The standard production-sharing contract divides oil produced into cost-recovery and production-sharing oil, with the allocations varying from contract to contract. Inmost cases, a maximum of 40 percent of oil produced is reserved for cost recovery; although theexact allocation depends on expected costs of oil and world prices at the time of production. Forinstance, in Egypt, approximately 10 percent of the oil produced goes to cost recovery, and theremaining 90 percent to production-sharing. Generally, an 80/20 split in favor of the governmentis standard in production-sharing contracts.

2.60 Nigeria can pursue other avenues for raising capital, such as through trade financingarrangements. Nigeria could also use its equity production to raise capital through commerciallending institutions, and by floating the state oil companies shares (partial privatization).

2. Market-Based Risk Management

2.61 Nigeria also has the option of using a variety of financial risk management tools totransfer (externalize) price risks. Since the development of exchange-related trading, severalmarket-based tools have evolved (forwards, options, futures, oil-linked bonds, and swaps).Market participants are now using these tools extensively to hedge price risks and to raise newfinance. New exchanges have emerged around the world and new oil products have beenintroduced to these markets. This has allowed arbitrage trading between markets and contracts.Among the various ways in which oil is now traded in the market (preferential, counter-trade/barter, term, products and spot), market-based trading has increased sharply. While thespot market volume may not have appeared to have changed significantly over the last five years,most OPEC producers have devised pricing strategies that link term-contract supplies to the spotprice of Dubai crude and Brent (Table 2.4). In fact, this practice has become so prevalent that

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Table 2.4: Forms of Sale of Crude Oil by OPEC, 1985 and 1989

1985 1989(mb/d) (%) (mb/d) (%)

Preferentiar 3.4 25.6 3.6 20.1Counter-trade/Barter" 1.5 11.3 2.3 12.9Netback 1.0 7.5 0.4 2.2Termd

OSP 1.5 11.3 0 0Other 2.0 15.0 6.9 38.8

Products! 2.4 18.0 3.5 19.7Spot' 1.5 11.3 1.1 6.2Total 13.3 100.0 17.8 100.0

Source: Petroleum Economics Limited.

' Contract terms based on "special" arrangements, usually with equity producers.' Contract terms based on exchanges of non-like materials (e.g., military equipment).

Contract terms based on the "value" of the crude at some future, predetermined time, usually pegged tothe value of the products that can be/will be made from the crude oil.

d Contracts based on "market-based' or "arms-length" third-party purchases, with "deals" involving liftingat more than one place or time.Official (government) sales.

r Sales of refined products rather than crude oil.' Contracts similar to "term" purchases with the exception that the deal usually involves only one lifting.

many contracts entered into by producers have price clauses that are in some ways linked to spotand futures prices.

2.62 Nigeria too has increased the number of its term buyers to 19 (from 14 in 1990). Termsales amounted to between 0.68 mb/d and 0.76 mb/d, accounting for between 40 percent and 45percent of total disposals (Table 2.5). Almost all remaining Nigerian crude oil is disposed of onpreferential terms. NNPC often exercises the option to take crude for itself for resale on the spotmarket since full amounts are not lifted by each customer every month. Nigeria should makemore extensive use of the other market-based instruments, such as options and futures as well aslong-dated instruments, such as swaps, for the sale of its oil to the world markets. These areviable means of transferring risks to the rest of the world. Mexico, for instance, pursued an oil-hedging strategy during the Middle East crisis (late 1990 and early 1991), successfully using acombination of financial risk management tools to insure its oil export earnings against priceuncertainty.

2.63 At that time, Mexico took advantage of the price run-up by locking in a US$22-25/bblprice for roughly 65 million barrels of its crude production. Mexico also used part of the oilexport revenues to establish a contingency fund to hedge against the expected decline in prices.Other countries-such as Chile (used price bands), Brazil (used swaps, futures, and options), andEl Salvador (bought calls to protect against price increases)-used a variety of financialinstruments to hedge price risks during the Middle East crisis. Unconfirmed market sources haveindicated that in 1992, Iran attempted to lock in a floor price for about one fourth of its crudeproduction. Other countries, such as Algeria, Kuwait, and Nigeria, are reported to have takensmall (and short duration) hedging positions in 1992 by using Brent futures markets. The Bankof Mexico's decision to hedge in 1993 about 30 percent of Mexico's oil exports is evidence ofthe growing use of market-based hedging tools by oil exporting countries. During the first

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Table 2.5: Nigeria's Term Buyers, 1991

Company Volume ('000 Company Volume ('000bblWd) bbl/d)

Sun 60 Veba 25Tevier 60 BRG 25Neste 40-50 ERT 25Chevron 30-50 Nova 20Philbro 35-45 Rheinoil 20Attock 40 OK Petroleum 20Arochem 30-50 Petrojam 20Wintershall 40 Texaco 30Ultramar 30 Shell 30C. Itoh 30 Elf 30Ghana 10-30Nigermed 30 Total 680-760

Source: Petroleum Economics Limited.

quarter of 1993, Mexico locked in a price for 150 million barrels of its crude oil exports (about0.41 mb/d) covering the period up to the end of 1993. Mexico is reported to have taken optionsthrough an investment bank in New York to sell its crude on the NYMEX at a guaranteed priceof US$19/bbl. Mexico's crude oil trades at a US$4-5/bbl discount compared with the West TexasIntermediate (WTI). Therefore, the effective floor price for Mexican crude is US$14/bbl. Thisis the longest and largest hedge undertaken by an oil-producing country so far.

2.64 In the particular case of Nigeria, there are many compelling reasons to use the existingrisk management markets. The first reason is that Nigerian oil, Bonny light, trades very closein the spot market to WTI oil. This is important because the most liquid market for oil futurescontracts, NYMEX in New York, is based on the WTI spot price. The close relationshipbetween Bonny Light and WTI means that basis risk (the fraction of risk not hedged) is small.Analyzing monthly data on Bonny Light prices and WTI futures prices from February 1988 untilJuly 1991, it was found that basis risk is less than 20 percent (about 13 percent for longer-datedfutures). Consequently, Nigeria can reduce more than 80 percent of the risk of short-term pricefluctuations using short-dated futures.

2.65 Second, the market for oil futures has become very liquid. Currently, these instrumentshave a maximum maturity of up to three years, with most of the liquidity of the instruments inthe first year contracts. The daily total volume of future contracts traded on NYMEX exceedsthe world cash trade (in terms of number of barrels of oil). From conversations with marketparticipants, it has become clear that, if executed over a reasonable period, Nigeria, couldwithout much problem, sell in futures markets a significant part of its oil export revenues. Thisis despite the fact that, in some developing countries, especially in the Far East market, the useof swaps has grown more rapidly than other market-based financial risk management instruments.This growth is partially attributed to the relative illiquidity of futures and option markets indeveloping countries compared with the industrial countries and partially because of the difficultyFar East producers face in using the NYMEX and the International Petroleum Exchange (PE)to hedge risk. These difficulties stem from the physical differences between crude oil and refinedproducts produced in the Far East and those traded on the NYMEX or the PIE. The crack-spread(or refiner-margin) is one of the most common swap strategies pursued in the Far East. Thiskind of swap allows refiners to lock in a profit margin on the sale of products derived from crude

43

oil. However, swaps are generally inflexible and not very transparent in prices compared withoptions. In a swap deal, the participant locks in a fixed price for a given period, which leaveslittle room for flexibility. Also, since swaps are for a long term, the creditworthiness ofcounterparts is a critical issue in drawing up a swap.

2.66 NNPC and its trading subsidiaries have only to a very limited extent used any oil riskmanagement instruments (in London), largely for short-term, transaction-oriented hedging.2 'The reasons for not hedging appear to be only in part lack of awareness of the benefits of theseinstruments among a wide group of officials. In practice, the implementation of an effective riskmanagement strategy in Nigeria faces several constraints. Unlike Venezuela's and Mexico's oilcompanies (PDVESA and PEMEX, respectively), NNPC is not a fully capitalized entity and isnot legally authorized to undertake financial operations, including hedging activities. Even whenundertaking basic financial operations, such as borrowing in international capital markets, letalone when engaging in relatively sophisticated hedging undertakings NNPC has to consult withthe treasury. These institutional barriers make these operations extremely cumbersome andunrewarding. Therefore, the removal of such barriers is a key to the successful implementationof appropriate risk management strategies in Nigeria.

2.67 Finally, although not related to the oil sector, it is worth mentioning that few privateentities in Nigeria manage their exposure to commodity price risk using market-based financialinstruments. This is partly a result of the fact that Nigeria has not had an open capital account,and several regulatory or legal restrictions are still in place that prevent private entities fromhedging. Since, for most agricultural commodities, the domestic marketing system in Nigeriais relatively liberal and exposures to commodity price risks are incurred by the various privateactors involved in the marketing chain (in different degrees) and not by the Government, a moreopen capital account and fewer restrictions imply that private companies will probably usecommodity risk management instruments more actively. Thus, regulations and laws should bemodified in such a way that those capable of hedging-likely the larger producers and most ofthe exporters-are able to do so and react to the adequate incentives to hedge. This may involveincreasing their awareness of the potential of using commodity risk management instruments,and/or preventing them from passing the risks on to a third party, particularly the smallerproducers.

3. Diversification Strategies

a. Diversification Within the Energy Sector

2.68 Nigeria's high dependance on crude oil and its high degree of exposure to variations inthe external environment underpins the need to develop a more diversified energy and economicbase. Diversification can be achieved by expanding the energy resource base, by improving theavailability of non-crude oil energy sources (including petroleum products), and by developinga broader industrial and service base. However, diversification within the energy sector shouldnot be viewed as a strategy to reduce Nigeria's exposure to variations in the externalenvironment, but only as means to make additional supplies of alternative energy sources,including crude oil derivatives available for domestic use and for exports. Diversification withinthe energy sector will probably not reduce Nigeria's exposure to oil price risks significantly, since

21 The foreign oil companies also do not hedge their oil sales from Nigeria separately, but only as part of theirglobal risk management.

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the prices of other energy sources are highly correlated with the price of oil. Historically, theprices of other energy sources (coal and natural gas) have followed the price of oil with a lag.2Y

2.69 Nigeria can achieve diversification within its oil sector by improving its capacity to exportrefined petroleum products. At present, its capacity to export petroleum product is very limited.Its four refineries produce roughly 0.44 mb/d mainly for domestic use. Domestic refineries facea host of technical problems. Equipment failures and shortages have caused occasionalbreakdowns of the Warri and Kaduna refineries. As a result of the technical problems, thecapacity utilization rate of Nigerian refineries is below 60 percent. The rehabilitation, expansion,and upgrading of the domestic refining capacity could serve as a means to diversify sources ofrevenues to include the higher value product market as well as achieve a greater degree of selfsufficiency in product requirements. Nigeria can also participate in downstream joint-ventureoperations with crude oil importing countries, such as the US and in Europe. This form ofintegration would enable Nigeria to secure outlets for its crude oil and sell crude oil directly tothose refineries, where it has acquired equity interest while eliminating third-party contracts withother trading companies. Several oil-producing countries are now pursuing such downstreamdiversification strategies, which involve acquiring interests in refining and distributing facilitiesin oil-importing countries.

2.70 Nigeria's abundant natural gas resource base also offers a viable option fordiversification. Nigeria's natural gas reserves are estimated at about 73 trillion cubic feet (tcf).Probable gas reserves are as high as 106 tcf. Roughly half of the known gas reserves are ofassociated gas. About 75 percent of associated gas is flared and associated gas is more expensiveto produce than nonassociated gas. However, the development of gas reserves is expensive,particularly because its involves huge capital costs to develop infrastructure for transporting gas.In addition, for most countries gas must be sold in internal markets. In Nigeria, the local marketfor gas is very thin; and domestic gas prices are fixed at artificially low levels. These factorshave hindered the participation of international companies to develop gas reserves.

2.71 Because of the high capital costs of developing gas infrastructure and the limited domesticmarket, natural gas may be a viable option only in the long run. For the medium term, naturalgas development policy should aim at reducing gas flaring, removing price distortions, andimproving domestic markets for gas, while encouraging joint ventures for developing natural gasprojects. Because gas is normally sold to state monopsony buyers, the foreign oil companyshould become involved in a close and long-term relationship with the relevant internal agencies.Therefore, the nature of the bilateral relationship between the oil company and local authoritiesduring a gas project, and the clauses that deal with this relationship, should be a part of the gasdevelopment strategy-as should the introduction of contract terms that encourage exploration,including concessional terms. By increasing supplies of gas, the harmful effects on theenvironment will also be reduced. Investments in LNG export projects would also improve theprospects for gas exports from Nigeria. However, Nigerian LNG projects presently do notappear to be competitive in world markets because of the high capital investments needed (LNGproduction and exporting involves investments in liquefaction plants, ship receiving terminals,and storage facilities).

2.72 Despite the existence of large coal deposits, coal does not offer an economically viableoption for the medium term. Flooding and poor maintenance mean that significant investments

n Econometric analysis of movements in energy prices indicates that changes in oil prices proceed and cause(as defined by Granger-Sims) changes in other fuel prices (Hamilton 1983; Duncan, Imran, Palaskas 1993).

45

will be needed to rehabilitate the coal mines. Also, the need to transport coal over long haulsrequires the existence of a transport infrastructure, which does not exist at present.

2.73 Renewable energy sources, such as solar and wind, are also options that can improveNigeria's energy mix. However, at present, renewable technologies are more costly thanconventional energy sources, although the costs have declined sharply over the last two decades.For instance, electricity generation costs of photovoltaic (PV) are now roughly C30/kwhcompared with c4.5/kwh, C6/kwh for coal, oil, and gas (combined cycle), respectively.However, for many applications when it is deployed at short distances (i.e., 4-40 kin) for thetransmission network, solar PV could be cost effective. Also, for large wind farms, the cost ofgeneration is roughly C6-7/kwh and are competitive with some oil-based (diesel) powergeneration. With technology advances, renewable technologies could be a viable source ofenergy supply especially in rural areas. However, the development of these options will likelyrequire large government subsidies.

