Report No. 36483-NG Nigeria Competitiveness and Growth Country Economic Memorandum (In Three Volumes) Volume II: Main Report May 30, 2007 Poverty Reduction and Economic Management 3 Country Department 12 Africa Region UK DFID Document of the World Bank GDP Gross Domestic Product GNFS Goods and NonFactor Services GSM Global Systemfor Mobile Communication GSP Generalized System of Preferences ICOR Incremental Capital-Output Ratio IFC International Finance Corporation IF1 International Financial Institutions IMF International Monetary Fund IPP IndependentPower Producer LGA Local Government Area LNG LiquefiedNatural Gas MAOTRI Market Access Overall Trade Restrictiveness Index MDG MillenniumDevelopment Goal METR Marginal Effective Tax Rate MFB Micro Finance Banks MFI Micro-Finance Institution MFN Most FavoredNation M M O Maintenance, Modification and Operation Mv Modern Varieties NACRDB National Agricultural, Cooperatives and Rural DevelopmentBank NAFDAC National Agency for Food and DrugAdministration NAICOM NationalAgricultural Insurance Commission NBS National Bureauof Statistics NDIC Nigeria Deposit Insurance Corporation NEEDS National Economic Empowerment and Development Strategy NEPA National Electric Power Authority NEPZA Nigeria Export Processing Zone Authority NERC Nigerian Electricity RegulatoryCommission NEXIM Nigerian Export-Import Bank NHF National HousingFund NIPP National Integrated Power Project NITEL Nigeria Telecommunications Ltd NNPC Nigeria NationalPetroleum Corporation NPA Nigerian Port Authority NRC Nigerian Railway Corporation NSE Nigeria Stock Exchange NSITF National Social Insurance Trust Fund NURTW NationalUnion of RoadTransport Workers O&M Operations and Maintenance OECD Organizationfor Economic Co-operation and Development ONGC Oil & National Gas Corporation OPFR Oil-Price basedFiscalRule PAYE Pay As You Earn PEMFAR Public ExpenditureManagement and FinancialAccountability Review PFA Pension FundAdministrator PHCN Power Holding Company o fNigeria PIM Primary Mortgage Institutions PPA Power PurchaseAgreement PPI Private Participation inInfrastructure PPP Public-PrivatePartnerships PSI Pre-Shipment Inspections ii PWD PublicWorks Department REA RuralElectrificationAgency REER RealEffectiveExchangeRate RPED RegionalProgramfor EnterpriseDevelopment RSA Republicof SouthAfrica SCF StandardCubicFeet SEC Securities andExchangeCommission SEZ SpecialEconomicZones SITC StandardInternationalTrade Commission SME SmallandMediumEnterprise SMI SmallandMediumIndustries SON Standards OrganizationofNigeria SSA Sub-SaharanAfrica TEU TwentyEquivalentUnits TFP TotalFactorProductivity UAE UnitedArab Emirates UBA UnitedBankfor Africa UDBN UrbanDevelopment Bank ofNigeria UNCITRAL UnitedNationsCommissionon InternationalTrade Law UNCTAD UnitedNationsConferenceon Trade andDevelopment UNDO UnitedNations IndustrialDevelopmentOrganization VAT Value Added Tax WTO WorldTrade Organization iii TABLE OF CONTENTS PREFACE .................................................................................................................................................... vii ACKNOWLEDGMENTS ........................................................................................................................ ... vi11 1 . A NEW OPPORTUNITY FORGROWTH ....................................................................................... 1 Introduction................................................................................................................................................. 1 I. Recent Economic Developments ................................................................................................... 1 I1. I11. Sourceso fNon-Oil Growth......................................................................................................... Features o fthe Domestic Economy ............................................................................................... 7 13 I V .Nigeria's Growth Objectives ....................................................................................................... 23 2. WHY HASSUSTAINEDGROWTH BEENELUSIVE ................................................................. 25 Introduction............................................................................................................................................... 25 I. 25 I1. The Binding Constraints to Growth inNigeria............................................................................ I11. MainRecommendations .............................................................................................................. Private Sector Perceptions o f Constraints to Growth................................................................... 42 43 3. CLOSINGTHE INFRASTRUCTUREGAP ................................................................................... 45 Introduction............................................................................................................................................... I Nigeria'sInfrastructureDeficit.................................................................................................... 45 . 45 I1. .Implications for FirmCosts. Competitiveness and Competition ................................................. 51 IV. Main Recommendations .............................................................................................................. I11 Closing Nigeria's Infrastructure Gap........................................................................................... 53 61 4. THE BUSINESSCONDITIONS FOR GROWTH .......................................................................... 63 Introduction............................................................................................................................................... 63 I. 63 I11. MainRecommendations .............................................................................................................. I1. Addressingthe Sources of Macroeconomic Instability ............................................................... Reducing Micro-level Risks ........................................................................................................ 73 74 5. ACCESS TO LONG TERM FINANCE ........................................................................................... 77 Introduction............................................................................................................................................... 77 I. Financial Sector Depth. Outreach and Missing Markets ............................................................. 78 I1 I11 IncreasingAccess to Financial Services...................................................................................... ..The Impact ofthe Recent Bank Consolidation............................................................................ 79 83 I V 90 V ..Improving Access to TermFinance ............................................................................................. 96 VI. MainRecommendations .............................................................................................................. Access to Infrastructure Finance.................................................................................................. 98 6. HARNESSINGTRADE FORGROWTH ...................................................................................... 100 Introduction............................................................................................................................................. 100 I StrengtheningtheFunctioningofDomesticMarkets................................................................ . 100 I1. ............................................................................................................. 102 IV Expanding Opportunities for Growththrough Regional Integration ......................................... I11. Nigeria's Trade Policies Role of Regional and International Trade Inthe Economy ....................................................... . 104 110 112 VI. MainRecommendations ............................................................................................................ V . Integrating into Global Markets................................................................................................. 122 7. POLICY CONCLUSIONS .............................................................................................................. 123 Introduction............................................................................................................................................. 123 iv I. I1. Nigeria'sCompetitivenessandGrowthChallenge.................................................................... 123 124 I11. Towards an AgendaFor CompetitivenessandGrowth............................................................. EmbeddingReformsfor GrowthandCompetitiveness............................................................. 126 BACKGROUNDPAPERS ....................................................................................................................... 132 REFERENCES ..........................................................................................................................................133 List of Tables Table 1-2: Structure of Economy. 1974-2004(percent of GDP at currentfactor costs) .................68 Table 1-1: Key macroeconomicIndicators. 2000-05 ...................................................................... Table 1-3: Comparative Indicators of Competitiveness.................................................................. 8 Table 1-5:Nigeria Indicators of Poverty....................................................................................... Table 1-4: ProbableDistribution ofthe Working Populationby Economic Activity (%).............11 12 Table 1-6: Sources of Growth inNigeria....................................................................................... Table 1-7:Nigeria: Main Crops, Area Harvested, Productionand Yield, 1999, 2003 and 2004 ..13 14 Table 1-8: Manufacturing Value Added, 1980-2005(%of GDP) ................................................. 15 22 Table 1-10: PotentialPoverty Impacts of Growth......................................................................... Table 1-9: Investmentand its Financing, 1976-2004(% of GDP at currentprices) ..................... Table 1-11: Medium-Term Macro-EconomicFramework, 2005-15: 7% Growth Target.............23 Table 2-1:Productivity of Investment- Returns ........................................................................... 24 27 29 Table 2-4: Comparative Structure ofManufacturing inNigeria and SSA 1992 and 2002............30 Table 2-3: Indicators of Size and Quality of HumanCapital ........................................................ Table 2-2: Banking Sector Liquidity ............................................................................................. 31 Table 2-6: Measures of Efficiencyofthe Financial Sector ........................................................... Table 2-5: Returns to Education.................................................................................................... 32 39 Table 3-1: ComparativeData on Selected Countries: Roads, Global Competitivenessand Table 3-2: Assessments of Condition of ClassifiedRoads inThree Oil-Producing Countries.....46 Electricity.......................................................................................................................... 47 Table 4-1:Cost BenefitAssessment of Reform Priorities............................................................. Table 4-2: CommonTax Administrative Complaints ................................................................... 64 Table 4-3: Import ClearanceSequence for Non-EPZ Firms.......................................................... 66 68 Table 5-1:Financial Intermediationacross countries, latest availableyear 2004-5 ...................... Table 4-4: Contract EnforcementIndicators.................................................................................. 72 Table 5-2: Approximation of term finance potential inNigeria.................................................... 78 91 Table 5-3 :Cost ofprimary bond issuance inNigeria's capital markets........................................ 93 Table 5-4: Cost of secondary markettrading................................................................................. 93 Table 5-5: Nigeria Capital Markets Indicators.............................................................................. 94 Table 5-6: InvestmentLimits and PerformanceBenchmarksfor PensionFund........................... Table 6-1: Structureof non-fuel manufacturinginNigeria, 2002 ............................................... 95 104 Table 6-2: MFNtariffs inNigeria................................................................................................ 107 Table 6-3: Import bans andtariffs by sector, November2005 (per cent) ................................ 109 Table 6-5: U S Imports from Nigeria, 2003-2005 ........................................................................ Table 6-4: Nigeria's officially recordedtrade with partners inthe region, 2004 (`000 US$) ....111 114 Table 6-6: Average ofMFNbarriers inpotentialpartnercountriesfor major non-oil exports from 119 Table 6-7: WTO Tariff Bindings ofECOWAS Members........................................................... Nigeria (per cent)............................................................................................................ 121 V ListofFigures Figure 1-2 :Fiscal Operationand Public Debt ................................................................................ Figure 1-1:Trends inGDP growth. GDP per capita. and sectoralcontribution to growth............2 4 Figure 1-3: Trends incurrent account balance and met FDI........................................................... Figure 1-4: Nigeria: Indicators of Oil Dependence......................................................................... 5 Figure 1-5: Cumulative TFP for Alternative Initial Capital-OutputRatios..................................... 7 9 Figure 2-1: Gross Fixed Capital Formation (% of GDP)............................................................... 26 Figure 2-2: Gross National Savings. including NCTR (% of GDP).............................................. 26 Figure 2-3: EMBIG Spreads ofNigeria's externaldebt ................................................................ Figure 2-4: Uses of Oil Windfall. Overall FiscalBalance and Inflation ....................................... 28 34 Figure 2-5: Seigniorageand Inflation. Uses ofthe Oil Windfall ................................................... Figure 2-6: Revenues andExpenditures. 1971-2005..................................................................... 35 36 Figure 2-7: Expenditurevolatility and Growth.............................................................................. 36 Figure 2-8: CapacityUtilizationandUnemployment.................................................................... Figure 2-9: Deposit and Credit structure of DepositBanks inNigeria PA). 2005......................... 37 Figure2-1: Telephone Subscribersand PenetrationLevels .......................................................... 39 Figure2-2: Fixed linetelephone subscribersinNigeria................................................................ 50 Figure2-3: Accessibility ofNITEL............................................................................................... 50 51 Figure4-1: Entry Procedures......................................................................................................... Figure 5-1: Private Sector Credit / GDP Nigeria and Rest ofthe World, 2005............................. 70 77 Figure 6-1: Non-fuel merchandiseexport growth by product-group, 1999-2003 ....................... Figure 6-2: Tariff profile inNigeria ............................................................................................ 103 108 Figure 6-3: Nominal and effective rates ofprotection(per cent) ................................................ Figure 6-4: Nigeria exportsto the EUeligible for preference, 2003 ........................................... 108 Figure 6-5: Use of ACP preferencesfor agri-food productsinthe EUmarket, 2002 (per cent) . 114 114 Text Boxes Box 2-1: DiagnosingPoor Growth inNigeria ...DutchDisease or Debt Overhang?.................. Box 1-2:Distributing Oil Revenues to Nigerians.......................................................................... Box 1-1:Nigeria's First SovereignCredit Rating........................................................................... 6 21 Box 2-2: Why is Volatility High InNigeria? ExpenditureVoracity or Overborrowing? ..........-38 37 Box 2-3: Findings from Nigeria Value and Supply ChainAnalysis......;....................................... 42 Box 2-1: RoadFreight Rates for Imports. Exports and CombinedTrade on Selected Roads.......43 Box 2-4: Nigeria: Key Constraintsto Growth............................................................................... 48 Box 2-2 : Opportunitiesfor private sector involvement inelectricity distribution........................ 55 Box 4-1: Importing Shrimpsthrough Apapa Port.......................................................................... Box 2-3 : The Government's New Railways InvestmentProject.................................................. 60 69 Box 4-2: MultipleLicenses: The Tourism Sector.......................................................................... 71 Box 6-1: The CalabarFreeTrade Zone....................................................................................... 106 Box 6-2: Major PreferentialMarket Access Programs................................................................ 116 vi PREFACE 1. After decades of economic decline, Nigeria has a historic opportunity to lay the foundations for a strong growth take-off. Adverse macroeconomic effects of oil dominance are being better addressed, the efficiency of public spending is being enhanced, and several other distortions that constrained the economy's competitiveness and productivity are being tackled. The debt burden on the economy has been reduced through the recent debt deal with Nigeria's Paris Club Creditors and the country has received its first Sovereign Debt rating at a respectable BB-. Nigeria is in a good position to break with its past history of economic stagnation and leverage its considerable oil resources and the ongoing oil boom effectively to create the foundations of a competitive, diversified andrapidly growing economy. 2. The Government is anxious to seize this opportunity. It is giving increasingattentionto the challenge of diversifying the economy and aspiringto reacha growth rate of 10%annually- considerably higher than the historical trend of under 4 percent. This will require raising the productivity of the economy and improving the capacity of domestic firms to compete effectively in domestic and eventually in regional and international markets. This report consequently focuses on constraints, opportunitiesand strategic choices associatedwith increasingproductivity and growth of the Nigerian economy on a sustained basis. Its objective is not to present a "blueprint" for Nigeria's growth but rather to raise issues and provide some options for the considerationof policy makers and other Nigerian stakeholders. 3. The report is structured in four main sections. The first section analyzes Nigeria's growth history, examines the recent growth pick up and assesses its sustainability. The second section analyses how the critical constraints to competitiveness and growth may be addressed. The third section discusses how trade -domestic and external - can be used more effectively to drive growth and poverty reduction. The final chapter provides policy conclusions and suggestions on what could be key elements of a growth agenda for Nigeria. It is hopedthat this report will provide useful input for several ongoing Nigerian policy processes including the definition of a second generationof reforms and preparationof the second version of the Nigeria Economic Empowerment and Development Strategy (NEEDS 11)-Nigeria's PRSP. 4. This report has been preparedjointly by the World Bank and UK-DFID working closely with a Nigerian CounterpartTeam coordinatedby the National Planning Commission. Several of the background papers for the report were prepared by local researchers or joint teams of internationaland local researchers. vii ACKNOWLEDGMENTS This reportthat has beenpreparedby ajoint World Bank/UK-DFIDteam. Members ofthe team andtheir responsibilitiesare as follow: Overall Coordination and Drafting: V.Kwakwa, M. Owusu-Gyamfi; Growth and Macro: S. Vin Wijnbergen, V. Kwakwa, N.Budina, P. Osei, I. Chessa; Infrastructure:M. Mukherjee, J. Runji; A. Manroth; Finance: M.Fuchs, T. Muller,A. Manroth; Business Environment: P. Mousley, M- Owusu-Gyamfi,H.Abdo, S. El-Wahab, G. Nzekwu, Domestic and InternationalTrade: S. Sinha, P. Walkenhorst, 0.Cattaneo, PoliticalEconomy: M.Owusu-Gyamfi;Logistics,Mission Support andDocumentProcessingand Quality:G. Kwembe, M.Jean-Baptiste andP. White. Other members of the World Bank NigeriaCountry Team notably Hinh Dinh, SimeonEhui and Lev Freinkman and other Staff of UK-DFID both in Abuja and London provided very useful commentsandguidanceto the team's work. Peer Reviewers are CelestinMonga, Vandana Chandra, Edgardo Favaro, William Kingsmill and EamonCassidy. This work benefited from several background papers prepared by local and international researchers and consultants. The macroeconomic analysis in the main text and in the technical annexes drew heavilyon the backgroundpaper: Nigeria's GrowthRecord: DutchDisease or Debt Overhang? On the Sustainability and Growth Impact of Nigeria's Macroeconomic Policies writtenbyNinaBudina., Gaobo Pang., and Sweder VanWijnbergen. A list of backgroundpapers is providedat the endofthe report. The teamworkedcloselywith aNigerianCounterpartteam, coordinated by the NationalPlanning Commission, including members from the Federal Government and the Private Sector. The Counterpart team facilitated access to key data and government documents commented on the concept note, drafts of backgroundpapers and helped shape the focus and content of the study. Members of the group are: F. Ogbera (NESG), G. Enamudu(FMI), A. Digwe, 0.Akpa (FMC), B. Giwa(FMW), H.Oyedepo, S. Ahmed (FMT), D.Ashiru (NEPC), K.Kwujeli (NPC), 0.Edun (FMARD), C. Anyanwu (CBN), P. Odiniya, 0.Imianvan (FMP&S), U. Endurance (MAN), G. Bello(NIPC), J. Olotu(PHCN), S. Aborishade (FMF). viii 1. A NEW OPPORTUNITY FOR GROWTH Introduction 1.1 Inthe 1970s, Nigeria appearedto have successfully leveraged two oil booms for growth. Both industry and service sectors grew rapidly with overall growth of the economy reaching as high as 27 percent in 1970 and averaging 7.4 percent annually. Per capita GDP increased 4 percent annually. This growth episode was however short-lived and by the late 1970s, the economy had begun to slow. When oil prices crashed in the 1980s, the economy went through several years of contraction. Stagnation continued in the 1990s. Per capita GDP in PPP terms fell 40 percent from $1215 in 1980, to $706 in 2000'. Income poverty level rose from 28.1 percent to 65.6 percent, and other indicators of welfare-notably access to education and health- also declined. The economy became more dependent on oil as productivity and competitiveness of the non-oil sector declined. The Nigerian economy i s now experiencing the fastest growth in the last twenty five years. The Government's aspiration isto buildonthis growth spurt and make the country the twentieth largest economy by 2020. This report addresses how the recent growth opportunity can be seized to beginto move Nigeria from a natural-resource-based to a developed economy. To set the context, the next section of this first chapter reviews recent economic developments, section I1analyzes the key features of the Nigerian economy and the last section discusses its potential sources o f growth. I. RecentEconomicDevelopments 1.2 Nigeria i s presented with a rare opportunity for growth. Oil prices are at unprecedented levels and projected to remain relatively high for the foreseeable future given significant upward structural shifts in global demand for oil. New mechanisms are being put in place to better manage oil revenues and reduce the inefficiency associated with past boom-bust cycles. Fundamental changes in economic direction are tackling distortions that have reduced incentives for investment and productive activity. Strengthening o f democratic governance is building demand for accountability from political leaders and policy makers. These developments are helping to create the conditions for growth and strengthening confidence of investors in the economy. In the last five years and especially since 2003, Nigeria's economy has grown faster and been more stable. Growth averaged 5.7 percent annually between2000 and 2005, picking up across a broad range o f sectors. The non-oil sector which provides livelihoods for the majority of Nigerians has grown at 5.9 percent annually accelerating to 7.4 percent in2004 and 8.2 percent in 2005. Provisional estimates for 2006, show overall growth o f about 5.9 percent, non-oil growth of about 8.9 percent, and growth in the oil sector of -0.8 percent due to disruption in oil production inthe Niger Delta. 1Centre for the Study ofAfiican EconomiesOxfordUniversity. April 2003, Sources o f Growthin Nigeria:An Initial Analysis 1 Figure 1-1:Trends in GDP growth, GDP per capita, and sectoral contribution to growth. 150, I60 I 140 50 130 40 30 120 20 110 10 100 0 1999 2000 2001 2002 2003 2004 2005 1999 2MK) 2001 2002 2003 2004 2005 -+GDP +Non-oilGDP -+- Nonoilpercapita capita(inU.S. dollars) -011 price,GDP per(inUS. dollars) (nght scale) 1.3 While oil dependent economiestend to grow rapidly duringoil booms, the current boom i s different from earlier episodes in that the non-oil sector has grownjust as strongly and in the last two years stronger than the oil sector. GDP per capita in current U S dollars has more than doubled from $358 in 2000 to $752 in 2005. Nevertheless to achieve the MDG on income poverty, Nigeria's growth needs to be stronger, create more jobs at higher wages, and be sustained over decades. 1.4 Improved fiscal management has been the driver of recent macroeconomic stability improvements. The introduction of an oil price based fiscal rule (OPFR) designed to link government spendingto some notionof a long-runoil price beginninginthe 2004 budgethas de- linked government spending from current oil revenues and also introduced greater fiscal discipline and prudence. The budget reference price for oil in the 2004 and 2005 budgets was $27 and $30 a barrelrespectivelywhile the 2006 budget was based on a priceof $35 a barrel. In comparison the realizedprice for Nigeria's crude oil exports was $ 38.3 and $ 55.3 a barrel in 2004 and 2005 respectively and estimated at about $68 in 2006. The implementationof the OPFR represents a major departure from Nigeria's history of highly pro-cyclical fiscal policy. The statutory limit on federal government's overdraft account with the CentralBank of Nigeria (CBN) has also been reduced from 12.5 percent to 5 percent of current projected revenue Complementary reformsincludinginbudget preparation, procurementand financial management are also contributingto the strengtheningof fiscal prudence' 1.5 Monetary and exchange rate policies also improved. In the past, monetary policy was dominatedby fiscal policy as the CBNtended to accommodatethe expansionary stance of fiscal policy. This is changingwith a more proactiveapproach to monetarypolicy. Specificmeasures include: (i)the introduction of a new settlement bank system; (ii)movingto daily open market operations at end 2003; and (iii) the withdrawalof CBN as a buyer from the primary market for government securities in parallelwith the gradual shiftto market-clearinginterest rates startingin the third quarter of 20043. A Monetary Policy Department and a Monetary Policy ImplementationCommittee have been created to help improve liquidity forecastingand ensure timely implementation. These improvements and greater fiscal prudence are strengthening the effectiveness of monetary policy and for the first time in over two decades, monetary policy targets are being met. Liquidity management nevertheless needs further improvement and the These are discussedingreater detailinthe reportNigeria: A FiscalAgendaFor Change InApril 2004, the CentralBank ofNigeria(CBN) and the Debtmanagement Office (DMO) began smoothing the maturityprofile on three monthtreasury bills. A six monthtreasury bill was introducedinOctober 2004. 2 CBN needs to rely less on direct instruments and ad hoc measures, and more on exchange rate and interest rate flexibility. Exchange rate management has been made more flexible with the implementationof a retail Dutch auction system (DAS) inJuly 2002 and the move to a wholesale system (WDAS) in February 2006. The free sale of foreign exchange to the interbank market under the WDAS has achieved the unification of the two major foreign exchange markets-the retail market for non-financial traders and investors and the interbank market. In the last few months, measuresto increase the supply of foreign currency and give Bureaus de Change (BDCs) access to official markets led the parallel exchange rate to appreciate and the exchange rates to converge. 1.6 These policy improvements have had a positive impact on macroeconomic outcomes. The overall fiscal balance strengthened from a surplus of 6 percent o f GDP in2000 to 9.3 percent of GDP in 2005. However the non-oil deficit expanded as a share of non-oil GDP from 30 percent in2002 to 34.2 percent in 2004 and 38.9 percent in 2005. The increasesreflect in part the government's efforts to settle outstanding claims from several years back including pension and domestic contractor arrears as well as the costs of some the ongoing reforms including the monetization of public service benefits. Settlement of these claims i s continued in the 2006 budget. Inaddition, the implicit subsidy on fuel consumption has been made explicit inthe 2006 budget (funded with about $150 billion split evenly between the federal government and state governments). These factors are likely to keep the non-oil deficit as a share of non-oil GDP high in2006. Provisional estimates for 2006 are an overall fiscal surplus of 12.0percent ofGDP, and a non-oil fiscal deficit o f 42 percent o f non-oil GDP. Strict adherence to the oil price fiscal rule, together with continued fiscal tightening, i s critical to avoid a slide back into the spending sprees following past oil booms. 3 Figure 1-2 :FiscalOperationand PublicDebt 50 { { cOverall Fiscal Balance to GDP Ratio Public sector net debt to GDP ratio, % 70 1 20 - \ I I I I I -8 10 - 1999 2000 2001 2002 2003 2004 2005 0 - I I I I I -Oil Rice, $ per bbl -Overall Balance,% of GW -10 1 \, 1 Non-oilprimary balance(% of non-oilGDP, cash basis) Expenditure growth in current $ -20 2020 2001 2002 2003 2004 2005 2006 -25 - 2000 2001 2002 2003 2004 2005 ~-45 J 1 1999 1.7 Higher oil income, a more cautious fiscal policy and the recently concluded debt relief agreement with the Paris Club led to a substantial decline in Nigeria's net debt position. Gross debt went down from 73 of GDP to 31 percent of GDP, and external debt fell from US$35.9 billion to around $5 billion between 2004 and 2006. Gross international reserves rose from 23 percent to 40 percent of GDP. 1.8 External balance improved dramatically. The current account balance moved from a deficit o f 8.4 percent in 1999 to a surplus o f 12.1 percent o f GDP in 2005 and an estimated 12.5 percent of GDP in 2006. This has been driven by the oil price hikes as well as increased FDI flows. Net FDIdoubled from US$3 billion in 2003 to more than US$6 billion in 2005. Close to 75 percent of FDIflows went to the oil and gas sector but non-oil FDIalso increased almost six- fold from $0.3 to $1.7 billion over the same period. The overall balance o f payments has been in surplus for the past two years, leading to an accumulation of sizeable foreign exchange reserves from $17 billion in 2004, to $28.3 billion at the end of 2005 and an estimated $46.5 billion in December 2006 after clearing arrears and completing a buy-back operation with the Paris Club. 4 Figure 1-3: Trends in current account balance and met FDI CurrentAccounl, % of NonGGDP -30 1......................... 1999 2000 2001 2002 2003 2004 2005 ~ ................................ 1999 2000 2001 2002 2003 2004 2005 IOtherFDI(net) IOil&GasFDI(net) 1.9 Inflation has been quite variable over the period but has declined substantially from the peak of close to 30 percent towards the end of 2003 to about 10 percent at end 2004. Annual inflation fell to 13.6 percent inJuly 2006 from 17.9 percent inJanuary 2006. The Government's objective is to achieve single digit inflation. The real exchange rate has appreciated over the period. By 2005, the REER was 18 percent above 2003 levels, eroding the modest competitive gains that hadbeenachievedduring 2002-03. . 5 Table 1-1:Key macroeconomicIndicators, 2000-05 Actual Est. 2000 2001 2002 2003 2004 2005 Growth. Investment. and Savings RealGDP growth (?A,at 1990factor costs) 5.4 3.1 1.5 10.7 6.0 7.2 Non-oil(?A,at 1990factor costs) 2.8 4.3 8.0 4.4 7.4 8.6 Gross investment (% of GDP) 20.3 24.1 26.2 23.9 22.4 20.9 Publicfixed investment (?Aof GDP) 9.6 13.8 10.0 9.7 9.1 9.1 Gross national savings (?Aof GDP) 32.0 28.6 14.5 21.1 27.0 33.4 Monev and Prices Broadmoney(%change) 48.2 27.2 21.6 24.1 14.0 16.5 Consumer inflation, (%; annual average) 6.9 18.0 13.7 14.0 15.0 17.9 Treasury bill rate (%; end ofperiod) 14.6 20.0 14.9 14.9 14.3 12.0 DASofficial exchangerate (nairaper US$;average) 102.2 112.0 122.2 130.9 134.3 131.0 Terms oftrade (%change) 53.2 -10.4 -0.5 2.5 20.5 37.8 PublicFinance(ConsolidatedGovernment) Governmentrevenueand grants (% of GDP) 42.5 42.1 36.4 37.1 43.1 43.3 Governmentexpenditure, total (% of GDP) 36.5 47.0 40.7 38.4 35.4 33.4 Non-oilprimarybalance (?Aof non-oil GDP,cash basis) -34.8 -43.2 -29.9 -34.4 -34.2 -38.9 Overallbalance (% of GDP,commitment basis) 6.0 -4.9 -4.2 -1.3 7.7 9.3 Balanceof Pavments Exportsof goods andservices (YOof GDP) 54.3 43.3 40.9 49.7 54.6 55.2 Imports of goods andservices (YOof GDP) 32.2 32.5 41.8 41.5 37.4 33.9 Current account balance (% of GDP) 11.7 4.5 -11.7 -2.7 4.6 12.6 Gross Internationalreserves (US$ billion) 9.4 10.4 7.7 7.5 17.0 28.3 Gross Internationalreserves (months of imports of goods and 7.3 6.5 3.9 3.4 6.1 8.7 services) Externaldebt Externaldebt outstanding(US$billion) a/, b/ 30.2 29.7 31.0 32.9 35.9 20.5 Externaldebt outstanding(%of GDP)a/, b/ 66.1 62.3 67.2 57.2 50.4 20.7 Debt servicedue (% of exports of goods andservices) 6.9 12.1 15.6 10.3 7.8 6.4 Source: IMF: a/ Nominal public sector short- and long-termdebt, end of period. b/ In2005 reflecting also a $7.1billionwrite-off of Paris Club debt. 1.10 Reflecting the improvements in the direction of macroeconomic policy, Nigeria has obtained her first sovereign credit rating at a respectableBB- Box 1-1: Nigeria's First Sovereign Credit Rating Inthe first quarter of 2006, two leading international rating agencies, Fitch Ratings and Standard& Poor's, assigned a "BB-" rating to long-term debt issued by the Nigerian Government. The ratings are an important indicator of how international capital marketsview the economic and political state of the Nigerian economy. A "BB-" rating indicates that inthe view ofthe two rating agenciesthe Nigerian Government is less likely to default on its debt obligations than other speculative grade borrowers. Due to large uncertainties and major exposures to adverse conditions, Nigeria cannot be considered investment grade and will not be able to attract more mainstream capital market investments. Nonetheless, the rating can be expected to attract further inflows from specialized emerging market investors with higher risk appetite. The ratings put Nigeria in a peer group with other large developing countries like Brazil, Indonesia, Iran, Turkey, Vietnam, Venezuela and Ukraine. In comparison to its peers, Nigeria has much healthier fiscal balances and its low leverage and high external liquidity resulting from increasing oil revenues and the 2005 Paris Club deal are considered its key relative credit strengths. Nigeria's per capita income is significantly lower than the peer group and it faces bigger social and economic challenges, including the diversification of its exports and government revenue base. Both rating agenciesconsider politicalrisk, institutional weaknesses, governance issues and a short track record of economic reform to be the major constraint to higher creditworthiness ininternational capital markets. 6 11. Features of the Domestic Economy 1.11 Nigeria's economy is similar in several respects to other low income developing economies inAfrica but is significantly different inits considerable oil and gas resourcebaseand the large size of the domestic market. In contrast to other large oil producers, Nigeria has not managed to use oil resources to diversify its economy and move towards higher productivity sectors. The advantage of a relatively large domestic market has not delivered efficiency gains for domestic firms. LimitedDiversification and Concentration of Oulput 1.12 The economy is dominatedby oil which has risen in importance from 29 percentof GDP in 1980to 52 percent in 2005. Oil and gas contributeabout 99 percent of exports and provide about 85 percent of government revenues however its contribution to employment is limited- estimated at around 4 percent. Public ownership of oil has also allowed extension of the public sector evidenced inhistoricallymuchhigher share of government spending in GDP than in other developingcountries4. Agriculture, the second largest sector, declined in importance from 48 percent of GDP in 1970 to 20.6 percent in 1980 and contributed 23.3 percent of GDP in 2005. An estimated 60 percent of'Nigerians are employed in the sector. Agricultural exports are negligible and represent about 0.2 percent of total exports. Manufacturing and services contributed4.6 percent and 19.9 percent respectivelyof GDP in 2005. The bulk of economic activity is therefore inprimaryproductionwith limitedprogressinmovingupthe value chain. Figure 1-4: Nigeria: Indicators of Oil Dependence 120 .......................................................... Nigena: Oil Dependence Nigeria: Revenue Dependence on Oil T ....................................................... 60 0 . . . . . . . . . . . . . -.-~-:. . . . . . . . . . . . . . . . ................ . . . . . . ............................... 0 ~ P r K ? 8 ~ g ~ ~ s 2 x % s g g g , L L L L 2 , , , , L " L 2 N N N +Oil exports (% of total exports) -c-Oil GDP (% of GDP. nght scale) -oil Revenue (% of Total Revenue) --coil Rice. BonnyLight(US$/bbl), rightscale 1.13 Nigeria's non-oil economy is essentially a domestic economy, producing to supply domestic demand. Activity in the sector is narrowly focused on and driven by markets for food and beverages. Agriculture is largely devoted to the productionof food. The largest crops in value and volume terms5 are all mainly consumed domestically while traditionalexport crops6 have declined in importance. The livestock and fishery activity is also mainly domestically oriented. Thus almost all of agriculturalGDP is directed towards meeting domestic demand. The manufacturingsector is similarly stronglyoriented towards food and beverages for the domestic market, accountingfor between 50- 60 percent7 of manufacturingGDP. The largest component of the services sector i s wholesale andretailtrade, ofwhichfood andbeveragesrepresent close to Inthe lastfew years this ratio has declinedfrom over 50 percentto aboutpercent in2005. 'cassava, yam, sorghum, maize, millet, cowpeaandrice paddy 'This Cocoa, coffee, rubber whilst palm oil production is now geared almost exclusively to the domestic market includes also informal manufacturing which is dominatedby the manufacture of food and beverages. 7 90 percents, with domestically produced food and beverages accounting for the overwhelming proportion o f value added. Food and beverages therefore account for between 50-60 percent o f non-oil GDP. Table 1-2: Structure of Economy, 1974-2004(percent of GDP at current factor costs) 1970 1980 1990 2000 2003 2004 Oil sector GDP 6.0 29.1 39.3 48.2 44.6 48.2 Non-oilsector GDP 94.0 70.9 60.7 51.8 55.4 51.8 Agriculture 41.3 20.6 29.7 26.3 26.4 16.6 Industry 7.8 16.4 7.4 4.5 4.8 8.7 Services 45.0 33.8 23.6 21.0 24.2 26.5 Source:NBSiIMF Declining Productivity and Competitiveness 1.14 Productivity and Competitiveness have been declining over time and the economy is one o f the least competitive globally and even in Africa. On several o f the "Doing Business Indicators" Nigeria does poorly compared to most other economies including low income economies in Africa. The World Economic Forum (WEF) 2006 report ranks Nigeria 88 out of 117 countries on its Global Competitiveness Indicators (GCI). Despite the large domestic market, only a small proportion o f producers have been unable to develop into sizeable businesses able to compete internationally, evidenced inthe long term decline o f non-oil exports. Table 1-3: Comparative Indicators of Competitiveness Country GCI 2005 Rank GCI 2005 Score GCI 2004 Rank SouthAfrica 42 4.31 41 India 50 4.04 55 Ghana 59 3.86 68 Source:WorldEconomic Forum 1.15 Total factor productivity growth' has been low and appears to have fallen consistently between 1970 and 200010. Increases in capital per worker have been negligible. High levels o f ICORS are also suggestive of low productivity and high inefficiency o fthe Nigerian economy. In agriculture, yields have been falling and in manufacturing, there i s considerable unused capacity, reflecting in part obsolescence o f capital and equipment. The economy's low efficiency reflects several factors including significant distortions to economic incentives through wrong policy choices especially on the trade regime. * Foodand beverages account for 65% ofthe consumption basket, Excludingexpenditureon items not sold in retailoutlets (Le. accommodationandutilities and transport), they account for roughly90% o fwholesale and retailexpenditure. Other studieson productivity growthinNigeriaincluding,Adenikinju and Soludo (1997); Chete and Adenikinju (1996) andAdenikinju and Chete (1999). Arrive at the same conclusion. 