2.74 In short, energy diversification may prove desirable because it would increase theavailability of other energy sources and moderate the rate of oil consumption, thereby freeinghigher volumes of oil for exports. Over the period May 1991 to May 1992, Nigeria's oilconsumption increased by about 9 percent. The share of oil in total energy consumption isroughly 75 percent. The ability to export larger volumes of crude oil and product would helpto offset the revenue impacts of a decline in the oil price. Therefore, an increase in theproduction capacity of oil-related products, such as petrochemicals, LNG, and fertilizers, forexports will improve the balance of trade.

b. Diversification Out of the Oil Sector

2.75 As stressed in Chapter I, diversification out of the oil sector involves an apparenteconomic dilemma. Because of risk-reduction requirements, Nigeria needs to diversify theeconomy away from oil, yet Nigeria has a clear comparative advantage in oil production(extraction). Therefore, as long as real oil price growth rates are expected to stay below ratesof return on alternative assets, it will be optimal for Nigeria to extract as much oil as possible.Otherwise, it would be more profitable to keep oil underground and sell it as soon as oil pricesincrease. A policy of extracting as much oil as possible will be optimal provided that a) asignificant fraction of, if not all, oil revenues are saved; and b) these savings are genuinelyallocated to investments (financial and real) with adequate rates of return. This will help ensurethat welfare levels grow uninterrupted at reasonable and steady rates during and after the oil era.

2.76 This savings policy will address the oil sector's critical feature of oil being a non-renewable resource. This policy, however, will not be enough. Throughout the oil era and aslong as the oil sector represents a significant share of the economy, Nigeria will be subjected tooil-price volatility. This requires a set of fiscal and monetary policies that maintain a competitivereal exchange rate and reduce its volatility, particularly expected exchange rate volatility. Thiscould only be possible with the existence of a framework to cushion external shocks, such as anoil stabilization fund and the increasing use of market-based hedging instruments, namely the sortof policies proposed in this report. In other words, diversification should be attempted only asa byproduct of general macroeconomic and savings policies and not as a primary economicobjective. Picking (non-oil) "winners" or subsidizing the costs of diversification (by subsidizingproduction and capital) to accelerate the diversification process, for example, will certainly leadto resource misallocation, and therefore impede economic growth. Nigeria has a comparativeadvantage in the oil sector and the highly capital-intensive oil technology is not transferable toother sectors. Also, because oil derivatives are an important input into the production of many

46

tradable consumer goods, the development of the oil sector underpins the growth in the tradesector. Therefore, as long as the fiscal and financial incentives to develop the oil sector withforeign participation are present, continued investments in the oil sector will not crowd out thenon-oil sector.

c. Energy Pricing

2.77 The full economic benefits of the expansion in energy supplies and diversificationstrategies can be realized only if energy prices reflect the scarcity value of the energy resources,and if energy is used efficiently in the economy. In Nigeria, government subsidies on energyprices have been among the highest of developing countries. Domestic prices have been only afraction of the international parity price of fuels as well as of the cost of supplying (producing)energy. The heavy subsidies on oil products, and policies to limit the passthrough of changesin world prices into domestic prices, have led to the wasteful use of energy and other factors ofproduction and have proved very costly. After a substantial increase of around 400 percent,Gasoline prices were in December 1993 only about c30/gallon (estimated at the free-marketexchange rate). Before this readjustment, the cost of petrol subsidies was about N27.7 billiona year (roughly 10 percent of GDP), if the opportunity cost in the form of export revenues lostis included.

2.78 Petroleum subsidies have also generated a host of other socioeconomic policies. Thelarge price differentials have encouraged smuggling to neighboring countries, leading tosignificant revenue losses for local governments as well as reducing the profitability ofdownstream operations. As much as 50,000 bbl/d of products are smuggled to neighboringcountries. As a result, Nigeria is forced to import large volumes at world prices to supplydomestic demand. It has squeezed capital out of the upstream budget as well as reduced theavailability of funds. This, combined with the poor transportation and distribution system, hasdiscouraged companies from participating in downstream joint ventures. The Government hasresisted a move toward efficiency pricing on the grounds that it will hurt the poor and fixed-income groups severely as well as increase the rate of inflation.

2.79 It is argued that, since energy constitutes a larger portion in the expenditure of poorpeople-given their very limited ability to substitute out of energy-an increase in energy priceshas a disproportionately greater impact on the poorer segment of the population. While this maybe true, it is not clear whether the benefits of the subsidy actually accrue to the intended segmentof the population. In fact, evidence points to the contrary. In India, where kerosene issubsidized, the actual price paid by consumers in the rural areas is significantly higher than theprice fixed by the Government. Also, in India, the use of diesel pumps has increased sharplydespite a heavy subsidy for rural power supply. The higher capital costs of electric pumps forirrigation purposes compared with diesel motors have limited the benefits of the subsidy topoorer farmers. However, more affluent farmers with greater access to capital have benefittedmore from the subsidy by installing electric pumps. When subsidies are financed by tax increaseson other energy sources, mainly gasolines (on the presumption that the burden of the gasoline taxwill fall on the rich), the regressive consequences of this cross-subsidization policy are equallysevere. Cross subsidies have also led to the adulteration of expensive fuels by cheaper fuels, suchas diesel and kerosene with gasoline, as well as leading to the inefficient and wasteful use of thesubsidized fuel.

2.80 Domestic price increases can impact the general consumer price index (CPI) directly andindirectly. The direct impact on the CPI is manifested through an increase in fuel prices andindirectly through its effect on the energy costs of producing goods and services. In general, the

47

impact of changes in energy prices is linked directly to the share of fuel prices in the consumerprice index, although the price elasticity of demand and the elasticity of substitution betweenenergy sources and between energy and other factors of production also have some influence.

2.81 While the impact of increases in domestic fuel prices on the level of the CPI can besubstantial if both the direct and indirect effects are fully accounted for, the impact of the subsidyon the rate of inflation may also be substantial via its impact on the budget deficit. Financingthe budget deficit (caused by subsidies) through borrowing either generates inflation or raisesinterest rates, or both. The impact on inflation, however, can be mitigated by offsettingmonetary policies.

2.82 Pricing reforms aimed at eliminating consumer subsidies would: (a) reduce the incentivesfor smuggling while increasing supplies to the domestic market; (b) improve economic efficiency;(c) reduce the strain on the treasury; and (d) improve the financial viability of downstreamoperations. The funds freed by the elimination of subsidies could be used to offset the economicimpact of price increases on fixed-income groups. This can be achieved by giving income taxrebates, direct income transfers, and/or transportation allowances, etc. Efforts to improve theefficiency of refining operations (through rehabilitation and upgrading), extend the domesticpipeline network, expand storage facilities, and integrate the refining centers would be a stepforward in improving downstream operations. Increases in domestic prices will improve theprofitability of these operations, induce a supply response and contribute to the improvement inthe performance of the downstream operations. Pricing reforms will also achieve part of thediversification objectives within the energy sector. The increase in the price of oil products willimprove the profitability of refining operations, and reduce oil demand, while increasing thedemand for alternative energy sources (through substitution effects). The second-order priceeffects will induce a supply response and improve the availability of alternative energy supplies.A combination of domestic energy pricing reforms, improvements in fiscal terms and financialincentives to international oil companies for oil development, and appropriate risk managementstrategies are, therefore, critical to improving the performance of the Nigerian oil sector and theeconomy as a whole.

F. Potential Public Managers of Oil Windfalls and Busts

2.83 Presently, oil revenues and, consequently, oil shocks in Nigeria accrue in the firstinstance to the Federation Account. Through the so-called revenue allocation formula, they arethen distributed among the central government, the states, and the local authorities. The NigerianGovernment currently maintains the so-called Stabilization Account, which is supposed to operateas a mechanism to cushion external shocks. In practice, however, its role as a stabilization toolhas been negligible and presently it is no more than a confusing accounting device with no clearobjectives. Except in name, the Stabilization Account is not a stabilization fund of the type thatthis report refers to.

2.84 Nigeria's past economic performance indicates that neither the central government northe states and the local governments have managed oil windfalls soundly. On the contrary,external windfalls appear to have been wasted at all tiers of government. There is no clearindication that one governrmental level has done better or worse than the others in managing itsshare of oil windfalls. This judgment is difficult to make because Nigeria has never had acomprehensive fiscal data base either at the state or local level, and the available and scatteredinformation is not reliable. Centralized oil risk management by the Federal Governmentfacilitates overall stabilization policy by tending to unify fiscal policy for the whole country andby assuming the risks that otherwise would go to the state and local governments. In the process,

48

however, the Federal Government may overlook the possibilities that individual regionalauthorities may have for managing external shocks according to local needs.

2.85 If properly implemented, the benefits of centralized risk exposure management may becompared with the benefits of a centralized Central Bank for conducting monetary policy. Ifexternal oil risk management is excessively transferred to the state and local governments overallmacroeconomic objectives would become more difficult to achieve. Fiscal policy at themacroeconomic level may weaken as a result. The state and local governments may notvoluntarily coordinate their responses to external and internal shocks. They may start costly andsuboptimal strategic behavior based on the expected behavior of the others. With some states,for example, spending at unsustainable levels, rather than generating compensatory savings otherstates may advance their own expenditures in order to avoid losing resources through higherinflation rates. The net effect may be even higher rates of inflation.

2.86 The state and local governments may face other difficulties managing external exposure.Their external creditworthiness may be lower than the Federal Government's and, hence, theircosts of hedging may be higher and their access to hedging markets lower. This would also makeoverall risk management more difficult to achieve.

G. Policy Recommendations on Oil Price and Other Commodity Risk Management

1. Using Externally-Traded, Market-based, Commodity Price-linked RiskManagement Tools

2.87 Nigeria should explore the possibilities of developing a risk management program forNNPC and/or its subsidiaries and trading companies. Other oil exporters (e.g., Colombia,Venezuela, Mexico) are moving in this direction. The first step should be the removal ofinstitutional barriers impeding the implementation of appropriate risk management strategies.Unlike Venezuela's and Mexico's national oil companies, NNPC is not a fully capitalized entityand is not legally authorized to undertake financial operations, including hedging activities.Presently, for all sorts of financial operations NNPC has to consult and obtain the approval ofthe Treasury. Once these obstacles are removed, a risk management program should consist oftwo parts, short-term and medium/long-term. Short-term, transaction-oriented oil price riskmanagement (using futures and options) should take place in NNPC (or its trading companies)under guidelines established by the Government. Experiences of the World Bank in othercountries (e.g., in Algeria, Colombia, and Costa Rica) have shown that sufficient lead time-totrain people, develop the institutional framework, put computer systems in place, etc.-would berequired. Medium-term oil price risk management should initially involve two- to three-yearswaps. Later on, long-term oil price-linked financing could be developed. It is recommendedthat an appropriate institutional framework be developed first. An example of the use of optionsto secure financing is the transaction by the Algerian state oil company, Sonatrach, which isdescribed in Box 2.2.

2.88 Policies aimed at developing the use of market-based hedging instruments should also takeinto account the domestic private sector. Although the private sector is not heavily involved inupstream activities, the Government could insure that domestic marketing arrangements involveas few distortions and are as close as possible to a free-market system. Also, the Governmentshould, in its efforts to redesign the domestic legal system, develop an effective domesticcontracting system, so that, among other things, domestic fixed price contracts between privateparties can be enforced. This will likely assure that the exposures to commodity price risks aretransparently allocated and will provide the best incentives for private agents to be involved in

49

Box 2.2: Sonatrach's Financing Using Crude Oil Options

An example of the use of long-dated commodity options to secure financing on favorableterms is the 1989 financing by Sonatrach, Algeria's state oil enterprise. Sonatrach entered into aconventional loan agreement ($100 million, seven-year maturity floating-rate loan) with a syndicateof banks. In addition, it entered into a series of oil-options transactions with the lead bank of thesyndicate. Under the options transactions, Sonatrach will have to pay the lead bank certain amountsduring the coming two years if the price of oil rises above prespecified ceilings. Since Sonatrach'srevenues will also increase if the price of oil rises, it can cover these additional costs from its exportearnings. The lead bank was able, in a series of separate transactions with the syndicate of banks,to use the value of the options to keep the cost of the conventional loan down to one percent overLIBOR, which was significantly below the expected cost of funds for Sonatrach without the optionsscheme. Sonatrach's arrangement implies that it sold some of the upside potential in its oil revenuesin exchange for an immediate reduction in funding costs, thereby reducing the vulnerability of itsrevenues to oil price fluctuations.

commodity risk management using market-based instruments.

2.89 Similarly, the Government may encourage the use of externally traded short-termcommodity price-hedging tools, such as options and futures, and other contingent financingvehicles, most notably longer-dated oil and mineral price-linked financing, on a well-consideredbasis.

2. Considering the Basic Elements for the Creation or an Oil Stabilization Fund

2.90 One of the key motivations for the creation of an oil stabilization fund is that ifgovernment expenditure simply reflected current perceived permanent income based on currentoil price levels this would likely imply a very unstable expenditure path. In turn, given that theGovernment is a large actor in the economy, relative prices would be unstable and there wouldbe a highly variable real exchange rate.

2.91 Furthermore, if the Government sets budgets simply on the basis of income at current oilprice levels there will be a relatively high probability of oil-related revisions to the budget. Inturn, this will have an effect on private investment and resource allocation decisions.

2.92 There is a strong presumption that over and above any benefits from pure smoothingthere will be high benefits to stabilization to avoid adjustment costs due to resource allocationsin the face of relative price fluctuations and budgetary revisions.

2.93 In practice, oil prices display very high serial correlation and nonstationarity cannot berejected on statistical grounds. This implies that the pure microeconomic benefit from smoothingmay not be very large. However, the arguments presented above make a case from adjustmentcosts for a stabilization fund, even if oil revenues do not converge to a long-run mean, and evenif all agents face no microeconomic costs (agents are risk neutral).

2.94 A stabilization fund should be seen as one possible technique to be employed to(a) stabilize the budgetary process and (b) promote macroeconomic stability more generally.

2.95 Consistent with the complementary nature that may exist between self insurance andtransferring-risk strategies, a stabilization fund should be seen as complementary to a hedging

50

program, which may also be a useful tool to promote macroeconomic stability. In particular, ahedging program using futures contracts will reduce the uncertainty associated with future cashflows. The use of credit markets and, in particular, a stabilization fund is better suited toreducing known instability of future cash flows. It is also possible that, by hedging, Nigeria maygain further access to borrowing possibilities, i.e., liquidity constraints may be relaxed. In theseways, hedging and a stabilization fund are complementary.

2.96 At the same time, the existence of the stabilization fund may allow a greater use ofhedging instruments. A well-managed stabilization fund, for example, may be partially used ascollateral for a number of financial undertakings. The NNPC could, for example, either issueoil-bonds or simply borrow to obtain resources to finance investment projects. The size of thebond issue or the borrowed resources may be a fraction of the size of the fund. To guaranteeperformance, the bond issue or the borrowing may be complemented with a swap arrangementwith similar or close maturities and payment dates as the bond or the loan. Similarly, thestabilization fund may be seen as the fund to guarantee payments on margin calls on futuresdealings. Alternatively, the payments in and out of the fund could be seen as at least partlyfinanced by the margin receipts and margin calls on a futures position. A conclusion of thisreport is that some consideration should be given to the joint analysis of hedging programs andstabilization funds.

2.97 The optimal size of the fund will depend critically on the objectives of the fund. If theobjective of the fund is solely to enhance the credibility of the government budget, the size of thefund can be determined by an assumed acceptable probability of budgetary revision. If theobjective of the fund is also to stabilize government expenditure and, hence, the real exchangerate, there will be a trade-off. A large fund may yield a greater degree of stability and, hence,lower adjustment costs, but it may imply greater funds being tied up as, say, savings in foreignassets. An optimum steady-state size of fund may be found depending on assumed values ofadjustment costs and the process for oil revenues.

2.98 A further justification for a stabilization fund is that it can impose an optimal spendingrule for oil revenues when different groups (e.g., the states of Nigeria) lobby for a share of anywindfall oil revenues. In other words, the stabilization fund implies a constitutional rule that cancounter political pressure from competing groups to spend too great a share of any windfall and,hence, it can help prevent an inefficient level of savings.

2.99 In practice, the stabilization fund for copper revenues in Chile has been successful at(a) resisting the pressure for increased expenditure at times of higher than trend copper prices,(b) enhancing the credibility of the government budget, and (c) to some extent at stabilizing thereal exchange rate. It has not been so successful at promoting macroeconomic stability as savingshave not been sterilized and increased savings have been accompanied by higher monetaryexpansion.

3. On Contractual Arrangements and Diversification Strategies

2.100 NNPC can reduce its cost and price risks exposure by reducing its stake in the jointventures by selling equity shares to companies. In addition, this strategy would reduce its callcommitments, which Nigeria has had difficulty in meeting recently. NNPC can also move toproduction-sharing arrangements so that the full financial burden for upstream activity and priceand risks costs are borne by operators.

5S

2.101 Within the sector, Nigeria can diversify by improving its capacity to export refinedpetroleum products which is very limited at the present. The country's abundant natural gasresource base also offers a viable option for diversification. Diversification out of the oil sectorshould not be pursued directly. This should come as a by-product of a well-considered generalmacroeconomic policy, including the use of risk-management instruments, that stabilizes the realexchange rate at a competitive level. If this is attained, the development of tradables other thanoil has a high probability. Finally, given the country's comparative advantage in oil,diversification should not be achieved at the expense of the oil sector.

I

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CHAPTER III. CURRENCY AND INTEREST RISK MANAGEMENT

A. Introduction

3.1 Nigeria's external risk exposure is not limited to the oil sector. At the end of 1993,Nigeria's stock of external debt stood at US$28,05 billion, of which US$23.6 was managed bythe External Finance Department of the Federal Ministry of Finance and Economic Development(FMF), and the rest by the Central Bank of Nigeria (CBN) (promissory notes). A significantfraction of this debt is denominated in currencies other than the US dollar-and some is interest-variable-which expose the economy and the public sector to significant risks. For example, ofits total debt stock of approximately US$35 billion in 1991, more than 60 percent was incurrencies other than the US dollar. Given this high proportion of non-US dollar debt, Nigeria'sdebt-service obligations in US dollar terms are highly sensitive to cross-currency fluctuations.Unanticipated changes in exchange rates will have adverse impacts on debt servicing wheneverthere is an imbalance between the change in the value of assets and liabilities resulting from theseunanticipated changes. Since the currency composition of Nigeria's debt is diversified (seeFigure 1.3, Chapter I), but its inflows from oil receipts and net trade are mostly denominated inUS dollars, Nigeria may have an imbalance and, thus, be exposed to exchange rate risks.

3.2 At the same time, there is another source of risk associated with debt management. Thiscan arise as a result of fluctuations in the interest rates. More than 30 percent of Nigeria's debtis variable interest rate debt. In absolute terms, the interest exposure is large. A 1 percentincrease in the world interest rate implies a change in total debt service of about US$100 milliona year. However, as explained below the analysis of interest rate risk should not be based on thenominal amount of variable rate debt only. Account should also be taken of the movementbetween the interest rate (e.g., LIBOR) and the export earnings. As shown in Chapter I, cross-currency exchange rates and interest rates have become much more volatile during the past twodecades. Particularly in the second half of the 1980s exchange rate variations played a major rolein the rapid increase in Nigeria's external debt stock and its debt burden.

3.3 The purpose of this chapter is to discuss some options for the management of Nigeria'sexternal risks associated with cross-currency exchange rate and interest rate fluctuations. TheFMF manages the bulk of the Government of Nigeria's external liabilities. The management ofreserves in Nigeria is delegated to the CBN which, in addition, manages some parts of Nigeria'spublic liabilities. This chapter discusses these in sequence.

B. Government of Nigeria's Liabilities

3.4 The bulk of the Government's liabilities-about US$23.6 billion as of December 31,1992-are managed by the External Finance Department of the FMF. External risks on this debtare large. For example, in 1991, when the total sock of debt stood at US$33.2 billion, about70 percent was in non-US dollar liabilities (with yen and pound sterling liabilities accounting formore than one third of such non-US dollar liabilities). The other, lesser, source of risk is onaccount of fluctuations in interest rates, with variable interest rate loans accounting for about32 percent of total long-term public liabilities.13

3 1991 is the last year we have reliable data on this type of debt composition.

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1. Data Availability

3.5 Any effective management of Nigeria's overall external assets and liabilities requires firsta close examination of the timing and currency composition of foreign exchange inflows into thecountry. Nigeria's export earnings are primarily from oil revenues. Non-oil revenues are largelyfrom manufactured goods.' The Trade and Exchange Relations Department of the CBN hasthe mandate to monitor non-oil external trade-related transactions in Nigeria. The Governmentfeels that its data on non-oil revenues are not fully satisfactory and has, therefore, set up an inter-ministerial committee to examine how the data-reporting mechanism for Nigeria's non-oil exportrevenues could be improved. So far there has been limited progress on this front, partly due toincomplete attendance at committee meetings, even though appropriate invitations are sent out tothe relevant government ministries.

2. Exchange Rate Risk

3.6 Exchange rate risks-unanticipated changes in exchange rates-can lead to adverseimpacts when exposures of assets are not balanced with exposures of liabilities, where exposuresare defined as the respective changes in the value of assets or liabilities at a future date withrespect to unanticipated changes in the various exchange rates. Nigeria's debt contains a largeshare of non-US dollar debt and may therefore appear to be imbalanced with respect to currencycomposition. However, such an imbalance can be established only when debt composition iscompared with the net foreign inflows available to service debt.

3.7 One comparison is on a cash flow basis. Much of Nigeria's inflows from oil exports aredenominated in US dollars, and most non-oil exports are likely in US dollars, with perhaps someyen, deutsche mark and British pound receipts.' Cash outflows for imports are morediversified, but here too the US dollar most likely dominates. As the currency composition ofnet trade (exports minus imports) is very different from the currency composition of debt, Nigeriamay have an imbalance and consequently an exposure to exchange rate risk.

3.8 A second comparison could be on the basis of trade direction, i.e., export destination andimport origin. When a country is a net exporter to a creditor country, it is likely that anappreciation of the exchange rate of the creditor country will imply more overall exports, andvice versa. Matching trade direction and currency composition of debt may then be sensible sinceit provides a match between debt-service obligations and capacity to pay. Note that the directionof a country's trade does not need to match the cash-flow composition, since, for instance,commodity exports may be denominated in US dollars and not in the currency of the tradingpartner. Table 3.1 shows that the cash-flow composition indeed does not match the direction ofNigeria's trade. Much of the non-oil export earnings and import expenditures are to or fromnon-US dollar countries. It can, however, be expected that most (non-oil) exports and importsare denominated in US dollars and not in the currency of the trading partner or the traditionalpricing currency.'

n The export of agricultural products (such as maize and yam) are prohibited, although it is alleged that someleakage from the economy is taking place.

25 This a worldwide phenomenon. Commodity export earnings are most often denominated and received inUS dollars, or at least are US dollar-linked in the short run.

25 It is very likely that the US dollar share in non-oil exports and imports is overstated in the customs reportssince, in the absence of any indication otherwise, US dollars will often be assumed to be the currency ofinvoice.

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Table 3.1: Direction of Trade, Average 1980-91

Value (billions of US$) PercentaeesExports CIF Imports FOB Net Exports Exports Imports Net Exports

Japan 0.04 0.67 -0.63 0.3 8.4 -12.7North America 5.15 0.79 4.36 39.9 10.0 88.3EEC 5.75 4.40 1.36 44.6 55.2 27.5Other 1.95 2.11 -0.15 15.1 26.4 -3.1TOTAL 12.90 7.97 4.93 100.0% 100.0% 100.0%

Source: IMF, DOT and World Bank staff estimates.

3.9 Cash flows and direction of trade patterns are not the only relevant measures when pricesand export volumes (of non-oil exports) are influenced by the exchange rates of Nigeria's maincompetitors. For example, cocoa prices and export volumes (e.g., to Europe) will depend on thebehavior of other competitors (e.g., Ghana), and may thus be negatively influenced by theGhanaian cedi/naira exchange rate. Also, demand factors can influence the relationship betweenprices and exchange rates. These factors are most relevant for primary commodities; prices ofprimary commodities (almost always quoted and often paid in US dollars) are also negativelyrelated to the value of the US dollar.27 This implies that non-US dollar borrowings may providesome hedging potential for Nigeria, since as non-US dollar exchange rates fall so do (non-oil)primary commodity prices and vice versa. However, as non-oil primary exports are minor, thismay be only of limited value to Nigeria.

3.10 While these relationships make the determination of the effective currency compositionof exports more difficult, and may require econometric estimation, it appears that in the medium-term export earnings of Nigeria are largely US dollar linked. Consequently, from a cash flowpoint of view, Nigeria should have a large share of US dollar debt. Its actual large non-USdollar share of external debt thus represents an imbalance. While better asset managementdiscussed above would reduce currency risks on the CBN's liabilities, the net exposures wouldstill remain high given the relatively small size of foreign assets.

3.11 The imbalance in the currency composition of Nigeria's external debt is somewhat moresevere in the near future as relatively less US dollar-denominated debt-service payments will falldue. In 1991, for example-the last year we have reliable data-about 31 percent was US dollarand 69 percent non-US dollar. Over the longer term, however, US dollar-denominated debt-service payments will constitute a larger share. For example, in the year 2000-on the basis ofexisting debt only-the shares of debt service payment will be 46 percent US dollar denominatedand only 54 percent non-US dollar. If the 1991 trend of borrowing a large share of US dollarsis continued, this mismatch will be further reduced. Regardless, Nigeria will need to improveits risk-management techniques.

27 This is because demand is in part from non-US dollar countries. The elasticity is between 0.75 and 1.00.This is however a long run relationship and may not manifest itself in the short run. This relationship doesnot exrst for the oil price.

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3. Interest Rate Risk for the Government

3.12 The analysis of interest risk should not be based on the nominal amount of variable ratedebt only. If nominal interest rates go up because of a worldwide increase in (expected) inflation,and real interest rates stay constant, borrowing at a floating interest rate may provide a goodmatch between (nominal and real) debt service and debt-servicing capacity, since nominal debt-service capacity will rise in line with the inflation rate, i.e., there would be a natural hedge.Borrowing at a fixed rate in such circumstances would not be a good match, since the real ratepaid would go up when the rate of inflation (and debt-service capacity) comes down, and viceversa. However, if nominal interest rates fluctuate because real interest rates fluctuate (i.e., theexpected rate of inflation is not reflected one-to-one in interest rates), with floating interest rates,the borrower takes on some real interest rate risks, while with fixed interest rates it is the lenderwho does so. In addition, the long-run effect of interest movements can be different from theshort-run effect. A nominal interest rate increase that is matched by an increase in the inflationrate can still create a liquidity problem (and possibly debt-servicing difficulties), especially fora country that is credit constrained.'

Interest Rates and Export Prices(Percentage Changes)

300 -

250 -

200-

1 50

1 00

-501966 1971 1976 1981 1986

Export Prices - Interest Rates

Figure 3.1

3.13 This implies the need to analyze the joint movement of interest rates (e.g., LIBOR) andexport prices to determine whether Nigeria has a natural hedge against interest rate changes.

2 Consider the case where the nominal interest rate goes up from 8 percent to 10 percent because of a rise ingeneral, long-run inflation rates of 2 percentage points (real interest rates remain thus constant). Assume thatthe debt-to-export ratio is 100 percent and that all debt is on a variable interest basis. The rise in interestrates will not cause net real wealth of the borrower-the NPV of export earnings minus the NPV of debtservice-to change, since the real interest rate and real exports earnings will remain constant. It will cause,however, the nominal interest bill to rise by 25 percent. Initially, nominal exports will increase little (byonly 2 percent in the first year) and the interest-to-export ratio will thus rise from 8 percent to 9.8 percent(10/1.02), a significant increase in the short-run cash-flow burden. Over time, the debt-service capacity willgo up by the rate of inflation, and since the real interest rate has not changed, there will be no increase inthe long-run debt-servicing burden.

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Figure 3.1 plots the behavior of LIBOR and export prices for Nigeria for 1965-88. As can beobserved, export price changes and LIBOR rates do move together, indicating the presence ofsomewhat of a natural hedge (i.e., LIBOR and export prices (and earnings) have a positivecorrelation (0.75 in levels and 0.21 in percentage differences). This result is robust to most oil-exporters: their terms of trade and international interest rates are positively related.2' The oilshock of 1973/74 and worldwide tight monetary policy in the early 1980s are periods when apositive relationship between LIBOR and export prices is the least evident.