10Details ofthe methodology and resultsused are providedin Technical Annex 1-B. 8 Figure 1-5: Cumulative TFP for Alternative Initial Capital-Output Ratios" 1- K(0) = lS'GDP(0) ----- K(0) = Z'GDP(0) I Source: World Bank staffbasedon WDI data Duality andHigh Levels of Informality 1.16 Duality and high level of informality is an important factor in the economy's low competitiveness andweak productivity. Firstthere is the glaringduality betweenthe oil andnon- oil sectors. The oil economy has high productivityand competitiveness, operating with modern technology, is externally focused, with per capita income estimated at about $4000. It has limited linkages with the non-oil economy which in contrast has low productivity and competitiveness, operates with outdated technology, is domesticallyfocused, with income per capita estimated at about $300. In each of the major sectors of the non-oil economy there is also a sharp divide between a small number of highly productive, internationallycompetitive producers and a very large number of small producers with low productivity. In industry and services, an added complicationis that the overwhelmingproportionof enterprisesare in fact informal,with limited links to the formal economy12.A survey of the informalsector in 2000 showedthat only 12 per cent of its raw materials originates from the formal sector and only about 8 per cent of its output i s sold to the formal ~ector'~.The barriers to expansion faced by formal SMEs and informal enterprises preventsthe buildup of competitivepressureandthe specializationneededto increase productivityand internationalcompetitiveness. 1.17 In agriculture, the types of linkages that have developed in countries such as Kenya between commercialand smallholder farmers have not developed in Nigeria. The requiredlong term investmenthas not provedan attractiveproposition, giventhe investment climate. There has been some progress recently with manufacturers concerned to ensure an assured supply of raw materials establishing nucleus estates and linking in smallholders. Butthe overallpictureremains one of a lack of linkages between the two types of agriculture. The duality of the economy is even sharper in industry and services. In terms of numbers of firms and employment, there is a 11 Details of the TFP analysis are provided inTechnical Annex 1-B 12 The ILO definesthe informal economy as encompassingthose employed informally in officially registered businesses and those self employed and employed in unregisteredbusinesses. Here, the term informal is usedto meanunregisteredbusinesses as much of the evidence inNigeriahas beencollected on this basis. l3 Main inputs purchased fiom the formal sector include electricity, fuels, flour, bagshacks, sugar, fish, cotton, cloth, thread, paper chemicals, ironrod, among others. 9 small, formal economy and a very large informal economy. Whilst the numbers of registered businesses is growing rapidly, they are numberedin the tens o f thousands and formally employ less than 1million. In 1999, the nationalsurvey of the informal~ector'~estimatedthat there were over 8 million informal enterprises employing 12.4 million people, roughly half the non- agricultural work force. But the large informal economy, mainly comprising self employed individuals, producedthe equivalent ofjust 7.2 percentof GDP. 1.18 Inthe formaleconomyas well, there is evidence of discontinuity.Outputis dominatedby large, long established businesses. They choose to focus on a narrow range of branded, high value products with economies of scale using capital intensive technology. This is intended to prevent cost disadvantages underminingprofitability and to shield them from competition from SMEs. As a result, value added per worker is comparativelyhigh, exceeding US$ 5000 in 2000 in manufacturing.These large businesses, often foreign owned, are able to compete in regional markets and exports of chemicals and paints, food and beveragesand plasticsare increasing.But they are restrictedto a narrowrangeof products. 1.19 In contrast, value additionin manufacturingamongst SMEs is lower,just over US$3,000 amongst the formal small businesses included in the WED survey. Investment climate constraints increase in severity, the smaller the enterprise. The large operate in better industrial estates with greater access to infrastructure,can invest in private generationof electricity and, in additionto loanfinance from the commercial banks may raise equity on the stock market. SMEs are therefore likely to be disadvantagedin competingwith the large and the transitionfrom small to mediumto large is progressivelymore difficult. 1.20 There is a sharper dividing line between formal and informal enterprises. All the investment climate constraints are likely to be amplified. In particular, registration is a pre- requisite for the business to open a bank account. Access to external finance amongst SMEs is very low, limited to informal "essusu" savings and loan schemes. As a result, value added per worker in informal manufacturingis much lower, estimated at $250 per worker. The 3.2 million peopleemployedininformalmanufacturingproducedthe equivalent ofunder 5 percentof GDP. 1.21 The greatest contrast of all is inwholesalingand retailingwhich accounts for over half (52 percent) service GDP. Formalwholesalingand retailing inNigeria remains traditional but to develop the large retail formats that are now dominant world wide, value added per worker is reasonable. In contrast, productivity per person engaged in informal wholesaling and retailing was only $30, with the majority having to find other employment to survive. All the 9 million people engaged in informalservices, nearly 20 percentof the workforce, producedthe equivalent ofjust 2.5 percent of GDP. 1.22 The duality of the economy thus causes low productivity and also results in a lack of dynamism and competition.Surveysrevealthat a very highproportionof large formal enterprises and even SMEs are long established busine~ses'~.As in the rest of the world, the longer established the firm the less dynamic Nigerian firms become in terms of growing output and employment. Addressing the duality of the economy is therefore vital for strengthening and sustainingnon-oilgrowth. Particularattention needsto be givento improvingthe productivityof smallholder agriculture. Addressing the investment climate constraints generally will be important with particular emphasis on those that restrict the growth of formal SMEs. Providing 14 A Study ofNigeria's Informal Sector, CBNIFOSMIESR, 2001 I 5See for instance, Lagos Strategy in Economic Developmentand PovertyReduction:the Performanceof NigerianFirmsinLagos. May 2006. 10 incentives for formalization and ensuring that those who remain informal have better livelihood opportunities,coulddeliver importantgrowthdividends. Lack of Jobs, Low IncomesandPervasivePoverty 1.23 Nigeria's population of about 130 million is the largest in SSA and also one of the fastest growing increasing at an estimated 2.5 percent annually. About 45 percent of the population is under 14 years. Available data (table 1-4) suggests the following sectoral distributionof employment: Table 1-4: ProbableDistribution of the Working Population by EconomicActivity (YO) Agriculture 50 ~ Manufacturing 10 Wholeslale and Retail 15 Public Administration 10 Health and Education 10 Others 5 1.24 Only an estimated 5-10 percent ofthe 6 millionnew entrants onto the labormarketfind jobs'6. Open unemployment of youth aged between 15-29 years is estimated at about 60 percent". This highlevelofyouthunemploymentis a major policy challenge of the government. There is considerable anecdotal evidence that official statistics which put unemployment at about 12percent significantlyunderestimatethe true size ofunemployment inthe economy. There is a lack of formal, full time jobs outside the civil service, publicly funded education and health services and the utilities. There are less than 1 million people employed formally outside the public sectorI8 and public sector employment is estimated at lower than 1.5 million. The vast majorityof the workforce is self employedin agricultureandthe informaleconomy or employed casually. The incomes provided are low and there is a lack of job security with poor working conditions. 1.25 The critical cause of low incomes and wages is low productivity. Small farmers are unableto cross the $l/day benchmark for their households.The vast majority of those employed in the informal economy are self employed and also earn low incomes. There are sizeable informalbusinesseswhose proprietorsearn good incomes. Generally those who are employedfull time inthese activitiesare `survivalbusinesses' deniedbetter incomeearning opportunities. 1.26 Remuneration (wages and personal benefits) is reasonable in formal employment ($100-120/monthfor unskilledlabor).Wages ininformalemployment are less than halfthis level ($25-$50). Casual laborers may expect to earn between$2-$5/daydependingon the nature of the task and location. Generally wages are lower in the North than the South and in rural areas comparedto urban. Though finding work may be unpredictable, the wage earnedmay be higher thanthe equivalent daily income from agricultureand informalself employment. 1.27 This has given rise to seasonal migration from North to South in search of casual employment on farms and along with a preference for urban life styles, has drivenurbanization. But frequently, those most inneed to supplement their farm incomes from non-farmsources are least able to do so. Whilst middle sized and large farmers are ableto supplementtheir incomes by 16FederalMinistry of Labor and Productivity based on data from CBN. 17FederalMinistry of Labor and Productivity 18 Ministry o f Labor and Productivity 11 trading and manufacturingfoods, the poor have to rely on casual labor for non-farmincomes as they lack access to finance. Thoughwage rates in agriculturehave risen to $2-$3/dayinthe North and as high as $4/day inthe South, peak demandfor labor coincides with their needfor labor on their own farms, denyingthem the most obvious opportunityto supplementfarm incomes. 1.28 The parts of the economy that are more productive such as formal manufacturingare not labor intensive. The 2001 WED survey estimated that the whole of formal sector manufacturing employed less than 300,000 people. The very large firms that dominate manufacturingemploy capital and skill intensive processes that do not create large numbers of jobs. Formal SMEs are more labor intensive but constrained to expand. The informal sector is largely made up of the self employed. Informal manufacturing performs better than informal services. Though the majority are self employed, engaged in processing food and other simple processes,the average firm employs close to 2 people and there are larger businesseswith up to 20 employees. A large proportion of 'employees' however, are unpaid family members and apprentices, payingfor their trainingandthe rightto enterthe trade. 1.29 The functioning of the labor market also plays a role in the failure to generate productivejobs. Inthe formal economy, labor productivityfalls with the degree of unionization, with days lost to industrialdisputes and highrates of ab~enteeism'~.There is evidence to suggest that the response is not only capital intensive processes but also greater skill intensity, using a smaller number of better qualified and remunerated people. The payment of higher wages has been found to be causal factor in SMEs not investingand growing2'.Moreover, inmost surveys, in contrast to large employers, SMEs complain of skill shortages, particularly technical skills, suggesting weaknesses inthe system of vocationaltrainingsystemthat prevents it from equating supply with demand. Employersingeneralcomplainofthe educationsystem producinggraduates that have limitedpracticalskills. 1.30 Nigerianlabor laws are stronglyprotectiveof workers rights and encourageunionization in larger firms. Further research is needed to ascertain whether they strike the right balance between the incentive provided to employers to increase employment, by increasing the flexibility to hire and fire and reducingpersonalbenefits, and the rights of workers. There is also a case for reviewingthe functioning of the vocationaland highereducation systems to see ifthey couldbetter matchthe needsofemployers. 1.31 With lack ofjobs and low incomes, poverty is pervasive. An estimated 54 percent of Nigerians live below the poverty line. Income inequality is high, with a Gini coefficient estimated at about 0.48. There does not seem to be a link between levels of poverty and inequality, although poverty is generally higher in the north and inequality is generally lower. Nonincomeindicatorsofpovertyare alsopoor (see Table 1-5). Table 1-5: Nigeria Indicators of Poverty 2004 IncomePovertyIncidence 51.6% PrimaryEnrollment 60.1% Infant<5 Mortality 1 out o f 4 children MaternalMortality 37,000 / year Access to Safe Water Source: Nigeria PovertyAssessment (2006) 19W E D Manufacturing Survey 20Lagos State Economic Development Strategy: The Performanceo fNigerian Firms in Lagos.May 2006. 12 111. Sources of Non-OilGrowth 1.32 Nigeria wants to seize the opportunity providedby current high oil prices to develop non-oil sources of growth and more importantlyshift the sectoralcompositionof growthtowards higher value addedproductivity activities. This section discusses first supply sources of non-oil growthfollowedby demandsources. Table 1-6: Sources of Growth in Nigeria A. Supply Side Sources (YOreal growth) 2000 2001 2002 2003 2004 2005 OverallReal Growth 5.4 3.1 1.5 10.7 6.0 7.2 Oil 11.5 1.4 -11.6 26.5 3.5 4.2 Non-oil 2.8 4.3 8.0 4.4 7.4 8.6 Agriculture 2.9 3.9 4.3 6.5 6.5 7.0 Industry 3.6 8.7 8.9 6.4 9.6 8.8 Services 2.5 3.6 13.0 1.2 8.1 10.7 B. Demand Side Sources. (YOreal growth) 2000 2001 2002 2003 2004 2005 OverallRealGrowth 5.4 3.1 1.5 10.7 6.0 7.2 Consumption -11.9 18.5 24.2 -7.5 5.8 28.9 Investment -11.9 18.5 54.7 -7.5 11.4 28.9 Exports 16.4 -3.9 -10.9 31.6 3.1 -1.9 Imports -0.8 8.9 20.6 10.2 3.2 21.7 1.33 Agricultur2'. Endowed with abundant land and water resources, Nigeria's agricultural sector has a high potential for growth. Its highly diversified agroecologicalconditions could allow production of a wide range of agricultural products including both tropical and more temperate products. Three maintypes of productionsystems can be distinguished: (i) medium- and high-potentialmixed systems in the humid south (dominated by cassava, yam, maize, and tree crops); (ii)medium- and high-potential mixed systems in the semi-arid middle belt (dominated by maize and sorghum); and (iii)low potential livestock-based systems in the arid north (dominated by livestock, millet, and sorghum). Production of crops dominates other agricultural subsectors contributing about 85 percent to agricultural GDP, livestock production activitiesabout 10percent, fisheries about 4 percent, andforestry productionabout 1percent. 1.34 Before the oil boom of the 1970s and 8Os, Nigeriahad a vibrant agriculturesector. The country was food self sufficient and a key exporter of several agricultural commodities notably cocoa, oil palm, rubber, groundnuts. Excessivereal exchange rate appreciationand overvaluation following the oil booms and other distortions introduced by implementation of an import- substitution industrialization policy reduced agricultural competitiveness and incentives for investment in agriculture. Large commercial private estates that made Nigeria a major exporter of tropical commodities declined in importanceand large foodmanufacturerswho usedto grow a proportion of their own raw material needs withdrew from farming. As agriculture declined, Nigeriabecame a significantfood importerandagriculturalexports all but disappeared. 1.35 Nigerian agriculture is predominantly small holder, subsistence based and weather dependent. Most farmers produce mainly food crops using traditional extensive cultivation ''A detailedanalysisofNigeria's Agriculture Sector is providedinthe report: GettingAgriculture Going In Nigeria" WorldBankReportNo.346 18-NG.Annex 1-Falso discussesthe mainproductivityand competitiveness issues affectingthe sector. 13 methods, making limited use of modern technologies and purchased inputs. The capacity of the agricultural research, extension and input distribution systems are weak and where available, modern technology cannot reach farmers. The country's vast irrigation potential remains largely unexploited: less than 1 percent of cultivated area under irrigation. Activity in the sector is also characterized by significant post harvest losses due to difficulties in reaching markets and the highcost oftransporting produce to markets. 1.36 Productivity has declined for both commercial and food crops in Nigeria over the last twenty years. For commercial crops production levels have fallen as well. In contrast, production levels of food crops have increased substantially and Nigeria has overcome its extreme import dependence. However, this growth has been driven by steady and substantial increase in the area cultivated and harvested" and crop land expansion i s increasingly taking place on marginal land where yields are lower. Productivity as measured by yields per hectare have therefore declined whilst internationally, yields have been rising. In the case of roots and tubers for example, a fourfold increase inareaplanted since the mid 1980shas beenaccompanied by a decline inyields in excess of 40 per cent. Similar, but less dramatic outcomes are observed for cereals, beans and groundnuts. (see Table 1-7)23Thus the current targeting output increase basedon area expansion is unsustainable over the long term. Table 1-7: Nigeria: Main Crops, Area Harvested, Production and Yield, 1999,2003 and 2004 MainCereals 18437 24133 25515 22478 29186 31477 1.22 1.21 1.23 Roots& Tubers 6849 9300 10344 66076 78830 84465 9.65 8.48 8.17 Pulses 10340 13961 14107 4603 5952 6140 0.45 0.43 0.44 Total 40920 54574 56753 1.37 The severe reduction in agricultural exports is further indication of the weak competitiveness of Nigerian agriculture. Agricultural exports fell from 2.5 percent to 0.2 percent o f total exports between 1980 and 2005. Nigeria has lost market share for exports such as cocoa, oil palm and rubber. Non-traditional agricultural exports are limited. While agricultural exports have strengthenedsince 2000, performance i s still far below the economy's potential. 1.38 Crop production is below potential and annual production of fish totals just over 510,000 tons compared to estimated production potential of 3.2 million tons indicating considerable room for further expansion. The potential to expand Nigeria's freshwater fisheries24 is vast, with about 2.25 million ha judged suitable for aquaculture. To date, this potential has not been exploited, although the number of commercial fish farms is growing rapidly. Only a small proportion of poultry is raised commercially and production could be expanded significantly for domestic market and for export. 22the statistics relateto areaharvestedand are likely to understate areacultivated since areas which yield no harvestare not included 23Itshouldbenotedthat thetable excludes the period 1972to 1985 for which comparableinformation is not available, notably for area harvestedandyields. 24With the offshore marine fishery alreadyunder pressure, and with pollution in estuaries andbrackishwaters reducingtheir productivity, future production increaseswill almost certainly haveto be achievedthrough aquacultureand restockingprojects involving inland fisheries FA0 2000. 14 1.39 Raising productivity is critical for realizing the considerable potential of agriculture in Nigeria. This requires addressing the low level of technology inthe sector evidenced invery low use of modern technology including limited use of improved seed and breed varieties, irrigation and mechanizationz5. It will take time to bridge the international competitiveness gap. So the strategic focus for the short term should be on improving competitiveness of Nigerian agriculture indomestic and regional markets inwhich Nigerian products enjoy natural and tariff protection. Growth is likely to continue to be led by smallholder farmers looking to improve their incomes. Policy should focus on improving access to and functioning of markets for inputs and outputs, so that smallholders have the incentive and means to improve productivity. 1.40 For the longer term though, the strategic focus should switch to restoring competitiveness of traditional exports (cocoa, oil palm, groundnuts) and the promotion o f newer, high value exports (shrimps, tanned leather, sesame, high value vegetables, etc). Competitiveness in these products would benefit from larger scale investment than smallholders are able to undertake. Therefore improving the investment climate so that large scale investment may resume over time inNigerian agriculture will be crucial. 1.41 Manufacturing and Industry. But Nigeria has not succeeded in appreciably raising its level of manufacturing and industrial performance over the last twenty five years. On the contrary, the economy has experienced some level o f de-industrialization and declining manufacturingperformance, reflecting the weak competitiveness of the sector. Nigeria is ranked 83 out of 117 countries on the UNDO Competitive Performance Index (CPI) and lower than other comparators including other major oil producingcountries. The economy's weak industrial competitiveness is evidenced in several other indicators of sector performance. The share of manufacturing in GDP fell from 8.4 percent in 1980, to 5.5 percent in 1999 and 4.6 percent in 2005. This compares poorly with other oil economies and even with some African countries. Manufacturing value added per capita has also declined marginally from about $17 in 1990 to about $16 in 2002. This compares with increase from $133 to $273 for Indonesia and $600 to $1066 for Mexico over the same period. 1.42 Nigerian manufacturing is dominated by small and medium scale firms. An estimated 87 percent of manufacturing firms are characterized as SMEs. Manufacturing and industrial activity i s concentrated around the major urban centres of Kano and Lagos and to a lesser extent Kaduna and Ibadan. Evidence from Lagos state which has the largest concentration of manufacturing firms suggests that Nigerian firms are foregoing scale economies. As indicated above, many sectors have low levels of market competition, with small numbers o f larger enterprises and a competitive fringe of smaller or tiny ones. However, firm sizes o f even the largest firms are very small by internationalstandards. Table 1-8: Manufacturing Value Added, 1980-2005(% of GDP) 1980 1990 2000 2005 Nigeria 8.4 5.5 4.5 4.6 Mexico 22.3 20.8 20.3 17.7 Indonesia 13.0 20.7 27.7 Brazil 33.5 17.1 Ghana 7.8 9.8 9.0 8.6 SouthAfrica 21.6 23.6 19.0 19.1 Source: WorldBank database 25 The agriculturesector is analyzed inmore detail inGettingAgriculture Going InNigeria. World Bank report No. 34618-NG December2005. Appendix 1-Fo fthis reportalso includes anote on Agricultural productivity and competitiveness. 15 1.43 Nigerian manufacturing is dominated by small and medium scale firms. An estimated 87 percent o f manufacturing firms are characterized as SMEs. Manufacturing and industrial activity i s concentrated around the major urban centres o f Kano and Lagos and to a lesser extent Kaduna and Ibadan. Evidence from Lagos state which has the largest concentration o f manufacturing firms suggests that Nigerian firms are foregoing scale economies. As indicated above, many sectors have low levels o f market competition, with small numbers o f larger enterprises and a competitive fringe o f smaller or tiny ones. However, firm sizes o f even the largest firms are very small by international standards. 1.44 Manufacturing sector surveys (2001, 2003, 2004) have repeatedly highlighted three worrisome features o f Nigeria's manufacturing sector: (i)firms tend not to invest at all or to invest very little; (ii)only a small fraction o f firms engage in export, the vast majority serving only the domestic market; and (iii) firms generally have a lot o f unused capacity. Less than 50 percent o f firms in the different surveys reported non-zero investments. And for investing firms the investment rate26 i s only large enough to balance depreciation and cannot cover much expansion. Larger firms are more likely to invest but tend to have lower investment rates. This pattern o f performance i s similar to that in several other African countries27. The survey data also suggests that the proportion o f firms engaged in export may have risen between 2001 and 2004 but still remains low at under 10 percent. Even in sectors such as food, textiles and garments where exports were relatively high, the numbers o f firms exporting was low. Again larger and more efficient firms are more likely to be engaged in exports. Nigerian firms are estimated to be 15 percentage points less likely to export than firms in Ghana and Tanzania. It i s also striking that a large Nigerian firm is less likely to export than a small firm in Tanzania or Ghana2* This firm level data confirms the macroeconomic evidence o f low manufactured exports. Capacity utilization rates have declined over the years and averaged about 45 percenf9 in 200430. Large firms tend to have the highest capacity utilization rates. A comparative study o f five African countries showed that Nigerian manufacturingi s about 30 percent less efficient than South Africa but has efficiency level similar to Ghana, and Kenya and higher than Tanzania by about 15 percent. 1.45 The technology intensity o f Nigerian manufacturing is also low. The share o f medium and high tech (MHT) industries in manufacturingvalue added (MVA) in Nigeria is considerably lower than in comparator countries. In contrast, the share o f low technology industries is one o f the highest in Africa and also higher than the average for developing countries (see Table 2-4 in Chapter 2). 1.46 Manufacturing can be an engine o f modernization o f the Nigerian economy, and can help create skilled and higher payingjobs for Nigerians. As can be seen from Table 1-6, industry has been the fastest growing sector between 2000 and 2005. The manufacturing sector is small and therefore has considerable room to grow including through (i)processing agricultural produce: for example leather production from livestock, and further processing o f leather into consumer goods such as footwear, garments, accessories, luggage and furniture; (ii) developing oil and gas based industrial activity such as refined fuel products, petrochemicals, plastics etc; and (iii)developing Nigeria's considerable solid minerals base-including several industrial minerals. 26 Definedas investmentexpendituredividedby the replacement value ofthe capital stock. See Soderboomand Teal 2002 page 29. 21 Soderbomand Teal, 2002 Soderbomand Teal 2002 29 Survey publishedinthe CBN StatisticalBulletin2005. 30 This reflects modest improvementfrom 44 percent in2001. 16 1.47 Datafrom the manufacturingsurveys confirmthat firm efficiencymatters for investment levels, for wages, for ability to export and for growth. Nigeria's past efforts to promote industrialization and manufacturing activity did not pay adequate attention to raising firm efficiency. Instead it created a highly distortedenvironment includingexcessively high rates of trade protectionthat inhibitedfirm efficiency and productivity. Some of the lessons have been learnt but there is still evidence of the old approach in continued use of a large number of import bans, and the tendency to create several special programs--e.g. recent program to support the textiles sector-- that still do not target the underlying factors in firm efficiency. The Government's industrial strategy needs to have at the centre addressing the constraints to firm efficiency. 1.48 Services. Nigeria's service sector is currently growing rapidly and has opportunity for further rapid growth. Services trade for example has developed more dynamicallyover the past decadethan non-oilmerchandisetrade. Services exports have outpacedother non-oilexports and in 2004 were almost four times as important as non-oil merchandise exports. While Nigeria remainsa net importer of services, the share in the total non-oiltrade deficit due to services trade fell from a third in 1995to 15 per cent in2004. SinceNigeriai s engaged in a substantialprogram of liberalizationand opening of its core infrastructureservices, includingtelecoms, services trade could play a significant role in the diversification and growth of the economy. Indeed, with the services sector currentlyrepresentingmerely 19.9 percent of GDP comparedwith 60-65 per cent for majorregionalservices hubs inAfrica the marginfor sectoral growthis evident. 1.49 The liberalizationof the telecommunications sector provides an example of a relatively successful services reform. Inparticular,the opening of the market fostered lively competitionto the ultimate benefit of consumers. About 450,000 jobs have been created to serve the mobile phone industry, some of which inthe informalsector, e.g. as vendors of pre-paidrechargecards. Similarly, the development of Internetservices has ledto the openingof an estimated 5000 cyber- cafes. Moreover, other forms of services trade have emerged at the margin of the telecoms reform. For example, Nigeria is due to open major call center facilities, based on initiativesby companies like British Airways and Resourcery. The opening of the sector also generated important investments, including by foreign investors. For example, two private equity funds invested US$43.2 million in Starcomms in 2004 - which was the largest FDI transaction in Africa duringthat year. 1S O Other areas for services growth includebankingand finance, transport-especially air transport, and tourism. Nigeria could become a regional finance and transportation hub. Nigerian banks are already extending services in neighboring countries, notably Ghana, and Nigerianairlines providethe bulk of air transport services within West Africa. Another potential area of services growth is the supply of services to the oil and gas sector. The government wants to strengthenthe linkages betweenNigeria's oil and non-oileconomies includingthrough greater involvementof Nigerianfirms inprovidingservices to the oil and gas industry. Inthis regard, it has set ambitious targets, to raise Nigerian content in the industry from 5-25 percent to 70 per cent by 2010. These content guidelines come on top of productionsharing agreements which commit companies to develop local economy and local staff by using local supplies, equipment, services and contractors if competitive in terms of performance, price and availability. But few oil producingcountries have beenable to sustain local content of 70 percent. It will therefore be importantto focus on growingNigerianContentratherthan onthe targets themselves. 1.51 A few other modificationscould help improve the chances of success of the policy. These include:(i) changingthe focus ofthe local content guidelines from the deepwater potential where projects require significant technological competence to onshore and shallow water 17 projects where Nigerian firms should have more of a competitive advantage; (ii)Encouraging more local content in the market for maintenance, modification and operation (MMO). Experience from most oil and gas producing countries shows that local companies share of the M M O market i s significant and far higher than the project markets. Local companies are close to the management of the facilities and can train and develop their staff and organizations to handle the MMO work. It will ensure a gradual development of the Nigerian petroleum industry; (iii) developing a strategy to promote the local supply industry through R&D programs where the oil majors contribute with funding, expertise or both. These are programs aimed at narrowing the technology gap between domestic and foreign companies, and have been relatively successful when there is an industrial base to build on. Nigeria may have a weaker industrialbase, but has a long perspective as a producer; and (iv) disclosing benefits and costs of local content policies can helpto reduce risk o f corruption. 1.52 Demand must increase to support realization of the supply side sources of growth discussed above. 1.53 Exports. Exports are widely seen as an important driver o f economic growth at the macroeconomic level and there is also considerable empirical evidence o f a positive relationship between firm level productivity and exports at the microeconomic level. Exports o f goods and services represents 53 percent of GDP in 2005, a relatively high level for a country of Nigeria's size. This is explained by the considerable oil resources and the dominance o f oil intotal exports. Between 2000 and 2005, the value of non-oil exports declined at an annual average rate of about 9 percent. But growth was 22 percent and 8 percent in 2004 and 2005 respectively. There has been some recovery in a few non-traditional exports: for example cocoa bean exports grew at close to 8 percent annually between 1999 and 2004. In addition, a selected non-traditional exports -such as shrimps- have also experienced rapid growth in the last few years. However overall, non-oil export performance has lacked dynamism, declining even in the midst of rapid growth of the non-oil sector. 1.54 Inmostof its non-traditionalexport markets,Nigeria is arelatively small supplier and should be able to increase supply without adversely affecting prices and potentially putting downward pressure on its export revenues. Inseveral other areas where Nigeria could break into exports, global demand i s either growing at a healthy pace or is not constrained. The challenge is for Nigeria to make the productivity/competitivenessimprovements that will allow rapid growth of exports to contribute to growth. Comparative analysis o f firm productivity shows that Nigerian firms are not significantly unproductive compared to firms in countries such as Ghana or Kenya and are more productive than firms in Tanzania3'. Thus Nigerian forms should be able to raise export performance to at least levels inthese comparator countries. 1.55 Improving competitiveness in regional markets where several Nigerian goods are already competitive should not betoo difficult to achieve. However achieving competitiveness on global markets will be more difficult and cannot be expected to happen in the short or even medium term. Nigeria's strategy to promote exports as a driver o f growth needs to recognize this and seek a better balance between tackling the more fundamental constraints to export competitiveness and the use of specific support initiatives which have tended to dominate Government efforts in the past. Moreover, these special export promotion initiatives need to be selected on the basis o f careful cost-benefit analysis and become much better designed to limit their distortionary impact. Inparticular programs needto be based on transparency, competition, accountability and results. The current strategy needs to be re-examined and specific program 3 1Soderbomand Teal 2002 18 redesignedto ensure that over time Nigeriais able to take advantageof foreigndemandto sustain rapidgrowth. Increasedexports will also improve efficiency andproductivityofthe economy. 1.56 Domestic Consumption. Nigeria's large population could in principle be a source of strong consumption demandto fuel rapidgrowthinthe short andmediumterm. Realgovernment consumption expandedrapidly at an annual rate of 14 percent during 1970-79, but contracted in the 1980s before recovering to more modest growth of 6 percent annum during 1990-99. Between 2000 and 2005, real government consumption has increased 22.8 percent. Private consumption, on the other hand, improvedsteadily during 1970-99 but with some slowdown in the 1980s. Since 2000, the growthof real privateconsumption has beenerratic, growingrapidly in some years and declining in others. Over the periodas a whole, private consumptiongrew at an average 12.8percent annually and was the largest contributorto the growth of demand inthe economy. 1.57 There is still substantial scope for import-displacementin a wide range of primary consumer commodities. In addition to natural growth of the population, domestic demand for basic food commodities with high income elasticity is being driven by increasedreal household incomes, and urbanization. In respect of poor households the income elasticity of demand for lower income staples also remains high as many households seek to improve their level of nutritional attainment. This will also depend on the increase in profitability of farming. Secondly, with respect to semi-processed food commodities it is reasonable to expect a rapid increase in the demand for feedstock for both the livestock and the fisheries industry. This has already occurred inthe case of the demand for maize and other grains as inputs to poultry feed andthere is a large potentialfor development ofthe currentlyunderdevelopedmarketfor feed for the rapidly growing livestock sector. In the short to medium term, these two forms of internal demand within the agricultural sector (for human consumption and for the feed industry) are likely to be more important than the demand for raw materials for deeper processing by the manufacturingsector, which is currently both small in relationto sector output and not growing fast. 1.58 Incomes should continue to rise in real terms for demandto continue to drive growth of the economy. The failure to createwell remuneratedjobs poses a realthreat to this.An additional threat comes from rapidincreases in prices outstrippingincomes. Since mid2004, the rateof rise of food prices has accelerated.There is evidence that tariff increasesand importbans have ledto sharp increases in consumer prices. This is especially true for rice and vegetable oils where the bans were imposed but appear to have had a knock-oneffect on other staples such as maize and sorghum and other foods. Prices of foods such as rice, cassava and oil palm are twice the world level. This has the effect of driving up wages which thus reduces the incentive to create jobs. Unless domestic agriculture can respond by increasing output dramatically the higher levels of prices are likely to remain. Combinedwith the failure to create productivejobs, high food prices are likely to cause consumptiongrowthto stall. Already, manufacturers have startedto complain of lack of effectivedemand3'. 1.59 One optionfor stimulatingprivatedemandcouldbeto find effectiveways of distributing some of Nigeria's oil windfall to Nigerians. In addition to helping stimulate domestic private consumption demandthis would haveother beneficialimpacts. Itcouldallow a larger number of 32Both the CBN and CSAE studies revealedthat lack o f effective demand was a constraint to growth. The SMEs that they interviewed operate in local markets with limited resources to develop national presence which may contribute to lack o f effective demand. Nonetheless, lack o f sufficient power does concern all businessesin Nigeria, even those who do operate nationally. 19 Nigerians to benefit from the oil boom and see improvements in their living conditions in a shorter period. The reduction in public sector control of oil resources that would result would reduce opportunities for rent-seeking around oil and relatedhigh levels of corruption. It would help redress the fundamentally negative impact of oil on Nigerian politics and governance. Some countries (e.g. state of Alaska) have used different instruments to directly distribute resource windfalls back to their populations. Government can draw lessons from these country experiences and design an approach that would be best suited to the country's social, economic and institutional context. 20 Box 1-2: Distributing Oil Revenuesto Nigerians Salai-i-Martin and Subramanian have suggested that the main problem affecting the Nigerian economy is the fact that the oil revenuesthat the government gets are regardedas manna fi-om heaven which tends to corrupt institutions and lower the long-term growth prospects. Starting fi-om this premise, they reach the logical conclusion that the best way to deal with the problem is to transform Nigeria into a "non-oil" economy. They suggest that one way to do this is to prevent government officials from appropriatingthe oil-resources directly. These resources should be distributed directly to the Nigerian citizens, ultimately their true and legitimate owners. This would replicate or simulate a situation in which the government has no easy access to natural resourcerevenue,just as governments incountries without natural resources.The government would lose all the revenue that it now collects directly from the sales of oil. This i s indeed what happens to most governments in the world and as most of those governments, if the Government wants to raise resources for necessary public expenditures, they would have to raise them by taxing Nigerian citizens and companies. This would therefore create the right incentives for governance, and would contribute to reduce corruption and other problems that affect Nigerian institutions. It would be desirable to embed this proposal inthe constitution as an inalienable right of each Nigerian to have access to an equal share of oil proceeds. The likely magnitude of payments to individual households under this proposal would be large. Under current and future production levels each household would get about US$140 which would amount to US$425 in per capita PPP terms (roughly $760 per adult), representing about 43 percent of current per capita PPP GDP andwell abovethe US$1per day poverty line. With full exploitation of gas, these amounts could increase to upwards of US$750 per capita (US$1330 per adult) in PPP terms.33 Clearly these sums are non-negligible from the point of view of individual households. This is a radical proposal, and a number of issues arise inrelation to its implementation such as who should receive the resources and whether all the revenues should be distributed or whether a certain share should be retained because of the government having to provide certain essential services (public goods). A national conference, comprising a broad cross-sectionof Nigerian society could be convened at the earliest possible date to debate this proposal. Implementing such a proposal would raise considerable administrative challengesthat would needcareful thought. Source: Salai-i-Martin X., and k i n d Subramanian2006. Addressing the Natural ResourceCurse: An Illustration fromNigeria Investment. Investmentrates inNigeria have trended downwards inthe last three decades. As a share of GDP, investment levels declined from over 30 percent during the mid-1970~~~to around 22 percent in 2004, slightly higher than the long-term trend of about 20 percent of GDP between 1974 and 2004. 33 Considerableuncertaintysurrounds the estimates ofthe futurerevenueflows from naturalgas relatingto the arrangements for their marketingand the terms offeredto companies for its exploitation.Butwhat is indisputable is the vast amountof reserves and its potential for exploitation. 34Duringthe oil boomofthe 1970s, successive governmentsemphasized heavy investment inpublic works, primarily aimed at building import-substitutingindustries. Public investment was financed by oil export earnings, some domestic financing, and relativelymodest external borrowing, primarily from multilateraland bilateralsources. 21 Table 1-9: Investment and its Financing, 1976-2004 (YOof GDP at current prices) 1976 1986 1996 2000 2001 2002 2003 2004 Gross Domestic Investment 31.5 15.0 14.4 20.3 24.1 26.2 23.9 22.4 Fixed Investment 31.5 15.0 14.4 20.3 24.1 26.2 23.9 22.4 Public 5.1 9.6 13.8 10.0 9.7 9.1 Private 9.3 10.7 10.3 16.2 14.2 13.2 Changein stocks 0.0 0.0 0.0 0.0 0.0 0.0 Gross National Savings 16.0 18.8 32.0 28.6 14.5 21.1 27.0 Foreign Savings -1.0 -4.4 -11.7 -4.5 11.7 2.7 -4.6 Source: World Bank database& IMF 1.60 Between 2000-05, investment levels have improved relative to trend averaging about 23 percent of GDP although performance has declined from a peak of 16.2 percent in 2002 to 13.2 percent since 2002. Investment has exhibited significant pro-cyclicalitylargely due to the influenceof oil and has been characterized by low levelsof efficiency- particularlyinthe public sector due to poor investment planning and corruption. This is evidenced by Nigeria's high ICORlevels. Privateinvestmenthas dominatedpublic investmentbut as a share of GDP, this has tended to be lower than in comparator countries. Investment inthe oil sector has been sustained at high, thoughfluctuating, levels relativeto GDPwhile non-oilprivatefixedinvestmenthasbeen low and declining. A striking recent development is the growing importance of foreign investment. Foreigndirect investment increasedfrom less than US$1billion in 1990to US$1.2 billion in 2000 and an estimated US$4.4 billion in 2004; as a share of GDP, foreign direct investmenthas increasedfrom 1.4percent at the beginningofthe 1990sto 2.7 percentby the end of the decade, and 6.2 percent in 2004. Non-oil FDI increasedalmost six-foldfrom $0.3 billion to $1.7 billion between 2003 and 2005 (paragraph 1.9). Cleary there is considerable scope for investment in the non-oil sector to drive growth and diversification of the economy but the investmentclimatewill needto improve to makethis happen. 1.61 Remittances?'. Remittances are also becoming an increasingly important source of growth inNigeria. In2004, Nigeriareceivedabout U S $2.26 billion inremittances. Remittances are importantto Nigeriaas a source of non-oilearnings and providesan additionalrevenue flow to grow the economy and enhance the capacity for better business investments. Nigeria is the largest remittance recipient in AfriCa36, receivingan estimated 65% o f total official remittance inflows within Sub-Saharan Africa (SSA) and 2 percent of formal global remittance flows3'. Figure 12 shows remittance flows to Nigeriabetween 1997 and 2004. In2001, Nigeria ranked 18th among the top 25 remittance receivingcountries in the world. In 2004, remittances flows were equivalent to 3.15 % of GDP3*andhave surpassedOverseas DevelopmentAid (ODA) since 2002, when they accounted for about five times more its value o f US$ 271milli0n~~.The common uses cited for remittances include housing improvement and construction, school fees, care for elderly relatives, source of income for unemployed relatives, care for orphans in the community, and investment income for traders and other small business ventures, funerals, weddings, religious holidaysand pilgrimages.Currently, individuals do about 90 - 95 percent of 35Extracted from "UK-Nigeria Corridor RemittanceStudy" World Bank, July 2006. 36Excludes North African countriesnamely Algeria, Djibouti, Egypt, Libya, Morocco, and Tunisia 31Orozco, Manuel. 2003. "Worker Remittances:An International Comparison". Project commissionedby the Multilateral Investment Fund ofthe Inter American Development Bank. February, 28. 38World Bank Development Indicators database, 2004. GDP was US $ 72,105,349,000. IMF Balance payments Statisticsdata shows that the total inflow to Nigeria in 2004 was US $2.273 billion. 39Shah, Valsa. 2005. DFID UK-Nigeria RemittanceCountry PartnershipScoping Mission Report. London, U.K. April. 22 real estate development or housing finance. Although government housing financing arrangements40exists, mortgagefinancingremainsan underdevelopedsector. Migrantswho wish to return home in the future invest in real estate projects. Some in the US have initiated substantial housing investments in their communities of origin in Southeastern Nigeria. In southeast Nigeria, remittances seem to be used extensively for housing development. Remittances is therefore a growingsource of financing consumption and investment which could spur growth. This potential driver of growth could be further increased through measures to strengthenandmakethe paymenttransfer systemeasier. IV.Nigeria's Growth Objectives 1.62 The Government is anxious to improve recent growth in order to meet the MDG of reducing poverty to 28 percent by 2015. Table 1-10 gives some indications of the possible impact on poverty inNigeriaof different growthrates. Assuming a similar patternof growth as in the last few years, growth would need to be at least 8 percent annually to achieve Nigeria's povertygoal. With 8 percent growthpovertycouldfall to about 27 percentby 2015. Table 1-10: Potential Poverty Impacts of Growth Annual Growth of 3% FGTO Population Population Share t t+1 t+5 t+10 Urban 55815119 44,l 43,l 42,8 41,7 40,7 Rural 70666915 55,9 63,8 63,6 62,5 61,O Nigeria 126482035 100 54,7 54,4 53,3 52,l Annual Growth of 5% FGTO Population Population Share t t+1 t+5 t+10 Urban 55815119 44,l 43,l 41,7 37,3 30,4 Rural 70666915 55,9 63,8 62,s 56,6 49,l Nigeria 126482035 100 54,7 53,3 48,l 40,9 Annual Growth of 8% FGTO Population Population Share t t+1 t+5 t+10 Urban 55815119 44,l 43,l 40,s 29,6 18,9 Rural 70666915 55,9 63,8 60,9 47,6 32,7 Nigeria 126482035 100 54,7 51,9 39,7 26,6 Annual Growth of 10% FGTO Population Population Share t t+1 t+5 t+10 Urban 55815119 44,l 43,l 393 25,3 14,4 Rural 70666915 559 63,8 59,6 42,3 23,2 Nigeria 126482035 100 54,7 50,8 34,8 19,3 1.63 The first NEEDS set a growth target of 7 percent per annum for 2003-2007. In the target of 10percent. Thiswould requireextremely highgrowthrates -around 13 percent- inthe context of preparation of the upcomingNEEDS 11, the Government aspires to achieve a growth 40Governmentpoliciesaimed at providing affordableand comfortable housingfor all Nigeriansinclude credit policies, InsuranceCompanies, SpecializedInstitutions, Statehlunicipal GovernmentFinancing, The Federal Mortgage Bank ofNigeria(FMBN), Primary Mortgage Institutions(PMIs), The FederalMortgageFinance Limited (FMFL), and the NationalHousingFund(NHF). Sources: 1) Sanusi, J.O. 2003. "Mortgage FinancinginNigeria: Issues and Challenges". Paper presentedat the ninth John Wood EkpenyongMemorial Lectureby the NigerianInstitutionof Estate Surveyors and Valuers, January. 2) World Bank BRCA Team interviewswith officials at the FederalMinistry o fHousingand Urban Development. 23 key non-oilsectors ofthe economy. Moreover, the ratioof investment to GDPwouldneedto rise from current level of about 21 percent of in2005 to 38 percent by 2010 and even higher than 40 percent of GDP beyond 2010. This would be even higher than was the case in the East Asian countries when they made rapid progress on growth. Particularly striking i s the considerable productivity improvements required to achieve this scenario4i. On average, total factor productivity gains of about 7 percent per annum is likely to be required. This is clearly not achievable. 1.64 An alternativehigh growth scenario would see growthrising above the periodaverage of about 5 percent to levels of 7 percent achieved in the last two years. This would require continuation and deepening of reforms to provide the right environment for rapid growth. In addition if policies could be put in place to ensure that growth is more broadly shared and in particular strengthen employment effects of growth, it is likely that this level of growth would take Nigeriavery close to the achievement of the povertyMDG. Investment rates would needto rise to 30 percent by 2010 and 35 percentby 2015. Public investment would expandto crowd in rapid growth in private investment in line with the government's objective of achieving private sector ledgrowth. 1.65 It is most likely that the balance of payments surpluses resultingfrom oil exports would start declining due both to projected decline in oil prices and the weight of large import requirements of acceleratedgrowthinthe non-oilsectors. Thus, the current account is likelyto go into a deficit as early as 2009. This would continue to widen thereafter and Nigeria couldthen face significant foreign financing needs in the medium-term. This would have to be managed carefullyto avoida repeat ofdebt overhang. Table 1-11: Medium-Term Macro-Economic Framework, 2005-15: 7% Growth Target 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 GDP Growth (%, at 1990 7.2 6.0 6.2 7.0 7.0 7.0 7.0 7.0 7.1 7.1 7.1 factor costs) Oil 4.2 4..3 5.0 5.2 3.4 8.7 3.4 7.9 2.4 5.7 2.3 Non-oil 8.6 6.2 7.2 8.0 9.0 8.1 8.6 8.0 8.7 8.3 8.8 Gross Investment(%GDP) 20.9 24.5 26.5 28.5 29.0 30.0 31.5 34.0 35.0 35.0 35.0 Public 9.1 9.5 9.8 10.0 10.2 10.4 10.6 10.8 11.0 11.2 11.4 Private 11.8 15.0 16.7 18.5 18.8 19.6 20.9 23.2 24.0 23.8 23.6 Gross National Savings ("h 33.4 32.7 32.3 30.2 28.3 29.0 29.0 31.1 30.9 30.9 30.5 GDP) Total Revenueand Grants ("h 43.3 45.1 41.0 37.0 34.1 31.8 29.5 28.8 27.1 26.1 24.3 GDP) Total Expenditure and Net 33.4 34.0 34.5 34.5 34.6 34.8 35.9 36.6 36.7 37.2 37.3 Lending(YOGDP) Non-oil PrimaryBalance ("h -39.8 - -36.7 -35.5 -35.3 -34.8 Non-oil GDP) 37.2 37.9 37.2 35.9 36.2 37.2 ExternalFinancingGap (US$ 0.0 4.0 4.0 4.2 4.3 5.4 6.4 10.9 13.4 14.4 15.9 billion) Gross internationalreserves 28.3 48.1 66.7 77.7 85.0 92.4 96.5 103.5 108.6 113.5 117.2 (US$billion) (months of imports) 8.8 14.3 15.9 15.4 15.5 15.3 14.8 14.8 14.8 14.7 14.6 Source:World Bank StaffEstimates 41For calculating factor productivity we have assumed: a Cobb-Douglas type ofproduction fbnction, share of capital to be around 30 percent, and a rough calculation of capital stocks based on a depreciation rate of about 3 percent 24 2. WHY HAS SUSTAINED GROWTHBEENELUSIVE Introduction 2.1 Nigeria will need to sustain rapid growth over the long term to achieve economic transformationand poverty reduction. Indonesiafor example sustainedannual average growth of 7.3 percent over 20 years between 1970 and 1995 and transformed itself from a poor resource based economy to a lower middle income newly industrializing economy. Similarly China has managedto lift about 400 million of its population out of poverty by sustainingaverage growth of 9 percent annually for close to 30 years and is on its way to becoming a global economic giant. Nigeria needs to make more progress in tackling the underlying causes of the economy's low productivity and competitiveness to tap its considerable sources of growth for economic developmentand transformation. 2.2 There are several factors in the low productivity and inefficiency of the Nigerian economy. These factors cannot and fortunately need not be addressed at the same time. Prioritizing and sequencingaction is important to ensure that Nigeria's reform effort is focused and uses limited government capacity and political capital judiciously to achieve the biggest impact on growth. This requiresa growth diagnosticsanalysis. This chapter identifies the factors inlow productivity that needto betackled first: the binding constraintsto growth which needthe most immediate attention to begin to transform recent growth into a sustained long term growth take-off. I.TheBindingConstraintstoGrowthinNigeria 2.3 The analysis follows the Hausmann-Rodrik-Velasco (HRV) approach42 to determining the binding constraintsto growth. Startingfrom traditional growth theory which emphasizes the importance of savings and capital accumulation, the approach posits that low levels of private investment and growth is due to either low returns or to low savings and associated high cost of finance. A decision tree methodology is used to drill down further to determine the binding constraint aroundwhich reform action could have the largest growth impact. Are Savings andAccumulation in Nigeria Low? 2.4 The accumulationof physical capital in Nigeria has been lower than in more successful and rapidly growing developing economies. Between 1980 and 2005, domestic investment to GDP in Nigeria averaged 19.5 percent. Private investment has dominated public investment, averaging about 14.4 percent of GDP between 1990 and 2005 but this has also been much lower than in comparator countries. Inaddition, the larger share of private investmenthas gone into the oil sector. Two other features of investmentperformanceare striking: its extreme pro-cyclicality which is explained largely by the influence of the oil cycle; and its low efficiency. Public investment in particular has been markedby low efficiency due to poor investment planning and corruption and ICORs have therefore been high averaging about 12.7 between 1974 and 2004 althoughICORshave fallen inthe recentpast. 41Hausmann, R., DaniRodrikandAndres Velasco 2005 "Growth Diagnostics" JohnF.KennedySchool of Government HavardUniversity. http://ksghome,harvard.edu 25 Figure 2-1: Gross Fixed Capital Formation (YOof GDP) I -t-Nigeria - Sub-SaharanAfrica East Asia & Pacific LatinAmerica & Caribbean Source: World DevelopmentIndicators2005 2.5 Savings performance has lagged performance in comparator countries, averaging 18 percent between 1980 and 2005. In the last few years domestic saving has risen significantly mainly because of the oil booma. Between 2000 and 2004, gross national savings averaged 25 percent annually. A large share of this (17 percent o f GDP) i s public saving reflecting improved fiscal prudence through implementation of the oil price based fiscal rule. Another feature of savings in Nigeria is the divergence between gross national and gross domestic savings. Gross domestic savings has consistently been higher than gross national savings confirming net outflow of savings from Nigeria. The gap was much higher inthe 1980s and early 1990s-as highas 10 percentagepoints in some years but has narroweddown inmore recent years. Figure 2-2: Gross National Savings, including NCTR (YOof GDP) I -World -w- Nigeria Mexico Brazil Source: World DevelopmentIndicators2005 I s Return on Capital in NigeriaLow? 2.6 The low productivity of the economy suggests that overall return on capital inNigeria is low. The available evidence/data supports a more nuanced conclusion: in a few select sectors returns to capital are very high; but returns appearto be low inmost other sectors and particularly 43 Using discount rate as a proxy 26 in the agriculture sector. High return sectors include oil, bankingand finance and some parts of the foodandbeverage industry. Inthe oil sector, highreturnis explained by the special nature of oil, and the fact that the industry operates at internationalstandards using global technology. Thus evenwith considerable unrest inthe Niger Deltaand increasedoperating costs includingfor security, returns are attractive enough to keep oil majors engaged and continuingto invest and expandtheir operations. 2.7 Before the recent bank consolidationreform, the more profitablebanks averaged about 35-40 percent on equity. What explains this? Comparedto other developingcountries, branch density is low in Nigeria, suggesting that Nigeria is under-banked. The high rate of return on equity therefore reflects high returns on marginal investmendlending opportunity. As the bankingsector is becoming more competitiveafter consolidation, there will be more competition for those investment opportunities and return on equity is likely to decline. However the high returnsbefore consolidationalso reflectsdistortionsinthe functioningofthe sector. Large banks made their profits primarily from foreign exchange transactions and investment in government securities and not from lending. Moreover, some bankswere more privilegedthan others intheir access to foreign exchange and this could explain the lower return on equity for non-top tier banks prior to consolidation. Thus the high return was not a reflection of a well functioning system. Instead the system was fragmented and delivered little credit to viable potential borrowers. A privileged tier of banks had superior access to foreign exchange which allowed themto makehighreturns. 2.8 Inthe food and beverage sector, the shrimp industry for example appears to be enjoying high returns because it has met international standards of quality and health safety and successfully cultivated and captured a segment of the internationalmarket. It is estimated that profits in the industry represent around 18 percent of value added. Other businesses in the food and beverage sector -mainly multinationals such as Nestle, Cadbury, Heineken-appear to achieve good returns and are expanding their investments while the bulk of firms are less successful. Another indication of high returns in some segments of the economy is the high market average price to earning ratio of 22.34 percent for firms quoted on the Nigerian stock exchange. Only 203 firms are registeredon the stock exchange and the market capitalizationof the exchange is less than half of GDP indicating again that this result is not necessarily widespreadacrossthe economy. 2.9 Forthe rest ofthe non-oilsector andparticularlyagriculture,returns are low evidenced in low levels of productivity and high levels of unusedcapacity in manufacturing,the latter due in part to obsolescence of machinery and equipment. On average therefore, returns in Nigeria can be argued to be low. Low returns in Nigeria is also consistent with low investment returns in Africarelativeto other regions. Table 2-1: Productivity of Investment Returns - Decade AFR EAP ECA LAC MNA SAR 1960-69 0.326 0.301 0.263 0.259 0.540 0.314 1970-79 0.243 0.316 0.215 0.274 0.239 0.225 1980-89 0.151 0.146 0.109 0.085 0.106 0.235 1990-99 0.074 0.191 -0.229 0.143 0.214 0.220 2000-02 0.109 0.237 0.258 0.048 -0.022 0.175 Source: World Bank 2006 "Flagship Study on GrowthInAfrica" 27 Is Low Investment Due to Low Savings or Due to Low Returns to Investment 2.10 Ifdomestic savings were scarce and the bindingconstraint on investment, highforeign debt or a large current account deficit would signal that Nigeria i s making extensive use o f foreign savings. This was the case during the 1980s and 199044. Current account recorded persistent and significant deficits. External debt rose to 120 percent o f GDP by 1987. Repeated rescheduling and continuing external debt arrears effectively shut Nigeria out from international capital markets for most o f the period. Evidence o f this lack o f market access is the prohibitive mark-ups that Nigeria would have had to pay on primary issues that can be derived from secondary market information. 2.1 1 This is not the case now. External debt to GDP followingthe recent Paris Club debt deal is only 5 percent o f GDP, and the external current account has been in surplus averaging 4.8 percent o f GDP over the last three years. The recent sovereign credit rating has also improved access to foreign savings and finance. Mark ups that Nigeria would have had to pay on international markets have fallen to manageable levels. Export credit agencies are showing willingness to resume full range o f services to Nigeria after a long period o f interruption. As indicated in Chapter One, remittances from Nigerians abroad are also an increasingly important element o f private flows reaching $3.5 billion (net) and 3.5 percent o f GDP in2005. Moreover, domestic commercial banks have traditionally been and continue to be highly liquid (Table 2-2). In addition, while the private sector complains about the high cost o f finance, real interest rates are comparable or lower than in similar countries including Indonesia. A 2003 report by USAID estimated that the total outflow o f savings by private Nigerians in 2003 outstripped the deficit inthe country's financial balance sheet. 44 Duringthe midto late 1980s, interest rate repressionlimited incentivesto save andthe economy relied stronglyon foreign savings evidencedinhigh levels of external debt and large current account deficits. Butthe low interest rate on deposits evenafter financial liberalizationalso suggests that while important, savings might not havebeenabinding constraint to growthevenduringthis period 28 Table 2-2: Banking Sector Liquidity Nigeria 1998 1999 2000 2001 2002 2003 2004 Liquid Assets / Total Deposits and Short-Term Borrowing (YO) 82 91 86 86 94 87 88 Liquid Assets I Total Assets (YO) 52 61 62 59 62 59 59 Banking Liquidity Index 10 10 10 9 10 10 10 Source: World Bank FinancialSector DevelopmentIndicators Liquid Assets /Total Liquid Banking Depositsand Short- Assets I Liquidity Term Borrowing (YO) Total Assets Index Nigeria 88 59 10 Kenya 14 30 5 Ghana 55 53 8 SouthAfrica 24 13 4 Tanzania 48 54 10 Sub-SaharanAfrica 44 40 6 Middle income 36 35 5 Low income 45 42 6 Source: World BankFinancialSector Development Indicators, 2004 2.12 The high variability o f interest rates and poor access to finance, especially long term finance are perhaps the more pressing challenges. Both are related to the poor development of the Nigerian financial system and its weak intermediation capacity. Private credit as a share of GDP has historically been lower in Nigeria than in other large oil economies and even countries in Sub-SaharanAfrica although levels have beenrisinginthe last few years. Bank credit remains the main source of funding of investment by Nigerian quoted firms. Relative to other emerging markets, the Nigerian stock market i s also quite small. Although the number of listed securities is increasing, trading activity i s still very thin due to reluctance o f institutional and individual investors to trade inthe secondary market. But the recent bank consolidation has boosted trading in the market. Small businesses have little access to credit, unless they are willing to pay rapid turnover money-lender rates of up to 100 percent annually and micro-credit programs are limited in reach and coverage. The equity market has only a small number of instruments and is only accessedbythe largest firms and the corporate bond market is virtually non-existent. 2.13 Term financing inparticular is scarce and constrains productive investment. Less than 16 percent of the 2001 WED sample reported having loans longer than one year in duration. Existing loan maturities do not meet the long-term financing needs o f enterprises and infrastructure projects. Ina financial market characterized by volatile interest rates and short-term funding, banks have historically only been willing to take maturity risk on borrowers with outstanding credit quality. For blue chip clients, some banks are prepared to take refinancing risk and provide medium-termloans by rolling over short-term funds up to a maturity of 7-9 years. With the exception o f the telecom sector, loan maturities fall short of the long-term financing horizon of 10-20years requiredfor investmentsin infrastructure and project finance. 2.14 The main cause of low investment and growth in Nigeria then appears not to be low savings but rather low returns to investment. This could inturn be the resulto f low social returns 29 and or low ability o f private sector to appropriate returns even where they exist or may be potentially high. I s the Problem Low Social Returns or Low Private Appropriability of Returns? 2.15 Are low returns inNigeria a problemof low socialreturns or is it that while social returns are high other factors constrain the ability of the private sector to access or appropriate these returns? The evidence suggests a combination of the two factors. Social return is determined by the underlying productivity of the particular economic activity. The low productivity of the Nigerian economy suggests that overall (social) return on capital in Nigeria would be low. But there is also evidence of high "transactions" costs that prevent economic agents from fully realizing potential returns. The relative importance o f these two factors is also likely to be different across the different segments ofthe economy. Inagriculture for example, it is likely that low social returns evidenced inlow yields, would be the more important o fthe two factors. Low Social Returns: 2.16 The HRV approach identifies three possible reasons for low productivity of an investment: (i) infrastructure, (ii) human capital; and (iii) geography. bad weak poor 2.17 Low Human Capital.Recent growth literature gives much greater prominence to human capital as a factor in productivity and growth. Nigeria's population o f about 130 million is estimated to be growing at about 2.5 percent annually. About 45 percent o f the population i s under 15 years old. The dependency ratio of 0.9, though highhas been declining inrecent years. Relative to Asian and several other large oil economies, this large human resource is poorly developed and lacks the skills neededto allow Nigeria move onto a path o f industrialization and integrationinto the global economy. Table 2-3: Indicatorsof Size and Quality of Human Capital Literacy LifeExpectancyat I Mortality Public expenditure on Rate Birth Rate EducationYOGDP 1970 2003 2004 Nigeria 20.1 66.8 1.02 Indonesia 56.1 87.8 1.3 Korea 61.4 74.2 4.3 Mexico 73.5 90.0 62.6 73.6 23.O 5.2 SouthAfrica 69.5 86.0 53.9 45.7 53.0 5.4 Source: World DevelopmentIndicators and CBNStatistical Bulletin 2.18 Gross primary enrollment is about 100 percent but enrollment at secondary and tertiary levels are only 35 percent and 10 percent respectively, compared to 62 percent and 16 percent in Indonesia. Net enrollment at primary and secondary levels are lower at 88 percent and 28 percent respectively. At the tertiary level, there is also growing preference for non-science and non- technology related disciplines. Between 1991/92 and 2001/2002, the share of enrollment for science and engineering disciplines dropped from 27 per cent to 23.4 per cent because of lower returns on education in these fields due to lower opportunities for employment. The quality o f education has fallen at all levels over the last two decades. This i s evidenced in worsening test scores, rising student-teacher ratios and other indictors of educational quality. Firms are also 30 compelledto spendhugesums of moneyretrainingnewrecruits or resortto the useof expatriates. Some firms now go overseasto recruitNigeriangraduatestrainedabroad~toensurequality. 2.19 Nigerianmanufacturingfirms are preponderantly in sectorsthat requirelow skills. Most are found in laborandresource intensive, low levelof technology, low wage and low TFP growth sectors. Inspite of Nigeria's relatively well developed manufacturingsector compared to other SSA countries, it has less of its manufacturingfirms in high-skill-technology and high wage sectors. Incontrast to Africa countries with the best TFP estimates inAfrica, Nigeriabelongs to the poorest performing set out countries in Africa, together with Ethiopia, Zambia and Mozambiq~e~~.This structure of firms in the Nigerianmanufacturingsector could be due to the poor skills base of Nigerian labor. An alternative explanationcould be that causality runs the opposite directionandthat the skills baseofNigerianlabor is low becausethere is no demandfor skills by firms. Table 2-4: Comparative Structure of Manufacturing in Nigeria and SSA 1992 and 2002 Categories Nigeria Sub-Sahara Africa I992 2002 I992 2002 1. Factor intensity (a) Labour andresourceintensive 63.4 62.9 71.4 70.4 manufactures (b) Low skill-technology,capital 14.6 14.7 10 10 andscale intensive (c) Medium skill-technology, 20.4 20.6 10 10.1 capita and scale intensive (d) High-skill-technologycapital and scale 1.8 1.8 6.7 7 2. Level ofTechnology (a) Low 65.3 64.8 74 73.2 (b) Medium 34.6 34.9 23.3 23.4 (c) High 0.3 0.3 0.8 0.9 3. Orientation (a) Resourceintensive 41 40.4 51.1 51.1 (b) Scale intensive 32.28 26.8 23.2 22.1 (c) Labor intensive 26.6 32.4 22.3 23.0 (d) Science based 0.72 0.72 2.9 3.0 4. WageType (a) Low 65.9 66.1 67.4 64.7 (b) Medium 32.5 32.1 24.3 26.2 (c) High 1.8 1.8 6.5 6.8 5. Rateof Productivity Growth (a) Low-TFP-growthsectors 32.9 32.7 44.5 43.8 (b) Medium-TFPgrowth 23.9 23.5 18.9 20.4 (c) High-TFP growth sectors 42.947 43.3 33.7 32.5 Source: computedfrom UNIDO Data 45Some analystsare of the opinion that it is inthe long-term interestsofNigerian firms and private sector at largeto invest more inthe Nigerian education sector. 46 Gelb A. et al. 2005. "Business Environment and Comparative Advantage in Africa: Evidence from InvestmentClimate Data, January 2005. 47The high figure ofNigeria here is becausethe underlying framework we used add textiles and clothing to the high TFP growth sectors. 31 2.20 Clearly low human capital development is a factor in low productivity and returns in Nigeriabut it is less clear that this is the bindingconstraint on growth. If low human capital is the binding constraint, we would expect to see high returns to education. The limited research and empiricalanalysis on this issue in Nigeriahighlightthe following results: (i)mean monthly earnings of workers increase with more years of schooling; (ii)private return to primary and secondary education in Nigeria are low, have fallen substantially from 1966 estimates of 30 percent to between 2-4 percent per year, (ii)private wage returns to post-secondary education have also fallen to between 10-15 percent per year compared to an estimated 34 percent forty years ago. The current estimates are low comparedto results for Africa, LatinAmericaandAsia estimatedover twentyyears ago. Table2-5: Returnsto Education Africa Asia LatinAmerica Primary 45 31 32 Secondary 26 15 23 University 33 18 23 Source: Psacharopoulos 1985 2.21 The low returns could be a reflection of the poor quality of education in Nigeria and needs further research. Howeverit cannot be arguedon the basis of the availabledata on returns to educationthat low human capital is the bindingconstraint on Nigeria's growth. Nevertheless the discussion above shows that strong human capitalwill be critical to Nigeria's ability to shift the compositionofproductiontowards higher productivityactivities andthereby create morejobs at higher wages. Since buildinghuman capital takes a longtime, it will be important for policy makersto strengthentheir effortsnow. 2.22 Bud Infrastructure. There is strong empirical evidence on the positive links between good infrastructureand economic growth and development. Access and quality across all key infrastructuresectors inNigeriais significantly below levels inmore rapidly growingeconomies. Electricity generation for example is below 4,000MW compared to about 39,000 MW in South Africa, with a populationless than one-thirdof Nigeria's. Per capita consumption of power is just a fractionof consumption incountries such as Malaysia, India, Indonesia,the Philippinesand South Africa. Poor quality is evidenced inrandom and frequent power brownoutsand blackouts and high variation in voltage quality which disrupts productive activity. This forces firms to divert substantial resources from re-investment in their productive business to self-generation. Available estimates indicate that costs of infrastructure investments (power, road, water, telecoms) constitute as highas 20 percentof the cost of new investment projectsinNigeria. Staff costs to run and maintainself generation efforts are in some cases as high as 10-15 percent of total payroll. Port costs are amongst the highest in the world, and poor roads are estimated to exact a cost on the economy estimated at about 3 percent of GDP. Poor quality and access to transport infrastructureincreasestime to market and is responsible for as much as 15-20 percent of agricultural produce never reaching market. Some businesses report losses due to poor infrastructure (especially power), of up to 20 percent of their output. Nigeria's considerable infrastructurecosts reduce firm profitability andreturnsto below levels for comparable activity in similar countries and potential levels inNigeria. At the same time the relatively high levels of returns to investment for some existing firms indicates limited competition. This could be attributedto barriers to entry for new firms resultingfrom infrastructuredeficiencies. Giventheir sunk investments in propriety infrastructure firms are protected against competition from new market entrants. Relieving severe infrastructure constraints is critical for raising investment returns, But significant improvements inthe efficiency of public spending is required in parallel 32 with increased public spending in this area to achieve the desired impact Bad infrastructure rather than low human capital then seems to be the bindingfactor inlow efficiency and returns. Low Private Appropriability 2.23 While the "hard" infrastructure issues discussedabove affect the underlying productivity of investment activity, there are "soft" infrastructure challenges that constrain the ability o f economic agents to realize potential returns. These challenges manifest at both the macroeconomic and the microeconomic levels. Macroeconomic risks stem from historically weak macroeconomic management that has led to macroeconomic volatility and instability and other macro level distortions discussed in the previous chapter. Micro level risks arise from the functioning of institutions, regulations and policies that are supposed to guide investment. Both levels of risks reflect primarily massive failure of government: failure to manage the economy to avoid volatility from oil prices and the failure of government in the pervasive corruption created around state dominance of the lucrative oil sector. This has in turn weakened institutions for service delivery to private sector entrepreneurs and unleashed predatory behavior of public servants on private agents. Market failure evidenced in poor self discovery and poor public- private sector coordination are also factors4*. 2.24 The high risk business environment means that investors will require much higher levels of return to undertake investment activities. Thus several investment opportunities with good returns that could contribute to growth are not taken up because returns do not compensate adequately for the high risk and "expected returns" on these opportunities are therefore low. In addition, the investor class is confined to a smaller group that has high enough levels of risk aversion and or has personal means at their disposal to mitigate against some o f these risks. This means that capital i s concentrated ina relatively few hands and i s not adequately dispersed. Both factors reduce investment levels and keep growth lower than potential. 2.25 Macroeconomic Risks. Poor management of oil revenue windfalls is at the heart o f poor macroeconomic management inNigeria. Incomparison to other oil rich economies, Nigeria has tended to spend more out of oil windfalls, allocate more o f the already high expenditure to consumption rather than to investment (Annex 1-C). Using 1970 as a benchmark, Nigeria gained an extra $390 billion in oil-related fiscal revenue over the period 1971-2005, or over 4 times 2005 GDP, expressed in constant 2000 US$. Strong acceleration o f capital spending of federal and state governments absorbed more than halfof the entire windfall4'. Much of this expenditure was conceived too hastily and endedup largely wasted. 48For further elaboration ofthese concepts andtheir impact on growth and industry and sector development strategies, see "Industrial Policy for the Twenty-First Century" September2004, Dani Rodrik 49Capital spendingof federal andstate governments accelerated rapidly from only 5.5 percent of non-oilGDP in 1970to 27 percentby 1976 andto six times their 1970 level by 1977. 33 Figure 2-4: Uses of Oil Windfall, Overall Fiscal Balance and Inflation Governwnt Expendlure (% of OilWindfall) R c a lBalance and hflaSon !OO .................................................................. .................................................. ~9 Current expendlture, % of Oil Windfall la Capltalexpenditure, % of OilWindfall 1 +Fiscal balance (% of Non-OilGDP) --*-Inflation (%), nght scale CurrentAccount and Net ForeignAssets Consumpionand hvestmtnt 80 ................................................................. 250 T~~ .............................. ............................................................ @ 200 ....................................................... 150 ...................... ...... I ir 100 50 0 rO - cNr - r - r - m m m mN m m m m mD ~ o~ o o ~ ~ ~ O ~ C O N ~ ~ ~ O N P zz.nzz.nzzz.nzz~z.ng00 N N +Current Account Balance (% of Non-Oil Public consumption, % of Non-OilGDP GDP? Net oreign Assets ("A of Non-OilGDP) 2.26 With inadequate adjustment to falling oil revenues during the downturn following the second price hike, large fiscal deficits emerged. The budget swung from a surplus o f 11 percent o f non-oil GDP in 1974 to deficit o f 10 percent o f GDP in 1978. The substantial windfall from the second oil price shock generated only a small budget surplus in the peak year o f 1980 and swungback into large deficits afterwards. A substantial part o fthe growing deficits was financed through increased monetization leading to high and variable inflation. On the external account, reserves were depleted - from $10 billion to $1.23 billion between 1981 and 1983 - externaldebt expanded - from 6.6 percent o f GDP in 1980 to 120 percent o f GDP in 1987- to finance the large current account deficit?'. 50 Data on domestic public debt for 1980s are not available, so the public debt stock figures for that period consist of external public debt only. Since 1990, data on domestic public debt, although available, are likely to understatethe true domestic debt burden, as information on state governments' domestic debt is not available. In addition, these figures do not include the substantial stock of domestic contractual and pension arrears, which at least in2003 were large. 34 Figure 2-5: Seigniorageand Inflation, Uses of the Oil Windfall Seigniorageand Inflation 8.0 ............................................................................ 100 6.0 .................... R.~..-...... ................................. h 80 60 40 20 0 ............................................................................ 1 - 2 0 1 +Seigniorage, % GDP I --cInflation,%,rightscale Expenditureand Oil Revenue (% of non-oil GDP) go ..................................................................... .............. ............... Capital Expenditure (% of non-oil GDP) --cOilRevme(%ofnon-oilGDP) 2.27 This poor management of the oil revenue cycle has created a highly volatile macroeconomic environment. Nigeria's economy has been more volatile than most and more so than can be explained by oil price volatility alone. Volatility of spending, rather than its level, is therefore a strong explanatory factor for Nigeria's poor growth. This is also confirmed in the results of a debt decomposition analysis (Annex 1-D) which suggests that from 1984 onwards fiscal policy has not been excessively expansionary compared to the size of oil revenues. Fiscal policy has contributedto volatility ratherthan to smoothingthe impact of volatile oil priceson the economy. Despite the government's attempts to save past oil windfalls, public expenditure remainedhighly correlatedwith oil fiscal revenue and fluctuatedwidely as a result of weak fiscal discipline and high oil price volatility. 35 Figure 2-6: Revenuesand Expenditures, 1971-2005 Ewpenditureand Revenue( O hof Non-Oil GDF') 90 .................................................................................. 80 70 60 50 40 30 20 10 &Total Expenditure (YOof non-oil GDP) 2.28 The volatility of public expenditure was in fact higher than the volatility of oil revenues during the first half of 1980s and during the1990s so government expenditure exacerbated, rather than smoothed, the volatility of oil revenues. Figure 2-6 and Figure 2-7 give a series of volatility measures; each data point represents the coefficient of variation of government expenditure divided by the correspondingmeasure using oil revenuessi The measureof relative volatility has declined from its peak of 3 in the early nineties but even in the most recent past has not sunk below one. Fiscal policy therefore pushed volatility beyond that stemming from variable oil prices; the Government itselfhas become a source of macroeconomicvolatility. This has come at a high cost shown in the negative correlation betweenthe excess-volatility of public expenditure over oil revenueand non-oil economic growth Figure2-6. 2.29 The macroeconomic instability and highly volatile real exchange rate from oil dependency can be seen as a tax on investment. Other studies52 have shown empirically that high volatility slows down productivity growth by a substantial margin in countries with a relatively underdeveloped financial sector like Nigeria. And there is substantial evidence that ORCs have more volatile economies than non-ORCss3. Thus there is logic to a focus on volatility as an explanatoryfactor for the poor growth recordofNigeria. Figure 2-7: Expenditurevolatility and Growth Nigeria: Volatility and Growth 3.5 20 3 15 2.5 10 2 5 1.5 0 -5 1 -10 0.5 -15 0 4 !-20 1970- 1976- 1981- 1986- 1991- 1996- 2001- 1975 1980 1985 1990 1995 2000 2005 --cRelativeVolatilityofGovt.Expenditureto OilExports -Real GDP Growth ( O h ,annual avg. right scale) -t Real Non-Oil GDP Growth (%. annual avg, right scale) 51Specifically, coefficient ofvariation(CV) is the quotient of standard deviationover the mean. The relative volatility is measuredas the CV of government expenditure(as % of GDP) dividedby the CV of oil exports (as %of GDP). 52Aghion et. al. (2006). Intheir sample, a50 percent%increase involatility slows downproductivity growthby 33% on average. 53Hausmannand Rigobon(2002). 36 Box 2-1: Diagnosing Poor Growth in Nigeria --- Dutch Diseases4or Debt Overhang? Traditional explanations of poor performance in oil rich countries (ORCs) like Nigeria focus on the so called Dutch Disease. Spending out of oil wealth increases demand for non-tradables and so draws productive resources into that sector away from the tradable sector. The non-tradable sector declines and since the presumption is that technological progress is faster in the tradable than in the non-tradable sector, this result in low growth of the economy. At first glance, Nigeria manifests several of the features of Dutch disease: strong real exchange rate appreciation, decline ofthe non-oil tradables sector especially agriculture, low productivity of the economy, and low overall growth. Yet on closer examination, there are difficulties in simply labeling Nigeria as another instance of Dutch Disease in an ORC. In particular, the mechanism through which high spending out of the oil sector leads to low growth is a fight for scarce resources drawing labor and capital out of the tradable sector. Resource scarcity at going factor prices is critical inthis explanation. On closer examination however, the argument ofNigeria as aDutchDiseasevictim falters becauseof the persistenceof considerable underutilizationof labor and capital. In diagrams below, various measures of excess capacity are plotted against time. While capacity surveys indicate higher capacity in the early oil boom years than in later years, the utilization rate never exceeds 75 percent, and for all of the time except 1980 and 1981 hovers at 60 percent or lower. Available unemployment data also point at considerable slack in labor utilization. Such numbers are at variance with Dutch Disease style pressure on scarce labor and capital leading to a diversion of resources from high growth tradable sectorsto aboomingbut low productivity growth non tradable sector. Figure 2-8: Capacity Utilization and Unemployment Manufacturing Capacity Utilization (Oh) 80 25 ........................................................... UnemploymentRate (%, Nigeriahflnitlon) ........................................................... 