3.14 Because there is some correlation between LIBOR and export price movements, Nigeriahas something of a natural hedge and less of an exposure to interest rate changes. It should thushedge less of its interest exposure on its non-CBN liabilities than the nominal amount of debtwould indicate. While it is difficult to give firm indications how much value the natural hedgehas, it would appear that (assuming the CBN hedged the floating rate promissory note) no furtherhedging would be required. In that way, the Government will hedge all its interest exposures.'

4. Recommendations On FMF Liability Management

3.15 Given the above factors, the FMF should consider the following improvements in themanagement of its external liabilities:

a. Currency Risks on the Government Debt

3.16 For new financing the Government should diversify funding sources as a method ofimproving the currency composition of net liabilities. It should actively seek to diversify itsborrowings away from non-US dollar-denominated loans toward US dollar-denominated loans andother types of borrowings. For its stock of outstanding debt, the Govermnent should considerthe use of currency swaps and other currency risk-management tools (including forwards andlong-dated currency options). This risk-management work will be more complex, may requireinstitutional changes and training, and should thus be considered a long-term option."

b. Interest Rate Risk on the Government Debt

3.17 To the extent possible, the Government should increase its share of financing borrowedat fixed rates. The Government should use interest rate hedging tools to manage its interest rateexposure. Even though asset (reserve) management can be used to mitigate interest rate risks (seeabove), this will be insufficient. Tools such as interest futures and swaps will have to be used.As with currency futures and swaps, this work should be considered a longer-term option.

29 The correlation coefficient for aU oil producers is 0.73 in levels and the t-statistic from a bivariate regressionin levels is 5.337. For Nigeria, the correlation coefficient is 0.68 in levels, 0.16 in first differences, andthe t-statistic from a bivariate regression in levels is 4.3.

3° Real interest exposures cannot be hedged directly-no instruments for this purpose exist in internationalmarkets. But, it may be possible to hedge the real interest rate exposure by hedging its constituentcomponents, i.e., by hedging interest risk and commodity price risks separately (see the previous section).

31 Any risk management wiU need to be integrated with the other borrowing activities of Nigeria, because ofthe obvious identical information requirements and strategic interactions. But, also because currency swaps(and other liability-management operations) can involve a reduction of available commercial financing, sincethey require the foreign commercial bank to allocate capital (as under the Basle (BIS) guidelines).

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C. Central Bank Assets and Liabilities

1. Assets

3.18 The Board of Governors of the CBN has broad responsibility for setting reservemanagement policies. The Foreign Operations Department (FOD) of the CBN has actual day-to-day responsibility, within the policy parameters set by the Board. Strategic decisions on reservesmanagement policies are made relatively infrequently by the CBN, with most key parametersdecided on an ad hoc basis (as compared with annual or even monthly meetings and decisions inmany other central banks). The goals of reserves management are largely determined byliquidity/cash flow needs and security. Profitability plays a lesser role.

3.19 The Central Bank's holdings of assets stood at US$0.7 billion at the end of 1993 downfrom more than US$4 billion during 1990-91. The composition of reserves as of July 1992 isshown in Table 3.2.

3.20 Consistent with the relative Table 3.2: Central Bank Reservesimportance of the liquidity and security (In '000s)objectives, most of CBN's reserves areinvested in very short-term and liquid assets, July 1992

i.e., government securities, highly rated us dollars S324,730

commercial bank deposits, and other secure DM $22,038assets. The average maturity of the reserve UK pounds $859,899portfolio is about one month, with a FF $1,076maximum of about three months. Reserves Yen $1,492are also diversified across a large number of Other $6,616currencies ($, pound, DM, yen, French franc, Gold/SDRJIMF gold tranche $607,902ECU, and Swiss franc). Counter-trade/escrow/attached $42,082

assets

3.21 The Nigerian authorities do not Miscellaneous $2,762,013actively manage their gold reserves or enter Total reserves $4,627,848into foreign exchange hedging operations.Most of the foreign exchange trading is done source: CBN and World Bank staff estimates.

in the spot market. No matching of foreign Note: Converted into US dollars using the average

exchange inflows and outflows is conducted. central rate for July 1992 of N 18.4379/US$.

In limited cases in the past, the ForeignOperations Department of the CBN hasentered into forward contracts on foreign exchange rates. These forward contracts have not hada maturity of more than 18 months. However, commercial banks which are authorized toconduct foreign exchange transactions (via foreign exchange-denominated "domiciliary accounts")appear to be actively managing their foreign exchange denominated portfolios, often with the usefor forward contracts. But this can only be done with prior approval from the Trade andExchange Department of the CBN.

2. CBN Liabilities

3.22 The CBN's liabilities consist mainly of promissory notes, about US$4.44 billion at theend of 1993. The CBN faces interest and currency risks on these liabilities as they are based onfloating interest rates, and to some extent non-US dollar debts.

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3. Data Availability

3.23 Information important to reserves and liability management comes to the FOD from theResearch, Debt, and Trade and Exchange Departments, often, however, in a manner that makesreserves management difficult for the FOD. For example, the FOD is notified only one weekin advance of the due date of debt service payments. Other data does not reach FOD on a timelybasis either.

4. Risk Management

3.24 The most straightforward way for the CBN to manage the risk on its liabilities is to useits reserves. The average size of foreign reserves (about US$2.8 billion over 1980-91) shouldallow the CBN to use some part of its reserves to match the structure of its liabilities and therebyreduce interest rate and currency exposures of its liabilities. This can be done in two ways:through dedication of cash flows or through duration matching.

a. Dedication: Cash Flow Matching

3.25 The concept of a dedication strategy, matching the cash flow structure of assets withliabilities, is derived from practices followed by major international corporations and commercialfinancial institutions. Its appeal lies in fully protecting the entity's balance sheet and income frominterest rate or currency fluctuations. If the size of assets were stable and roughly equal to thesize of liabilities, and if the currency composition and interest rate structure of assets matchedroughly exactly that of liabilities, the portfolio of liabilities would simply be a source of liquidityfunded by floating rate borrowings, with a carrying cost equal to the difference between theentity's borrowing costs and the available rate of return on investment (e.g., if the marginal costof borrowing was 0.75 percent above LIBOR and the rate of return was LIBOR minus0.25 percent, the cost of carrying would be simply 1 percent).

3.26 In theory, the same approach is extendible to reserves (assets) management by a centralbank such as the CBN. However, there are some major difficulties. First, the identification ofvarious assets and liabilities may not be completely possible. Second, the future assets andliabilities are both subject to great uncertainties, especially in an open capital account economy,and potentially major fluctuations due to factors outside the immediate control of the CBN.Third, the availability of appropriate assets in the desired maturities would be a problem.Consequently, the concept of matching assets with liabilities as a way to manage reserves andthereby reduce interest rate and currency fluctuation risks is of only limited value to a centralbank reserve manager.

b. The Duration Matching Strategy

3.27 The CBN should instead manage its reserves on the basis of a (modified) durationmatching strategy, which would permit far more flexibility than a dedication hedging strategy.It would involve matching-as well as possible-the (modified) duration of assets with that ofliabilities, differentiated by each currency and periodically balanced, especially if the liabilitystream is altered. Duration matching involves assuring that changes in the market value of assetsas a result of changes in interest rates are offset by equal changes in the market value of

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liabilities.32 From a consolidated public sector perspective, duration matching will assure thebest protection against the effect of interest rate movements on the CBN's net asset value.Matching the currency composition of reserves with that of liabilities will reduce overall currencyrisk. It is a much more attractive objective than the current policy of general currency andinstrument diversification, which leads to mismatches between assets and liabilities.

3.28 The recommended practical approach to achieve this duration matching strategy mightbe to treat separately the (new) commodity stabilizationfund, which is unlikely to be drawn downin the very near future; and treat the remaining part of reserves as a short-term portfolio to beused for short-term liquidity needs, such as for debt service, fluctuations in foreign exchangedemands and imports, and other needs. The (new) commodity stabilization fund would beinvested in marketable securities with longer maturities and remain a secure and easily liquidatedsource of financing in the event of exceptional circumstances, such as in the event of largeadverse balance of payments developments as a result of oil price drops or sudden capitaloutflows. The short-term portfolio would be invested in short-maturity instruments, such as time-deposits largely of less than one month maturity.

3.29 Management of the short-term reserves portfolio can be improved by allowing a broaderrange of instruments to be invested in or used.33 Adding more instruments could enhance yieldand limit exposures to banks. Furthermore, forward and option contracts can be used to managemore efficiently foreign currency transactions, and can also lead to an improvement in return(through hedged investments). The short-term portfolio can be managed independent of strategicALM considerations and, as such, has some more flexibility for its risk/return tradeoffs. Thisincrease in flexibility of risk/return tradeoffs has both advantages and disadvantages and wouldrequire closer supervision and adequate monitoring procedures and systems.

3.30 The CBN may want to consider using gold swaps, forwards, and loans to obtain a betterreturn on its gold holdings. After careful analysis, including custodian arrangements, the CBNcould enter gold transactions with other countries' central banks, the Bank for InternationalSettlements (BIS) and, possibly, commercial banks. The CBN should be able to earn a goldreturn of about 1-2 percent with these measures.

5. Recommendations on Central Bank Reserves and Liabilities Management

3.31 The main recommendations on reserve management are thus that the CBN should(a) make much greater use of its reserves to match its liabilities as a tool for risk management;(b) seek to improve the returns to its reserves; and (c) improve its information systems (and stafftraining).

n Duration is derined as the weighted average maturity of an asset or liability, where the weights are definedwith respect to the effects of movements in the yield curve on the present value of each payment falling due.Note that duration matching is most effective in the event of parallel yield curve shifts. Mismatchedconvexities, or second order differentials, will matter in the event of non-parallel yield curve shifts, but aregenerally of smaller order than that arising from mismatched durations.

's In particular, US and other government securities; SDRs; highly rated commercial bank bonds; commercialpaper of supranational (e.g., the Swiss franc note program of the World Bank) or of the highest credit privatccorporations with adequate liquidity; discount notes; Euronotes; CDs; and bankers' acceptances should alsobe considered as investment vehicles.

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CHAPTER IV: INSTITUTIONAL AND INFORMATIONAL ISSUESFOR EXTERNAL LIABILITY MANAGEMENT

A. Introduction

4.1 This chapter primarily addresses three issues that are related to improved external liabilitymanagement by the Government of Nigeria: (i) the Government's external debt managementpractices, especially the institutional structure within the Government for making decisionsregarding the country's existing external debt and future external borrowing strategy; (ii) thecomposition and management of the external liabilities of the parastatal sector, and the stategovernments in Nigeria, along with their linkage to the fiscal budget of the Federal Government;and (iii) the procedures for the issuance of sovereign guarantees on external borrowing, onlending of external loans, and the possible assumption by the Government of interest rate andcurrency risk associated with external borrowings by the parastatal enterprises and stategovernments. In so doing, policy recommendations are provided for the streamlining of theinformation flow between the different entities in the Government, including the states, that arein any way related to the recording and monitoring of Nigeria's external debt and debt servicepayments and its external assets. In addition, the influence of the external payments obligationsof the state governments on the fiscal budget of the Federal Government due to the contingentliability associated with these publicly guaranteed external loans is examined.

4.2 The first step toward effective strategic external liability management is to examine theinstitutional and legal framework governing the management of Nigeria's external liabilities andthe adequacy of the existing structure of debt reporting and management. This is provided inSection B. Section C provides a discussion of the issues of relevance to macroeconomicmanagement of Nigeria's external debt. This includes discussions of the Government's currentoverall strategy for debt-data management, the use of the Stabilization Account of the FederalGovernment in making external debt-service payments and the procedures for the issuance ofgovernment guarantees, on lending of external loans. The role of the parastatal enterprises andstate governments in the context of Nigeria's external debt- management strategy and thecontingent liability of the Federal Government associated with guaranteed external borrowingsby the state governments, the parastatal sector, and the commercial banks are evaluated in SectionD. Policy recommendations for the improvement of the institutional structure for external asset-liability management in Nigeria are provided thereafter.

B. Institutional and Legal Structure for External liability Management

4.3 An assessment of Nigeria's exposure to external shocks will not be complete without athorough examination of the country's institutional constraints in the area of external debtmanagement. In particular, it is necessary to have procedures and guidelines in place for entitiesin Nigeria to acquire external financing in a transparent and systematic fashion. In addition, thepolicymakers should be able to make informed decisions about the magnitude of their expectedexternal payments obligations in the medium term and whether that level is sustainable. Thisrequires that a system be in place for recording and monitoring external assets and liabilities.Relevant information should be shared between the different entities in the Government, tosupport the formulation of a coherent external liability-management strategy (i.e., to answerquestions such as: who should borrow, how much, and using what form of financing). In this

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section a comprehensive evaluation of the legal and institutional framework that governs themanagement of external assets and liabilities in Nigeria is provided.'

1. Legal Framework

4.4 The Federal Government circular entitled "External Borrowing Policy" (February 1988),outlines the strategies for increasing foreign exchange earnings that will be encouraged by theNigerian Government, and sets out the criteria for external borrowing and the mechanics forservicing external debts (public and private) that are incurred by Nigerian entities. It alsooutlines the roles and responsibilities of the various organs of the federal and state governmentsas well as the private sector in the management of external debts. The circular stipulates criteriafor contracting external loans in Nigeria, which include the requirements that: i) projects in theeconomic sector should have positive internal rates of return, which are at least as high as thecost of the external borrowing, while projects in the social services and infrastructure sector willbe ranked by the Government on the basis of cost-benefit ratios; ii) externally financed projectsmust be supported by feasibility studies; and iii) international capital market financing is preferredfor quick-yielding private and public sector projects, while concessional financing is preferredby the Government for social services and infrastructure projects.

4.5 The two primary governmental bodies that are involved in all foreign exchangetransactions in Nigeria are the FMF and the CBN. State governments, parastatal enterprises, andprivate corporations must obtain prior authorization from the Federal Government for any newexternal borrowing (whether guaranteed or nonguaranteed by the state). All states and parastatalenterprises should borrow externally only after obtaining sovereign guarantees from the FederalGovernment. But these are not legal stipulations under Nigerian law, merely guidelines issuedby the Federal Government that should be met by Nigerian entities when contracting externalloans.

4.6 The relationship between the FMF and the CBN on external debt-management issues isstipulated in The Central Bank of Nigeria Decree No. 24 (1991). According to Section 34 of theCBN decree, the issuance and management of federal government public debt (external anddomestic) has been entrusted to the CBN. The CBN has been given the mandate to administerall private nonguaranteed loans contracted from abroad. There are no limits set by the authoritieson the total amount of private nonguaranteed debt outstanding at any point in time. In addition,the CBN is responsible for the management of the Debt Conversion Program of the FederalGovernment, which was launched in July 1988. A Debt Conversion Committee, chaired by theGovernor of the CBN is serviced by a secretariat that has been set up as a special unit within theCBN.

4.7 All loan agreements with external creditors must be discussed with the FMF and the CBNprior to commencement of formal negotiations. In the case of external loans that have beenguaranteed by the Federal Government, prior notification of drawdowns on committed loans mustbe provided to the FMF by both creditor and debtor. State governments and parastatalenterprises may draw down on existing commitments as the need arises, but should immediatelysend copies of instructions after such drawdowns to the FMF. There is no such specificstipulation in the case of private nonguaranteed external loans.

34 This section relies on the findings of the joint Bank-Commonwealth Secretariat Needs Assessment missionthat was in Nigeria at the same time as this macroeconomic risk mission. Their findings are reported in thedraft Commonwealth Secretariat Report entitled Debt Management and Management Systemfor the CentralBank of Nigeria, November 1992.

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4.8 The naira equivalent of debt-service payments due on pre-SFEM obligations andtransactions covered by rescheduling agreements must be deposited direcdy to the CBN by theStates and parastatal enterprises or by debiting their accounts with the CBN.35 When it was inoperation, all other external debt-service payments by the public sector entities had to be madethrough the foreign exchange market (FEM). The Federal Government reserves the right todeduct the naira equivalent from the state governments' shares in the Federation Account and thebudgetary allocations for parastatal enterprises. In the case of loans that are onlent by the FederalGovernment to state governments, debt service payments may be deduced from the statutoryallocation and paid to external creditors by the FMF. In the case of external loans incurred bythe Nigerian private sector, export-oriented private firms can make their payments directly outof their foreign exchange export earnings while others had to utilize the FEM-when it was inoperation-to obtain the necessary foreign exchange to make such scheduled debt-servicepayments to their external creditors.

2. Organizational Structure

a. Federal Ministry of Finance and Economic Development (FMF)

4.9 Figure 4.1 shows the organizational chart of the FMF. Relations with the World Bankand the IMF are the responsibility of the Multilateral Department of the FMF. All external loansand grants given directly to the Federal Government of Nigeria (i.e., official bilateral assistance),except for those from the World Bank and the IMF, are negotiated and monitored by the ExternalFinance and International Aid Department (EFIA) of this Ministry. EFIA maintains records ofall external contracts, agreements and other legal documents relevant to foreign aid transactions,and is responsible for liaising with donor governments and their agencies other than the WorldBank and the IMF. It is supposed to make sure the external financing comes in and projectedcommitments and disbursements are taken into account in the balance of payments projections ofthe CBN. Local currency implications of such financing are, in turn, incorporated into theFederal Government's annual fiscal budget. Negotiations with official bilateral creditors arehandled by this Department. The Office of the Accountant General of the Federation in the FMFhas to authorize all debt service payments on PPG debt as they fall due prior to theirexternalization by the CBN.

4.10 There are no explicit ceilings on official bilateral loans that can be contracted by each ofthe ministries and state governments in Nigeria. A determination as to what external loans willbe contracted and negotiated is made on a case-by-case basis at the FMF in consultation with theOffice of the President and his Cabinet. When the EFIA negotiates with official creditors loansthat will be on-lent to a particular parastatal (or group of parastatals), representatives of each ofthe relevant parastatal enterprises also participate in the negotiations. The EFIA also has themandate to manage publicly guaranteed debt contracted by the parastatal sector in Nigeria as well

M Pre-SFEM Obligations. Prior to the introduction of the FEM, whose auctions were reinitiated in December1990, Nigerian private sector firms deposited naira to the CBN in order to make extemal debt-servicepayments. The nairas were to be converted to the required foreign currencies at the exchange rates prevailingat the time. These local currency debt-service payments by private firms were acocepted by the CBN, butwere not externalized due to the foreign exchange difficulties that were being experienced by the CBN atthe time. The Government, however, took over the responsibility of making these extemal debt-servicepayments at a later date on behalf of the final borrower. Meanwhile, the naira was devalued (by 40 percentin March 1992) and arrears have accumulated on the outstanding debt-service obligations. The FederalGovemment is bearing the foreign exchange cost associated with these pre-SFEM obligations. Data providedby the CBN show that US$185 million of pre-SFEM and dedication account arrears were outstanding as ofend-1992.

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Organizational Chart or the Federal Ministry or Finance

MINISTER OF FINANCE

DIRECTOR GENERAL

EXTERNAL FINANCE & FOREIGN ACCOUNTANTINTERNATIONAL AID MULTI- EXCHANGE GENERAL

DEPARTMENT LATERAL & TRADE OF THEDEPARTMENT RELATIONS FEDERATION

DEPARTMENT

DEBT AFRICA & INT. DEVELOP- ECONOMIC TREASURYMANAGEMENT BILATERAL CAPITAL MENT AID AFFAIRS DEPT.DIVISION DIVISION MARKETS DIVISION DIVISION

I ~~~ I|DEB T ||DEBT RE- | CI I 1 CM ||MULI T- MULT-SE S

IIDATA I STRUCTURING |BRANCH 11 |BRANCH 2 1 LATERAL IILATERALI| BRANCH| BRANCH I (STATES)| (FEDERAL) |BRANCH 11 |BRANCH 11|

I I ~~~~~~~~~~~~~(WB) II(IMF)I

Figure 4.1

as external loans and grants given directly to the Government of Nigeria. It is also responsiblefor liaising with the other departments of the Ministry of Finance as well as the Central Bank.

4.11 The EFIA Department of the FMF is broken down into five divisions, namely:

* the Debt Management Division (DMD)* the Africa and Bilateral Division (ABD)* the International Capital Markets Division (ICM)* the Development Aid Division (DAD), and* the Economic Affairs Division (EAD)

4.12 The DMD, which includes the Debt Data Branch and the Debt Restructuring Branch,maintains records of all public and publicly guaranteed debt owed to creditors abroad. Inparticular, it is responsible for maintaining data on a) all external borrowings by the FederalGovernment, and b) state government borrowings and external debts of the parastatal enterprises,with or without sovereign guarantees from the Federal Government of Nigeria. Data on theexternal borrowings by the private sector are also maintained in the DMD, although their primarysource is the Debt Management Department in the CBN. The Debt Data Branch of the DMDmaintains the newly established (in May 1991) Commonwealth Secretariat Debt Reporting andManagement System (CS-DRMS), Version 5. The DMD also processes debt-service paymentson all public and publicly guaranteed debt except those owed to the IMF and the World Bank.Input is also provided by the DMD in establishing and reviewing policies on new externalborrowing; and in fulfilling the queries of end-users of the debt database. The DMD of the EFIA

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Department provides the debt-service projections for the Government's annual balance ofpayments projections and information to the Planning Office of the FMF to assist in theformulation of the annual fiscal budget of the Federal Government. It also provides data onpublic and publicly guaranteed debt to the Debtor Reporting System of the World Bank incollaboration with the Multilateral Department of the FMF.

4.13 The ADB is mandated with the task of managing the external debt owed by Nigeria tothe African Development Bank, the ECOWAS, and other official bilateral creditors (includingparticipation in loan negotiations). Public and publicly guaranteed external financing raised bythe Federal Government, state governments and the parastatal enterprises in international capitalmarkets (i.e., commercial loans) are managed by the ICM. Bilateral aid is coordinated by theDAD, while the EAD manages UNDP projects. However, once any external PPG loan isconsolidated under a restructuring agreement, its management is transferred within the FMF tothe DMD.

4.14 The fulfillment of Nigeria's exchange control provisions on all of Nigeria's external debt(public or private) is administered by the Foreign Exchange and Trade Relations (FETR)Department in the FMF. Any private firm that is negotiating an external loan (even if it is notguaranteed by the Federal Government) must seek prior authorization, in principle, from thisdepartment and then proceed with any importation of capital equipment into Nigeria. TheTreasury Department of the Office of the Accountant General of the Federation must provide themandate to the Central Bank to execute foreign exchange transactions related to Nigeria's publicand publicly guaranteed debt.

b. The Central Bank of Nigeria (CBN)

4.15 Foreign exchange related issues are handled by three departments within CBN, namely,the Debt Management Department, the Foreign Operations Department, and the ResearchDepartment. Figure 4.2 shows the existing overall organizational structure of the DebtManagement Department of the CBN, which has the mandate for managing Nigeria's MLTprivate external debt and short-term obligations. This consists of promissory notes, par bondsthat were issued in the context of Nigeria's London Club debt and debt-service reductionagreement and short-term debt owed primarily to suppliers.

4.16 The Debt Management Department of the Central Bank (DMD-CBN), which was set upin 1990, has two divisions-the Multilateral division and the Bilateral division-which have beengiven the responsibility for external debt management and recording in the CBN. Thisdepartment was previously a part of the Foreign Operations Department of the CBN. TheBilateral Division of the DMD-CBN is involved in the recording and analysis of data on Nigeria'stotal external debt stock and debt-service payments. It provides regular reports containing debt-service projections and debt indicators to the senior management of the CBN. This division isalso responsible for maintaining data on and managing outstanding promissory notes and foreignexport credit guaranteed short-term debt of the Nigerian private sector. It liaises with the FMFand other Ministries in the Government on external debt-related issues, and, when invited by theFMF, participates in loan negotiations with some external creditors. The Multilateral Divisionof the DMD-CBN processes and administers external loans incurred from Nigeria's officialmultilateral creditors, like the African Development Bank, the IMF and World Bank. A separateUnit within this Division (The SME Apex Unit) manages the US$270 million World Bank Smalland Medium Enterprises Loan, which is onlent to final borrowers in the private sector throughthe domestic banking system.

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Organizational Chart of the Debt Management Department,Central Bank of Nigeria

|DIRECTOR|

DEPUTY DIRECTOR DEPUTY DIRECTOR14JLTILATERAL BILATERALDIVISION DIVISIO1N

EXTERNAL LOANS EXTERNAL DEBT REFINANCING ADMINISTRATIVESME APEX UNIT & GRANTS | STATISTICS OFFICE OFFICE

OFFICE |& STUDIES

Figure 4.2

4.17 The Foreign Operations Department (FOD) of the CBN processes all foreign exchangetransactions in Nigeria. Once a demand notice for debt-service payments on a sovereign debtobligation (PPG) is received by the borrower from its external creditor, approval is sought fromthe relevant division of the FMF that is responsible for the category of loan, followed byexchange control approval from the FETR Department in the FMF. Then a communication issent to the Accountant General of the Federation (Treasury Department), which maintains thenaira account of the borrower in question.

4.18 This account is appropriately debited, and a mandate for externalization of debt-servicepayment is provided to the FOD of the CBN. Unless this mandate is received by the CBN, debt-service payments cannot be externalized, even if the borrower has paid the naira equivalent ofits obligations to the Central Bank. Once the funds are externalized, the Investments Division ofthe FOD-CBN furnishes the Office of the Accountant General of the Federation (TreasuryDepartment) with copies of the letter going to the Director General (FMF), Director of ExternalFinance, Federal Sub-Treasury, and the Deputy Director of the DMD in the EFIA Departmentof the FMF.

4.19 The Research Department of the Central Bank is responsible for producing the balanceof payments projections for its Annual Report and provides input into the formulation of theannual foreign exchange budget of the country for planning purposes. No criticism is made hereof the present structure.

C. External Liability Management Strategy and Issues

1. Overall Strategy

4.20 As mentioned above, external borrowings by Nigerian entities, with or without agovernment guarantee, are approved by the Federal Government on a case by case basis. Nospecific limits on external borrowing are stipulated by the Government to Nigerian borrowers,and no announced rules must be followed when applying for government guarantees. In

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contracting new loans, the availability of external financing is often the most important factordetermining the choice of project to be financed from abroad. Terms of the loan (cost andmaturity structure) are the next most important factor in influencing choice of creditor. To theextent that the availability of external financing from a particular source is an important criterionin the Government's decision to provide government guarantees on a project, the choice ofproject to be undertaken and the currency denomination of the external loan may be implicitlyinfluenced by the source of available financing (even it may not be explicitly tied to the creditorcountry's exports). Experiences of other borrowing countries has shown that the viability ofbalance of payments over the long term is significantly enhanced if financial feasibility analyses(net present value calculations) are carried out at the initial stages of project selection and,thereafter, financing for the projects acquired from creditors abroad. A minimum internal rateof return should be specified in determining which projects would be guaranteed by theGovernment when external loans are solicited for these projects. The current stipulation by theGovernment in the "External Borrowing Policy" circular is too general to insure effective projectselection for obtaining financing from abroad.

4.21 In the case of debt-service payments, the availability of foreign exchange is the mostimportant factor in determining the amount and creditor to whom the debt-service payments willbe made. This, in turn, is heavily dependent on oil revenues. Debt-service payments by theFederal Government on behalf of the state governments and parastatals is crucially dependent onthe amounts determined (on a case by case basis) to be deducted from the Statutory Allocationof the Federation Account and the Stabilization Account in any particular year.'

4.22 Nigeria has successfully lowered the average interest rate (from 6.6 percent in 1990 to6.1 percent in 1991) and increasing the average maturity (from 19 percent in 1990 to 21.7percent in 1991) on new external loan commitments. In the two London Club debt-restructuringagreements, the Government was successful in fixing the interest rate and currency of repaymenton the eligible debt with its external private creditors. In the case of other creditors, theGovernment has made some efforts to fix the interest rate on some external loans, but to no avail.Among the Paris Club creditors, a few loans owed to Denmark and Japan carry fixed interestrates; the rest are variable interest rate loans.