70 60 50 40 30 I t 20 ........................................................... 5 .................................................. 10 ........................................................... 0 I w w I tN4TK)N4L+URMN -+-RUWL Another line of reasoningis volatility of spending rather than its level as a factor inNigeria's weak growth. This could inturnbe explainedby debt overhang, which until recently hasbeenakey feature oftheNigerian economy. Source: Budina, N.,Pang, G. and Van Wijnbergen S., 2006. "Nigeria's Growth Record: Dutch Disease or debt Overhang? `` 2.30 Poor macroeconomic management also led to considerable exchange rate overvaluation. Exchange rate policy was not attuned to the many shifts inaggregate expenditure triggered by oil price volatility and therefore did not help to minimize the adverse macroeconomic impacts of massive oil revenue inflows. Flexible real exchange rates could have prevented or reduced the impact on output volatility on growth but Nigeria followed a rigid nominal exchange rate policy, relying on inflation and parallel markets to provide the needed real exchange rate adjustment. Rigid nominal exchange rates led to the emergence of a parallel market for foreign exchange. This was not sufficient to resolve the imbalance. Inflation fuelled by substantial monetary financing of the deficit, brought further real exchange rate appreciation. Relative prices and wages in sectors producing non-tradable rose leading to a shift in the allocation of domestic resources and economic structure away from the production of export goods (agriculture), and into the services sectors. The periods of the highest over-valuation, as indicated by rapid increases in parallel market premia, occurred in the periods after high oil prices reaching 330 percent when oil prices collapsed. Inthe end the oil price collapse, high interest rates and public debt problems made the high nominal exchange rate unsustainable and massive nominal and real 54 Recent researchby Xavier-Salai-i-Martin also shows several problems with the Dutch Disease explanation o f Nigeria's poor economic performance, highlighting waste o f resourceslinked to rent-seeking around oil and related poor quality o f institutions. 37 exchange rate depreciation followed in the early 1980s. In the last few years exchange rate management has improved significantly and the exchange rate premium has been eliminated. Nevertheless the continued appreciation of the real exchange rate of the exchange reduces export competitiveness. Box 2-2: Why is Volatility High In Nigeria? ExpenditureVoracity or Overborrowing? One explanationfor high volatility in ORCs, is competitionbetweenvarious interest groups for resource rents, similar to the overgrazingof the commons and indeed historically there has been considerable competition for oil revenues betweendifferent ethnic groups inNigeria. This has beenreferred to inthe literatureas the "voracity effect" (Lane and Tornell (1995)). An expenditurebehavior that leads to overspendingin good days and under-adjustment in bad days may end up with an economy with evenhighervolatility than that generatedby volatility in its revenuestreams alone. An alternative explanation of high volatility in ORCs, starts from the surprising fact that many ORCs have had debt problems. Their access to externalfinance becomes more difficult preciselywhen it is most needed becausethe value of their oil wealth (defacto collateral) is falling at the same time income drops and the need to borrow increases commensurately. This perverse link between income shortfalls and declining collateralvalues is an obvious recipe for debt overhangproblems. New lenders will fear too much of their money will be divertedto service old debt, thereby reducingthe value of their claims even ifprojectsfinanced by the new moneyshave a sufficiently high rate of returnto service the new debt in the absence of outstanding claims. This is the classic debt overhang problem, triggering a larger need for adjustment than just the current fall in income, as debt repayments coming due cannot be refinanced either. In this way debt overhang problems raise the costs of adjustment substantially and may also explain why volatility of government expenditure inNigeria has exceededthe volatility of oil prices. The two hypotheseshave different implicationsfor policy. Ifthe voracity effect hypothesisis dominant, the top priority should be institutional reform. There is then a need for non-discretionaryallocation mechanisms guaranteeing that expenditureplans remainwithin financial limits set by current income. The "overgrazing of the commons" needsto be stopped. The debt overhang hypothesis has more macroeconomic consequences because since under this hypothesis it i s morethan likely that external funds will not be forthcomingin years of falling oil incomethe case for the build up of financial buffers in the form of an easily accessible oil fund is much stronger. Such a fund-rule should obviously be started in good years, which in turn has the added benefit that expenditure volatility will not only be brought down to the levelof income volatility, but will be reducedfurther. Results of regression of government spending on oil-related fiscal revenues over the period 1970 - 2005 (Annex 2, provide clear evidence of a voracity effect before 1984, particularly in government consumption,but over the whole periodandcertainly after 1984the Debt Overhanghypothesisdominatesstrongly. Extractedfrom:Budina, N., Pang, G.and Van WijnbergenS., 2006. "Nigeria's GrowthRecord: Dutch Disease or debt Overhang? " 2.3 1 One implication of the volatility of the economy is the reluctance o f banks to commit to long term financing to the business sector. Figure 2.8 shows the maturities o f loans for Nigerian banks. There is clear preference of deposit banks for loans o f shorter maturities. The proportion of commercial banks loans maturing over 1 year declined from 22 per cent of total loans in 1980 to 17 per cent in 1996 and in2005 was only 14.2 percent. 38 Figure 2-9: Deposit and Credit structure of Deposit Banks in Nigeria (YO),2005 E 40 30 20 10 0 Below 30 days 31-90 days 91-180 days 180-365 days Above 365 days Durrtlon Source: Soludo (2006) 2.32 Policy instability and unpredictability has also been an important factor in the unstable macroeconomic environment. In particular frequent changes in trade tariffs and in the use o f import bans has been a major source o f uncertainty for investors. Moreover, before the move to the ECOWAS CET in October 2005, the Nigerian economy was one o f the most protectionist. In 2003, more than 42 import categories were banned including most types o f textiles, men's footwear, etcss. In 2005, the number stood at 44. This protectionist stance contributed to inefficiency in part because firms were not compelled to seek competitiveness improvements. Nigeria's unweighted trade tariff has now declined to 12.1 percent and the maximum tariff from 150 to 50. There is however still considerable resort to ad hoc import bans. Distortions in the financial sector are also reflected in historically high spreads and high risk premium on liquidity (Table 2-6). However interest spreads have declined in recent years, and the larger banks created via consolidation are likely to continue that trend. Table 2-6: Measures of Efficiency of the Financial Sector Interest Rate Spread RiskPremium on Liquidity 1990 2002 1990 2002 Nigeria 5.5 8.1 6.9 5.7 Indonesia 3.3 3.4 na na Mexico Na 4.4 1.1 South Afiica 2.1 5.0 3.2 4.6 South Korea 0.0 1.8 Source: WDI 2004 2.33 Micro risks are considerable and contribute to low private returns to investment in Nigeria. Key amongst these are weak institutions and corruption. These in turn impact on key factors inthe business environment. 2.34 Weak Institutions and Corruption. Problems o f weak institutions and corruption are not uncommon in oil rich economies and Nigeria has suffered significantly from this. During 55Nigeriahas formally adoptedthe ECOWAS CommonExternal Tariff (CET) with tariff bands of 0,5,10 and 20 per cent. However, atariff bandof 50 per cent will still be applicableinthe interimfor some selected import competinggoods. 39 decades of autocratic military rule both public and private institutions were systematically undermined and allowed to be run down. Power was concentrated in the executive. Other institutions of government, including the legislature, judiciary and civil service, had limited influence and capacity. In additionthe larger society has had limited "voice" in policy making. Moreover, selected interest groups which have special access to those in authority are able to capture policy making and exercise considerably greater "voice". Policy decisions therefore often did not reflect broad economic interests and was also more subject to capture by special interest groups. This has ledto a shiftingand unpredictablepolicy environment that has not been conducive to private investment. Sincethe returnto democracy and constitutionalrule, there has beena gradual shift inthe balanceof power. The NationalAssembly has begunto reassert itself, and some elementsofthe civil service linkedto the reformprogrammehave beenreinvigorated. 2.35 Corruptionand rent seekingthrivedunder weak institutions. Public sector dominanceof the oil sector helped create a "rentier" state whose principalconcern was sharing resource rents through large scale public spending, job creation in government and public enterprises, and through protectionof numerous sectors of the economy. In addition patronage politics become pervasive. For longperiodsthe lack of broader democratic legitimacymeant that in order to stay in power regimes have had to rely on dispensingpatronage. In such conditions public resources were usedwastefully and often for corrupt purposes. Because governments have not neededthe private sector for revenue or job creation, they have failed to provide the public goods and conducive investment climate that are essential to enable the growth of a competitive private sector. The lack of diversificationof the base of the economy led to a configuration of socio- economic interest groups, in which the most influential felt threatened in the short term by productivity-and competition-enhancingreforms. 2.36 Weak institutionsand poor governance contributedsubstantially to Nigeria's public debt problems, as the majority of projects financed by public borrowing during the late 1970s and 1980s failed to generate an adequate rate of return neededto improverepayment capacity.56The resultingdebt overhang constrained reduced incentives for investment. Corruptionis negatively and significantly associatedwith the accumulation of physicalcapitalGDP growthS7.Differences in institutionalquality account for a major share of cross-country growth differences". While Nigeria's corruption erception indexs9of 1.9 representsimprovement over the last few years the country still ranks 6 from the bottom out of a total of 155 counties ranked. Nigeria is ranked tR very poorly on all the indicators of institutionalinfrastructure.Nigeria's score on civil liberties scale was only surpassedby those of China andVietnam. Inaddition, Nigeriahadthe worst score -1.13 in the rule of law index. All of these indicators are hardly suggestive of environment conducive for private sector growth6'. Nigeria is also ranked poorly on other institutionaland governance indexePWeak institutions have increased the cost of doing business for Nigerian firms and loweredprofits availableto be made by businesses and firms. Different surveys have documented evidence that "unofficial payments" by firms for access to even the most basic economic infrastructure is quite common. This is particularly in respect of public service connections, licensing and permit processing, government contracts and customs. Respondents also consistently rank the quality, integrityandefficiency of most public institutionsas very poor. s6A study carried out by the FederalMinistry o f Financein 1996 of commercial external loans from bilateral and commercial creditors (amounting to about 70 percentof externaldebt outstandingin 1996) has documented problems encounteredby externally financed projects. 57 Mauro (1995) 58 Knack and Keefer (1995) 59 Measuredby TransparencyInternational 60 See Narula 2004. 61 E.g. Heritage Foundation 40 Firms also report paying bribes to secure government contracts. The data shows clearly that several of these indicators are improving suggesting some strengthening of institutions and declining corruption levels. Nevertheless corruption and related weaknesses in institutions remain a major contributor to high business transactions costs. This has created a business environment that is extremely hostile to competition, investment and growth because it severely limits private appropriability of returns. 2.37 Lack of "self-discovery " and innovation. Productivity and innovation are critical for sustaining Nigeria's growth. Defining a product discovery as the growth of exports in a product category from less than US$ 10 000 in each of three base years to more than US$ 1million in each of three target years6', analysis at the SITC 4-digit level for export development between 1993-95 and 2002-2004, gives only one product discovery ("Liquefied natural gas"). If this criteria is modified by reducing the target year threshold from US$ 1million to US$100 000, only two additional products are identified ("Waste and scrap of paper or paperboard", and "Waste and scrap of cast iron"). None of these discoveries represents a productive non-oil output. In comparison, in a sample of 53 countries there was an average product discovery rate (at the HS 4-digit level) of more than six per country63.There are nevertheless a few some more positive cases of cost discovery: for example the success of the light manufacturing clusters in Nwewithat have continuedto survive and producewith very little external support, inthe face of the most hostile business environment. Over the past 25 years, there has been significant cost discovery accomplishmentsrealized in this cluster. Entrepreneurshave reachedout to Taiwan in particular to obtain technology and know-how which has been introduced into their Nigeria operations. 2.38 Overall however, there appears to be a deficit in Nigeria with respect to the uptake of new productive activities. The absence of these new ideas is a factor in low private returns to investment. This is due to failure to identi@ considerable numbers of potentially profitable new non-traditional high productivity investment opportunities. One way for government to help the discovery process and overcome existing information and coordination deficiencies would be to reduce the anti-export bias in the trade regime and assist potential exporters in identifying new overseas opportunities by providing better developed and targeted market and industry information than is currently available to them. In other areas where there is clear additional export growth potential - such as leather and shrimps, specific strategies can be developed to foster improved performance and growth. In the case of leather, this would entail targeted market-driven performance-based initiatives to augment the quality of hides and for both activities, significant appropriability gains could be achievedwith government streamliningofthe licensing procedures that absorb significant management time and squeeze profit margins. Additionally the domestic catfish industry is a burgeoning market where better capture of information externalities - particularly in regard to access to and uptake of new technologies - together with improved coordination within the industry could go a long way to providing the opportunity for better returns. These would be captured by those producers that can exploit quality improvement opportunities and convertthese into successful cost discoveryoutcomes. 2.39 Recent econometric work64on entrepreneurship (measured in terms of cost or self- discovery, the policy and institutional environment inwhich it operates) and the role of reform in augmenting private sector led growth suggest that where there is poor cost discovery--arguably 62 Klinger and Lederman(2004) 63 Klinger and Lederman2004 64 "On Efficacy ofReforms: Policy Tinkering, InstitutionalChange and Entrepreneurship", October 2004, Murat Iyigunand DaniRodrik. 41 the current case in Nigeria--considerableentrepreneurial activity can be triggered by relatively modest, rather than major structuraland institutionalreforms.This can certainlybe seen to bethe case for the value chains that are showing growth and resurgence (see Box 2-3) - such as leather and shrimp Entrepreneurship also thrived in Nwewi with the most modest of improvements. Some of the businesses inthe cluster attributedthis to their own ability to coordinate sufficiently to provide some basic defence to past highly predatory government behavior that threatened privateappropriability. Box 2-3: Findingsfrom Nigeria Value and Supply Chain Analysis The cassavavalue chain 0 an example of a nascent industry attemptingto grow into maturity but hampered by fundamental constraints in the sourcing of cassava root as raw material -- its value chain is characterized by low social returns (bad infrastructure, low human capital and poor geography) and high cost of finance determined by high punitive interest rates. An estimated massive 33% of total cost is attributable to movement of primary inputs from numerousanddispersedsmallscale farms to the factories. 0 Compoundingthis is disruptiveand high cost delivery of public utilities which drive up productioncosts-these costs represent the binding constraint of the chain by far, accountingfor 24% of value added and deplete any profit margin. Poor electricity in particularsuppresses firm productivity -- thecassava starch producer studied inthe value chainis forcedto supplementgrid electricitywith its own generator for 60% of itsneeds. 0 Finally, capital charges make up on average 21% of the capital intensivecassava starch chain value - limiting the use of borrowedfunds and driving up debt service costs, both of which are prohibitive to efforts to develop this dynamic, high potentialindustry. Finished leathergoods 0 The domestic market for footwear is increasinglydominated by Chinese imports. The export of leatherhides is enjoying success particularly to the Italian and more recently Chinesemarkets. Key binding constraintsrelate to quality of raw material andhigh cost capitalfinancing. 0 To recapture domestic market share which in contrast to exports has fallen dramatically -- onlytwo companies are left with the industry at the point o f extinction, despite the advantage o f a large domestic market of 130 million people-technology upgrading is needed. However, again, inexpensive capital financing is simply unavailable. The shrimp value chain 0 An example of industry revival -once in decline because of falling fish stocks it has developed high-value shrimp exportsto the EuropeanUnionwhich recordedjust under $55 million earnings in2002. 0 Capital financing mostly comes from abroad and, while high and very lumpy (essentially trawlers and working capital) is notthe key constraint. In additionto issue of fish stocks, private appropriabilityremains akey problem as evidencedby the excessivelicensingrequirementsfacing shrimpoperators. Lowerpotential value chainsincludetextiles 0 This is an industrythat hasbeen indecline sincethe late 1990s.Low returnshavebeendrivenby bothlow social returns resulting from low human capital and bad infrastructure.The skills base and productivity of laborjust isn't up to par inasectorwhich requireshigh skills. 0 A strong labor union means Yearly wage rates are increasingat about 10% per annum, and there is also rigidity in the labor market. Moreover, a high degree of absenteeism, especially in spinning operationsresultsin 10% of spinning machinestypically out of operation. Firmsparticularly struggle to offset administrativecosts wasted on supervisionof this low quality labor- some management spend 50% of their time checking and policing staff to safeguardthe security oftheir operations. 11.PrivateSector Perceptionsof Constraintsto Growth 2.40 To a large extent private sector perceptions of the most severe constraints to their activitiesconfirmsome of the conclusions ofthe growthdiagnostics. Various firm levelsurveys have repeatedlyidentifiedinfrastructure, access to and cost of finance, macroeconomic instability and business and regulatory impediments as the most severe constraint to economic activity. What is most strikingaboutthe survey analyses(Table 1.6) is the consistency inresults across the surveys each of which take a different angle for analysis. Whether looking from a nationwide manufacturingenterprise perspective (WED study), or focusing on specific States (Cluster and Lagos surveys), or disaggregating according to firm size (Lagos study) or by industry (value 42 chain analysis) we find infrastructure, access to finance and government policy and administration(whether measured in terms of uncertainties and\or the additional administrative managementcosts that end up beingborne by the firm) revealed as the most severe impediments to improved investment levels and therefore to firm productivity improvements, growth and employment creation. Box 2-4: Nigeria: Key Constraintsto Growth Source Key Constraints As Reported in the Diagnostic Work WED 1. Infrastructure: inparticularPOWERtwicethe problemas eitherofthe nexttwo problems.(94% survey of firms cited as number one). Virtually all firms have a facility to allow them to generate their own (2002) power (between93 and 100% sample across size and location). 2. Credit: Secondmost importantconstraint - due to high cost and limited availability. 38.5% of the full sample of firms considers themselves credit constrained. This differs depending on the size of the firm.48% of micro enterprises view credit as a constraint, only 25% of very large firms. Indigenouscompanies are far more constrainedthan foreign companies. Long term finance is rare- less than 16% of the sample reportedhaving loans longer than one year in duration (service sector have best access). 3. Uncertainty: High level of uncertaintyabout Governmentpolicy and administrativeperformance and lack of confidenceof managerswhen predictingfuture sales and investment plans, especially in long run. Business environmentuncertainties highlightedare (i)Legal andjudicial systems which do not offer a reliable basis for dispute resolution, protection of property rights and enforcement of contracts; (ii)Tax system is complex, poorly administeredand widely evaded(iii)businessregulatory and licensingprocedures are complex andlengthy(iv) Customsand MIX are poorly administeredand subject to widespread evasion.(v) Governance and policy formation is weak at state and local level thus muchduplicity. Cluster 1. Infrastructure: Over 90% of firms highlightedthis as the main constraintwith 85% indicating survey high utility costs to bethe mainconstraint. for Abia 2.-Access- to credit: Over 90% of firms highlightedthis as the secondkey constraint. and Anambra 3. The unpredictability of laws and regulations: 80% o f the firm sample highlighted this as a States major constraint.Further specificationincludes: (2003) Unilateral actionby State andLocal Governmentspresents another significantproblem(78%) Official corruption(over 85%) Many firms have had to find ways to internalizeproblemskostsrelatedto barriers e.g. infrastructure etc (private provision); one extreme example is in the case of import/export procedures where only 12%now claim that this disruptstheir business. Lagos Large Firms: Main determinants of financial performance(FP), productivity and export orientation survey (PEO) and employment creation (EC) are: (i)access to finance; (ii) infrastructure and business 2006 environment; (iii)barriersto entry and competition SMEs: Mainfactors determiningFP andPEO are quality of trained staff; infrastructureandlogistics. Sole proprietaryalso tends to reduceinvestment levelandtherefore also EC. Informal Sector Firms: access to formal sector finance and infrastructure services and the main drivers in cost and profitability of informal firms. Access to sub-contracts is a further major determinant of FP and EC Value Textiles: inputs (36-71%of total cost); capital charges (5-13%); administration(5-13%); utilities (5- chain 15%). analysis Cassava: inputs(46% ofwhich 56%to labor); logistics\transport(33%), capitalcharges (21%). 2005 Leather: inputs(33-50%); labor (11-12%); capitalcharges (19%); utilities (5-8%) Shrimp: fuel (36%), administration(13%), capitalcharges (10%) 111.MainRecommendations 2.41 The immediate threat to sustaining recent growth inNigeria does not appear to be low savings but rather low productivity/eEciencyof the economy and therefore low private returns. This is inturn a result of bothlow investmentreturns and limitedcapacity ofthe privatesector to appropriate returns evidencedinan extremely difficult businessenvironment. 43 2.42 The immediate focus o f government should therefore be on reforms and investments to improve investment returns, particularly enhancing access to and cost of physical infrastructure. The next area for policy makers' attention is reforms to raise the ability o f economic agents to appropriate returns. This refers to actions to address macroeconomic instability particularly from oil revenue volatility and microeconomic risks from corruption and related weaknesses of institutions and regulations to guide investment behavior. While the diagnostics suggests a higher priority to infrastructure, it is also clear that actions to strengthenthe business environment would be generally easier to implement and could helpdeliver some quick wins. 2.43 Building human capital and skills does not come out unequivocally as a binding constraint to growth. Nevertheless action i s needed on this front since without stronger human capital and skills Nigeria cannot achieve the desired change in the competition of economic activity towards higher productivity activity. In addition Nigeria will not be able to benefit from full integration into global markets to sustain rapid growth over time. Action on this front needs to start immediately since results will take time to achieve. While savings is not the key factor in past low growth, enhancing access to capital especially term finance will be important for higher productivity including through promotion of longer term investment. 2.44 The next three chapters address issues in the top three areas of constraint: infrastructure, the business environment and access to finance. The issues of human capital and skills are addressed in parallel and ongoing economic and sector work on Nigeria. The last chapter discusses how Nigeria could better harnesstrade for growth. 44 3. CLOSINGTHE INFRASTRUCTURE GAP Introduction 3.1 Limited access to poor quality infrastructure was identified as one of key constraints to growth in Nigeria in the growth diagnostics of Chapter 265. This is confirmed in firm level surveys which have identified lack of access to appropriate infrastructure services as the most severe constraint to economic activity in Nigeria. Low quality and unreliable electricity i s often cited as the biggest bottleneck to business growth in the country66. Transport and telecommunications have also been highlightedas major constraints that hinder the connectivity betweeneconomic agents and markets. Much of Nigeria's infrastructure was built in the 1970s and 1980s. Since then under-spendingon rehabilitation and maintenance and on new investment, and poor quality of spending has resulted in poor access and low quality of available infrastructure. Since 2000, the Federal Government has significantly increased infrastructure spending-especially for power and for roads. I.Nigeria'sInfrastructureDeficit 3.2 Nigeria lags significantly behind comparator countries on access, quality and affordability o f key infrastructure. Table 3-1 highlights the extent o f Nigeria's infrastructure deficit by comparing access to electricity and road inNigeria with seven other countries. 3.3 Efectricity. Only 30 percent of Nigerians have access to electricity. Installed generation capacity is currently 6,000MW but available energy output i s only about 3,000MW while demand is estimated to be 10,000MW6'. Power generation facilities are in poor shape and therefore rarely operate at capacity. Transmission and distribution networks are poorly maintained and inefficiently operated hence it is difficult to move power from generation sites to consumption points. Low levels o f tariffs coupled with high level of losses inthe system (50 percent of power supplied is never billed and an even smaller proportion i s collected) mean that the sector is not financially viable. 65 See Chapter 2. 66 The Global CompetitivenessReport 2005-2006. 67 A detaileddemandstudy that will pinpoint the actual locationsof load is yet to be carried out 45 I 0 0 0 2 z c? m W 5 r- m m N o! m 2 - 3 2 0 0 0 c? m c! m Q- 00 o\ 0 3 0 0" 3 c 2 0 12 Q\ In W d 12 m 12 m m N m m W 12 v) v) --- 0 00 m v) m W m 3 2 z j 00 10 v) 0 o?. o? ? o - 3 3 v3 53 r! N - 0 0 0 0 I- m 3 % 3 3.4 Roads. Nigeria's current classified network is estimated at about 195,000 kilometers. O f these, 32,100 (16.5 percent) are Federal roads, linkingstate capitals and other major towns to one another; 30,900 kilometers (15.8 percent) are state roads linking towns and major settlements; and the remaining 132,000 kilometers (67.7 percent) are Local Government Authority (LGA) roads, linkingsmaller communitiesto one another and to LGheadquarters. 3.5 Over the past twenty years, the expansion of the classified road network has been lower than in comparable countries including other major oil producers. Table 3.1 demonstrates that relative to population and notably, cultivable land7', the road network now falls below that in several other countries except Ethiopia. Although expansion of the paved road network has been greater than rural roads, it still falls substantially below the increase achieved in other oil producing countries. Furthermore, about 50 percent of the country's national roads are in poor condition7'- see Table 3-2 below. 3.6 More than 80 percent o f Nigeria's road network i s managed by States and LGAs. The institutional and financial capacity to discharge this responsibility is weak especially at the LGA level. This is reflected by the poor state of the country's rural road network both in terms of coverage and maintenance. With more than halfo f the population living inthe rural areas and 47 percent rural accessibility to all season roads, more than 30 million rural inhabitants live further than 2 kilometers from the nearestroad. The problem is compounded by the fact that most LGAs have ceded their road management responsibilities to their respective State Governments. Unscientific determination of interventions and erratic allocation o f resources are the other contributors to the poor state of rural roads inNigeria. Table 3-2: Assessmentsof Condition of ClassifiedRoadsin Three Oil-Producing Countries NationalRoads RegionalRoads Local Roads Overall Network %of YO %of YO % o f % Total % Total poor Total poor Total poor kilometers72 poor Indonesia 8.5 <10 12.5 >35 79.0 <50 311,000 42 Mexico 16.2 31 27.5 40 56.3 55? 302,000 47 Nigeria 16.4 30 15.9 40 67.7 >50 195,000 46 Sources: For Indonesia: WorldBank2004. Indonesia-Averting an Infrastructure Crisis:A Framework for PolicyandAction For Mexico: WorldBank 2005. Mexico-Infrastructure Public ExpenditureReview (IPER), ReportNo. 33483-MX 3.7 The lack of effective action to control excessive axle loads has also contributed to the serious damage to road surfaces and increased expenditure requirements for maintenanceh-econstruction. Pre-existing weighing stations have outlived their effective life, and budgetary allocations have beenmade for only 2 of the 32 new ones proposed by the Ministry. A 1989 survey showed 30 percent or more of heavy goods vehicles on some key roads exceededthe legal axle load limit. It is likely the problem is worse now. 3.8 On road freight, the evidence (see Box 3-1) suggests that overall costs in Nigeria ($0.034 per ton-km) are comparable with other countries (Ethiopia US$O.O4-0.06; Zambia and Malawi US$O.O65-0.070; South Africa and Zimbabwe US$O.O2-0.03). Nigeria appears to be more competitive on some roads, such as Lagos-Kano, reflecting the fact that certain major roads have 70 the sum of landthat is recordedby FA0 as arableor underpermanentcrops 71 According to an inventoryby the FederalMinistry of Works in2004 72 Figures come from countryreports and may differ from those quoted from World DevelopmentIndicatorsin Table 3-1. 47 been built andor maintained to higher standards. Whilst the Lagos-Kano link is critical for industrial and agricultural production, it is unlikelythat major improvement on the road initself is sufficient to reduce the average operating costs nationwide in significant proportion. Regular maintenance of this and similar roads would reduce vehicle operating costs. Box 3-1: Road Freight Ratesfor Imports, Exports and CombinedTrade on Selected Roads (UScentspertkm) Imports Exports Combined Mombasa-Kampala(1,170 kms) 10.2 5.9 8.0 Dar es Salaam-Bujumbura (1,400 kms) 10.3 7.8 9.0 Lagos-Kano (1,156 kms) (a) Lorry drivers (all sizes) 3.2 2.1 2.6 (b) Companies (30-ton loads)) 3.2 1.3 2.3 (c) Lorry drivers (30 tons) 3.0 1.8 2.4 EasternNigeria (1,000 - 1,500 kms) (a) Lorry drivers (all sizes) 2.5 (b) Lorry drivers (below 30 tons) 3.4 (c) Lorry drivers (30 tons or more) 2.1 3.9 The cost of operating a truck inNigeria is estimated at about 75 percent of gross revenue. Factors in this high operation costs include: poor roads and narrow bridges (39.6 percent), the menace of armed robbers on the highways (23.3 percent) and harassment by security officials (12.5 percent). Touting was ranked fourth with a score of 10 percent. These four problems together account for 86.2 percent of freight operators costs, which influences road freight rates in the country. 3.10 Although public expenditure on roads never exceeded 1percent o f GDP inthe 1990s, it is estimated to have risen to between 1.3-1.6 percent of GDP73inthe last few years. Unfortunately, its impact has been limited due to weak contracting procedures, poor planning and supervision, slow completion of projects and serious under-funding o f maintenance. Furthermore until recently budgetary allocation for road investment was erratic and releases which were generally lower than those approved in the budget were affected late in the financial year. These financial uncertainties and delays- compounded by weak project supervision - were reflected in high unit costs and delays in project completion. Funding for maintenance of rural roads which are critical for rural economic growth i s significantly low compared to other parts of the road network. The sum total of the direct and indirect costs of these inefficiencies to the economy are likely to be significant and estimated to be as high as 3 percent of GDP. 3.11 Ports. Despite its good coastal location Nigeria has not been able to develop an efficient port service. Port services are amongst the most inefficient and expensive in the world as evidenced by: (i) High waiting times: ships wait up to 20 days for berths at the Apapa container terminal which handles a large part of Nigeria's international trade in terms o f value, excluding oil. These long queues at Apapa are very poor in comparison to container ports in other countries where waiting times are negligible; (ii)Low handling speeds: the largest operators in Apapa average only about 6-7 crane moves per hour, relative to the 25 crane moves per hour achieved at efficient ports. Handling speeds for bulk and conventional cargo are also very low; and (iii)High 73 Would be between 1.4 and 2.4% ifdata for additional states is added 48 container "dwell time^"'^: these average about 25-30 days which is five times higher than international best practice standards. This results in severe congestion on the quays and further falls in container handling speeds due to congestion. Apapa should be able to handle about 1.2 million TEU at operational levels in line with international standards but it is only handling 350,000 TEU and with great difficulty, as evidenced by the long queues. 3.12 As a resultof these inefficiencies, costs of shippinghave spiraled upwards. The shipping lines have imposed surcharges o f around US$700 per TEU to cover the time ships spend waiting adding about a third to freight rates from Europe. Surcharges are unusual in other countries, and where they exist are usually far below those applied at Lagos. For example the port of Tema in Ghana has a surcharge of $150 per TEU and Cotonou $215 per TEU. There is no surcharge in Abidjan. 3.13 The costs o f moving a container through the port are also very high. The basic container handling charges are about $223 per 20 foot container (consisting o f $187 for ship-shore handling and $35 for delivery). But the shipping lines incur other transactions costs, including the costs of deploying their own staff to "assist" the NPA staff. The cost of container handling in well run internationalports is often inthe range $100-125 per TEU, i.e. about halfof that inLagos. 3.14 Port entry charges at Lagos are the highest in the region, driven by Nigerian Port Authority (NPA)'s need to pay its workforce of about 11,000. Salaries are high by Nigerian standards and account for 48 percent ofNPA's costs. 3.15 Railways. The railway sector is not playing its naturalrole inthe Nigerian economy. The sector offers minimal services although there i s an unsatisfied demand for medium and long distance freight and passenger traffic by rail, as well as for rail commuter traffic in Lagos area. About 95 percent of all freight is done by road. 3.16 Railway infrastructure is dilapidated and there is a lack of serviceable locomotives and rolling stock. Locomotive availability o f Nigerian Railway Corporation (NRC) at 6 percent is dismal in comparison to locomotive availability percentage of about 75 in Africa and 85-90 in more efficiently managed railways elsewhere. The availability o f wagons (28 percent) and passenger coaches (29 percent) is also low in comparison to international standards of 95 percent and 90 percent respectively. The traffic hauled has declined to less than 50,000 tons of freight and about one million passengersper year from 3.0 million tons of freight and 15 million passengers per year inthe past. The market share ofNRC is not significant and is estimated to be ofthe order of 1percent. 3.17 The impact is a virtually bankrupt NRC which costs Nigeria between billions to sustain annually. Revenues in 2003 were N 596 million against expenses of N2946 million. For every naira o f revenue earned, NRC spends N5. In 2003 and 2004, the Federal Government provided subsidies ofN3.9b andN1.6b respectively. 3.18 Telecommunications. In contrast to other sectors, Nigeria has made considerable progress in access to telecommunications infrastructure in the last five years. Up until 2001 Nigeria was classified as one of Africa's most underserved telecommunications markets. Today, it is one world's fastest growing telecommunications markets. With mobile cellular subscribers growing at an annual average 114 percent (between 1998 and 2003), the Nigerian telecommunications market is growing at 3.5 times the world average and almost twice the 74 The times the boxes spend inthe port 49 African svcrage-', The total number of' ~ e ~ e ps~bscr~~ers ~ i ~ ~ ~ eincreased from less than j00~000 s ~ ~ b s ~ ratid~aetete~~ensj~ ~ r s of less ttiari one percerit in 2000 tu nearly 20 rnilliori s~bscribersand a ~e~edens~tj csf tiearty IG percent in 2005 see Figure 3.1. -3.1 'd Inthe area of data services. a good nun~~ernetwork csperators haw emerged deplojing of VSAT and fiber optic Local Area Networks as u e l i as Wide Area Networks fbr corporate bodies. TeleeornmzltiicariOnsvalue added service providers and ~r~st.~ttrtions. Users of internet services in the countv are currently estimated at about 2.24 rriillioii showing an average arzntial grmsrh rare of' about 130 permit from a nitre 107,194 uscrs in 2000. Xntcrtict ~ e n e t has~increased from ~ ~ ~ ~ n 0.1 per cent in 2000 to about I.75 per cent at the end of 2005. 3-30 Nearlc 95 percent of the new s~rbscr~bers have been added during the last rive 3 ews that. have been s t ~ b ~ c r itoeone of the ccltrrlnr phone nctworks o~era~ing ~ r ~ in the coutitry. ~ ~ ~ ~ l ~ o ~ the totat riuniher of fixed h e su~scrib~rs not grown as ~ r a ~ ~ a t ias ~mobile subscribers, has c ~ l } a p p r o ~ i ~ ~S~~~0c l, }net) ~tines have been added fur total of r-tearlj 1 million fixed s~~~scribers 0 ~ it as of Deceinber 2005. Most of the grlu-t'ii irz the fixed tine sector is accotrntcd for entirely by N1"I'EL"sfixed wireless private c ~ ~ ~ ~ -i seecFigure~3-2 rbeloow. ~ t ~ o ~ Fixed line telephonesubscribers in Nigeria, 000s 3.21 The rapid progress in Nigeria's telecommunications sector has been largelythe resultof the federal government's aggressive effort to put inplace a competitiveandtransparent legaland regulatory framework. However, the poor performance of NITEL reduces the impact of the recent growth inthe telecommunications sector. As can be seen in Figure 3-3 below, NITEL's performance falls well short of fixed line operators in other African countries against severalkey indicators - including accessibility (fixed lines per 100 inhabitants), investment and efficiency. Nigeriais at the bottomofthe leaguetables in `networkedreadiness anddigitalacce~s.'~ Figure3-3: Accessibility of NITEL Accessibility to NITEL Compared to Specific African Countries 14 12 10 8 6 4 2 0 Nigeria Benin Ghana Sudan Morocco Egypt Sub-SaharanAfrica SouthAfrica W Main lines per 100 inhabitants (2003) Source:ITU. African Telecommunications Indicators2004 3.22 Furthermore, due to major inadequacies in NITEL's backbone infrastructure, mobile operators haveto use unreliablesatellitelinks.The impact is increasedinvestment costs and poor reliability as mobile companies and PTOs are forced to either rely on base stations or invest heavily in their own backbone infrastructure. This is inhibiting growth of mobile and PTO networks and holding back the rate at which the Nigerian economy can benefit from improved communications. 11.Implicationsfor Firm Costs, CompetitivenessandCompetition 3.23 Nigeria's infrastructure deficit imposes significant additional costs on businesses and reducestheir competitiveness. Firms are forced to invest in self-generation, divertingsubstantial resources from reinvestment intheir productivebusinesses. 