2. External Debt Data Management

4.23 In the area of External Debt Data Recording, the Federal Ministry of Finance initiatedthe process of computerizing data on the country's PPG medium- and long-term (MLT) debt inMay 1991 under the Bank's Economic Management Technical Assistance Project (EMTAP).This consists of the installation of the Commonwealth Secretariat (ComSec) Debt Reporting andManagement System, CS-DRMS, and the concurrent training of staff in the External Finance andInternational Aid Department of the FMF. Progress has been made in this regard with thecompletion of the entering of transaction-level data on Nigeria's MLT external debt owed tomultilateral creditors. The description, terms, and conditions of all loans owed to all creditorshave also been entered into the CS-DRMS at the FMF. Although a ComSec-financed technicalspecialist is providing on the job training to FMF staff on the CS-DRMS, the data recordingprocess is moving slowly, primarily owing to the severe attrition of the staff from the DebtManagement Division in the FMF. While basic loan details on most external loans have been

M Some parastatals, such as NNPC, have becn given a blanket authorization to borrow externaly up to aspecified limit without going for specific approval to the Federal Government for a guarantee. In the caseof some large external borrowings by NNPC, offshore escrow accounts have been set up to ensure timelydebt service and other payments on each of these loans. These escrow accounts are managed by NNPC itself.

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entered in the CS-DRMS, information on transactions (debt service payments, disbursements,reschedulings, buybacks, etc.) remains to be entered into the electronic database. This is acomplex and time-consuming task as there has not been any systematic recording of allcomponents of external debt transactions in the past, so they now require verification from severalentities within the FMF and in the CBN prior to their entry into the CS-DRMS. In addition,there have been three Paris Club reschedulings and three London Club agreements whose effectsneed to be incorporated into the database. The fact that all loan agreements are kept in thedifferent divisions handling different categories of debt, rather than a centralized library of loanagreements and other relevant materials makes this task all the more difficult.

4.24 It is recommended that the division in the FMF that has been given the mandate tomaintain the external-debt data of the Government, i.e., the DMD-FMF, should keep copies ofall external loan agreements and any endorsements to these documents. Under the currentorganizational structure for debt management in Nigeria, this could easily be achieved for newloans by Decree (with penalties imposed for noncompliance). For existing loans this may be adifficult task. Information flow within the different divisions of the EFIA Department of theFMF are slow and sometimes incomplete. For example, when a loan, which was managed byeither the ICM Division or the ADB Division is restructured, its management is transferred tothe DMD-FMF (Restructuring Branch), but there are significant delays in the transfer ofsupporting documents of the loan to the DMD. In this context, the DMD-FMF shouldsystematically maintain copies of all the mandates for external debt-related transactions that itreceives from the Accountant General of the Federation and the responses it receives from theFOD-CBN. In this way, it could keep track of debt service-related transactions on amacroeconomic basis for the country as a whole. Ideally these transactions should be enteredelectronically through a computer network that connects the DMD and the Accountant General'sOffice in the FMF. Backup copies of these entries must be kept in hard copies at the DMD-FMF.

4.25 The situation in the Central Bank, which is responsible for maintaining information onthe country's short-term external debt and that owed to private creditors (promissory notes andLondon Club debt), is somewhat different. The organizational changes within the Central Bankinstituted in September 1991 led to the creation of the Debt Management Division. Theorganizational structure of this division appears to be unduly complex, with an unclear mandatebeing given to its staff. There seems to be an uneven flow of information within the differentunits in this division. This is not helped by the partial relocation of some of the relevantdivisions in the Central Bank and the FMF to Abuja from Lagos. The reconciliation processinvolving short-term debt is a cumbersome and time-consuming one, which is contributing to thebuildup of arrears on Nigeria's external payments obligations.

4.26 The current organizational structure of the Debt Management Department of the CentralBank appears to be unduly complex, with more decentralization than is warranted. The CBN,being responsible for maintaining data on promissory notes, London Club par bonds and post-cutoff date (October 1, 1985) private sector export credits, needs to track all transactions relatedto these categories of debt. Currently, the promissory notes are managed by Chase ManhattanBank (New York) and par bonds are managed by Citibank (New York). Both these firms sendregular detailed reports to the DMD-CBN. The ongoing verification of transactions related toinsured short-term export credits (that are covered under the three Paris Club agreements) thatis being undertaken by the Refinancing Office of the DMD-CBN has accounted for 95 percentof the loans. Once the remaining 5 percent are accounted for this office will be redundant underthe current organizational structure at the DMD-CBN. Some units of the DMD-CBN are doingtasks that are already being performed in the Research Department of the CBN.

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4.27 Officials at the Central Bank have expressed interest in installing the CS-DRMS tocomputerize all its debt records (including those that are already being handled by the DMD inthe EFIA Department of the FMF). It may be prudent to initiate this process by first proceedingwith the computerization of the data on external debts that are the immediate responsibility of theCBN. Thereafter, one could endeavor to link this database with the FMF CS-DRMS, whichcontains data on Nigeria's public and publicly guaranteed medium- and long-term external debt.Standard merger procedures of the CS-DRMS located in different locations already exist in theprogram software. The ComSec computerization project currently being provided to the FMF,and proposed for the CBN, provides for this and technical assistance is available for the purpose.Periodic updating of the database in this manner is recommended. Thereafter, it would bepossible to get accurate information on all categories of Nigeria's external debt at any point intime. Periodic reports, in standard agreed format between the FMF and CBN, could then becirculated among all entities within the Nigerian Government that are involved in any way withexternal debt-related transactions. These reports should be automatically distributed to relevantoffices in the Government, rather than on demand.

4.28 In order to manage the external debt more effectively after the two databases are linked,it would be necessary to ensure that an appropriate institutional structure is in place within theGovernment (in particular the FMF and the CBN) to ensure effective external asset-liabilitymanagement with complementarity of functional units, as opposed to the competitive andsometimes duplicative operations of the respective divisions within the FMF and the CBN.

3. Issuance of Government Guarantees

4.29 In Nigeria, all external loans that are undertaken with a formal government guaranteerequire prior authorization from the Office of the President. There is no overall limit to theamnount of public and publicly guaranteed debt that can be contracted in any year. However, theOffice of the President does examine whether a proposed project that has to be financed byexternal borrowing with a government guarantee is part of the list of proposed projects that wereapproved in conformity with the country's Rolling Plan. In January each year-the beginningof the Nigerian Government's financial year-a list of projects that will be financed out of thecapital budget of the Federal Government is announced. These include projects that are to befinanced by external loans, which are guaranteed by the Government. Under the new institutionalarrangements instituted in the summer of 1992, the Planning Office of the Federal Secretariat isresponsible for formulating the capital budget of the Government on the basis of bilateraldiscussions between the parastatals (and their parent ministries) and the state governments, whoseprojects will be included in the Rolling Plan of the Government. Nevertheless, the process ofgranting government guarantees on specific external loans remains somewhat ad hoc, owing tothe absence of clear and transparent rules that should be followed for obtaining governmentguarantees.

4.30 In the case of parastatal enterprises, bilateral discussions between the parent ministriesand the Office of the President and his Cabinet determine the short list of firms that will qualifyfor government guarantees on their external borrowings. Some parastatals, such as NNPC, haveblanket authorization to negotiate external loans of less than a certain prespecified limit withoutseeking specific approval for a sovereign guarantee from the Federal Government. When aparastatal enterprise identifies an external creditor, it applies for a government guarantee, throughits parent ministry, from the Office of the President. Once authorization for provision of thegovernment guarantee is given and communicated to the FMF and the Accountant General'sOffice, an application is processed by the External Debt Department with appropriate inputs fromthe other departments in the FMF. The CBN, in its capacity as banker of the Federal

70

Government, is then authorized to make the foreign exchange allocation for debt service andrelated transactions associated with the loan.

4. Foreign Exchange Forward Budget

4.31 Effective management of Nigeria's overall external assets and liabilities will require aclose examination of the timing and currency composition of foreign exchange inflows andoutflows. This is in addition to Nigeria's external debt-management strategy and projectedpayment obligations. Currently, there is very little ex ante coordination between external debt-service payments and foreign exchange management in the CBN, except for an annual foreignexchange budgeting exercise, which is reported in the Annual Report of the Central Bank.

4.32 The foreign exchange forward budgeting process is conducted by the ResearchDepartment of the CBN with information obtained from several sources: oil-related exportrevenue projections are provided by NNPC, and non-oil export revenue projections are providedby the FETR Department of the FMF and Customs. Data on import-export related foreignexchange transactions (including information on letters of credit) are reported to the CBN fromthe commercial banks, while debt-service projections are provided by the Debt ManagementDepartment and the Foreign Operations Department of the CBN. Projected foreign directinvestment flows (net) are imputed on the basis of project authorizations that have been given inthe past. All projections are done in terms of US dollar equivalents without specific considerationgiven to the currency composition of each component of foreign exchange inflows and outflows.In order to better monitor the behavior of foreign exchange, it is recommended that the foreignexchange budgeting exercise be undertaken on a more frequent basis (at least quarterly, if notmonthly) by the CBN, possibly in the Foreign Operations Department, which executes foreignexchange-related transactions in the Central Bank on a daily basis.

5. The Stabilization Account

4.33 The Stabilization Account of the Government of Nigeria should have played the role ofa cushioning mechanism to manage external shocks. In practice, however, the StabilizationAccount has been no more than a rather confusing accounting device with no clear purposes. Forthis reason, this report has left aside the Stabilization Account from the discussions regarding thepossible creation of an oil stabilization fund for Nigeria. This subsection, however, gathers someinformation concerning recent plans of the Nigerian Government to define the principles thatmight guide the Stabilization Account.

4.34 The Planning, Research, and Statistics Department of the FMF is primarily responsiblefor monitoring the effectiveness of the institutional arrangements within the Nigerian federal, stateand local governments for revenue generation (external and internal) in terms of efficiency inrevenue collection. It also deals with revenue sharing between the three levels of government.Export revenues of the Federation account are dominated by oil receipts. A Federation AccountCommittee convenes monthly meetings to determine the allocation of resources out of theFederation Account. In accordance with the Government's revenue allocation formula, about twothirds of the revenue in the Federation Account is shared among the three tiers of governmentand the remaining is transferred to the Stabilization Account.3"

37 In 1991, 33.6 percent of Federation Account revenues was transferred to the Stabilization Account. Thiscompares with 28.2 percent in 1990.

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4.35 It is our current understanding that the resources in the Stabilization Account are beingallocated on an ad-hoc basis. General guidelines for the management of the Stabilization Accountare just being prepared in the FMF. The principles to be adopted in the management of theStabilization Account call for the following:

* funds should not be left idle in the stabilization account;* they should be used in a noninflationary manner;* they should be used in a manner that will eventually increase the revenue base

of the Government; and* they should assist in minimizing the revenue shortfalls accruing to the different

levels of government in the provision of their basic functions (defense, education,infrastructure, and social services).

4.36 The internal memorandum, which is under discussion within the Government, alsoprovides guidelines for the instruments to be used for overseas investment of these funds in theStabilization Account. Institutional changes within the entities of the Government that managethe Stabilization Account as well as the projects that can be financed with these resources willalso be clarified in this document.

4.37 Above all, if the Stabilization Account is to be transformed into a stabilization fund, theprinciples guiding the management of this critical account should be firmly based on theconceptual and institutional considerations discussed in Chapters I and II. Meanwhile, given thatit is very difficult to find any indication of in-house capacity on the part of the Government toactively manage the resources of the Stabilization Account, it may be prudent to engage a reputedinvestment firm to manage this portfolio and set performance criteria (such as a benchmarkportfolio) on the basis of which the returns from this portfolio can be evaluated. In order to keepthe management of the Stabilization Account separate from the day to day management ofNigeria's reserve assets and foreign exchange in the Central Bank, it is recommended that anautonomous Trust vehicle be used to manage the Stabilization Account. Specific and narrowterms of reference should be provided to the trustees of the Stabilization Account, and theyshould be held accountable for adherence to these principles. The World Bank can providetechnical assistance in this regard.

D. Eternal Debt Service and the Fiscal Budget

4.38 Given that the main export commodity/resource sector in Nigeria is in the hands of thepublic sector, as is the external debt, the behavior of the public sector deficit will be closelylinked to changes in interest rates, exchange rates, and the expected debt-service profile. Inparticular, it will be necessary to ascertain the magnitude of the contingent liability, which hasto be borne by the Government in the event of nonpayment of debt service by parastatals andstate and local governments in Nigeria. Any implicit subsidies being provided by theGovernment through absorption of interest rate and currency risk will have direct consequenceson the fiscal budget. The speed and effectiveness with which the destabilizing pressures on thefiscal deficit are brought under control will be closely linked with the ability of the Governmentto bear the financial burden and the overall foreign exchange requirements of Nigeria's externaldebt-service obligations. Therefore, effective external-debt management is associated with short-term macroeconomic stabilization and long-term output growth in Nigeria.

4.39 There are four issues that will need to be addressed by the authorities in the context ofNigeria's public and publicly guaranteed debt and its direct impact on the fiscal budget:

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(a) The nonpayment of debt service by state governments and parastatals. Apartfrom the delays that take place during the process of authorization for foreign exchange from theCentral Bank and conversion of naira to foreign exchange, there exists the additional problem ofpartial or nonpayment of debt service on external debts by some of the parastatals (loans that areguaranteed by the Government). Any amount paid by the Government of Nigeria on behalf ofthe parastatals to external creditors, over and above the partial payments of debt service by thestate governments and the parastatals, to enable full payment of debt service due by the parastatalsector to creditors abroad implies a direct adverse impact on the fiscal budget as well as a drainof foreign exchange reserves (or foreign exchange earnings from other sources). Table 4.1 shQwsthe recoveries that were made from Statutory Revenue Allocations due to states from theFederation Account and the state government balances in the Stabilization Account. There wasa large increase in the payment out of the Statutory Account of the Federal Government on behalfof the state governments in 1992 relative to previous years.

Table 4.1: Summary of Federal Government Finances, 1989-92

1989 1990 1991 1989 1990 1991

(As % of federally(In billions of naira) collected revenue)

Federally collected revenue 50.2 68.6 88.1

Oil revenue 41.3 54.7 68.8 82.3% 79.8% 78.1%

Non-oil revenue 8.9 13.9 19.3 17.7% 20.2% 21.9%

Less: Independent revenue' 0.9 1.7 3.0

Equals: Federation Account 49.2 66.8 85.1

Net statutory allocations to

states & local govts. & others 14.4 23.1 27.3 28.6% 33.7% 31.0%

Net transfers to Stabilization Fund 9.2 6.0 28.6 18.3% 8.7% 32.5%

Federal Govt. retained revenue 26.7 39.5 32.2 53.2% 57.6% 36.6%

Source: Central Bank of Nigeria. Annual Report 1991, Table 4.1-2, pp. 50-51.