3.24 Poor access to reliable power has a direct impact on the risks faced by enterprises. Particularly for start-up firms lacking experience and market knowledge, the risk that enough market share and adequate returns may not materializeis substantial. This is likely to discourage entry. Givenpoor access to finance it is additionallydifficult to mobilizethe funds for suchhigh investment requirements. Thus older firms, particularly those who may have fully or substantially amortized their infrastructureservice investments are at a significantcost advantage relative to new entrants. Interviewswith private sector firms indicatethat the need for start-up companies to invest in backup generators is frequently a requirement for obtaininga commercial bank loan. With diesel prices uncertain and rising, it raises risk perceptions enough to pose a 76 Bureauof Public Enterprise (2005), TelecommunicationsPolicy Positioning PaperNo 3 -Adam Smith Institute 51 non-negligiblebarrierto entry. Thus competitionfor existingbusinessesfrom new entrants in any given sector is reduced. This can also present barriers to entry for new firms resulting from infrastructuredeficiencies. 3.25 The 2001 WED survey found that a representative business enterprise in Nigeriaspent an annual average of N 50,703 for electricity, ofwhich 31percentwas payment for public-sector electricity and 69 percent was the running cost of the business-owned generator. In contrast, a representativebusiness enterprise in Egypt reported that only 5 percent of their energy cost was for running a business-ownedgenerator. In2003, a Nigerianenterprise spent US$576 annually on electricity while a comparable Egyptian enterprise spent $201. On average, in Nigeria, generators and related accessories accounted for 22 percent of the value of equipment and machinery in the business. The figure reported by Nigerianfirms for average losses of finished product attributable to power outages was 30 percent while firms in India Egypt and Brazil reported losses of 8.9 percent, 6.1 percent and 2.5 percent respectively. Nigeria is clearly an outlier and this must have a major impact on both the cost of production as well as competitiveness. The survey also revealed that firms in Nigeria have responded to the inadequacy of public-sector electricity by adjusting their mode of production to favor less electricity-intensiveinputs, usuallywith sub-optimaltechnology andproduct mix. 3-26 Hightransport costs dueto poor roads; portandrail conditionssignificantlyincrease time to market and adds to the cost of doingbusiness inNigeria. The lack of good access roads also reduces rural productivity, especially in agriculture. The opportunity cost of weak transport systems is clearly high. It is conservatively estimated that a rehabilitated and an efficiently operated railway system in Nigeria has the potential of growing freight traffic volume to 4.2 million tons by 2010. Assuming no capacity constraints, in subsequent years the traffic by rail could be expected to grow further in line with the economic growth of the country. The traffic volume on the existingnarrowgauge system couldpossiblygrowto 5.6 milliontons by 2015 and to 7.5 milliontons by 2020 assumingan averagegrowth intraffic volume at 6 percentperyear. In the light of intense competitionfrom road transport interms of high frequency and low cost, the prospects of rail passenger business in Nigeria are limited. Nevertheless, passenger traffic is estimated at about 9-10 million per year by 2010. This would significantly reduce the current pressure onthe roadnetwork. 3.27 Recent economic researchshows a direct link betweengreater mobilephone penetration and GDP growth". A developingcountry with an average of 10 extra mobile phones (per 100 inhabitants) can unlock 0.6 percent of additional GDP growth, compared to an identicalcountry (without the extra 10 mobiles per 100 inhabitants). Assuming an efficient NITEL unlocks an additional20 percent growthin mobilephones, growthinGDP per capita inNigeriacouldrise 21 percent from 3.7 percent to 4.52 percent. Similar analysis shows that increased telecommunications penetration can be associated with higher foreign direct investment (FDI) e.g. a 1percent increase in mobile penetration rates has been associated with 1 percent per cent higher rates of FDVGDP in Sub-Saharan Africa. Internationalstudies show that full or partial privatizationwill increase telecoms output by an average of 118 percent and will also boost line density. Furthermore, labor productivity, in terms of real output per employee was found to increase following full or partial privatization. Government should benefit from increased corporate tax revenue, and throughdividends while it retains a minority shareholding in NITEL. Furthermore, Government is likely to recover payment for the N5Obn loans borrowedby NITEL which it has hadto assume. 77 Waverman, Leonard, MeloriaMeschi and Melvyn Fuss, The Impact o fTelecoms on Economic Growth in Developing Countries 52 111. ClosingNigeria's InfrastructureGap Cross-Cutting Challenges 3.28 Recognizingthe importance of improvedinfrastructurefor competitiveness and growth, the federal Government has embarked on several infrastructure reforms. The focus of these reforms is on enhancing government's capacity to provide appropriate infrastructure services, increasing private participation in infrastructure provision, and strengthening government's ability to effectively regulate infrastructure services development and provision. Through the program, government is redefining its role from an exclusive provider of infrastructureto a dual role of both infrastructureprovider and facilitatorof privateinfrastructureprovision. Successful implementationofthis dual role requires success ontwo cross-cuttingfronts: (i) strengtheningthe efficiency of public infrastructure investment spending; and (ii)creating a framework including regulationfor effectiveprivateparticipation. 3.29 Planning and Efficiency of Public Investment in Infrastructure. To maximize impact, public infrastructure investments need to be better planned and prepared and execution should promote greater efficiency. Efforts are now being made to strengthen investment planning and preparation in the context of broader public expenditure management and budget reforms. However there are still some gaps. Medium term strategies for infrastructure planning and budgeting needto be strengthened in several ways: (i) to link more closely with clearly defined and realistic targets for infrastructure development; (ii)to prioritize and fully cost alternative investments; and (iii) to provide clear indicatorsand establish a clear monitoringmechanism to measureprogressinexecution andjustify continuedfundinguntil completion. 3.30 Furthermore, the existingpublic infrastructureinvestment portfolio needsto be critically reviewed. Several have been under execution for several years. Such a review could form the basis for weeding out projects that can no longer be justified and ensuring that resources are focusedon a smaller and sounder set of projects. Projectsneedto be muchbetter preparedusing technical and financial analysis and transparent and meaningful criteria need to be adopted to form the basis ofprioritizationand selection betweendifferentpublic expenditure and investment options. Considerable capacity building will be needed for infrastructure sector ministries on preparation of medium term plans, project appraisal techniques as well as on project monitoring systems. 3.3 1 The use of sound criteria for infrastructure investment allocation will also help bring better balance between spending on rehabilitation and maintenance and spending on new infrastructureinvestments. Comparisons with other African countries show that Nigeria suffers in almost all infrastructure sectors from underinvestment in maintenance which significantly reduces infrastructureservice levels. For example, the maintenancebudget of the Federal Road Maintenance Agency (FERMA) is sufficient to carry out routineand emergency maintenance on less than half of the federal road network and states and local governmentstypically allocate less than 10 percent of total road spending to maintenance. New construction tends to be given preference due to political visibility, while global experience shows that maintenance and rehabilitationof existinginfrastructureassetsyieldsignificantlyhighereconomic returns. 3.32 In the electricity sector until the health of the distribution sub-sector is improved, additionalpower generatedwill not be able to reach its intendedend-users. This means potential customers who are not on a distributionnetwork that is connected to the transmission network, cannot receive power. Significant investment in transmission and distribution is needed alongside the ongoing expansion of generation. Similarly the location of all new plants in the 53 same part of the country (Niger Delta) as is currentlybeing implementedmay not give rise to the development of secondary markets for gas and power, and may not create sufficient direct local economic development in various areas that are anchored on the power sector. This might jeopardize the growth impact of the investment. 3.33 Finally it is important to strengthen coordination between the different tiers of government for infrastructure investment planning, implementation and monitoring. An integrated framework for infrastructure investment planning between federal, state and local governments beginning at the level of individual infrastructure sectors needs to be put in place. This is important to ensure that potential synergies between investments at the different tiers are exploited and sub-optimal use of public infrastructure is avoided. Indeveloping the framework, the issue of institutional capacity at the level of the three respective tiers vis-a-vis the responsibilitiesthat they are intendedto cover will needto be adequately addressed. 3.34 Private Participation in Infiastructure. Private participation in infrastructure can alleviate fiscal pressures and improve the efficiency of infrastructure service delivery. Key benefits of Public-Private Partnerships (PPPs) in infrastructure include (i)efficiency gains from access to innovative technologies and economies of scope, (ii)cost reduction through improved risk allocation to the party which is equipped to manage a specific risk at least cost and performance incentives for the private sector (iii)earlier project realization as government payments are transformed from one large upfront payment into a flow of smaller payments over time, (iv) enhanced public management capacity as government focuses on infrastructure facilitation and monitoring, leaving service provision to the private sector. In the Nigerian context, PPPs can provide all of these benefits combinedwith the added advantage of supporting the irreversibility of infrastructurereforms. 3.35 The Infrastructure Concession Regulatory Act (PPP Act) adopted in November 2005, provides the legal basis for pursuing PPPs in all infrastructure sectors in Nigeria. It foresees build-operate-transfer (BOT) concessions for greenfield infrastructure projects, while contracts for existing infrastructurewill be awarded on a repair-maintain-operate-transfer ( M O T ) basis. The Act also established the Infrastructure Concession Regulatory Commission to regulate, monitor and superviseinfrastructurecontracts. 3.36 The private sector can be involved in all levels of infrastructure provision, including oversight (user participation in planning and regulation), execution (sub-contracting work to private enterprises) and management (providing part or all of the needed capital investment with an interest in the overall success of the project). The choice of concession model and degree of private sector involvement depends, among others, on the size of the investment needs and the potentialofrecoveringthemthrough user fees. 3.37 Inthe energy sector, all levels of private participation are feasible. Investments inthe transmission system will be undertakenby government, while the private sector will be brought in on a management contract basis. Inenergy generation, IPPsare being built both by the public and private sector with credit enhancement for the private sector. In distribution, at least two distribution zones have been identified to be commercially viable7* which provides an opportunity for the private sector to undertakesome investmentas well -see Box 3-2. 78 Abuja, Ikeja 54 Box 3-2 :Opportunitiesfor private sector involvementin electricity distribution Two types of PPPs are feasible in implementing distribution reforms (i) distribution business outsourcing and (ii) distributionfunctionoutsourcing. These two models are currently under developmentby BPE. (i) distributionbusinessoutsourcing,aselectedpartofthedistributionnetworkorcustomerclustercouldbering Under fenced and given as a concessionto a third party operator. The operator could then purchasepower from NEPA or other generators in bulk and distribute it to customers in the cluster, payingwheeling charges to NEPA for use of the distributionnetwork. All investmentsmadeby the operator inimprovingthe networkwould be accountedfor. (ii) Under distributionfunction outsourcing, FGN would make investments in a variety of goods and services. Bids would be prepared for private third parties to take up these initiatives individually on a turn-key basis for a pre- specifiedpart of the distribution network or customer cluster. The contract would be on a BOT basisfor e.g. metering, installation of online capacitors, setup of customer care centers, and launch of rapid response vehicles. The contract would be on a BT basis for initiatives such as HVDS, HT and LT meters, and the introductionof spot-billing. Under this arrangement the FGN would contribute to the cost of goods and installation, while the utility or concessionaire would bear the cost of services andoperatingexpenses. 3.3 8 Significant investment and rehabilitation needs in the transport sector require ongoing public sector investment, while private participationappears most feasible on an operating and maintenancebasis. Inthe port sector, concessionshave been designedas operatingconcessions, with the private concessionaire being mainly responsible for operating and maintaining port terminals and the public sector maintainingoverall responsibility for dredgingand other major investments in port infrastructure. Twenty four concessions of cargo handling terminals have been successfully awarded to private operators. The process which followed best practice principles, based on competitive bidding procedures and regulation by contract, attracted a number of high profile operators - including global industry leaders. At the same time, paid concession fees were generally high. This is likely to increase user charges significantly with unclear impact on demand." To fully realize the potential impact of the port concessions the to be addressed.. slow customs processingtimes which contributes to significantcongestionat the terminals needs 3.39 In the railway sector, feasibility studies show that investment needs will need to be shared in order to make the planned railways concessions financially viable for private concessionaires. The BOT and RMOT schemes for roads and bridges foreseen by the PPP Act would require significant investment innew construction and rehabilitationby the private sector with adverse implicationsfor cost-recovery in the absence of any form of government support. Instead, large scale investments inrehabilitationandnew constructioncouldbeundertakenby the government, allowing for maintenanceand operating costs to be borne by the private sector on a cost-recoverybasis. Thiswould havethe benefitof clearly separatingpublic andprivatefinancial responsibilities under PPPs, limiting government support to investment requirements and reducingthe needfor potentialrevenuesubsidies. 3.40 In the telecom sector, private participation has been high with a number of investors engaging in the provision of mobile and fixed-line services. Following liberalizationin 1999, Nigeria's telecom sector today has four mobile operators and more than 20 fixed-line operators. Significant private sector participation reflects (i)the relatively lower capital intensity of the sector combinedwith marketbasedtariffs and significantpent-updemand, allowingfor relatively fast cost recovery, and (ii)an established and transparent regulatory framework with an independent regulator (Nigeria Communications Commission). Furthermore, government is close to the completion of sale of 75 percent of NITEL. The main challenge - in additionto the completion of the NITEL sale transaction - is that of strengthening the regulatory capacity of Government and ensuring that private providers increase the quality and availability of telecom 79 Inparticular, the high fees paid for concessioningthe main containerterminal at Apapa 55 services at a competitivepriceto support connectivity and economic development in all areas of the country. 3.4 1 Goingforward, a number of remainingimplementationchallenges needto be addressed to ensurethat PPP is able to effectivelycontribute to closingNigeria's infrastructuregap: Unclear policy for government support: Depending on the type of concession adopted, government support ranges from full-scale investment, direct subsidies as well as indirect subsidies through instruments such as minimumrevenue guarantees and partial risk guarantees for project debt. According to the PPP Act, no federal ministry, agency or corporationcan provide guarantees or lettersof comfortto PPPs without the approval of the Federal ExecutiveCouncil. However, this has not been applied uniformly. A standardized and transparent approachto government support in PPPs needs to be developed and implemented. The regulationrequiringFederal Executive Council approvalof all guarantees or letters of comfort to PPPs needs to be complemented with a standardized and transparent approach towards offering government support to PPPs with a view to (i) attract a maximumnumber of bidders to foster competitionand reduce prices, and (ii)limit fiscal costs to the government. For example, Federal Government guarantees couldbe limited to projects which are economically viable but not financially viable without credit enhancement. Guarantees can provide credit enhancement to help projects achieve an investment grade rating, making them eligible for and thus providing access to capital market funding which could not be achieved without government support. Consistent policies regarding government guarantees across sectors are important to send coherent signals to investors and financial markets and to limit Government's contingent liabilities. A number of outstandingSOE liabilities: Public utilities inNigeriaare faced with a number*of outstanding liabilities including commercial arrears, payment arrears to private contractors and unfunded pension liabilities. These arrears and liabilities needto be resolved beforeany privateparticipationin infrastructurecan be attracted. In the energy sector, government plans to pay NEPA's commercial arrears to contractors and pension arrears through a combination of non-core assets sales, budget payments and potentially a bond issue. Additional analysis is ongoing to determine the magnitude of pension liabilities and potentialproceeds from non-core asset sales. Outstanding SOE liabilities in other infrastructure sectors need to be tackledthroughtakingstock ofall forms of liabilitiesanddevelopinga workout plan. High regulatory and governance risk: Regulatoryframeworks in all infrastructure sectors apart from telecommunications are incomplete. While the energy regulator hasjust adopted a multi-year tariff regime, tariff structures and the potentialfor cost recovery for private investors in other sectors remains unclear. While the PPP Act aims to providean enabling environment for private investment, it leaves large room for discretion in areas such as procurement, contract enforcement, board members and policy direction. This increases uncertainty from the perspective of a private investor. Actions are neededat individualsector leveland within PPP framework to address these regulatory and governance risks including further developments of regulatoryframeworks andclarificationofprocurementprocessesfor PPPs. Duplication of institutions and unclear implementation responsibilities: In principle, infrastructure line ministries are supposed to be responsible for sector 56 policy formulation including PPPs, while the regulator's responsibilities include technical, safety and economic considerations. InNigeria, however, a multitude of government agencies are involved in infrastructure with overlapping responsibilities. At the policy level, government stakeholders include the Ministry of Finance, line ministries, the National Economic Committee and the infrastructure sector steering groups o f the National Council on Privatization. At the regulatory level, the PPP Act duplicates existingand planned regulators by setting up a separateregulator for PPPs. It is unclear how responsibilities will be split between the Infrastructure Concession Regulatory Commission, the existing electricity regulator (NERC), the planned Transport Regulator and the Bureau of Public Enterprises in the negotiation, implementation and monitoring of infrastructure PPPs. This increases transaction costs and uncertainty for the private sector. The Concession Regulatory Commission could be based in an already existinginstitution in order to avoid further duplication, complexity and potential deadlock between a myriad of institutional structure and responsibilities. Institutional roles need to be clarified e.g. through a clearly defined process for PPP identification, negotiation and monitoring. To improve oversight over private participation, the Ministry of Finance could consider establishing a PPP unit in the next 1-2 years. Responsibilities of such a unit could include (i) establishing standardized criteria for projects eligible for PPP, (ii)establish guidelines on risk allocation practices in PPPs, (iii)supervising and checking economic and financial project analysis and value for money analysis conducted by line ministries, (iv) establishing a coherent fiscal framework for government support for PPPs, and (v) acting as the authorizing body to approve government support for PPPs. Capacity constraints: As the government's implementing agency, BPE has built a track record in infrastructure privatizations and concessions. Over the past six years, BPE has privatized a total of 43 enterprises in various sectors. Despite this impressive performance, staff turnover is relatively high. Given the government's ambitious PPP schedule and numerous requests for assistance including from state governments, BPE may reach its capacity limits. Capacity building is required both at the federal and state levels to successfully implement the government's concession program. 3.42 In addition to these broad sector wide issues, a few actions are needed in the individual infrastructure sectors. 3.43 In the electricity sector additional areas for government attention include: (i)power generation; (ii) financial sustainability; and (iii)regulation. 3.44 Power Generation Inparallel with ongoing reforms, the Government is addressingthe - electricity generation shortfall as the immediate bottleneck to growth. It has asked international oil companies to build large host power plants (IPPs) for total generation capacity of 3,200 MW. Power Purchase Agreements (PPAs) are being signed and financing structures are being negotiated. In addition, government itself has launched the National Integrated Power Project (NIPP) to build additional IPPs for total additional capacity of 4,500 MW with $2.5 bn out of the oil windfall. While these initiatives contribute to the short-term alleviation of electricity shortfalls, they will only create sustainable long-term electricity supply if combined with ongoing commitment to sector reforms and complementary investments in distribution and transmission networks. A few actions are neededto ensure this: 57 A detailed electricity demand study is needed to help government conclude Power PurchaseAgreements (PPA) with eachnew plant. The exact locationof demandfor each plant should be established, so that the revenue sources that will underpinthe PPA are identified. Transmission and distribution linkages, as well as utility management upgrading e.g. through CREST initiatives, should be in place to enable the required revenuesto be realized. The efficiency of supply must be addressedurgently to reduce the current levelof close to 50 percent losses. Otherwise only half of the proposed7,700 MW can be expectedto reachthe endusers. 0 Investment is needed intransmission and distributionalongside expansion of generation to improvethe healthofthe distributionsector. This will ensurethat the additionalpower reaches its intended end-users. Without this, the push on power generation expansion will be difficult to sustain. A monitoringand oversight system for the sector in the event that guarantees under oil- company sponsored IPPs are called inneedsto be established". This is likely to happen since distributionmightnot generateenoughrevenueto pay for the increasedpower. 3.45 Financial Sustainability Operations in the power sector are currently not financially - sustainable due to current high levels of technical losses and inefficiencies. Inaddition, current tariff rates are not high enoughto allow commercial operators recover costs. The tariff structure will needto be revisedto ensure incentives are providedto privateoperatorsto participateinthe market, invest ininnovationandreducethe current leveloftechnicallossesand inefficiencies. 3.46 Regulation - With regards to regulation, the capacity and funding of the newly established regulator, the NERC needs to be strengthened. While key staff are in place, further capacity building is requiredto adequately equip NERC for the implementationof the new tariff order. In addition, securing a long-term funding base for NERC is key to ensuring its independence. In addition, the operational framework for the unbundlingof the former NEPA companies still needs to be developed. Unbundling transmission, distribution and generation requires both the development of market rules and additional investments in transmission and distribution networks. In particular, the regulatory framework for fuel supply needs to be developed to ensure adequate gas supply to power generation assets under construction. This includes three aspects (i)development of non-associated gas, (ii)the development of the gas transportationor pipelinenetwork, and(iii)independentregulation. 3.47 Inthe transport sector, the key areas for additionalactionbeyond the ongoing reforms are: (i) financingfor roadmaintenance(ii) economic analysis of railway rehabilitationrelated to concessioning; (iii) regulation;and(iii)institutionalarrangements. 3.48 Road Maintenance - The development of the road network will continue to depend significantly on budgetary funds. However the fairest and most efficient way of increasing the funding available to the sector is by raisingmore revenues from network users. An increasing number of countries have found it useful to put some or all of the revenues raised into funds reserved for expenditure in the transport sector, thereby linking the user contributions more 80This wouldbe neededto providebackup sources o fcollateralto pay for the obligationsunderthe PPAs if distributiondoes not generateadequate revenues. 58 clearly with results obtained from application of the funds, and also accelerating their availability to the sector. 3.49 The principal revenue-raising means that could be used inNigeria inthe near term for a Roads Fund is a surcharge on motor fuel, supplementedby vehicle registration fees and fines for overloading. It may not be possible to take much action on fuel surcharges before the 2007 elections but a start on a system aimed at eventually raising from users the amount required for routine and periodic maintenance (one-third of total costs or about 1 percent of GDP), would be demonstrably fair and should also minimize controversy over regional allocations: the funds would be distributed inproportion to expenditures on maintenance, with the aim of coveringtheir full annual levelwithin a fewyears. 3.50 Budget funds as well as those from the proposed Roads Fund have to be channeled more effectively into the various networks, and especially to the networks for which the LGAs are responsible where there is a considerable backlog of maintenance and links with getting agricultural produce to markets are greatest. State and local government networks together should receive about 58 percent o f total expenditures over a ten year period,'l compared with the 40 percent received in 2000-02. Resources from the Roads Fund would be allocated to federal, state and LGAs, with an intermediary role played by a state-level Rural Roads Board. A PrivatePublic Board would need to be created to manage the Fund, assign resources to eligible programs and monitor their performance", and audit its collection and use. 3.51 It is important that ongoing reforms in the road sector result in the creation of a road management agency whose main task is to anchor Nigeria's road management on economic efficiency principles, thus ensuring proper utilization of revenues accruing from the reformed financing arrangement. It is envisaged, that the large majority o f maintenance work would be contracted out by the responsible agencies to private providers, paid increasingly on a road performance basis, verified by visual inspections. The Roads Fund Board's grants to the responsible agencies would be o f the conditional nature and agencies which failed to secure reasonableresults would be suspended from the program and, in extreme cases, required to repay the grant provided. 3.52 Railway Rehabilitation Inthe context of ongoing railway conce~sioning~~,government - may have to pay for the large majority of track rehabilitations and future improvements. This is consistent with global experience. Total cost of these works i s estimated at between US$l.O and US$1.5 billion. However investments of this likely magnitude requires very serious analysis in light of real traffic potentials and likely costs of rail transport compared with other modes, particularly road and inland waterways. Railway proponents often appear to assume that the concessionaires would, for example, quickly win a high proportion of inland container movements, not recognizing that the railways carry only 17 percent o f such traffic in South Africa, seven percent in India, and 2 percent in Pakistan with its relatively efficient road freight services. 81An importantexpectedside-effectofthe steadier andmorereliable flow of cash for employmentof local people on maintenanceofthe LGA roads is to makeit easier for themto maintaintheir ownCommunityroads (providing access to the LGA network)onthe age-gradesystemcommoninmanyparts ofNigeriaor alternative '*The forms of community self-help. vitally important role that a properly constituted Board of this nature can play is well illustratedby the experience of Tanzania outlinedinTechnical Annex 3-A. 83 Sincethe initial work for this reportwas done, the Governmenthas put on holdthe concessioningof the sector and embarkedon a significant railwayspublic investment program. 59 3.53 Even if the shodmedium-term economics o f some or most o f the requisite track rehabilitation were unattractive, the government might still decide to undertake the investments, given the crucial contribution that they might make to enabling a better long-term structure and pattern of regional development, less concentrated around the Lagos agglomeration, The railways also have a potential long-term role in providing better links with neighboring countries such as BeninandNiger. Butgovernment needsto have a clear view ofthe costs involvedbefore making such decisions. If these turn out to be too large, government could for instance, decide to experiment first with rehabilitation and concessioning on a more limited scale, such as in the South-West (around Lagos and its environs), to test out the practical effectiveness of this path. 3.54 Regulation - To ensure the best results from rising private participation in transport, economic regulation across transport sectors needs to reinforce general anti-monopoly and fair trading legislation and enforcement procedures. As regards the port concessions so far let and planned, the underlyinggovernment assets have been restructured to ensure a reasonable degree of competition and the contracts have been well written, so that only light supervision from an economic regulator should be required. Nonetheless, it is important to start the process of buildingup capacity for such regulatorywork. Particular issues that will requireattention include the important ancillary services contracted out by the Port Authorities, and the effective functioning of the mutual track access rights of the railway concessionaires north of Kaduna- Kafanchan. Also, formulae for price adjustment over time, such as built into the contracts, have sometimes proved undulyrigid inother countries' experience Box 3-3 :The Government's New Railways Investment Project As the railways concessioning and reform processes were underway in late 2005, the Government and a Chinese construction fmentered into negotiations for the conversion o fthe Western line, a route lengtho f 1315 km, from the present narrow gauge to double track standard gauge at an estimated cost o f $8.3 billion. The project is likely to negatively impact the ongoing rail sector reform and would particularly affect the concessioning plan since the Western and the Eastern lines had been strategically linked to improve their financial attractiveness and encourage competition. The fast tracking and timing o f this project could be an indication o f Government's frustration emanating from its perceived slow rate at which the rail reform process was unfolding. However it could send negative signals on the way Government intends to do business now and inthe future. The discerning private sector is likely to factor this into their proposals and would consider the possibility o f Government embarking on future conversion o fthe Eastern line while the concession was in progress a real possibility. On the choice o f intervention, the capacity expansion from single to double line and gauge conversion ftom narrow gauge to standard gauge track, have not been shown to be either economically or financially justified. In addition the cost o f $8.3 billion over a period o f four years would imply a budgetary allocation o f over $2 billion annually on the railway sector alone, a significant share o f the national budget. Other side effects o f the choice to convert the line are that: (i) unless the branch lines along the Western line are also converted, they will be rendered unusable; (ii) the western line will for now be unavailable to the concessionaires and post completion arrangements are not clear (iii)a new set o f locomotives and rolling stock will have to be procured; and (iv) future regional connectivity is not certain as it would also depend on Nigeria neighbors' ability to convert their existing lines to standard gauge. 3.55 Action is also neededat both federal level and in major cities, to introduce effective and honest systems for registration and licensing of providers o f commercial road transport services and their operators. At federal level the Ministry of Transport has been working with stakeholders to develop basic standards, and systems for their implementation, which would improve the safety and security of services and encourage competition among different types of provider. These will need to be implemented. At the city level, the needs relate mainly to passenger services and improvement of their organization by formation of associations and larger 60 companiesthat can provide more reliable services incompetition with one another. This is ajob for Urban TransportAuthorities. 3.56 To enable the regulator to develop a sound overview of the functioning of the different concessions, a database of key performance indicators on each concessionedoperation needs to be built and maintained. Regular publication of such comparative indicators can be a useful stimulant to improved performance. Incorporation of these functions for all transport modes into a single Transport Regulatory Commission, which would have another main department for coordinating safety regulation of each mode would be useful. Regulatory functions must be handledby bodies independentof ministerial control and therefore recognizedas neutral between the public and private parties to the concession agreement. It will be important to coordinate transport sector regulation with the recently approved legislation for an Anti-Trust Bureauin the MinistryofJustice. 3-57 Institutional Roles and Arrangements. Ongoing reforms should enable the transport Ministries to give much more attention to the overall policies affecting the development of the sector and to structural and strategic planning. Operational work will be hived off to Executive Agencies still responsible to the Ministry but working at arm's length and against overall performancetargets agreed with the Ministry, and they in turn will be contracting out almost all work to private-sector consultants and contractors. Regulatory functions will as explained above be largely devolved to the independent bodies when the division of responsibilities between public and private sectors is morebalancedthan it has been inthe past. 3.58 Formulation, implementation, monitoring and revision of policy will be able to receive the attention that has been lacking. For example the Ministry of Transport and BPE would be able to focus on completing the draft updated Transport Policy showing how increasedprivate- sector participation would work in the different modes. This could be used to build as much consensusas possiblearoundtransport sector policy issues inthe country. 3.59 The Ministries, and correspondingbodies at state and especially metropolitan level, must also take a continuing role in leading and coordinating planning efforts, particularly for the road sector and for inter-modal coordination. 3.60 Given that the various federal Ministries currently responsible for transport will have much reduced functions and hence in staff, and that a critical dimension of the policy and planning functions will be inter-modal coordination, serious consideration should be given to possibilities of wrapping FMW and the Ministry of Aviation into a unified Federal Ministry of Transport. There are also important duplications and inefficiencies from overlapping responsibilitiesof departments in different ministries. Ifthe proposed amalgamationof different ministries is not possible, a serious effort is neededto review, adjust and clarify the remits of the various existing bodies in order to minimize overlap and grounds for unproductive conflict. While the problem must be much less at the level of the states, a number of them also appear to be movingtowards combination of responsibility for all transport matters ina single body. IV. MainRecommendations 3.61 Medium-term investment strategies for all infrastructure sectors need to be strengthened to bring closer links between strategies and achievement of realistic infrastructure targets; to ensure proper costing and inclusion of clear performance indicators. In addition project preparationshould be strengthened and clear criteria for selectingbetweendifferent infrastructure 61 projects adopted. Significant capacity building and a change in the way Government does its work including reforms where appropriate will be neededto achieve this. 3.62 An efficient rural infrastructure is important especially for the growth of the non-oil sector of Nigeria's economy. The effective implementation o f the National Policy on Rural Travel and Transport should ensure seamless infrastructurallinkage between rural Nigeria and the rest of the country. Proper planning and execution of infrastructure related investments will have to take place also at the non-federal tiers of Government. The first steps towards achieving this will be to: (i) and rationally apportion rural road network responsibilities within the three assess tiers of Government; and (ii)enhance planning and implementation capacity in the States and Local Governments. 3.63 A standardized and transparent approach to government support in PPPs needs to be developed with a view to (i)attracting a maximum number o f bidders to foster competition and reduce prices, and (ii) limitingfiscal coststo the government. 3.64 A detailed electricity demand study should be undertaken to help government conclude PPAs on PPs. 3.65 The tariff rates in the power sector needto be reviewed to ensure financial sustainability of private distribution operators and adequate incentives to invest in technical innovation to reduce current levels o ftechnical losses and inefficiencies. 3.66 The capacity ofNERC needs to be strengthenedand a longterm fundingbase secured for to ensure its independence. An operational framework for the unbundling o f the former NEPA companies needs to be developed. 3.67 A reevaluation of the current road network classification should be carried out including an assessment o f the appropriateness of the current apportionment of road network responsibilities among the three tiers of Government. 3.68 A Road Fund for periodic and routine maintenance of roads to be funded through a surcharge on fuel needsto be established. The Fundwould be managed by a private/public Board. Inaddition, acommercially orientedHighwaysAuthority to managethe federal roadnetwork on behalf of the federal Ministry o f Works should be created. In order to maximize the expected efficiency gains, similar agencieswill be requiredand the State Government levels. 3.69 An economic analysis o f the merits o f government funding the large majority o f track rehabilitations and future improvements inthe context of ongoing railway concessioning needs to be carried out. This review should inform discussion of alternative ways of proceeding with the concessioning. 3.70 Economic regulation function for the transport sector should be established and coordinated with the recently approved legislation for an Anti-Trust Bureau in the Ministry of Justice. The economic and safety regulation functions for transport sector should be consolidated in the Transport Regulatory Commission. A database of key performance indicators on each concessionedoperation should be published regularly. 3.71 At the institutional level, Federal Ministryof Works and the MinistryofAviation andthe MinistryofTransport could be mergedinto a unifiedFederalMinistryofTransport. 62 4. THE BUSINESSCONDITIONSFOR GROWTH Introduction 4.1 The growth diagnostics presented in Chapter Two showed that Nigeria's difficult business environment-demonstrated in both micro level risks and extreme macroeconomic instability--limits the ability o f the private sector to appropriate returns and therefore keeps private returns low. This is an immediate threat to increasing and sustaining recent investment and growth. Micro level risks arise from the policies, regulations and laws that guide private sector development and their implementation. These represent core areas where the government plays a crucial role in creating an environment conducive to business confidence and investment. The Doing Business surveys have demonstrated that an improvement inthe institutionsthat guide businesses can result in increased growth performance o f up to 2.3 percents4. There is also considerable conclusive evidence in the empirical analysis on the negative impact o f macroeconomic instability on growth. As explained in Chapter Two, inNigeria the fundamental cause o f macroeconomic instability has been poor management o fthe oil revenue cycle. I.ReducingMicro-levelRisks 4.2 The most critical legal, institutional and regulatory factors impacting the overall investment climate in Nigeria are taxation, trade facilitation, business regulations and licensing and contract enforcement, inthat order. 4.3 Rationale for Prioritization. Wherever monopoly position and discretionary power prevail, inefficiency can thrive. The four areas identified provide considerable scope for government misuse o f its monopoly and discretionary powers, inflicting some o f the most severe constraints to business growth in Nigeriaa5. They also represent areas where relatively quick progress can be made which could impact positively on firm efficiency and performance. Three o f these indicators - taxation, licensingkegistration and trade facilitation - entail some o f the most direct interaction that the three tiers o f government have with businesses. As such, progress in these areas provides an opportunity to build confidence inthe facilitative role o f government for private sector led growth. This could have a major positive impact on enterprise investment and formalization decisions. 4.4 The vast majority o f Nigerian economic agents (businesses and individuals) whether registered or not do not comply with business regulations or pay taxes, choosing to operate informally. This makes it difficult for government to enforce rules that protect the public interest (health and safety, product standards etc). In addition it makes it difficult for government to diversify its revenue base outside o f oil, thereby setting the stage for the fiscal volatility that has undermined growth in the past. Almost all the non-agricultural work force outside the public sector is employed informally, mainly as self employed individuals in unregistered businesses or undeclared workers o f formally registered businesses. The informal sector also suffers acutely from lack o f access to infrastructure and finance which prevents a large proportion o f the work force and the majority o f businesses from contributing fully to growth. This means that large 84"Growth and Regulation" ,S. Djankov, CaroleeMcLeishand RitaRamalho, March2006 85Inmany ways customs services at the Lagosport providesthe mostgraphic exampleofhow costs-both in terms oftime and money can spiral as aresultofthe poor exerciseby agovernment agency o f a monopoly role - and aset of discretionarypowers . The industrycase studies ofthe "Nigeria Value and Supply Chain Study"; P. Yee and M.Paludetto, ConsiliumInternational,March2005 andthe Doing Business2006 assessmentadd further evidenceto the impactof poorgovernmenton enterprise sector development. 63 parts o f the work force earn their incomes in low productivity and hence poorly remunerated activities, thus preventingthem from escaping poverty. 4.5 Taxation, licensing, contract enforcement and trade facilitation, together with the provision o f hard infrastructure lie at the heart o f informality in the Nigerian economy and determine the basic relationship between the state and the private sector. Excessive regulations that place unnecessary burden on firms, coupled with what are viewed as unjust taxes, is a major determinant ina firm's decision not to operate inthe formal sector. Lowering the transaction cost associated with excessive regulation will encourage firms to move to the formal sector thereby contributing to Nigeria's growth goals. Addressing these issues will enable the private sector to forge a new contract with the state knowing that complying with the regulatory regime and paying just taxes will result in the creation o f public goods that will increase wealth creation in future. This could have a major positive impact on enterprise, investment and formalization decisions, thus contributing to the rates o f non-oil growth that the Government wants to achieve. 4.6 The reform agenda outlined in this chapter was based on the priority accorded to actions in each area in terms o f links between investment climate reforms and growth. Additionally the assessment o f the reforms was guided by a number o f underlying criteria (feasibility, sustainability and synergy) as set out in Table 4.1 below. The four areas are ranked according to the relative ease and absence o f losers versus winners in the proposed reforms, the potential capacity constraints and institutional resistance to the reforms and the more diffuse character of the reforms. Using the criteria, the proposed sequencing and prioritization is: (i)taxation, (ii) trade facilitation, (iii)registration and licenses; and (iv) contract enforcement. However the key to success in all cases i s the effectiveness o f the public private dialogue and partnership to tackle these constraints. Ifthese reforms are effectively pursued the impact will be increased investment and employment growth and a rebuilding o f trust and commitment between government and business that can provide the engine for sustainable market-drivengrowth Table 4-1: Cost BenefitAssessment of ReformPriorities Trade Taxation Licenses Contract Facilitation Enforcement A. Relevance -- Policy Priority 4 4 3 4 Constraint Index 16 12 12 11 B.Feasibility -- Political Institutional Capacity 2 8 6 5 Will 2 9 3 4 C.Capital -- Revenue Cost\Sustainability & Recurrent 3 2 -2 -4 Sources 6 6 7 4 D. Synergies --- Linkages Demonstration 6 6 5 4 6 5 5 5 Public Support 6 10 8 6 TOTAL 51 62 47 39 Taxation 4.7 With a marginal effective tax rate (METR) o f 27.1 percent, the tax burden on businesses in Nigeria is internationally competitive. It compares well with countries such as India (43.2 percent), Indonesia (38.8 percent), Kenya (68.2 percent), and South Africa (43.8 percent). However this competitiveness i s undermined by an extremely burdensome tax administration process. It takes 1120 hours per year for a company to pay these taxes in Nigeria compared to 64 340 hours in Ghanaand 350 hours in SouthAfrica. This administrativeburdenrepresents one of the worst worldwideand is well beyondthe bestpracticeof 12 hoursthat prevailsinUAE. 4.8 The administrativeburden is compounded by the fact that taxes are administered by all three tiers of government. Each tier has a distinct role and there is little coordination of these roles. Enterprise-relatedtaxationis administeredbythe FederalGovernment, throughthe Federal Inland Revenue Services and comprises petroleum profits tax, companies income tax, value- addedtax, withholdingtax on companiesandnonresident individuals,educationtax, capital gains tax on companies and nonresident individuals, stamp duty on instruments to which company is party. State governments, throughthe StateBoardsof InternalRevenueadminister the following taxes: personal income, capital gains on individuals, withholding on individuals, stamp duty on instruments executed by individuals, pools betting and lotteries, gaming and casino taxes, road taxes, business premises registration fees. Local Governments through the Local Government Revenue Committee collecttaxes on shops and kiosks, tenement rates, on-and off- liquor license fees, marriage, birth and death registration fees. A detailed summary of the taxes applicable to businesses is providedinAnnex 4A. The impact is a system of multipletaxes and a proliferation oftaxes, some of which are illegaland not ratifiedby the appropriate legislature. Inan attemptto improve revenue collection, many state governments have handed over their tax collection to privatecontractors, practicinga systemoftax farmingthat results inarbitraryassessmentsandthe use of coercion (moral and physical) which all but damages the integrity of the tax system in the eyes of individualsandbusinesses.Evasionis therefore widespread. 4.9 Despitethe fact that Nigeria'stax burdenrelativeto other countries is modest, enterprises invariablycomplainabout the country's tax regime. Detailedanalysis shows that dissatisfaction of businesses in Nigeriais due to two factors. The first which lies beyond the purview of the tax authorities, is the legitimate sense firms have that they do not get value for money for the taxes they pay - most specifically in terms of infrastructure services. The second key complaint is relatedto the administrativeinefficienciesinthe tax system. Risk and uncertaintyin the Nigerian business environment is heightenedby the overalladministrationo f a tax regime across the three tiers of government. Firms have, in many cases, internalizedthe costs and constraints associated with their interface, finding ways to evade and avoid taxes and coping with the cost of compliance, and therefore tend to rank this constraint lower relative to other concerns (namely infrastructureandaccess to finance). 4.10 The true extent to which the tax regime constrains business is reflectedin the results of recent surveys in Abia and Anambra states that sought to assess the problems experienced by businesses dealing with Nigeria's tax systems6.Sixty-eight of the firms surveyed rated tax regulations and high tax rates as a significant barrier to the growth and development of their business.This levelof frustration encompasses issues such as the number and incidence of taxes, frequent changes in tax rates and procedures and the significantadministrativeburdenassociated with tax demands, including overlapping claims from the different levels of government. The table below outlines a list of complaints made by a cross-section of the businesses in Eastern Nigeria. It includes both direct taxes and indirect costs. Direct taxes represent the multiple/duplicativetaxes that businessoftenfindthemselvespaying. Indirectcosts comprisethe management resourcesthat a firm must devote to dealwith the inefficiencyof the tax regime and the needto hire intermediariesto deal with overzealous tax officials. Almost 90 percent of firms 86ClusterDevelopmentPrograminEasternNigeria:Administrativeand InfrastructureCost Survey ofthe ManufacturingSector (Abia and Anambra States), A Reportby IFC and Skoup Consultants,February2003. 65 interviewed employed full-time accountants and lawyers or outsource their taxatiodaccounting requirements on an `as needed' basis. Table 4-2: Common Tax Administrative Complaints Tax Problem BusinessPermit Agents behave liketouts in order to extort money Local Governmentdoes not provideany service CapitalGainsTax Sincebills are estimated, overchargingoccurs frequently Company IncomeTax High and Excessive Bills are estimated Assessment problem: arguments about what turnover actually is versus what thetax consultantswant it to be Difficult gettingaTax Clearance ExciseDuty Continuouslyon the increase Property Tax Corrupt officials Improperassessmentleadsto over estimation Vehicle Emblem Extortion andexploitativeby local governments Regulations lacksclarity Value AddedTax Double taxation - e.g. VAT paid on raw materials and again on finished goods8' 4.11 Federal government capacity to administer enterprise taxes - particularly capacity to correctlyassess taxes is limited. A recent study on tax policyreformshighlightedthe fact that the number of tax administrators is limited, they are badly trained and equipped and poorly remunerated". This administrativeconstraint is compounded by the lack of computerization and the multiple tax administrative activities emanating from the different tiers of governments9. Specific transactions, suchas tax refunds or duty drawbacks are extremely difficult to obtain and can take extended periods to effect. Firms have limited access to up-to-date informationon tax structureandthe rates or levies applicableto differenttaxes". 4.12 Another aspect of the tax system that stretches administrative capacity and frustrates businesses is the government's incentives programs. Tax incentives are providedto businesses operating in the manufacturing, solid minerals or tourism sectors, export processing zones and other exporters. (e.g. the Pioneer Firmprogramwhich providesupto five year tax break to firms who bringnew investment intothe country; the NEPZAtax benefits; the ExportExpansionGrant which is a subsidy for firms exportingprocessedproducts up to a maximumvalue of 40 percent and the Manufacturing In-Bond Scheme an incentive involving duty free materials to be processedfor exports). Although good ideas in principle,there are substantialproblems with their 87FIRS make the point that VAT inNigeria recognizedboth input and output elementsso that manufacturersare allowed to net-off input VAT charges. The problem reflected inthis table is probably more to do with implementation rather than policy or legislation. 88Tax Policy Reforms inNigeria, UNU-WIDER, ResearchPaper, Ayodele Odusula, 2006. 89Multiple taxation is clearly prohibited inthe Constitution of the FederalRepublic ofNigeria (paragraphs 8 and 10 of Part I1o f the Second Schedule). Businesses and stakeholders have beenencouragedby the Joint Tax Board to stand up for their legal rights and challenge any tier of government that engage in multiple taxation, either individually or collectively through industry, trade or business associations. 90firms notedthat this was particularly the case for customs duty laws where there is needfor greater transparencyregardingthe base for calculation 66 administration due to conflicting interpretation o f regulations. In the Pioneer Firm Program for example, beyond the broad objectives of the program, there are no detailed criteria for selecting firms. Overall, there i s a sense that tax benefits are for many never fully realized. In addition there is no effort to estimate ex ante the cost of such programs and more importantly to carry out and base decisions on cost-benefit analysis of the incentives. 4.13 At state and local government levels, there are two major issues. Firstthe tendency for taxes to proliferate as a result of state and local governments' effort to raise additional revenues through new taxes, some of which they are either not constitutionally empowered to raise or which have not been approved by the legislature. Second the contracting out of taxes to `consultants' inan attempt to increasetax collection provides incentives for consultants to impose new taxes and levies, resort to arbitrary and inflated tax assessments and use coercion. The fact that private organizations are allowed to collect tax is possibly unconstitutional and in some cases enables criminals to prey on individuals and businesses by pretending that they are officially mandated. 4.14 There is therefore a lack of clarity as to what taxes should be paid, at what rates and to whom. Seeking redress through the court system is slow and expensive. The poor administration and multiple government layers represent a major disincentive to formalization of businesses and reduce the tax base as a result. The burden on management also detracts from other strategic responsibilities, drivingdown productivity and competitiveness. 4.15 Reforming the tax administration system to reduce some o f the problems associated with multiple taxation and administrative inefficiencies in Nigeria is imperative. Tax administration reform is an integral part of the federal government's economic reform program. The Government has prepared a tax reform agenda and a series of bills that are presently being considered by the legislature. They are aimed at improving taxpayer services and education and hence achieving greater clarity o f taxpayer obligations, increasing the constitutional powers and improving the effectiveness of the Revenue Authority in its various administrative functions, from tax assessment, to collection to audit and penalty enforcement. Passing and implementing these Bills in parallel with actions to strengthen capacity o f tax agencies at both federal and state levels is important to help reduce high transactions costs from taxation. In addition the Government needs to signal strongly that predatory behavior of tax officials will be strongly dealt with. Trade Facilitation 4.16 The Doing Business Survey of 2006 rated Nigeria in the bottom 20 countries assessed globally on trade facilitation." Ittakes 53 days to clear goods from Lagos ports compared to 26 days in Senegal and 16 in The dire state of the Lagos ports contributes to the delays and increasesthe costs for firms who use them. Furthermore, the inefficiency provides incentives for informal trade. The very costly delays at the ports (discussed in Chapter 3) are further compounded by onerous administrative and customs procedures. Table 4-3 outlines the complex sequence of activities associated with import-export clearance for non-export processing zone firms. 4.17 In 1994 in an effort to reduce the burdensome customs regulations, the government introduced Pre-Shipment Inspections (PSIS)as a replacement for physical inspection. Despite the 9'DoingBusiness 2006 92Ibid 67 expenses associatedwith outsourcingPSIS,little use is made of risk managementtechniques. In 1999,whenthe scheme failed, Governmentre-introducedphysicalin~pections~~.The potentialfor delays is further exacerbatedby an import-exportprocessing systemthat is almost entirelypaper- based, with informationtechnology only partially implementedthrough the ASYCUDA system. Itis characterizedbyexcessivedocumentation, andrepeatedchecking ofthe same information.A firm must go through 15 separate proceduresto receive cargo and 14proceduresto ship one. The firm's competitor in Senegal, however, is ableto importandexport inhalfthe time. Table 4-3: Import ClearanceSequence for Non-EPZ Firms Time Rank Activity Lapse cost 1 Pro-formainvoice sent to clearingagent 2 Clearingagent obtains andcompletesform M Clearing Agent purchases cargo insurance and submits Pre-shipment 3 receiptto bank Procedures 4 BankapprovesForm-M andsendsto other agencies PSI agent assigns cargo an SEIC number and completes 5 inspectionand issuesCRI ClearingAgent obtains single goods declaration form and 6 with documents provided calculates duties owed for company to pay at abank 7 Clearingagent takes all documentsto CPS at Port 8 Deputy comptrollerreviewsdocuments 9 DeskOfficer verifies documents Accounting Officer verifies documents and gives to + Post shipment 10 Deputy comptrollerfor final verification procedures 11 ASYCUDA assigns serialnumber 12 ManifestdepartmentcertifiesBill of Lading 13 Customs examination shed officers check cargo against documents 14 Valuation Unit InspectsCargo andrelease 15 _-ClearingAgent confirmspayment andclaims goods - As seen from Table 4-3 above, the sequenceof activitiesassociatedwith import-exportclearance for non-EPZ firms is complex. Some 71 signatures on 13 different documents are required for imports into Nigeria. Clearing and forwarding agents note that importers typically avoid the principal import document (Form M) and its financial obligations by dealing with port-based signatures and stamps. For a fee of N1,OOO - N4,500 these syndicates provide a Form M and syndicates. For a fee of N1,OOO - N4,500 these syndicates provide a Form M and forge bank bank signatures and stamps94.Procedural requirements are also overlapping at times. For example, after a clearingagenttakes the completeddocumentationto the DeputyComptrollerfor review,the package is passedroundto botha desk officer and the accounting office beforebeing returnedagainto the deputy comptrollerfor final verification. It is only then that they are passed to an officer at ASYCUDA. Clearance procedures for an EPZ are significantlymore streamlined butthe EPZ still has many ofthese problems. 93 Evidencefrom Pakistanandthe World Bank Customs Modernization suggests that there is no monitoring benefit from 100% inspectionsas it facilitates corruption 94 Sometimes forged 68 Box 4-1: Importing Shrimps through Apapa Port A shrimp trawling firm must go through an average of 80 distinct procedural requirements in preparationand clearance of a container9'. The firm must then deal with the 100%inspectionprocedures of four different agencies (Customs, NAFDAC, Standards Organizationof Nigeria (SON), and Nigeria Drug Law EnforcementAgency) in sequence. The result is 40 days on averageto receive acontainer and6 days to ship one. 4.18 Studies demonstrate that these cross border proceduresincrease import costs for firms in Nigeriaby 45 percent on average. Some enterprise managersnotedthat they must spendbetween 30-50 percent of their time on procedures This is considerably higherthanthe 14 percent inKenya, 13 percentinIndiaand 5 percentfor Indonesia97. 4.19 The impactis a reductionof export volumes by 1percent inNigeria.It is estimatedthat a reduction of "factory-to-ship" time from 41 days to 27 could increase exports from Nigeria by almost 15 percent9'. 4.20 As discussedin Chapter three, port reforms are proceedingwell. Improvementsare also being made to the administration of the destination inspections policy.99In addition to these reforms, the government needs to focus on streamlining customs procedures in line with the Kyoto ConventionGuidelinesto reduce delays whilst strengthening control processes. This will requirea comprehensiveset of simple complementary customsproceduresandcapacitybuilding. BusinessRegistrationand Licensesloo 4.21 Over the past five years significantreforms have taken place inthe process for Business Registration in Nigeria. The Corporate Affairs Council (CAC) has initiated a reform agenda which includes computerization, institutional renewal, staff reform and a program of national outreach which resulted in the establishment of 25 State offices'o'. Ina recent survey taken in Abia and Anambra, 40 percent of firms cited improvement in the last 5 years in the number of days it takes to register a business, and the average cost of business registration declined 46 percentover the same periodlo2Figure4-1below outlines the official steps for anew entrant firm in Nigeria and current estimates of the time required to complete each step. The outstanding challenge is updatingthe current data base to eliminate companies that are no longer operating and ensure that annual reportingof registered companies is completed in a thorough and timely manner. 95Value and Supply Chain Analysis ,Consilium International 96Ibid 97Consilium Value Chain Study 98Trading on Time, World Bank Group, 2006 99As ofJanuary 2006 looAccording to Doing Business 2006, Nigeriaranks amongstthe 50 worst performingcountries when it comes to settingup a business, at 105/155. 101"Nigeria makes it easy for small businesses to register", USAIDmigeria Program and Policy Development Office, Development Policy Series, No. 3, Abuja. 102EasternCluster program Report, 2002 69 Figure 4-1: Entry Procedures \ 4.22 The impact of the reform can be seen not only in the reduction in the time and cost measures but also the growth in registration numbers. The Corporate Affairs Council (CAC) estimates that up to 150 firms are registering daily with some days reachingas high as 250. In addition to the achievements of the CAC, another notable area of reform has been the establishment of the One-Stop Investment Centre (OSIC) at the NigerianInvestment Promotion Commission. The OSIC bringstogether under one roof over a dozen ministries,departments and agencies (MDAs) that are directly involved in the institutional, administrative and regulatory aspects of doingbusiness in Nigerialo3.The objectiveof the OSIC is to reduce the time required to obtain basic investment information, business incorporation,tax registration, immigrationand custom services, export and importguidelines, etc. The governmentplansto setup similar offices in Lagos and possibly Port Harcourt.Although this is an improvement, further streamliningthe registrationprocesswill havea broader impact on a larger number ofbusinesses. 4.23 The processof licensingis still a significantchallenge. DoingBusinessranks Nigeriaas the sixthworse performeron the speed of obtaininga license. Although Nigeriaand Ghana both have 16procedures for obtaininga license, it takes 121days to complete the proceduresinGhana and 465 in Nigerialo4.A recent analysis of five major industries in Nigeria identified a list of annual and monthly licenses that firms typically have to obtain to operate in the country. It identified 29 basic permits and inspections which firms had to comply with such as registration fee and expatriateentry and re-entrypermits. Inadditionthere are industryspecific licenses (e.g. a shrimp company i s required to secure 17 additional licenses to operate'05)which are often a duplication of the procedures the firm must go through at the federal level. The plethoraof IO3Agencies currently operating at the OSIC include the NIPC, Standards Organization o f Nigeria (SON), Nigerian Customs Service, Federal Ministry of Finance, Bureau of Statistics, Central Bank o f Nigeria, CAC, FederalInland Revenue Service (FIRS), Ministry of the FederalCapital Territory, National Agency for Food and Drug Administration and Control (NAFDAC), Ministry of Solid Minerals, National Office for Technology Acquisition and Promotion (NOTAP), and the NigerianImmigrationService. 104Doing Business2006 105Taken from Nigeria: Value and Supply Chain Study, Consilium International March 2005 70 licenses at the federal level is compounded by state and local government licenses which are often duplicate federal level processes. Box 4-2: Multiple Licenses:The Tourism Sector The multiplicity of permits required by all three levels of government present a key bottleneck to rapid development of the tourism industry. In additionto the 16 separate permitsrequiredfor service providers in the tourism industry, specific states impose additional specific burdens on their operators. For instance, a report by the Presidential Council of Tourism identified the regulatory environment in Edo State as particularlyonerous due to the duplicativecharges for boreholes and generators and unofficial charges levied by both state and local governments. Hoteliers are critical o f the lack of transparency surrounding the administrationwhich leaves the systemopen to fraud and corruption and increases operationalcosts to a point that underminescommercialviability'06. Permit Requirementsfor TouristEstablishments o VeterinaryFees o Registrationfor Issuance ofHealtWSanitation o BusinessPremises o SignBoardandAdvert Permit o Tenement Rate o EnvironmentalProtectionboard, SewageandRefuseDisposal o NTDC RegistrationFees o VATITAX o IndustrialTraining Fund o Pay as you earn (PAYE) o NationalSocialInsuranceTrust Fund(NSITF) o Company'sIncomeTax o On andOff Liquor License o Radio and TelevisionLicense Fees o EducationTax o NEPA Bills andDiesel 4.24 The high cost o f compliance associated with setting up a business and/or dealing with licenses places an unnecessary burden on firms and can play a major role in their decisions to migrate to the formal economy. Registration processes can be streamlined further. However reform o f licensing is a more intractable challenge since it requires coordination across the three tiers o f government and changes inthe way public officials behave. ContractEnfor~ement"~ 4.25 Nigeria ranks 119 out o f 155 countries surveyed in Doing Business 2006 on contract enforcement. It takes an average o f 730 days to enforce a contract (with a total o f 23 procedures required for enforcement) and costs 37.2 percent o fthe debt value for a business to settle a basic contractual dispute through the court system in Nigeria. This compares poorly with 360 days in Kenya, 277 in South Africa and 200 in Ghana. This delay i s a strong disincentive for a business to enter into contracts or risk funds beyond a trusted circle o f family and business contacts, inhibitinginvestment, innovationand market exchange. At the same time, Nigeria is losing out on the economic benefits o f an effective judicial system which include more bank credit to businesses, increased new firms entry and hiring by established ones, and reduced demands on government budget. 4.26 The formal judicial system is currently faced with a huge backlog o f cases. The costs and time delays involved in using the judicial system to settle a dispute vastly outweigh the 106HotelOwners Forum, Abuja 107A more detailed analysis o f Commercial and InvestmentLegal Framework is provided inAnnex 4-D 71 potential benefits for the majority o f plaintiffs. As such only large firms can afford to use the system. This problem is compounded by the fact that in a number o f critical areas, Nigerian legislation is outdated and inhibits modern business activity and practices. Much o f this body o f laws (e.g. bankruptcy and insolvency) remains the same as at independence 45 years ago. Commercial and investment laws need to be reviewed to bringthem up to date with international practice and the government's new drive to achieve private sector led growth. 4.27 Experience has also shown that the Arbitration and Conciliation Act (ACA) has failed to achieve one o f the underlying philosophies o f the UNCITRAL Model Law which is to minimize judicial intervention in the arbitral process. In Nigeria, arbitration is often perceived as the first stepto litigation, and the arbitral process often becomes entangled inthe extremely protracted and cumbersome process o f Nigerian litigation. Thejustice system generally and courts inparticular should be fast, fair and accessible. However, as can be seen from Table 4-4, Nigeria's justice systemis far from that. 4.28 There are also strong arguments for reform o f thejudicial system -boththe court system and alternative dispute resolution (ADR). Research reveals a strong correlation between high bank lending and easier contract enforcement. For example in Italy, in regions with efficient judicial districts lendingto the private sector was equivalent to 40 percent o f the region's annual income. In contrast those with a significant case backlog had lending equivalent to only 10 percent o f their annual income. Efficient courts also increase entry by new firms and hiring by established ones. Court reform could also reduce demand on the government budget"'. Table 4-4: Contract Enforcement Indicators Country No. of No. of Cost as YOof Procedures Days Debt Claim Angola 47 1011 11.2 Cameroon 58 585 36.4 Ghana 23 200 14 4 Ivory Coast 25 525 47.6 Kenya 25 360 41.3 Sudan 67 915 30 UnitedArab Emirates 54 614 16 UnitedKingdom 14 288 17.2 UnitedStates ofAmerica 17 250 7.5 Source:DoingBusinessReport2006, CreatingJobs (WorldBankReport) 4.29 The NEEDS calls for enhancing access to justice through simplifying proceedings and laws and encouraging the use o f alternative dispute resolution mechanisms. In response, the government (federal and states) has taken a number of steps to address the constraints to efficient contract enforcement. These include: the establishment o f the National Committee on the Review o f Investment Laws o f Nigeria with the mandate to reviewthe laws guiding investors Nigeria and proposing amendments where necessary; court reform in Abuja, Lagos, Cross River, and Kaduna and the introduction o f Model Courts in some States (e.g. Cross River); the establishment o f the National Committee on the Reform and Harmonization o f Nigeria's Arbitration and ADR Laws to review and recommend improved legislation relating to arbitration and use o f ADR'". ~ 108DoingBusiness in 2006, Creating Jobs, Reportof the World Bank Group 109The recommendationsofthe Committee(Report o fNational Summit on Judicial Reform, Abuja 20thto 231d July, 2004) has resultedin a draft Billto be submittedto the National Assembly 72 4.30 An effectivejudicial reform program inNigeria should comprise a three-fold approach - reform of the laws, reform of the court system and the introduction of legally recognized formal and informal ADR mechanisms that can provide cheaper, faster and more accessible dispensation of justice for those segments of the enterprise sector (particularly micro and small and medium enterprises) that would for the most part find the formal court process a prohibitive option. 11.Addressingthe Sources of MacroeconomicInstability 4.3 1 Chapters One and Two have demonstrated that Nigeria has experienced considerable macroeconomic instability due to poor management of the oil revenue cycle. Beyond instability, poor management also led to large fiscal deficits and the accumulation o f debt which also contributed to a weakened investment environment. 4.32 The role of fiscal policy inminimizing the impact of oil wealth volatility on the economy by de-linking public expenditure from volatile oil revenues is crucial if debt overhang and associated low growth are to be avoided. The Government has since 2004 adopted an oil price based fiscal rule (OPFR) to de-link current expenditures from current oil revenues and by so doing to smooth expenditures and the stance of fiscal policy over the oil revenue cycle. In contrast to earlier attempts"O, the Federal Government has been successful in convincing state governments who have considerable autonomy over their fiscal decisions to implement this rule. 4.33 Debt sustainability analysis (Annex 1E) indicates that if oil prices remain at close to $60 per bbl, fiscal sustainability is not going to be an issue inNigeria ifthe current OPFR is adhered to. Followingthe rule would lead to a very fast accumulation of foreign assets, so that at the end of 2011 the net asset position will reach 100 percent of GDP. Sizeable oil assets accumulation is the main reason for this favorable debt dynamics. The strong initial position (as a result of the combinationof the Paris Club debt reliefand the highoil prices) is also important. 4.34 A returno fthe oil price to historical averages of around $25 a barrel inreal terms, would put the budget reference price slightly higher than the assumed oil price. This would lead to net outflows from oil savings to compensate for the difference between the budget reference price and the actual oil price, but would not exhaust savings. Thus if the recently adopted fiscal strategy i s continued, it is likely that Nigeria would be able to survive a sizeable negative oil shock of at least another 5 years duration, without requiringdramatic fiscal adjustment and with only modest debt accumulation. Ifthe duration of the shock is beyond five years, this policy rule may needto be reconsidered to avoid over borrowing. 4.35 In contrast, ifNigeria abandonsthe OPFR and oil prices returnto their historical "base level" ($25 per bbl in real terms). This would lead to rapid increases in the non-oil deficit. Nigeria will exhaust its oil savings very rapidly, after which sizable financing gaps would emerge. The options available to the government are to borrow or to print money. This would lead to confidence crises, credit rationing by external capital markets, sizeable depreciation, rapid increasesinreal interest rates, hyperinflation, and deep real economic recession. This would lead ultimately to unsustainable levels o f public debt (mainly domestic) only five years after the PC debt agreement. This highlights the importance of the fiscal policy rule and the conservative reference price chosen to underpin it: both are necessary to bring sufficient robustness to Nigeria's macroeconomic policies and avoid a returnto excessivemacroeconomic instability. ~ 1I OFederalGovernment first attempted to implementa fiscal rule in2000. Howeverstatestook federal governmentto court and federal government as compelledby the courts to distributeall proceeds of oilrevenues 73 4.36 To date the fiscal rule has been applied on the basis of a "political'' agreement between the Federal Government and State Governments. To sustain this important reform, the Federal Government has prepared a Fiscal Responsibility Bill that will give legal backing to the current "informal" agreements betweenthe tiers on managingthe oil revenue cycle. Itwill bind all three tiers of Government to implementing the oil priced based rule. Passage of this Bill i s central to effectively tackling this key source of macroeconomic instability in Nigeria. The Bill is nevertheless likely to be strongly contestedby some of the states on constitutional grounds since the constitution stipulates that all oil revenues collected by federal government on behalf of the federation should be distributed between the different tiers in accordance with the revenue sharing formula. Some states could even seek through court action to prevent implementationof the Bill once it is passed. One option the federal government could consider ifthe Bill does not pass on constitutional grounds, is to lead by example and pass a Fiscal Responsibility Bill for the federal government alone. It can then explore incentives to encourage states to pass similar legislation intheir state legislatures. 4.37 Beyond passage of the Bill, the government needs to design a more formal framework for management of the oil savings. Currently this is held in an account at the CBN. Global experiencedemonstrates that it is important to formalize savings as a fund under the professional management of an autonomous body, such as the Central Bank. It should also be independent and free from political interference. Proper governance of such a fund is key to success. Clear rules governing investment and withdrawal from its resources are needed and it should be subjected to the strictest standards of accounting and reporting, including comprehensive disclosureguidelinesh-equirementsand regular preparationand wide disseminationof accounts. 111.MainRecommendations 4.38 There are several reforms already ongoing to improve Nigeria's business environment and thus raise the ability of the private sector to appropriate returns, In several areas, the most importantnext step is to strengthen implementationof ongoing measures and ina few other cases additional measures are neededto make more demonstrable impact on business conditions. This is reflected inthe main conclusionsprovidedbelow. Micro Risks 4.39 Taxation: 0 The National Assembly needs to pass federal government's tax policy and administration proposalsto allow their implementation. 0 Federal and state governmentsneed to resolvethe issue of multiple taxation between them and abolish all illegal taxes at state and local government levels. This initiative could be ledby the Joint Tax Board. 0 State and local governmentsneedto review impact of outsourcingof tax collection to private sector and address adverse side effects on business activity. 0 Federal and state governments need to increase tax administration efficiency at federal and state levels through computerizationand staff skill strengthening 0 Federal and state governments needs to implement a communication strategy to enhance public awareness on what taxes are payable and to whom, and institute a 74 mechanism(includingclear performance targets) for private sector monitoringoftax agency performance. This will empower private sector to demand better performancefromtax agenciesandofficials. 4.40 TradeFacilitation: FederalGovernmentneedsto: 0 Simplify trade documentation requirements and provide public information on procedures. 0 Introducepre-shippinginspectionswith randomor risk-basedsite inspection 0 Enforcereductionof agencieswith permanentportpresence Implementcustoms reforms, includingstreamliningcustoms procedures in line with Kyoto Convention Guidelines. Given the difficult political economy issues in this area, one option might be to beginby exploringpossibilitiesfor contractingcustoms services intargetedbusiness-intenselocations suchas Tinapa. 4.4 1 Business Registration and Licensing. In addition to continuing ongoing efforts to improveregistrationaccess, it would be importantfor federal governmentto: 0 Further streamline federal agency involvementin registrationto harmonizeFIRSand CAC requirements. 0 Reviewand streamline licensingrequirements for key sectorsacrossthe three tiers of government. 0 Set benchmarksfor official license processingwith some privatesector monitoringof performanceto bringabout pressurefor improvedperformance. 4.42 ContractEnforcement. Legaland Courtreformas well as improvementsto ADR are at a relativelyearly stage. Goingforwardfederaland state governmentscould 0 Extendthe fast track courts model being implementedinLagos to other states. This could include the introduction of a computerized system to enhance efficiency of case management, 0 Scale up successful ADR pilot programs 0 Reformcourtjurisdictions(e.g. thresholds), civil procedures, practices (e.g. abuse of adjournments). Review and revise or repeal key business legislation including the Company and Allied Matters Act, the Investment Decree sundry access to finance legislation related to hire purchase and related issues and the Tax Act in respect of accounting procedures affectingtaxable amounts between1essorAessee on leasingarrangements. Introduce new legislation including Competition Act (currently pending at the NationalAssembly), anda SecuredLendingAct 0 Buildcapacity ofjudges, registrarsandcourt clerks to leadreformeffort 75 0 Builda paralegal profession to support contract enforcement objectives over time. 4.43 As regards reform approach, in order to obtain measurable results within a reasonable timeframe and, takinginto account the different constraints across the states and across industries, a strategic option for reform to strengthen the business conditions for growth i s to target initially specific states and industries where impact could be greatest. States should opt-in to pursue reforms at their level and benchmarking needs to be implemented in parallel with efforts at the Federal level. Inthe case of industrytargeting, those sectors that offer the strongest potential for non-oil sector employment based growth should be the first to benefit from a reform program. This would suggest strongly that the first generation candidates should include key agricultural crops, particularly those with the greatest value-adding and export potential such as cassava, palm oil, leather and rice. A further sector for particular attention would be tourism covering both service and product (e.g. artisanal products) sub-industries. The solid mineral and construction sectors, which could also play important roles in Nigeria's non-oil sector, could also be considered. Macroeconomic Instability: 4.44 Governments at both federal and state level needto continue implementation o fthe oil price basedfiscal rule to address the fundamental source of excessive macroeconomic instability inNigeria. Three important actions are needed: 0 Passage o fthe Fiscal Responsibility Billbythe National Assembly. 