Comprises sources of revenue within the jurisdiction of the Federal Board of Inland Revenue and transfers from CBNsurplus of preceding year.

(b) Incomplete or delayed reporting of external loans contracted by public andprivateentities in Nigeria. This problem persists both within the Government (for example between theFMF and the CBN) as well as outside the Government. Some parastatal enterprises often do notreport all their drawdowns of committed new external borrowings promptly to the Central Bank,even though they may have a sovereign guarantee of the Federal Government. Delays inexternalization of debt-service payments result, due to disputes between the final borrower andthe relevant department in the CBN and the FMF about the validity of the claim and the internalclearances, while penalty interest and arrears accumulation are taking place from the point ofview of the external creditor. This problem exists even in the case of official bilateral claims(mainly, suppliers' credits that are guaranteed by the creditor governments or their agencies).Also, in the case of foreign exchange transactions undertaken by the Bureaus de Change-nowabolished-about one fifth of the bureaus did not submit returns to the CBN on their operationsin 1991.

(c) Lack of clear guidelines and external borrowing limits to state governments andparastatals. Although there are no explicit limits set on external borrowings as well as policieson the type of external financing to be utilized for different types of projects, there have recently

73

begun regular meetings between the Commissioners of Finance of the States, chaired by theAccountant General of the Federation, on external debt-related issues. On the basis of thesemeetings, and others, deductions are made for debt service payments from the statutory allocationof each state in the case of previously rescheduled debt on the basis of the state's ability to payat the time. The remaining debt-service payment is borne out of the Stabilization Account of theFederal Government. It is not always necessary for all scheduled debt-service obligations of allstates to be met in this manner, so arrears may accumulate. Payments of post-cutoff date debtare made directly by the states to the CBN for externalization.

(d) Asset-Liability Management by Parastatals. The Federal Government isincreasingly and explicitly transferring its currency and interest rate risks on external liabilitiesto the parastatals and state-owned banks. Much of its external borrowings from multilateral andcommercial sources in the past has been for the needs of parastatal enterprises in the differentsectors (e.g., power, telecommunications, ports); or by state-owned banks engaged in financialintermediary on-lending operations. This trend is expected to continue over the medium term.In the past, the Government has at times assumed some of the foreign exchange and interest raterisks by on-lending the proceeds of external loans in naira at fixed interest rates. Currently, theGovernment charges a variable naira interest rate on-lent funds and intends to pass on allcurrency risks to the final borrower. For the future, it would be desirable to maintain thispractice under which the final borrower remains fully responsible for all risks in order to achievegreater risk sharing and risk dispersal throughout the economy, and to allow for the functioningof these enterprises as fully commercially oriented entities. Assuming the existence of a policyframework for external liability management by the parastatals and state-owned banks (seebelow), it would, however, be important to encourage these entities to practice active externalasset-liability management, and remove as many barriers in order for them to be engaged inactive risk-management activities as possible.

* Commercial Parastatals Debt and Risks

4.40 Parastatals that have access to foreign finance are expected to bear fully their own riskson such borrowing. However, they rarely enter into interest rate and currency hedgingoperations, in the absence of an adequate government policy framework on managing such risks.It would be important for the Government to lay down such a policy framework for external riskmanagement by its parastatals, the key elements of which could be: (a) an annual statement bythe parastatals of their debt position, including an assessment of their currency and interest raterisk exposures; (b) an annual statement of plans to manage these risks; and (c) submission ofplans to a government committee for prior approval to enter into actual transactions to reducetheir exposure to risks. In time, and provided the appropriate government monitoring andregulation is in place, the prime responsibility for managing risk should rest with the parastatalenterprise and annual submission of plans should not be necessary. For other commerciallyoriented parastatals, it would be desirable for the Government to transfer explicitly currency andinterest rate risks on the external borrowings by the Government on their behalf. However, sincemany parastatals are not allowed by law to borrow on their own accord, they are also preventedfrom directly entering into transactions in international markets to reduce their exposure to suchrisks. Under these circumstances, the parastatals could enter into such transactions indirectly,through a domestic bank acting as an intermediary on their behalf. The Government could allowsuch transactions to take place under a policy framework exactly similar to that for parastatals,who are allowed, on a limited basis, to borrow directly abroad (such as the NNPC).

* Non-Public Loans

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4.41 For large, quasi-public borrowings (publicly guaranteed borrowings) and for large,private borrowings with a significant development impact, the Government should encourage abroadening of Nigeria's external financing and financing with better risk-sharing features. Thisalso requires a better distinction between sovereign and private, non-recourse financing. At themoment, this distinction is not always clear and, consequently, investors when providing fundsto the private sector assume that government guarantees ("bailouts") are implicitly present. Thisleads not only to distorted investment and financing decisions, but it can also greatly increase thedebt burden of the Government. Similarly, the entities should be encouraged to fully managetheir currency and interest rate risks on external borrowings.

4.42 For external financing acquired by small, private enterprises, the Government shouldallow the further development of a private naira/US dollar swap market. Some limited hedgingoperations were undertaken in the past by the Bureaus de Change-now abolished-and thecommercial banks that are managing the "domiciliary accounts" on behalf of their clients.'This will allow these enterprises to access as many international risk management instruments aspossible without uncertainty as to the US dollar/naira exchange rate risks.

E. Conclusions and Recommendations

4.43 In the area of External Debt Management, the obscure flow of information between therelevant departments of the FMF and the Central Bank that are involved with Nigeria's externaldebt-related operations remains. There is a need for strengthening of the external debt-management capacity in the Debt Management Division of the Central Bank through the settingup of the CS-DRMS computerized Debt Management System, which will computerize therecording and reporting of Nigeria's external payment obligations that are not already being doneat the FMF (short-term debt, par bonds, and promissory notes). However, it is imperative forthe Government to streamline the institutional structure for external debt data recording andmanagement at the Central Bank prior to the installation of the CS-DRMS system, as well asexpedite the implementation of the ongoing computerization at the FMF. It is necessary to ensurethat an appropriate institutional structure is in place within the Government (in particular the FMFand the CBN) to ensure effective external asset-liability management with complementarity offunctional units as opposed to competitive and sometimes duplicative operations of the respectivedivisions within the FMF and the CBN.

4.44 Currently no technical working-level committee exists to make day to day decisions onthe management of Nigeria's external assets and liabilities. Ex ante matching of foreign exchangeinflows and outflows is not a primary consideration in the Foreign Operations Department of theCentral Bank. Hedging operations against foreign exchange and interest rate fluctuations are notundertaken by the authorities. The financial system appears to be preoccupied with hedgingagainst expected devaluation of the naira and not cross-currency fluctuations in foreign exchange.New borrowing that is being undertaken from abroad is short-term in nature, trade financing isbeing obtained (albeit limited in amount) on a cash-collateral basis. Access to internationalcapital markets for MLT financing is almost nonexistent.

38 Domiciliary accounts (current or savings) can be opened with a minimum of N100 equivalent of theapproved foreign exchange. The operation of such an account is open to Nigerian citizens, foreign nationalsresident in Nigeria, corporate and unincorporated enterprises that are registered under the relevant companylaws operating in Nigeria, foreign diplomats, and international organizations, among others. These accountscan be used to transact in foreign exchange as long as they are operated for one's "own use." There are noclear and published rules and limits imposed by the Federal Govemment on the volume of foreign exchangetransactions that can go through this avenue or any clear definition of what one's "own use' of these accountscan be.

75

4.45 There is a need for advisory services in the setting up of an appropriate institutionalframework within the Government that will enable the authorities to effectively manage thecountry's outstanding external debt and formulate a viable external borrowing strategy. Issuessuch as the smooth exchange of information between all entities in Nigeria that are involved inexternal debt-related transactions and the announcement of clear guidelines on the issuance ofsovereign guarantees need to be addressed in this context. Keeping track of the external debtobligations of the state governments has been made difficult by the creation of new states. TheGovernment is in the process of determining the external liability of each state and, in turn, thecontingent liability of the Federal Government.

4.46 There also needs to be closer coordination between the FMF and the Central bank.Periodic reports on the status of Nigeria's external debt should be provided by the DebtManagement Division of the FMF automatically, not only on demand, to all the departments inthe FMF and the Central Bank that are involved in any way with external ALM in Nigeria. Thisshould include information on parastatals and state governments that are behind on their debt-service payments to the Federal Government, and the allocations that have been made out of theStabilization Account (if any) to make payments to external creditors on behalf of these entitiesin order for the Government to meet its sovereign external debt-service obligations.

4.47 Improving the debt-servicing capability of the parastatals by better management andrestructuring of some of the parastatals is only one of the possible avenues for alleviating thepressure on the fiscal budget due to the assumption by the Government of the responsibility topay external creditors on behalf of a parastatal that is delinquent on its payments (in naira) to theGovernment. Efficient overall management of external liabilities and reserves wouldappropriately complement this effort. The Bank could provide technical assistance to theGovernment on this matter.

4.48 It is imperative for the authorities to get a clear view of the total contingent liabilities thatthe FMF will have to deal with prior to embarking on a privatization program. A strategy fordealing with these debts has to be carefully thought out at this time. To this end, debt and debt-service reduction may be a possible component of the strategy. The Government is in the processof considering such an option for its official bilateral external debt after having just successfullycompleted a DDSR operation involving its London Club creditors.

4.49 The Government should make a very strong effort to ensure that any agency or enterprisethat either explicitly or implicitly relies on the backing of the Government in its internationalfinancial transactions is carefully monitored and regulated. For private enterprises seeking accessto international markets that do not rely on government backing, adequate safeguards should beput in place to limit the possibility of assumption of these liabilities by the Government in casethese private enterprises experience some negative shocks. In general, the Government shouldassure itself that any implicit calls on it due to explicit or implicit guarantees that arise fromparticular firms or banks being too large to fail or being too important to Nigeria's externalreputation, are minimized.

4.50 The Nigerian authorities have expressed interest in receiving technical assistance in theintroduction and familiarization of the different hedging instruments that are available in theinternational financial markets and which instruments would be available to Nigeria. Appropriatetraining in the setting up of a trading desk in the Central Bank could be provided in this context.

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APPENDIX I: ESTIMATION OF THE MACROECONOMIC ADJUSTMENT COSTSOF THE TWO NEGATIVE OIL SHOCKS'

A. Methodology

1. This appendix explains the methodology employed to estimate Nigeria's macroeconomicadjustment costs to the two negative oil shocks in the 19802 presented in Chapter I (Tables 1.1and 1.2). Nigeria was forced in the 1980s to adjust to two dramatic external shocks thatproduced real income contractions hardly seen anywhere in the developing world. Oil exports,which reached almost US$26 billion (at current prices) in 1980, declined to a level that oscillatedbetween US$10.4 billion and US$12.6 billion in 1983-85. This was the first oil shock. Then,in 1986, oil exports fell to half their 1985 value and remained depressed until the outbreak of theMiddle East crisis.

2. In general terms, cuts in external income force any economy to reduce domesticabsorption or increase output in order to return to balance of payments equilibrium. The needfor real expenditure reductions imposes an inevitable cost. This is usually defined as the primaryadjustment cost, and is an optimal cost required to return to external balance. If all domesticoutput were perfectly tradable, adjustment costs would simply equal the external shock minuswhatever excess income over absorption existed at the moment of the external shock. This shockarises even if there is perfect factor switching across sectors so that internal balance continues tobe maintained. Since not all output is perfectly tradable, part of the cut in absorption falls onnontradables and, consequently, does not directly improve the balance of payments. -If theeconomy shows failures of switching mechanisms or real wage rigidities, adjustment will implyoutput losses and unemployment. This is the secondary adjustment cost referred to in ChapterI. While primary adjustment costs are unavoidable, secondary adjustment costs are due toinefficiencies and are, at least in principle, avoidable. These two costs should be distinguishedfrom the actual adjustment cost, which may be above or below the summation of the previouseffects depending on whether the economy has over- or underadjusted. Finally, it should benoted that primary costs may be positive or negative, depending on the sign of the shock.However, secondary shocks will be positive, as they reflect the losses in resource reallocation thatwill occur due to rigidities independently of the sign of the shock.

3. The efficiency of the economy's adjustment to the first and second oil shocks of the19802 is presented in Figures 1.1 and I.2, respectively. These exercises are based on nationalaccount figures in real 1987 prices. Considering first the first oil shock, the primary adjustmenteffect is estimated by taking 1980 as the base year, when the value of exports peaked. Asmentioned above, the primary adjustment effect has two components: the external shock and theinitial current account surplus. The external shock in year (t) is estimated as the differencebetween the 1980 purchasing power of exports in terms of imports less the purchasing power ofexports (in units of imports) in year (t). The initial current account surplus (deficit) is the baseyear (1980) current account. Given that the original figures are expressed in real 1987 prices,the 1980 real current account figure is naturally corrected by the corresponding terms of tradeadjustment. These, as all other costs, are expressed in units of counter-factual non-oil GDPQTNOGDP), which is assumed to grow at the rate of 1 percent in 1980-85. This is certainly avery low growth rate. It is so low, because the economy was close to full employment by 1980

This appendix is based on the conceptual underpinnings found in Corden (1988), MclUer (1990) andHausmann ct al (1992). The particular methodology employed in the empirical calculations closely followsHausmann et al (1992).

78

and productivity had deteriorated significantly. In any case, choosing a higher counter-factualrate would only show a more inefficient adjustment.