0 Effective preparation by federal and state governments for implementation of the Bill including preparation o f neededguidelinesand implementation manuals and building implementation capacity at state and local government levels 0 Agreement on by federal and state governments and institution of a more formal and transparent mechanism for managing oil revenue savings. 76 5. ACCESS TO LONGTERM FINANCE Introduction 5.1 As discussed in Chapter Two, lack of savings is not a binding constraint to growth in Nigeria.Banks are burdenedby excessliquidity anda large share of savings is not channeledinto productive investments. Excess liquidity exists primarily because financial intermediaries lack investment opportunities with sufficient returns and have limited ability to appropriate returns. The immediate focus of the government needs to be on reforms to improve investment returns and raise the ability of economic agents to appropriate returns including the ability of the financial sector to secure and enforce propertyrights. 5.2 The discussion also highlightsthat access to finance- especially longterm finance--and high interest rate variability are severe constraints that need attention by policy makers. These reflectweaknesses inNigeria's financial systemwhich is still shallow(Figure 5-1 andTable 5-1). Cross-country, industry, firm level and country case studies confirm that countries with higher levels of financial development experience better resource allocation, higher GDP per capita growthandfaster rates of povertyreduction. Figure 5-1: Private Sector Credit / GDP Nigeria and Rest of the World, 2005 2 00 100 - 050 - 000 - 7- 1 0.50 1.oo- 1 I O 5.00 10.00 20.00 30.0WO.aho.00 GDP per capita (thousands 2000 US$) Nigeria All Other Countries Sample size: 122countries Time period: Latestavailableyear: 2004-05 Source: FinancialStructure Database,rev. 2006; World Development Indicators,2006 (TheWorld Bank) 5.3 This chapter addresses primarilythe term financing needs in the Nigerianeconomy and explores what role the recently consolidated banks, pension funds and capital markets can play. The chapter also discusses issues relating to the outreach of the financial system, increasing access to finance for SMEs includingthe Government's recent micro-financeand rural policy initiatives.SectionIprovidesa briefoverview of financialsector development inNigeria; Section I1reviews the recent bank consolidationreform; Section I11discusses increasingaccessto finance 77 and outreach; Section IV is devoted to a discussion of increasing term finance; and Section V explores options for enhancing infrastructure financing to address the infrastructure constraints discussed in Chapter Three. I.FinancialSectorDepth,OutreachandMissingMarkets 5.4 While banks' private sector lending has expanded significantly over the last years and is expected to grow further as a resulto f capital increase inthe banking system, it i s still below that o f comparator countries and averages for Sub-Saharan Africa (Table 5-1). The financial sector is characterized by limited diversity and missingmarkets and the majority of Nigerians lack access to any formal financial service providers. Table 5-1: Financial Intermediation across countries,latest available year 2004-5 Liquid Private Overhe Net Stock Life Non-Life Liabilities Credit I ads I Interest Market Insurance Insurance I GDP GDP Total Margin Capitaliz Premium Premium Assets ation I Volume I Volume I GDP GDP GDP Nigeria 20.39% 14.24% 5.21% 6.39% 17.15% 0.10% 0.50% Ghana 30.3% 12.0% 8.77% 9.54% 19.02% Kenya 39.8% 25.3% 6.83% 7.40% 28.63% 0.85% 1.94% Tanzania 22.1% 7.8% 6.60% 5.91% SouthAfrica 61.51% 106.89% 5.29% 6.89% 213.51% 10.80% 3.02% Sub-Saharan Africa 32.33% 20.90% 5.88% 7.36% 47.76% 4.02% 1.92% Low income 31.15% 17.99% 5.00% 6.28% 30.35% 0.86% 0.71% Source:FinancialStructure Database (2006), The World Bank 5.5 The credit market is fragmented with the commercial banks historically targeting only very limited market segments with highreturns and low risks. The Government, large borrowers and the oil sector have good access to finance, while funding i s severely restrictedfor most small and mediumenterprises and private households. The REPD survey results differ dependingon the size of the firm: 48 percent of micro enterprises as opposedto 25 percent of very large firms view credit as a constraint. The incidence of zero investment in the MNES was found to be more prevalent with micro and small scale industries.Market segmentation correlates with significant interest rate differentials betweenthe interest rates for Government and large corporate borrowers and SMEs and retail borrowers"'. 5.6 Financial sector outreach is very limited with little or no access to financial services by the low-income and rural population. An extrapolation of existing data basedon a cross-country comparison suggests that only 15 percent of Nigerian adults have an account at a financial institution, compared to 16 percent in Ghana, 27 percent in Senegal and 46 percent in South Africa'12. While 53 percent of Nigeria's population and more than 70 percent of its poor live in rural areas, fewer than 2 percent of rural households in Nigeria are estimated to have access to formal or semi-formal finance.'13 The microfinance sector is underdeveloped compared to many other countries inthe region. IllUSAID (2003) reportsthat interest ratesrangefrom a low of20-25% for largerbusinesses, to 30-35% for medium sizedcompanies. 112Honohan 2006. 'I3Bagazonzyaet al(2005) 78 5.7 Bank credit remains the main source of external funding o f investment by Nigerian firms. Non-bank financial sector and capital market development remain substantially below comparator countries. Insurance premiumsare negligible compared to GDP and the sector fails to provide essential risk mitigation and savings instruments like private health insurance, property insurance or life insurance to a broad section of the Nigerian population. Property and casualty insurance is primarily targeted at corporate customers. The equity market caters only to the largest firms and market turn-over is largely drivenby the banking sector, which accounted for 78 percent of turn-over in August 2006 and constitutes a major share o f total market capitalization. non-existent. The bond market is weak with little secondary trading. The corporate bond market is virtually 5.8 Existingpension fund assets of N650 billion are relatively small at 5 percent o f GDP, however, pension reform will provide a substantial source of long-term finance going forward. Annual pension contributions are projected to add N200-300 billion per year as a result of the reforms. Investment assets in the insurance sector (life and non-life) totaled $37 million in 2002, a mere 0.7 percent o f GDP. 5.9 Beyond size, the sector also lacks adequate products and lending technologies to increase access to financial services and outreach. Most financial institutions in Nigeria do not provide credit products based on the security of personal property (movable property). The absence of secured lending products such as leasing, supplier's credit, warehouse receipts, factoring and other forms of secured finance limits access to finance to larger, formal companies that can offer real estate collateral and have long credit histories. Salary loans, mortgage financing or progressive housing loans could provide relatively low-risk opportunities to provide access to finance for broader segments of the population. As will be discussed in more details below, the development of such products will require an adequate legal and judicial framework and development of adequate financial information infrastructure. 5.10 Deposit and payment services are largely unavailable. Households and firms need reliable savings and payment mechanisms to smooth consumption patterns and lower transaction costs, not least to facilitate remittance flows from overseas and within Nigeria1I4.The introduction of innovative products like smart cards, no-frills savings accounts, cellphone banking and mobile banking units could be very successful in bringing such financial services to larger segments of the population. 11. TheImpactof the RecentBankConsolidation 5.11 The Nigerianbanking sector has long sufferedfrom low levels o f intermediationand high fragmentation. As described ingreater detail inAnnex 5-A, the late 1980sand early 1990s saw an influx of new banks. In part due to an unstable macroeconomic environment, many of those banks focused on activities other than lending, contributing to a low level o f credit to the private sector.The sector was therefore characterized by a large number of small banks that taxed supervisory capabilities. On July 6, 2004 the Central Bank o fNigeria (CBN) raised the minimum capital to N25 billion from N 2 billi~n"~. was intended to help bring about a diversified, This stable financial sector that would ensure the safety o f deposits, while at the same time contributing more to economic development via intermediation. These larger banks were also Remittancesand the importanceo f efficientpayment system infrastructureare the subjectofthe World Bank / DFIDstudy:"The U.K.-NigeriaRemittanceCorridor -Challenges of EmbracingFormal Transfer Systems ina DualFinancialEnvironment", 2006 115Bankswere expectedto comply with this new regulationbyDecember 31, 2005. 79 intended to compete more effectively in the regionaland global financial system. A relatively successfuloutcome has beenachievedfromthe consolidation. 5.12 An accounting decomposition indicates that interest spreads have declined in recent years, and that the larger banks created via consolidation are likely to continue that trend. A prolonged period of relative macroeconomic stability has coincided with a slight upturn in lendingto the private sector and a decline in spreads and bank profit margins from 2002 to 2005 (Annex 5-B).Within the banking sector, the larger banks charge relatively low interest spreads, due inpart to their relativelylow overheadcosts.Those banks also pay substantiallyless for their deposits than others. Despite their relatively low spreads, low deposit costs and overheads contributeto higherprofit margins for larger banks. 5.13 Consolidationalso brought about a flight to quality among depositors, leavinga number of the larger, more stable banks highly liquid. The regressions indicate that banks which hold a high level of liquid assets also charge significantly lower spreads, consistent with the view that they are competing with one another for new lending and investment opportunities. Thus, provided the macroeconomic situation remains relatively stable, the analyses in Annex 5-B suggestthat the banksresultingfrom consolidationare likely to charge lower interest spreadsthan their predecessors. 5.14 A second round of consolidationseems likely. Twenty five banks emerged from the 89 entities which were trading pre-consolidation.Only 14 banks were unable to achieve the new minimum capital or secure merger partners116.However, the banks themselves believe that the recentlycompleted compulsory consolidation, basedon raisingthe minimumcapitalthreshold, is only the first stage. They believethat a market driven second round of consolidationwill occur motivated by (1) the desire of re-capitalized foreign-owned banks' (currently with very few branches) for quick gain of market share through branch expansion, and (2) opportunitiesfor acquisitionpresentedby integrationproblems insome re-capitalizedbanks leadingto sub-optimal use of capital. The banks themselves identify that from 12 to 15 of the banks have a solid future and the rest are likely to face problems of varying severity. The analysis inAnnex 5-A indicates that the market is discriminatingbetween banks on the basis of size (capital and balance sheet footings) and the structure ofthe new bankinggroups, with its implicationsfor management. As far as size is concerned, the market sees half a dozen banks with balance sheet footings, plus off- balance sheet trade finance business, in excess of N350billion. There is a second tier of banks with footingsofN15Obillionto 300billion, andwhat was referredto simply as "the rest". 5.15 Followingthe raisingof a total of about N470billionof new capital in the consolidation process, the banks are ina real sense over-capitalized. Before consolidation,the more profitable Nigerianbanks averaged 35-40 percent return on equity. Most understand the capital increase will almost certainly reduce their return on equity, possibly below 20 percent. However, many are convinced that this will be a short-term phenomenon. The result i s that they will now seek aggressively to expand their business. There is much common ground between the banks as to the preferred market sectors in which they will attempt this expansion. Banks nominated the following as interesting opportunities: (i)lending more to existing large customers who previously had to raise finance outside Nigeria. (ii)expanding into other countries in the West Africa region: Ghana was the most frequently mentioned country; (iii) enteringretail banking; and (iv) Limitedexposureto housingfinance. 116the liquidationprocesshas commencedinonly three banks. 80 Risks to the stability of the consolidatedbankingsystem 5.16 The speedand effectivenessof the resolutionofthe 14banksthat failedto reach the new minimumcapitalwill have an effect on confidence in the future. Although it is positivethat the CBN has intervened and stopped those banks taking deposits, there is still a possibility of reputationaldamageto the system ifthey are not liquidatedinan orderlyfashion. 5.17 There is also a question concerning the capacity of the capitalmarket to support further bank equity issues. As demonstratedin Annex 5-A, some of the smaller banks especially those that were eventually merged with multiple partners experienced difficulty in achieving full subscription for their share issues. Should the other banks in the system begin to face similar difficulties, the reputational damage to the sector as a whole could reduce the availability of funds. Itwould beworse still ifthe CBNwere to haveto disallowadditionalcapital.Itremainsto be seen how well the banks cope with the stresses of completingthe variety ofmergers they have undertaken. At the same time they will likely incur the normal risks associated with rapid asset expansion and declining margins and spreads. There may also be an increase in the number of large credits and thus concentration risk. Because banks are now bigger, each of them poses a larger risk to systemic stability than many of the banks before the consolidation. This may restrictthe regulatoryoptions for dealingwith problemswhichmay arise. 5.18 The risk of rapid expansion has a strategic dimension as well. Most banks base their beliefthat there is a lot of available profitablebusiness inNigeriato absorb their new capacity on a number of simple macro-economic indicators. For example, only 35 percent of the population has access to bank facilities, or Nigerianbanks are small in comparisonto those in other major Africancountries. It seems that there is little real informationconcerningthe demand on the part of the customer for credit. Another critical factor, sufficient geographical concentration of demandto enableprofitableexploitationofthe market does not seem well understood. There is a risk that banks will invest heavily in overhead to reach markets that do not have the capacity to sustainthe investment. This risk is increasedwhen many of the banks planto turntheir attention to the same areas ofthe market. Implicationsfor the intermediationcapacity ofthe bankingsystem 5.19 Existinglarge customers are likely to be the mainbeneficiariesofthe capitalaccumulated by the banks. Some of the banks now have capital well in excess of the minimum capital, and several indicated an ambition to increase capital still further to in excess of NlOObn (approximatelyUS$ 800million). This would give them the capacity to consider advances to a single counterparty of well over US$ 100million. This would not widen the outreach of the bankingsystem, as existinglarge customerswould be the mainbeneficiaries. 5.20 Although banks planto expand into retail bankingand housing finance, they almost all identifiedspecific segments. Most banks plan to use retail deposits gathered relatively cheaply from the middle class urban areas which are already served by banks in order to drive down their cost of funds. This is a defensive strategy inthe face of the shrinkingreturns on equity the banks foresee. The retail credit that banks intend to offer is aimed principally at those with stable employment, where oftenthe employer is a valued customer of the bank. Muchthe same is true of many ofthe plannedhousinginitiatives. Althoughit i s a valuable activityto fundthe moreup- market housingunits of the middle class employed, it is unlikelyto make much contributionto the housingproblemsofthe less well-off. 81 5.21 Inthe aftermath of the consolidation, banks are a little more confident of their position and there is some expression of interest in longer term exposure. There is always some dynamic tension in a bank betweenthe needfor stability andthe intermediationof short term deposits into long-termfinance. In essence, the more volatile an economy, the more banks need to maintain high levels of liquidity to meet potentialdepositor demand, and this limits the amount of funding which can be deployedlongterm. At presentmost ofthis relates to loansup to four or five years. This is of limited value for many infrastructure projects. However, some interest was encounteredandthe options for infrastructureare explored later inthis chapter. 5.22 The analysis of interest spreads in Annex 5-A suggests that the consolidationwill have some impact on improvingintermediati~n."~However, the efforts ofthe banks are unlikelyto be sufficient to enable the financing of infrastructure development or the development of poorer ruralareas. This is areflectionpartlyofthe banks' strategic ambitions, andpartlythe fact that the total amount of funding available throughthe banks is always going to be small in comparison with the capacity of an oil revenuerich government. Gross international reservesat end 2006 are estimatedat about of $46.7 billion, or N5.9 trillion. For comparison, CBN estimates total capital inthe bankingsector at onlyN768 billion. Implicationsfor banksupervision 5.23 The nature of the new banking system will place more demands on the capacity of the CBNandNDICto take earlier, moreguidance-based,interventioninthe behaviour ofbanks. It is therefore appropriate that the CBN is planning to implement risk based supervision to provide structure to the judgmental decisions which will become increasingly necessary to ensure systemic stability. The supervisors are makinggood progress in defining their new approachto ensure that they can take a consistent view of banking risk and the probability of problems arising. The CBN plans to roll out risk-based supervision in banks during 3'd quarter of 2006. Similar supervisory and prudential frameworks will also be applicable to Primary Mortgage Institutions (PMIs), community banks (CBs) and micro finance banks (MFBs) (with some adjustments) to be licensedunder the new micro finance policy. The implementationof the risk- based supervision framework poses serious challenges in terms of supervisory capacity and scope. The CBN recognizes this and has formulatedspecific requests for technicalassistanceto support this development. 5.24 Corporate and bank governance issues are a key risk to the success of the non-oilgrowth agenda. The CentralBank has given high priority to improvingbank governance and identified the followingkey areas"'. 0 Weak corporate governance, evidenced by high turnover in the Board and management staff, inaccurate reporting and non-compliance with regulatory requirements; 0 Late or non-publication of annual accounts that obviates the impact of market disciplineinensuringbankingsoundness; 0 Gross insiderabuses, resultingin largenon-performinginsiderrelatedcredits; 1I 7Going forward, the bank-level data provided by CBNwill also be usedto construct statistical models describingthe efficiency and profitability ofthe banking system post-consolidation. As yet, the post- consolidation period is too short to facilitate that analysis. 118 Governor Soludo inhis key addressto the July 2004 SpecialMeetingof the Banker's Committee 82 5.25 While the CBN has published new bank governance guidelines for the consolidated banks that are broadly based on internationalbest practice, the implementationand enforcement of the guidelines represent a major challenge going forward. There are strong indications that some of the larger commercial banks put more emphasis on governance issues in order to distinguishthemselves from competitors so as to attract local deposits and facilitate access to the capital markets. Potentialforeign investment also provides significant incentives for banks to implement improvements in their governance. For example, the IFC has successfully instituted bank corporate governance contracts in the context of IFC equity or convertible bond investments. However, bank governance is likely to continueto be a challenge for many of the weaker banks, especially inthose bank groups that have beenbroughttogether mainlyby force of circumstance. 111.Increasing Access to Financial Services 5.26 The future challenge for financial sector development in Nigeria will be to harness the success of bankingconsolidationandto develop non-bank finance to (i) improveservice delivery and the availability of appropriate products for large and medium enterprises as well as (ii) improve access to financial services at a small-scale to meet the needs of households, micro- enterprises and small businesses. Improvingaccess to finance for the private sector, especially small and medium enterprises, will matter for growth.However, to achieve shared growth it will also be important to increase financial sector outreach and access to finance by low-income households. 5.27 Privatesector financial sector institutionswill have a major role in developingdeeper and more diversified financial markets. Banks and non-bank institutions need to invest in new products, systems, skills and risk managementcapacity to providethe financial services required to support private sector growth. There is a substantial knowledge gap about the demand for financial services as well as the size and scope of commercialbanking opportunitiesoutside the large corporate sector and urban, middle-incomeretail market. Increasingthe scope for "down- scaling" commercial bank activities and the identification of specific geographical and demographicalaccess gaps shouldbecomea policy priority for financialsector development.l19In the medium term, microfinance and SME finance will provide substantial business opportunities for those commercialbanks that are in the process of developingstrong retail and mass market businessplatforms. 5.28 Althoughany financialsector strategywill rely substantiallyon privateactivitythere is a major policy role for government in providing adequate incentives, building financial sector infrastructureand providingan enabling lendingenvironment. Difficulty inobtaining information about financial health, credit history and identity of prospective clients discourages financial institutionsfrom expandingtheir lendingbusiness into new market segments. Inefficientlandand property registries stifle the ability of banks to offer secured lending products and mortgage finance. Robust creditor rights and insolvency systems will be necessary to foster greater confidence in commercial contracts and facilitating the management and resolution of default risk. Financialinstitutionsrely on effective creditor rightsto reduce deteriorationof asset values andpromote accessto credit. 5.29 In this section, we will discuss some of the key priorities for financial sector policy in Nigeria.Section IV will discuss the requirements for developingcapitalmarkets as well as bank II9The current donor initiative to carry-out access surveys inNigeria will be crucial for the formulation of policies to promote access to finance. 83 and non-bankfinance to increase the availability of term finance. SectionV addresses options and challenges for providing infrastructure finance. The remainder of this section will outline key policy priorities for (i)developing the lending environment in particular for MSME finance, (ii) microfinance (iii)rural finance, (iv) housing finance (v), as well as (vi) development finance institutions. Lending environment 5.30 Weaknesses in the lending environment, weak creditor rights and lack of financial information infrastructureaffect small and mediumenterprises more than large enterprises. SMEs and households often rely on secured lending and reputational capital for access to finance and depend on a lending environmentthat supports these financing technologies. Betterprotectionof property rights and stronger institutions will increase the availability of financing for small-scale borrowersto a greater extentthan for larger firms. 5.3 1 For example, Nigeria lacks sufficient credit information infrastructure. Private bureau coverage is negligible with 0.3 percent of adult population and public registry coverageextents to only to larger credits (Doing Business 2006). Informality and lack of individual identifiers add to the inability of lenders to perform credit checks and establish credit histories. Recent private sector initiatives to establish private credit bureaus should be supported by the government through a sound legal framework including adequate consumer protection mechanisms. The government could play a key supporting role in coordinating the various private initiatives and ensuringthat a sufficient degree of bank participation and information sharing is achieved. 5.32 Nigeria possesses the basic legal framework, closely modeled on English common law, for granting and enforcing security, in real and personal property, as well as a mechanism for court-supervised liquidation. Companies law in Nigeria also provides for the creation and implementationof schemes of arrangement.There are, however, many indications to suggest that creditors have very little confidence in the current system. As discussed in Chapter Four (para 4.26), it takes an average of 730 days to enforcea contract (with a total of 23 proceduresrequired for enforcement) comparedto 360 days inKenya, 277 in SouthAfrica and 200 in Ghana'20.There are very few reported cases of successful restructurings being achieved in Nigeria and the mechanism for addressing cross-border insolvency issues, despite the vast sums of foreign investmentpouring into Nigeria's oil industry, are less well established.Increasingconfidence in the legalsystem to secure and enforcecreditor rights will be crucialto encourage banksto expand lending to new market segments. A substantive review of the creditor rights and insolvency framework with a view to provide legal mechanisms to make enforcementless costly is needed'21. Ongoing initiatives for establishing streamlined commercial court procedures in Lagos and the FCT could provide important policy lessons for other regions. 5.33 Enabling MSME access to finance through secured lending based on movable property will require a combination of legal reform and improved financial infrastructure. Banks and businesses identify inadequatelaws applicable to security interest and a lack of reliable sources of information as to existing charges on personal property as key impediments to secured lending practices, including leasing. The process of submitting and processing collateral registration is cumbersome and there are no means to identify the existence of previous charges over collateral. In addition, long enforcement periods typically result in significant depreciation of collateral 120DoingBusiness2006. I21A World Bank Reviewof Standards and Codes for CreditorRightsand Insolvencyis currently being undertakenand could provideaplatform for future Government initiatives. 84 value. MSMEfinancingwould benefit substantively from a stronger secured lendinglaw and the establishment of efficient property registries to enable leasing, supplier's credit, warehouse receipts and other forms of securedfinance. Access to finance on a small-scale 5.34 The Government recognizes the importance of enhancing access to finance and has identified the challenges associated with promoting microfinance in its recent microfinance framework policy. This policy focuses on establishing a framework for licensingnew so-called microfinancebanks (MFBs). Under the micro-financepolicy all Community Banks are obliged to be re-licensed as MFBs within a two year period. Experience in Tanzania, Pakistan, and several Latin American countries show that countries that do not already have a critical mass of soundmicrocreditprovidershave difficulty in "jump-starting" a microfinanceindustryby simply opening a new licensingwindow. A similar new licensingwindow produced a lot of private rural, but mostlytiny, banks inIndonesia, the Philippines,andGhana. The arrivalofMFIsinthe deposit takingbusiness is a positivedevelopment. The total amount of funding available through this channel is however likely to be small, as the CommunityBank assets are currently less than one percent of those ofthe commercialbanks, so the development ofMFBsintomoremeaningful players canbe expectedto take time. 5.35 There is a risk that the new MFB licensing window will not produce effective microfinanceinstitutions. Many or most of the new MFB license applicationswill be motivated by regulatoryarbitrage by the owners of existing community and commercialbanks who would rather be doingregularbankingbusiness. Their existingskill set and businessfocus is unlikelyto promote further outreach. Inall likelihood,the definitionof microfinanceand its outer boundaries will become contentious regulatory "hot spots." Previous analogous initiatives like the Community Banks have failedto make a significantimpact on an intractableproblem. The most obvious weakness o f the present approach is that it seeks to convert several hundredCommunity Banks into effective MFBs. The authoritiesare sparing no effort to ensure that community banks receive appropriatetraining and guidance for this shift intheir status. However, the international experience with microfinancedevelopmenthasbeenthat trainingor technical assistancealone are unlikelyto turnweak managers into good ones. 5.36 In some of the most successful countries the expansion of a few well-managed and capable pioneers, who provided a demonstration effect for the rest, were the most powerful engine for dissemination of microfinance management knowledge and skills. High capital requirements and a highly prescriptive approach to the geographic spread of MFB activities obstruct the emergence of strong pioneers that could lead innovation, skill development and competition. As in most other countries at an early stage of microfinance development, the binding constraint in Nigeria is a shortage of competent retail management capacity, not the absence of full geographical spread in the applicationof that capacity. Grameen, BancoSoland other successfulMFBs went first to the more promisingareas in their respective markets. They only moved to difficult geographic and demographic areas once the low-hangingfruit had been harvested. The Governmentmight be able to achieve better results by facilitatingthe emergence and expansionof a few successful pioneers rather then remodelingthe landscapeon the basis of geographically prescriptiveapproach. Further entry of new microfinanceinstitutions which are backed by experienced investors should be supported by the authorities to provide necessary momentumindevelopingthe industry. 5.37 Implementationof the new microfinancepolicy will require strong commitment by the authorities to achieve growths of the sector. Closing the knowledge gap about demand for 85 financial services, developing mechanisms for commercial banks and non-bank institutions to play a role in supporting the sector and establishing a supportive regulatory oversight function will be important challenges going forward. RuralFinance 5.38 Rural financial markets in Nigeria are characterized by a range of formal, semi-formal and informal providers. Commercial banks have greatly reduced their level of activity in rural areas since the end of compulsory agricultural lending. While most rural branches mobilize deposits, they have limitedoutreach and very low levels of lending. 5.39 Providing financial services to rural households and agribusiness in poor and marginal rural areas remains a challenge. High transactions costs, high information costs, and high covariant (particularly with respect to agriculture) and idiosyncratic risk are among the key obstacles to the development of financial services for the rural poor. In many ways, rural borrowers and rural banks are limited by the same constraints. Lack of transport and telecommunication infrastructure lower the returns of rural farmers and restrict their ability to service and repay loans. At the same time, infrastructure constraints increase the costs of financial services provision and banks need to charge higher interest rates for rural financial services. 5.40 Current efforts to strengthen financial sector development and, in particular, the new microfinance policy provide an important overall framework in which rural finance initiatives must operate. However, particular attention to the specific issues surrounding the demand and supply o f rural finance is necessary. This is particularly true given that rural finance often extends beyondthe formal regulated banking sector into semi-formal and informal provision. 5.41 Nigeria has a long history of rural finance initiatives. Federal and state initiatives include the creation of specialized financial institutions such as the Nigerian Agricultural Insurance Corporation (NAIC), the National Agricultural, Cooperatives and Rural Development Bank (NACRDB), community banks, compulsory agricultural sector lending targets for commercial banks, compulsory rural branch openings, on-lending schemes for cooperatives societies, and guarantee schemes such as the Agricultural Credit Guarantee Scheme Fund(ACGSF). Inaddition to these direct interventions, a number of wider government programs have also had rural finance components. Yet with the exception o f NAIC and ACGSF, best efforts have not resulted in sustainable access to rural finance, particularly outside of agriculture. The NACRDB, for example, is trapped by a subsidizing mandate and has achieved very limited outreach. With lending mostly at 8 percent per annum or less (i.e., about half of the market rate), a staff of 2,300 (down from 4,500 in 2002), and low level of capital, the NACRDB is drawing on its T-bills holdings to meet its liquidity needs. With very limited outreach in its lending to only 60,000 borrowers, a tiny proportion of Nigeria's 10 million rural households, the current business model of the NACRDB would appear to have failed. 5.42 The FGN is looking into alternative ways to support agricultural finance and is mobilizing N50 billion from banks to finance investment projects in the sector. Banks will consider loan requestsfor financing inagriculture. An interest rate ceiling of 14 percent has been set on loans provided. Farmers will pay only eight percent while the CBN will cover the remaining cost through a subsidy from its resources. This initiative differs from earlier subsidized agricultural credit initiatives since it includes an effort to measure performance and to link the subsidy to performance. This aspect will needto be fully implementedto send the right signals to beneficiaries. However, the experience with subsidized credit inNigeria and globally 86 has not been satisfactory, especially because it often failed to reach low-income rural dwellers and smallholder farmers. Failure o f subsidized credit can be traced to a) the lack o f incentives for financial institutions to invest in rural intermediation infrastructure, b) interest rate ceilings that do not adequately compensate risks and overhead costs, c) poor organization and development of rural and agricultural producers. Implementation of this new initiative needs to incorporate these lessons and will need close monitoring to allow refinements over time. The initiative could also profit from exploring innovative instruments that promote rural access to finance without the distorting effects of credit subsidies. 5.43 Various knowledge gaps need to be addressed in order to develop a sustainable rural finance development strategy. Policy formulation lacks information about the relative profitability o f different farm and non-farm activities, the extent o f effective demand for a wide range of rural financial services, the role and mechanics o f supply side finance, the true transaction costs of rural financial service providers under different circumstances and the conditions under which different policies and products are successful. International experience could provide helpful lessons about effective instruments and technologies to improve rural accessto finance. 5.44 A rural finance strategy for Nigeria should be based on a comprehensive approach including: a) introduction of competitive products that fit the agricultural/livestock production cycle and the other financial needs o f rural people, b) use o f advanced technology to reduce transaction costs and expand outreach, c) linkages between mainstream and specialized financial institutions to reach more rural entrepreneurs, and d) training o f rural consumers o f financial services to increase awareness and consumer protection. Already a number o f programs aimed at strengthening the semi-formal and formal provision o f rural services and service providers are underway in Nigeria, which could provide an important pillar for a broader rural finance strategy'". These programs include working with member-based organizations on the ground in terms of supporting an enabling environment, strengthening organizations and their apexes, and promoting linkage programs. HousingFinance 5.45 Nigeria has a large housing supply deficit in rural and urban areas estimated to range between 12 - 16 million housing units. Addressing the housing needs will require significant financial resources and it i s evident that public funds alone will be insufficient to provide adequate financing to respond to the demand for housing in Nigeria. Promoting access to affordable housing finance through the private sector will be key in achieving the Government's goal to increasethe availability of adequate housing. Annex 5B includes an extensive discussion of the potential and challenges in developinghousing finance inNigeria. 5.46 To date the provision o f loans for housing has been negligible. Total mortgage loans extended by private or public financial institutions are estimated to be approximately N70 billion, representing less than 0.5 percent of GDP. This is low compared to other developing economies, although not unusual in Sub-Saharan Africal23. The share of mortgage loans and advances in the banks' loanportfolios is less than four percent and these loans are concentrated inlarge urban areas like Lagos, Abuja and Port Harcourt. Among these, IFADhasrecentlylauncheda seven-yearRuralFinanceInstitutionsBuildingProgramme (RUFIN)with the aimof strengtheningruralmicrofinanceinstitutions (Rh4FIs)andestablishinglinkages betweenthese andformal financialinstitutions. 123The ratio is 15 percentin SouthAfrica and Chile 87 5.47 Long-term finance for housing inNigeria is constrained both on the origination (primary) and the funding (secondary) side. Financial institutions are reluctant to extend long maturities to mortgagees because of a weak lending and operational framework and simultaneously lack the ability to access long-term financing to fundmortgage portfolios on their balance sheets. 5.48 The Government's current framework for promoting housing finance has been largely ineffective. PMIs have failed in achieving their mandate which was to facilitate mortgage financing by distributing low interest loans funded by the National Housing Fund. Total PMI assets represent less than four percent of total bankingassets and mortgage advances account for only 23 percent o f consolidated P M I balance sheets. The majority o f P M I assets are held has deposits with other banks. Most stand-alone PMIs suffer from weak capitalization, little capacity to collect deposits, governance and skill deficiencies. Contributions to the National HousingFund (NHF) resemble a regressive tax and their deployment has failed to promote long-term housing finance. The impact of the NHF on development of housing finance has been minimal. NHF's cumulative disbursements over 13 years have been only N5 billion. This i s a result both of NHF's small funding base and long delays between application and fund allocation (up to 2-3 years). Annex 5-B discusses options for reformingthe NHF. 5.49 Banks are reluctant to develop mortgage financing capacity, as the mortgage lending environment is inadequate. Housing loans are large relative to the income of individual borrowers. Financial institutions rely on real estate as collateral so as to mitigate their credit exposure. Weak legal protection of secured property rights and enforcement of collateral, incomplete land titles and registration as well as land transfer restrictions hamper the development of housing finance. 5.50 Mortgage finance relies on the ability to transfer property ownership expeditiously and with limited costs. The provisions of the Land Use Act which governs property ownership and transfer - in particular the requirement that the Governor's consent to title transfers - result however, in significant delays and costs. Consent fees amount to 15 percent or more of property valuations, and total stamp duties, registration fees and other levies can amount to 30 percent. These very hightransaction costs are a significant deterrentto the formalization of property rights -especiallybylowincomeholdersofcustomarytenurerights-andhamperthedevelopmentofa secondary property market. They provide a significant inducement for corrupt practices. Reform of the Governor's consent process inthe FCT and Lagos state are steps inthe right direction and should be replicated by other states, (see Annex 5-B). 5.51 The lack o f long-term fundinghas hitherto limitedthe ability of banks to fund long-term risks. While the deposit base o f Nigerian banks is growing and they may be willing to increase their exposureto the mortgage market, banks' appetite for term lendingwill be constrained bythe lack a long-term funding (maturity risk). The availability of term-funding i s expected to improve due to the recent launch of pension reforms. Such reforms further weaken the rationale for NHF insupporting the housingmarket with artificially low interest rates, especially givenNHF's weak track record in fulfilling its mandate. 