FIRST OIL SHOCK: ADJUSTMENT COSTS(AS A PERCENTAGE OF TREND NOGDP)

70

so

sO

40

30

20

10

-10

-20

1982 1983 19894 19g

O PRIMARY CA) I SECONDARY C6B 0 TOTAL CA-9) a TOTAL ACTUAL

Figure 1.1

SECOND OIL SHOCK: ADJUSTMENT COSTS

GDP COD)ThscpuethloAS A PERCENTAGE OF TREND NOGoPd

70

So

40

30

20I

10

0

-10 I L_1996 1987 198B 1999 1990

0 PRIMARY (AD + SECUNOARY (B) 0 TOTAL CA-8) a ACTUAL ADJUSTMENT

Figure 1.2

4. Secondary adjustment costs are estimated as the difference between actual non-oil GDPand counter-factual non-oil GDP. Again these differences are expressed in units of trend non-oilGDP (NOGDP). This captures the loss of output as the economy adjusts to the extemnal shock.Finally, absorption costs were estimated as the difference between the actual and the 1 percent

79

absorption trend, measured in units of non-oil GDP. If the difference between actual absorptioncosts and total adjustment costs is positive, there is excess adjustment expressed in currentaccount surpluses. If the difference is negative, then the economy has adjusted insufficiently andis either borrowing abroad (or accumulating arrears, or rescheduling its external interestpayments) or running down its stock of foreign reserves to finance absorption.

5. For the second oil shock, a 5 percent growth rate for non-oil GDP and total absorptionis utilized. There are many reasons for this relatively high rate. First, the absorption contractionduring the first oil shock of the 19802 was not only dramatic, but it also led to highunemployment rates and excess capacity. Second, from 1986 onward the Nigerian economybegan to benefit from the measures taken under the SAP which corrected the most egregiousdistortions of the economy, not least the significant real exchange rate appreciation. Assumingthat non-oil GDP and real absorption grow at rates of 2 percent above the population growth rateis not unrealistic.

B. Results

6. Figures I.1 and 1.2 show the dramatic adjustment costs that Nigeria incurred in the 1980sas a consequence of the two oil shocks. Considering first both shocks together, it may be notedthat the actual absorption adjustment was in both occasions below the total adjustment costs. Thisindicates that, despite the dramatic contraction in absorption, the actual adjustment was notsufficient. This corroborates the macroeconomic fundamentals behind Nigeria's external debtaccumulation. Having borrowed in the 1970s, Nigeria was unable to generate a current accountsurplus in any single year of the 1980s. As Chapter I shows, other important factors accountingfor the significant increase of the debt stock expressed in US dollars was the depreciation ofeuropean currencies and the yen vis-a-vis the US dollar.

7. Turning to the first oil shock, the unavoidable contraction of absorption to return toexternal equilibrium was on average over 50 percent of non-oil GDP in 1982-85. Total costsreached the astonishing figure of more than 70 percent of non-oil GDP in 1983-84, as non-oilGDP departed significantly from its trend which peaked at 20 percent of GDP in 1984. It isremarkable to note that the while the shock was more than evident in 1981 and 1982, actualabsorption actually increased above trend in those years (it reached 30 percent 1981), againconfirming how Nigeria kept overspending for a long time. Of course, this helped maintainsecondary (inefficient) costs quite low up to 1982. As actual absorption was finally contracted,the secondary costs exploded, peaking at more than 20 percent of non-oil GDP in 1984.

8. The adjustment costs during the second oil shock were higher even though they wereefficient in the sense that secondary costs were negligible. Total adjustment costs, in this casealmost completely determined by primary (unavoidable) costs, stood at 70 percent of non-oil GDPin 1986-88, while actual absorption contraction remained at almost 40 percent below trendbetween 1989-90. Although total adjustment costs fell significantly in 1989 and 1990, theyremained above the actual absorption adjustment. Only in 1990 was the economy, helped by thepositive effects of the Middle East crisis, close to closing the current account gap.

9. In summary, adjusting to changes in absorption due to income variability inducedsignificant output losses during the first oil shock. Output losses were negligible during thesecond oil shock. Given the extraordinary magnitudes of the primary costs (external shocks), therelatively small inefficiency of the adjustment, particularly during the second shock, is explainedby actual absorption contractions that did not match the (negative) external shocks. Whiledampening the effects of output and employment, this policy exacerbated the external debt

80

problem. There are other macroeconomic costs that are not estimated in this study. They arecosts associated with declines in growth rates caused by lower investment rates or by expenditurerevisions. They would simply add to the macroeconomic costs presented here and the costsassociated with exchange rate and interest rate variations discussed in Chapter I. Nigeria'sreliance on oil production for income generation clearly has serious implications for its economicpolicy management.

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APPENDIX Il: ESTIMATION OF THE ELASTICITY OF GOVERNMENT OILREVENUES WITH RESPECT TO THE INTERNATIONAL OIL PRICE

1. One of Chapter II's central conclusions is that the risk assumed by the NigerianGovernment is associated with taxation policy as defined by the Memorandum of Understanding.The most critical issue is the minimum guaranteed margin to oil companies, which implies that,given extraction and other costs and royalty taxes, the profit tax rate becomes endogenouslydetermined and it starts falling below a certain world oil price. This leads the oil tax revenuesto change more than proportionately to oil price variations, thus increasing the risk assumed bythe Nigerian Government.

2. In what follows, the analysis is centered on Profit tax receipts from the 40 percent thatcorrespond to the oil companies share according to the joint venture agreements. Calling thisrevenue (R), profit tax receipts may be expressed as:

(1) R = t(Po)PoX

where t is the profit tax rate, which is a function of the oil price, Po, over a certain oil pricerange and X is the volume of exports (40 percent). Given present legislation, the tax rate hastwo values:

(2) t = 0.85

for profit margins above US$2.5/bbl, and

2.5(3) t = I-

Po - r

when the profit margins are below US$2.S/bbl (2.5 refers to the US$2.51bbl profit margin); (t)is given by:

(4) T 0. 19[Po - 3.5] + 3.5

where 0. 19 is the Royalty tax, and 3.5 refers to the extraction cost per barrel of oil, which iscurrently estimated at US$3.5.

3. From equations (1) and (3), it is possible to show that the elasticity, tx, of the revenue,R, with respect to the oil price, for price ranges at which profit margins would be belowUS$2.5/bbl is given by

(5) tx = 1 + tp

where:

2.5Po(6) tp =

(Po - T - 2 .5)(Po - 3 .5)

is the elasticity of the profit tax rate, and it is clearly positive. This guarantees that the elasticityof this portion of oil tax revenues with respect to the world oil price (tx) is greater than one, thus

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making government revenue riskier vis-a-vis foreign oil companies' income. From (6), it is clearthat the risk (the elasticity) increases with the guaranteed oil margin: the larger the margin, themore exposed government revenues become to oil prices. Furthermore, from (3) and (4) it isstraightforward to show that the critical oil price (Po) below which this elasticity starts increasingis US$23.99. At this price, the elasticities of revenue and income tax are estimated to be 1.20and 0.20, respectively. At oil prices of US$17 and US$10, the oil revenue elasticities are 1.38and 2.39, respectively. Given that it is unlikely that the oil price will increase above US$24 inthe foreseeable future, the Government of Nigeria will absorb a higher share of the oil price riskthan the oil companies should present contractual arrangements between these two parties remainunmodified.

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APPENDIX III: ORGANIZING FOR DEBT MANAGEMENT:LESSONS FROM INTERNATIONAL EXPERIENCES'

1. The institutional framework for debt management varies from country to country.However, there are some essential features of, and functional requirements for, effective debtmanagement that must be satisfied in all countries. This section highlights, from internationalexperience, what these essential functions are, and how best countries can institutionally organizethemselves to carry out these functions. One of the avenues adopted by some countries is toassign the major policy decision-making function on external debt-related issues to a high-levelDebt Management Committee within the Government and then to have a more technical workinglevel interministerial committee to deal with the day to day external debt-related issues on thebasis of specific operational directives provided by the high-level Debt Management Committee.The institutional practice of setting up a high-level Debt Management Committee is prevalent inmany other major borrowing countries such as Malaysia (Financial Resources Chaired by thePrime Minister); Sweden (The National Debt Office, which reports directly to Parliament); andThailand (The Committee for National Debt Policy chaired by the Minister of Finance). Theexperience of other developed and developing countries, such as Chile, Malaysia, Thailand,Turkey, and Sweden has shown that the establishment of a permanent, but small, Committee,comprising heads of the main economic ministries and the Central Bank, and a specialized debt-management office will assist in attaining a more orderly and informed process of decisionmaking on external borrowing, a better balancing of macroeconomic and sectoral and inter-sectoral priorities. In the long term this endeavor, if conducted appropriately, will contribute toa lowering of Nigeria's borrowing costs and enhance the availability of a wider source of foreignfinancing (i.e., eventual access into the international capital markets at reasonable terms) due toincreased confidence on the part of external creditors.

2. Successful debt management is an instrument to aid governments in taking informeddecisions to minimize the risks and costs of external borrowing, and to ensure that a country'sdebt burden remains at prudent and manageable levels. It requires coordination among all theinstitutions that: (a) incur debt for which the government is or may be responsible; (b) control,manage, and monitor that debt; and (c) raise the resources to repay the debt. This must includenot only the central bank and the ministries of finance and planning, but also the major executingagencies for projects (e.g., the ministries of energy, and public works) and important publicsector enterprises. To the extent that the private sector raises capital that incurs obligations inforeign currencies, it too, must participate, voluntarily or not, in the country's debt-managementprogram. Large developing country borrowers, such as Turkey, have, therefore, typicallyemployed elaborate systems to control and manage external debt.2

3. How is such coordination to be secured? Debt management is still a relatively new andundeveloped function of governments in most countries. To date, efforts to improve debtmanagement have largely focused on data collection, validation, and dissemination-or in the area

This section summarizes the cross-country lessons drawn by World Bank staff on organizing for effectivedebt management. See Debt Management Systems, Debt and International Finance Division, World BankDiscussion Paper, 1990.

2 This has included: (a) a ministerial-level coordinating committee to set annual borrowing programs andoverall policies; (b) core responsibility for operational debt management to the Treasury (equivalent to theministry of finance)-for arranging and negotiating all public borrowings, implementing a system of strictapprovals for direct borrowing by other agencies, debt data management, etc; (c) extensively staffed andspecialized departments in the Treasury to carry out these functions; and (d) close supporting functionscarried out by the central bank and the state planning agency.

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of debt data management. While this is crucial, less attention has been paid to the morefundamental aspect of organizational issues. As depicted in Figure 111.1, debt data managementis only the initial step to support the information requirements for effective debt management.Effective debt management in turn depends on the broader institutional setting-requiringcoordination among a number of agencies; and this coordination is best secured when it isrecognized as an integral toolfor macroeconomic management. External debt cannot be treatedin isolation from other macroeconomic aggregates-it is affected by and affects both the domesticfiscal environment and the management of a country's balance of payments. In order to makeexternal-debt management an integral part of economic decision making, it needsinstitutionalization, in the form of a high-level national debt office. There is no one ideal modelfor the location of this debt office. Given a large number of functions of this debt office, thework may be typically decentralized among various institutions-the Central Bank, and Ministriesof Finance and Planning-under an overall coordinating body or committee, and with acentralized statistical unit, which coordinates and integrates the data gathered by variousdecentralized participants of the system. Alternatively, it may be more feasible to create acentralized debt-management office.

Organizing for Effective External Debt Management

INSTITUTIONAL SETTING

DEBT MANAGEMENT

* *

* DEBT DATA MANAGEMENT ** *

* *. . . . . . . . . . . . . . . . . . . . . . .

* *

* . COMPUTERIZATION ** *

. . . . . . . . . . . . . . . . . . . . . . .* *

* *

** * ** * ** * * * * * * * * * ** ** ** * *** ** *

Figure 111.1

The Function of "The Debt Office"

4. There are five essential functions that different units of a national debt office(decentralized or centralized) must perform. The different units and the functions they shouldperform are:

Policymaking and Approving Unit. The first unit is the policymaking andapproving unit that coordinates the activities of all government agencies dealingwith external debt. This body, typically comprising the heads of economicministries such as finance, planning, and the central bank, decides how much

85

should be borrowed, the broad parameters of the types of borrowing, and setsgeneral guidelines about foreign borrowing policy to other borrowing entities,such as the private sector. It also approves the annual borrowing program of thegovernment and public enterprises.

* Secretariat or Control Unit. The second unit is the control unit, which performsthe staff function or serves as the secretariat to the policy body. This unit carriesout all the detailed analysis and makes recommendations about the sustainablelevel of borrowing, its appropriate composition and allocation, and other aspectsof debt management. It also typically approves the annual borrowing program,issues guidelines on negotiations of loans, on the use of guarantees, on-lendingterms, makes projections of private borrowings, etc.

* The Advisory Unit. A third key unit is the advisory unit, which acts as a centralfocal point that follows trends in international financial markets and interest rateand currency development. It analyzes and appraises different types of financialinstruments, including hedging and market-diversification instruments for theirrelevance, applicability, and use by the characteristics, volume, and costs. Thisunit is particularly valuable for market borrowers that float bonds, syndicatedloans, and other commercial paper, and for borrowers who actively use market-based hedging instruments.

* The Statistical/Accounting Unit. The critical function of registering allindividual loan agreements and contracts negotiated by government borrowers iscarried out by the statistical unit. This unit also keeps track of all governmentguarantees provided and collects all information, based on strong legal backing,on private debt. The unit prepares a monthly or quarterly status report on theoverall debt situation and projections for the near term on outstanding debt bycurrency, debt instrument, interest rate, maturity, type of borrower, and type ofcreditor; cumulated interest payments and debt repayments; and projections ofdisbursements out of existing loans. Where the national debt office and itsfunctions are decentralized, the statistical unit should prepare a common set ofdata to be employed by the various units of the government concerned withpolicy analysis. Sufficient powers must be granted to the unit to ensure that allnecessary information is reported to the unit accurately and in a timely manner.

* The Operational Unit. The operational unit or units are the financialintermediary that borrows abroad, a parastatal, or other authorized borrowingentity. It appraises specific proposals for borrowing , obtains necessaryapprovals from the control unit, then negotiates individual loans, and reports tothe statistical unit on all transactions related to the loans.

5. It should be noted that an essential prerequisite for successfully carrying out all these fivefunctions is the ready availability of appropriately organized external debt data through a "shared"comprehensive database. In addition, improved data quality and consistency will enhance creditorperceptions of sound external debt-management practices in a debtor country. Specific issues ofconcern in the context of external-liabilities management in Nigeria and recommendations forstreamlining the current institutional structure are discussed in section C of chapter IV.

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