5.52 Developing secondary mortgage markets i s challenging and simplicity is key. The sequencedintroduction o f more complex solutions will allow the development o f critical mass in the primary mortgage market and provide the time to carry out needed reform of the legal framework, including strengtheningcreditor rights and bankruptcy regimes as well as introducing market standards for mortgage contracts and servicing o f securitized portfolios. 88 5.53 In the early stages of mortgage market development off-balance sheet financing of mortgage portfolios through securitizationis unnecessary. Keeping mortgage portfolios on the balance sheet of financial institutions in the early stages of mortgage market development is attractive for banks. Bankscan divers@ their balancesheet structure with goodriskheturnassets and mortgage finance provides a catalyst for building-up adequate retail risk management capacity. Banks and other mortgage originators can access long-term funding by issuing mortgage bonds. Mortgage bonds, which are secured by priority claims on the mortgages portfolios on the bank's balance sheet, provide efficient vehicles for tapping capitalmarkets and are less costly than securitization. The sale of entire mortgage portfolios through mortgage- backedsecurities will only becomenecessary, once the share ofmortgages inbank balance sheets becomestoo large, inparticularwith respect to their capitalbase.For the time beingthis will not be a constraint. 5.54 The design of the Federal Mortgage Bank of Nigeria's (FMBN) planned bond issue warrants further consideration, particularly as regards the efficient use of guarantees (see Annex 5-B). Provided further institutional reforms are undertaken, the FMBN could fulfill several catalytic functionsto support long-termmortgagefunding. The mandatedreforms ofthe primary mortgage environment, the consolidationof the bankingsector and recent pensionreformshould considerably augment the availability of mortgage funding. Given these reforms, pressure on FMBNto provide fundingshould subside, andFMBNshouldbe able to focus on its core mandate as the apex institution for housing finance - providingpublic support and reducing distortions that hamper overallmarket development. Severaloptionsbasedon internationalbest practiceare discussed inAnnex 5-B. Development FinanceInstitutions 5.55 Experience with Development Finance Institutions (DFIs) in Nigeriahas been mixed.'24 While the Bank of Industry (BOI) has been successful in addressing market failure in niche segments, other DFIs continueto be a fiscal drainwith little provisionof outreach and quality of financial services to their intendedtarget clientele. For example, the UrbanDevelopment Bank 2002125--ands accumulating significant losses--Nl.1 billion in 2002. The Nigerian Export- (UDBN) does not provide any significant quantity of lending--only N212 million in loans in i Import Bank (NEXIM), while seemingly not losing money, performs a very limited function. The Government could consider reform of various DFIs so that they are required to address specific market failures or development needs - along the lines of the new emerging BO1 businessmodelfor SME finance andthe reformofthe FederalMortgageBank(FMBN). 5.56 The BO1serves an unfilled market niche in SME lending, which is likely to persist for some time as commercial banks focus on different market segments. Commercial banks are reluctant to enter SME financing and point to the high risks due to the exposure of SMEs to infrastructure constraints, primarily electrical power and means of communications. BO1has initiated innovative policies to address specific market failures in SME financing, such as financing of business park development. The BO1 intends to undertake these investments in cooperation with states and communities whose responsibility will be to address infrastructure constraints by providing integral infrastructure services and facilities. Experience with such businessparks in other countries demonstratesthat they can be successful in lowering set-up and operating costs for SMEs when they focus on infrastructureservice provision and closeness to 124See discussion ofNACRDB inthe section on rural finance above. CBN 89 markets. However, political capture and pressures to establish such facilities often result in expensive "empty shells". GoodgovernanceofBO1investment decisionswill becrucial. 5.57 It is thus unclear whether BOI's market strategy canjustify any large capital expansion, especially inview of the medium-termprospect of commercialbank entry into the SME market, even though BOIScapital of N5 billion is small compared to the minimumcapital of the newly consolidatedbanks. IV. ImprovingAccess to Term Finance Potentialto ProvideTerm Finance 5.58 A number of structuralissueswill needto be addressedto facilitate the intermediationof increasedterm finance for growth. Theserelateto creatingan enablingenvironment for long-term bank lending and capital market development. As the basis for any form of fixed rate term finance, there is a need to develop a long-term pricing benchmark combined with predictable monetary policy to reduce interest rate volatility. To develop Nigeria's capital markets, market liquidity will need to be improved and transaction costs reduced. All market participants, including banks and institutional investors, need to build capacity in analyzing and monitoring long-termcreditrisk. 5.59 Nigeria's financial systemnowhas significantpotentialto provideterm finance. Market- based sources of term finance for banks include shareholders' funds, that can be leveraged, and core deposits. Incrementalcapital as a result of bankingconsolidation is estimatedto be at least N469 bn ($3.6 billion). If 30 percent of loanable funds are assumed to be lent long-term, this implies an incrementalterm finance capacity of about $10 billion (seeTable 5-2). Based on the conservative assumption that 10 percent of deposits are core deposits, term finance capacity has increased by an additional $1.5 billion. Combined with long-termfunds from existing pension assets, total existing term finance capacity of Nigeria' financial system can be indicatively estimated at $14 billion. With a stable macroeconomic environment, the domestic market's capacity to provide term finance will continue to increase goingforward, as banks increase their appetite for term lendingbasedon successfulpilot transactions and as funds available to pension fundsreflecttheir full contributionlevels. 90 Table 5-2: Approximation of term finance potentialin Nigeria Naira billion US$ billion" Banking System a) Incremental capital 469 3.6 CAR 10% 10% Loanable funds 4,690 36.4 Assumed % term finance 30% 30% Termfinance capacity 1,407 10.9 b) Deposit base2004 1,895 14.7 Share of core deposits 10% 10% Term finance capacity 190 1.5 (a)+(b) Total term finance capacity 1,597 12.4 Pension Funds Existing assets 500 3.9 New funded assets 130 1.o Total funded assets 630 4.9 Investment incorporate bonds / debt** 30% 30% c) Existing term finance capacity 189 1.5 a)+b)+c) Total existing term finance capacity 1,786 13.8 Source: Bankscope 2004/5 data, PenComdata, World Bank assumptions ** Translatedatin * the official exchange rate of 129Naira: 1US$ Investments debt instrumentsare taken as aproxy for term finance capacity 5.60 Realizing the potential of Nigeria's financial system to provide term finance depends bothon access to long-termfundingand bankableinvestmentopportunities. While consolidation has provided banks with the potentialto use their increasedcapital base for long-termlending, this potentialwill only be realizedif (i)banks have sufficient access to long-termfunds in order to leverage their increased capital base, such as time deposits and savings from institutional investors, and (ii)banks can invest in suitable investment projects, such as commercially viable infrastructure projects. As the supply of high quality investment projects is limited and only comes 'on stream' gradually, there is a risk banks and pension funds will finance lower quality projects,thereby potentiallyerodingtheir capitalbase. Improvingbankintermediationfor term finance 5.61 To date, term loans from local banks have been available to selected sectors and borrowers only. In a financial market characterized by volatile interest rates and short-term funding, banks havehistoricallybeenwilling to take maturity risk on borrowerswith outstanding credit quality only. Consequently, term loans were provided mainly to large corporates in the manufacturingand telecom sectors (see Annex 5-C). For these creditors, domestic banks raised sizeable local currency financing up to $450 million in total. Loans were typically syndicated between 8-16 domestic banks which contributed $10-30 million each per transaction. Existing loan maturitiesdo not meet the long-termfinancing needs of housingand infrastructure sectors. For blue chip clients, some banks are preparedto take refinancingrisk and providemedium-term loans by rolling over short-termfunds up to a maturity of 7-9 years. With the exception of the telecom sector, these maturities fall short of the long-term financing horizon of 10-20 years required for investments ininfrastructureandhousing. 5.62 Given perceived term-financing risks, banks have developed rational risk-mitigation strategies. Risks related to term finance can broadly be categorized into (i)refinancing risks, 91 including liquidity and interest rate risks, and (ii)credit risks. As a partial hedge against refinancingrisk and interestrate volatility, banks have deployed roll-over loan structures which provide a refinancing or redemption option after an agreed maturity. Banks also offer bridge loans, suchas to equity sponsors in infrastructureprojects beforethey can secure long-termloans from IFIs. Interms of credit risk, banks focus on secured structures and existingprojects rather than projects under constructionfor term lending.lZ6Secured lending, such as mortgage finance, provides a suitable entry for banks to extend tenors while limiting long-term credit risk. In infrastructure,banks are reluctantto finance greenfieldprojects, given substantial risks and lack of debt service capacity during construction. Successful pilot transactions such as the Lekki toll road in Lagos (see Annex 5-C) will serve as catalysts to increase maturity and credit risk taking by banks going forward. Provided the macroeconomic environment remains conducive to assuming term-risk, banks can be expected to build sufficient capacity in analyzing, structuring andmonitoringcredit andrefinancingrisksto scale upterm lendingover the mediumterm. 5.63 Increased term lending by banks translates into higher demands on the supervisory capacity of the Central Bank. As banks are under pressure to diversify their revenue base and find new profit opportunities,term finance is a potentially attractive, high marginbusiness. The CBN's move to risk-based supervision is timely, given the specific risks associated with term- financing and banks' limited experience in term lending. While a number of banks have established risk management departments, their capacity to assess, document and monitor long- term credit and refinancingrisks is currently limited. Close CBN supervisionof the banks' loan concentration risks is advisable, as - basedon their significantlyincreasedcapital base-a fewer number of banks will be able to implement large loan syndications. For similar reasons, bank governance structures requireclose scrutinyandpossiblestrengtheningas discussedabove. Developingliquid capitalmarkets 5.64 While a natural source of long-termfunding, Nigeria's capital markets currently have no intermediationcapacity for term finance. They lack depth and liquidity for bothequity and debt finance, thereby increasingthe refinancingrisk for local banks. This explains their aversion to providing term loans with maturities beyond 5-7 years. Access to Nigeria's capital market is hamperedby several structural factors, including (i)the lack of a long-termpricing benchmark and high interest rate volatility, (ii)an underdevelopedprimary bond market for corporate bond issues, and (iii) the absence of a liquid secondary market for sovereign and non-sovereignbonds. Nigeria's yield curve is not yet well developed. At the short end the Debt Management Office (DMO) has initiated monthly T-bill auctions with maturities up to 3 ears.''^At the long end, earlier attempts to issue sovereign bonds with 7 and 10 year maturitiesfailed, but there is some optimismthat planedissues with suchmaturitieswould bewell receivedby the reformedpension funds. Interest rate volatility has historically been high, with interest rates on 2-3 year T-bill issues fluctuating between 8 and 15 percent. Interest rate volatility increases long-term risk, driving prices of long-term securities (benchmark rates plus risk premia) beyond affordability. Thus, a more stable monetary policy environment will provide the foundation for less volatile interest rates and the emergence of more affordable fixed-rate securities for long-term investments. 5.65 Primary corporate bond issuance in Nigeria has been muted to date, reflectingseveral barriers to entry. In the period 1999-2005, 11 corporate bonds were issued for a total nominal At the end of 2004, only 21% o ftotal bank loans and advanceswere unsecured. Inthe second half o f2005, Government throughthe DMO issued7 series ofNaira 20 billion (US$lSO million equivalent) for a total of US$l billion. 92 value of approximately $178 million, only four of which remainoutstanding. Historically, low primary issuance reflects high issuance costs as well as limited issuer and investor capacity. Total issuance costs have averaged 5.4 percent of gross proceeds over 2000-2004, drivenmainly by the cost of fees to financial intermediaries and publicity/marketing'28(see Table 5-3). While the Nigeria Stock Exchange(NSE) monitorscompliance, public disclosure of issuancefees could contribute to reducing costs through improved information transparency and competition. In addition, potential issuers and investors are not familiar with the benefits and risks of debt securities, and local rating agencies lack expertise in rating corporate bonds. Re-kindling Nigeria's corporate bond market would have multiple benefits by: (i) allowing banks to raise long-term funds from pension funds and other institutional investors for term-lending and (ii) building capacity for more sophisticated products such as asset-backed securities, Real Estate InvestmentTrusts (REITs) as well as infrastructure projectbonds. Table 5-3: Cost of primary bond issuancein Nigeria's capital markets YOGross Issue Proceeds 2000 2001 2002 2003 2004 Fees to Regulatory Authorities 1.37 1.58 2.11 2.07 1.76 i.SEC 0.69 0.70 0.62 0.82 0.60 ii.NSE 0.50 0.56 1.09 0.96 0.94 iii.Others 0.18 0.30 0.39 0.28 0.21 Fees to financial intermediaries 2.06 3.20 2.60 2.73 2.53 Fees to Professionals 0.16 0.16 0.18 0.18 0.17 PublicityMarketing 0.48 0.75 0.93 0.61 1.26 TOTAL 4.07 5.69 5.82 5.59 5.72 Source: Securities & ExchangeCommission 5.66 The lack of secondary market liquidity is a key structural obstacle to term finance in Nigeria. The absence of a secondary market for government and corporate bonds in Nigeria creates substantial liquidity risk for investors, as they are less willing to invest in long-term securities without a liquidexit option. Lack of secondarymarket liquidity is a function of limited supply, encouraging buy-and-hold behavior by investors, and poor market infrastructure. The capitalmarkets currently lack market makers and Over-The-Counter (OTC) tradingis negligible. Reflecting limited competition, broker fees are as high as 2.75 percent of trading volumes (see Table 5-4). NSE has formed a bond market steering committee to improve secondary market liquidity, includingthe establishing an OTC market, and is working with the Debt Management Officeto develop a primarydealer framework. Table 5-4: Cost of secondary market trading Item Fee ('YOtrading volume) Broker 2.75% SEC 1% ifpurchase NSE 0.5% if sale Central Securities Trading System 0.5% ifsale TOTAL 3.75% Source: NSE 5.67 In contrast, equity markets provide substantial financing to the economy and were a major source of bank capitalizationin the consolidationprocess. At the end of 2005, 214 equity Nigeria currently allows media marketing for securities issues includingTV commercials. This does not conform to best practice standards andunnecessarilyincreases issuancecosts. By regulation, primary debt issuancecosts are cappedat 6% of gross proceeds. 93 securities were listed at NSEwith a total market capitalizationofN2.5 trillion (about $20 billion), corresponding to 26 percent o f GDP (see Table 5-5). Liquidity, while improving, remains low with aturnover ratio around 10percent. Banks account for a significant amount of activity inthe equitymarket, with 40 listed securities, 8 out ofthe 10most actively traded stocks by volume and 23 out of the 27 new stock issues in 2005. Between 2003 and 2005, banks raised a total of N358 billion (about $2.8 billion) through share issues, N296 billion (about $2.3 billion) o f which were issued in 2005 alone. These numbers indicate the substantial potential depth of Nigeria's equity market. Table 5-5: Nigeria Capital Markets Indicators (Naira Billion) 2000 2001 2002 2003 2004 2005 Number of equity listings 195 194 195 200 207 214 Number of debt securities listings 65 67 63 65 70 74 Totallistings 260 261 258 265 277 288 Equities MarketCapitalization 467 649 749 1,326 1,926 2,525 Debt MarketCapitalization 12 14 16 34 186 375 TotalMarket Capitalization 479 663 765 1,359 2,113 2,900 Equities MarketCapitalizationYOGDP 10.0% 12.2% 13.3% 17.6% 20.1% 26.4% Debt Market CapitalizationYOGDP 0.3% 0.3% 0.3% 0.4% 1.9% 3.9% TotalMarket Capitalization % GDP 10.2% 12.4% 13.6% 18.0% 22.1% 30.3% Value of Equities Transactions 28.2 57.6 58.9 113.8 223.9 254.7 Turnover ratio 6.0% 8.9% 7.9% 8.6% 11.6% 10.1% GDP at market prices 4,676 5,339 5,632 7,533 9,575 NA Source: SEC, IMF 5.68 Strong coordination among financial regulators, strengthened supervision and strong corporate governance provide the foundation for successful capital market development. Improved primary market issuance and secondary market liquidity depends on efficient coordination of policies and actions between all relevant capital markets authorities and regulators, including the Central Bank (CBN), Pension Commission (PenCom), National Insurance Commission (NAICOM), Securities and Exchange Commission (SEC) and Nigeria Stock Exchange (NSE). This will involve (i)capacity building for all authorities in risk assessment and monitoring, as issuers and investors diversify into long-term finance and new products, (ii)improved financial reporting standards and data reliability as provided by potential issuers, (iii) implementation o f strengthened standards and codes for corporate governance, and (iv) streamlining o f NSE's and SEC's relatively strict historical reporting and transparency requirements for publicly listed companies, which may act as a barrier to entry for potential issuers. Attracting institutionalinvestorsto term finance 5.69 The ongoing pension reform creates a significant funding source for investment in long- term assets. Existing pension fund assets and new collected contributions to date are estimated at about N630 billion (see Table 5-6). According to the new Regulation on Investment of Pension Fundassets, pension funds can invest30 percent oftheir assets incorporate bonds and other fixed income instruments. Including the reinvestment o f funds which are currently held mainly in short-term assets and real estate, term finance ~apacity'~'from existing funds is estimated at about N190 billion (about $1.5 billion). In 2005, monthly pension contributions averaged about N6 129Usinginvestments incorporate bonds and other fixed income investmentsas a proxy for term finance. 94 billion or N72 billion per year. Going forward, annual pension contributions are projected at N200-300 billion per year, corresponding to an incrementalterm finance capacity of N60-90 billion($500-700 million) per year. 5.70 The new pension regulation, while providing a sound framework for the sector, also limits investment options and increases transaction costs. With a view to safeguarding pension assets and developing confidence in the pension system, PenCom has taken a conservative regulatory approach. While encouraging portfolio diversification (see Table 5-6), the current investment guidelines allow investments in listed securities only, preventing investment in unlisted projects and companies. Equity investments are only allowed in companies with a history of at least 3 years of dividend payment, while direct investments offshore and in real estate are currently not permitted. To maximize the potential contribution of pension fund savings to productive sectors such as infrastructure, it would be advisable to review these restrictions, once capital markets develop and Pension Fund Administrators (PFAs) build sufficient capacity in investment analysis and portfolio management. In addition, the current guidelines set minimumrating requirements for shares, bonds and other ~ecurities.'~~There are likely to be considerable costs associatedwith requiringtwo independent ratingsas well as daily assetvaluations.These costs are likelyto morethan outweighthe informationalbenefits. Table 5-6: InvestmentLimits and Performance Benchmarksfor PensionFund Administrators Asset Class Maximum investmentas Minimum benchmark YOof pensionfund assets Government securities 100%(federal) Weighted average government 20% (states) 2-year bond rate Corporate Bonds / Debt (incl. REITs, 30% Weighted average government Mortgage and Asset Backed Securities) 2-year bond rate + 1% Money Market Instruments 25% 365-day T-Bill rate Ordinary Shares 25% NSEall share index (ASI) Open- and closed-end Funds 5yo NSEall share index (ASI) Source: PenCom 5.71 Giventheir small size and ongoing industryconsolidation, insurance companieswill play only a limited role in term finance over the medium term. Nigeria currently has 106 insurance companies which are expected to consolidate to about 25 by 2007.13' A number of insurance companies are heavily invested in equities, but lack experience in evaluatingbond investments. Following consolidation,the investment guidelines for insurance companies would benefit from review. Introducing minimum rating requirements would be beneficial. In addition, due to insufficientactuarial data insurance companies currently invest more in a shorter term portfolio than would be required to accommodate unforeseen claims. Nonetheless, only over the long term, as consolidation and the recent introduction of regulation on compulsory insurance for companies with more than 5 employers take effect will the growth of life insurance assets and their availabilityfor long-terminvestmenthavea more significantimpact. 5.72 While small in size, Nigeria's collective investment savings schemes contributeto asset diversificationand increased competition. As of June 30, 2005, 24 unit trusts and mutualfunds were registeredwith the SEC with a total net asset value of about $150 mm. Such funds can be I 3 OGenerally, pension funds can only invest in investment grade securities. Investments in bank assets require a minimumcorporate rating o f 'A'. 13' Government has raised minimumcapital requirements to N2 billion for life, N3 billion for general andN5 billion for composite insurance companies. 95 expected to be beneficiaries of portfolio diversification by pension funds. Pension funds can invest up to 5 percent o f their total portfolio in open and closed-end funds, provided these funds live up to the stipulated fund eligibility requirements. Scaling up collective investment schemes will increase competition for the investment of pension fund assets with a beneficial impact on asset returns. 5.73 Nigeria's recent sovereign rating should make it easier to attract foreign investors to further build capital market liquidity. With a BB- rating the country's equity and debt capital markets become eligible for investment by a number of international emerging market investor funds. The entry of international institutional investors will bring benefits in the form of (i) greater competition with pressure to lower transaction costs, (ii)increased availability of long- term debt and equity funds, and (iii) import of best practice investment standards. Through their demand for transparent governance and supervision structures and for reliable market information foreign investors will contribute to strengthening the institutional infrastructure o f the Nigerian market. 5.74 Increasing the depth and liquidity of Nigeria's capital markets will depend on ongoing capacity building for all stakeholders and regulatory agencies, including the 12 PFAs licensed to date, PenCom, the SEC, the NSE and the National Insurance Commission (NAICOM). The strengthening o f these regulators will enhance their capacity to monitor compliance with investment and asset valuation guidelines. Institutional investors also needtraining in long-term investment risk analysis and portfolio management. Improvement inthe disclosure and reliability of market and corporate information will also buildconfidence inNigeria's capital market. V. Access to Infrastructure Finance 5.75 Nigeria's substantial investment needs in infrastructure cannot be met by the public sector alone. In addition, the efficiency of public sector provision o f infrastructure has been limited in the past. Manufacturing firms in Nigeria consider inadequate infrastructure, particularly power, as their most severe constraint to doing business. Access to private sector finance for infrastructure is important to secure much needed investment and improve the efficiency o f service delivery. Local currency finance for infrastructure brings additional benefits of increasing the absorptive capacity o f the economy, channeling domestic savings to productive investments and reducing foreign exchange risk. To maximize their contribution to growth, policy makers need to ensure that the benefits o f ongoing financial sector reforms translate into improved access to term finance for infrastructure. 5.76 Supply side constraints. As a result o f banking consolidation and pension reform, Nigeria's financial markets have considerable capacity to provide local currency term-financing. However, a number o f structural supply side issues impede access to term finance for infrastructure in the short term. By their nature, infrastructure projects require long-dated, fixed- rate debt financing at affordable interest rates and on a limited recourse In developed financial markets, commercial banks providing medium-term loans to infrastructure projects look to refinance long-term risk through issuance o f securities on the capital market. Structural bottlenecks to domestic term finance for infrastructure in Nigeria include (i)the lack o f a long- term pricingbenchmark, (ii)the absence of fixed-rate loans and securities, (iii) limited bank loan maturities, (iv) the absence of a corporate bond market, (v) lack o f secondary market liquidity, and (vi) minimumrating and listing requirements for eligible investment by pension funds which 13'Inlimitedrecourse financing creditors have norecourseto the assets ofthe sponsoringcompany. Their claims are limitedto the project assets andproject cash-flows. 96 are not commensurate with investments in start-up project financing structures. In addition, the capacity to assess, structure and monitor infrastructureproject risks varies significantly among banks'33and is limitedamongthe recentlylicensedPFAs. 5.77 Furthermore, the availability of domestic equity finance for infrastructure projects is limited. Potentialproject sponsors as well as domestic privateequity funds in Nigeriaare small innumber andsize. Foreignequity funds are equally limitedandhave investment horizonswhich are not commensurate with the needs of infrastructureprojects. While infrastructure projects require long-termfunding for 15-20years, domestic and foreign private equity funds inNigeria have an investment horizonof well below 10years. Inaddition, domestic lenders and investors are not familiar with providing quasi-equity finance such as subordinated debt. International financial institutionssuch as the IFC providepassive equity and quasi-equityfinance and act as a triggerto attract additionalinvestment from domestic and internationalequity 5.78 Demand side constraints. On the demand side, a number of Public-PrivatePartnerships are being planned in the various infrastructure sectors, the most immediate ones being in the power andairport sector andothers plannedinthe road, rail andwater sectors (see Chapter 3 for a more detailed discussion). These projects can potentiallyprovide attractive long-terminvestment opportunities for domestic banks and pension funds. At the same time, several demand side constraints currently limit access to private and local currency financing, as political, regulatory, commercial and credit risks are relativelyhigh. Regulatory risk is the single biggest challengeto private infrastructurefinance in Nigeriaas sector regulators, tariff regimes and market rules are still beingdeveloped. Credit risk is highfor projects with government off-take arrangements, as federal and state governments have a track record of non-paymentto utilities. Losses resulting from the absenceof meteringtechnologies, non-paymentand fraud increase commercialrisk. All these factors impact the predictability of project cash flows and debt service capacity, reducing the willingness of banksand investorsto providelong-termfinance at affordablerates. 5.79 Financing solutions. In light of the supply and demand side constraints outline above and the magnitude of Nigeria's infrastructure investment needs, an integrated public-private approach to infrastructure finance is required. Federal and state governments will need to continue financing infrastructureinvestments which are not financiallyviable. At the same time, public resources needto be leveragedto attract privateand domestic finance for infrastructureto create fiscal space. A guarantee facility provides a mechanismto increase access to private and domestic finance for infrastructureat limitedfiscal cost. 5.SO An infrastructure guaranteefacility can provide risk mitigation to international and domestic financiers by providingcoverage against specific risks which are beyondthe controlof the lender and project sponsor. To attract foreign and domestic lenders, risk coverage can be provided against regulatory risks in projects with significant government involvement, such as regulated energy generation and distribution projects or toll roads. For foreign lenders, guaranteescan mitigate specific political risk factors. For domestic lenders, identified long-term credit risks can be shared by the guarantee facility to help extend loan or bond maturities and reducerefinancingrisks inthe absenceof liquidcapitalmarkets. 133Several banks have expressed interest inproviding and scalingupterm finance for infrastructure. While 16 domestic banks participatedinthe recent loan syndication for VMobile, most ofthem havejust begunto set up risk managementunits for term finance. 134An exampleis the CAPE Iprivateequity fund whichwas the first privateequity fund in West Africa and launchedwith IFC participation. Given its success, asecondfund CAPEI1has beenset up. 97 5.81 Guarantees typically only cover a portion o f total project debt. This limits contingent liabilities for the Government while triggering access to private finance which might otherwise not be forthcoming. As guarantees improve credit ratings of infrastructure loans and bonds, the latter become eligible for investment by institutional investors such as pension funds which are bound by minimum rating requirements. In addition, banks are more willing to lend to infrastructure projects ifat least a portion of senior debt benefits from a guarantee. 5.82 Guarantees equally reduce financing costs which, if passed through to the consumer, can lower user fees. Experience in other African countries shows that guarantees significantly reduce interest spreads for infrastructure finance. Furthermore, by mitigating those risks which the private sector is not yet comfortable taking, such as long-term credit and refinancing risk, guarantees promote financial sector development through lengthening of loan and bond maturities. 5.83 Inline with internationalbest practice, it is recommendedthat the proposed infrastructure guarantee facility be managed by an independent, private facility manager selected through a competitive process. Project eligibility criteria would be pre-defined and standardized. Private facility management needs to be combined with clear and transparent governance structures. Facility management would need to closely liaise with all relevant stakeholders, including Ministry of Finance, infrastructure line ministries, BPE, commercial banks, institutional investors, financial sector regulators and donors. 5.84 To be successful, the proposed guarantee facility needs to be embedded in a clearly definedinstitutional framework for PPPs inNigeria. For this purpose, technical assistancewould be provided to government entities in areas such as infrastructure investment planning and infrastructure project preparation and to commercial banks, institutional investors and financial sector regulators in project finance and long-term credit analysis. Annex 5-D describes the proposed facility structure inmore detail. 5.85 While a guarantee facility can mitigate key risk factors to infrastructure finance in the short term, sustainable access to private and local currency term finance for infrastructure in Nigeria depends on further progress in infrastructure and financial sector reforms. Key areas for reform include (i) completion of regulatoryreforms, (ii) systematic framework for infrastructure a investment planning, (iii)a clear institutional environment for PPPs, (iv) the establishment of a fiscal framework for government support to PPPs, (v) strengthening o f governance structures of public utilities and infrastructure regulators, and (vi) capital market development. VI. MainRecommendations The salient recommendations o fthis chapter can be summarized as follows: 0 The future challenge for financial sector development in Nigeria will be to harness the success of banking consolidation and to develop non-bank finance to (i)improve service delivery and the availability o f appropriate products for large and medium enterprises as well as (ii)improving access to financial services at a small-scale to meetthe needs of households, micro-enterprises and small businesses. 0 Following the bank consolidation exercise, the solidity o f the banking system will depend on augmented supervisory capacity of the CBN and NDIC to take earlier, more guidance-based, intervention in the behavior o f banks. It is therefore appropriate that the CBN is taking the first steps towards implementation of risk 98 based supervision, thereby providingstructure to thejudgmentalinterventionswhich will becomeincreasinglynecessaryto ensure systemic stability. Improving the lending environment will be key to increasing the ability of new funding. Without improvements to creditor rights and insolvency frameworks, investments in credit infrastructureand technology etc., financial intermediaries are likely to increase lendingto existing customers rather than expand their services to new market segments. Closing the substantial knowledge gap about the size and scope of the demand for financial services outside the corporate sector andurban, middle-incomeretailmarket will be important for the Government and private sector institutions. This will help develop strategiesfor access to finance. Addressing structural issues in the capital markets, including (i) lack of a long- the term pricing benchmark and high interest rate volatility, (ii)the underdeveloped primary bond market for corporate bond issues, and (iii)the absence of a liquid secondary market for sovereign and non-sovereign bonds. This will support the processof increasingthe availabilityof long-termdomestic investmentfunding. 0 Creating a public-private facility for infrastructure in Nigeria would help address market failures and maximizelocal currency financingfor infrastructure. As various infrastructurePPPs inNigeriaare faced with similar risks, a cross-sectoral approach to facilitating private participation in infrastructure would be beneficial. The objectiveof such a facility would be to provide a coherent frameworkfor investment prioritization, private sector participation and government support though various instruments such as a guarantee facility, a liquidity facility and subordinated debt and equity funds. 99 6. HARNESSINGTRADE FOR GROWTH Introduction 6.1 Several countries have achieved and sustained rapid growth through an export led approach. Small economies in particular have very little opportunity to achieve productivity and efficiency gains to support growth without tapping larger markets through external trade. Nigeria's relatively large domestic market can support some growth but alone cannot deliver sustained growth at the high rates neededto make a visible impact on poverty. Nigeria will need to rely on foreign markets as well. 6.2 Historically, the country has had a very restrictive trade regime that generated substantial transfers to domestic producers and strong anti-export bias. In its current poverty reduction strategy (NEEDS) however, Nigeria has identified deeper regional and global trade integrationas a means to foster economic growth and reduce poverty. Border tariffs are being reduced, trade regulations are under review, and ambitious modernization programs for customs services and port infrastructure have been launched. 6.3 This chapter focuses on further trade policy actions that could help Nigeria exploit more fully the potentialofdomestic trade as well as facilitate its integration into the regional andglobal economies. The first section discusses key actions to strengthen the functioning of domestic markets. Section I1analyses the role of regional and internationaltrade inthe economy, followed by an analysis of external trade policies. Section IV describes and assesses Nigeria's regional integration agenda. The last section analyzes the effects of trade policy changes at the multilateral level, notably those occurring in the context of the Doha Round of WTO negotiations. I.StrengtheningtheFunctioningofDomesticMarkets 6.4 Unlike most other countries in Sub-Saharan Africa Nigeria has a potentially large domestic marketthat could form the basis of sustained growth and the developmentof firms able to compete effectively in domestic and export markets. This advantage is not being fully exploited. Only a small number of producers have been able to develop into sizeable businesses able to compete internationally. The functioning of domestic markets needs to be strengthened to draw onthe efficiency advantages it could provideto Nigerian producers. 6.5 Domestic markets are segmented and fully integratedzonal or regional markets that will drive competition and efficiency gains have not emerged. Individual segments are also poorly coordinatedand participantssuffer from poor facilities and predatory behavior of public officials. Traders are often requestedto make paymentsfor transporting goods across local government and state boundaries. Most of these charges are adhoc and illegal and add to the costs of internal trade. Aside from addressing transport infrastructure issues which contribute to this135,several other factors needattention '35See discussiono f Chapter 3. 100 6.6 The high transactions and coordination costs associated with small scale farming is a factor in the poor functioning o f agricultural markets. In almost all value chains, the process of consolidation starts with small scale local buyers who buy agricultural produce at the farm gate and sell in local markets to households, local processors or middle men. They in turn sell the product in larger regional or national commodity markets from where larger merchants then dispatch them to larger end users (processors, caterers) or sell them to wholesalers in large urban markets for sale to retailers. Almost all transactions are `spot' with little forward buying or selling. There are a substantial number of transactions amongst a large number o f intermediaries raising transaction costs and making it difficult to co-ordinate. 6.7 Although there are sizable players, the overwhelming proportion of intermediaries are small, informal businesses. There are few large scale market participants able or willing to invest in developing supply chains that provide reliable supply of assured quality products from the farmer to the consumer. The absence of effective mechanisms to enforce contracts, combined with the cost of coordinating extensive supply chains, has meant that almost all large end-users preferto buy `spot, through buying agents rather than through contractual arrangements. 6.8 The federal government has established three commodity marketing companies (arable crops, tree crops and livestock and fisheries) with the mandate to supply inputs to farmers, manage government subsidies on inputs and purchase agricultural produce. These companies are intended to be owned by farmers and floated on the stock market, but since becomingoperational in 2005, all their funds have been public. They have no statutory powers and were supposedto operate commercially, raising their funds in the private sector. But the chances of these companies succeeding are remote. They will most probably, become wholly dependent on public revenues raising the risk that they recreate the government failures of the old marketing and commodity boards. They could also crowd out the private sector. The Government needs to signal a change in attitude to this crucial part of the economy, showing its willingness to reduce predation, increase the incentive to invest and to address market failures in crucial markets for agricultural commodities. 6.9 Markets are also poorly developed and maintained'36.The local governments that own them regard them as a means to raise income, leaving it to market associations to take care o f their up-keep. Local governments give low priority to investing inthese markets, even ifthey are potentially sources o f greater revenue. As the market associations do not own the land, they do not have any incentive to invest in physical infrastructure, including access roads, building storage and investing in public facilities. Complaints of lack o f trading space, inadequate storage facilities that cause highspoilage, unsanitary drains and general squalor are frequent. 6.10 Formal institutions play a very limited role in the governance over markets. Instead, informal or semi formal rules, drawn up by the market associations, provide the effective institutional framework. The role o f the public sector is mainly to extract revenue from the markets. The market associations raise funds by levying their members and arrange to pay the local government tenement rates, levies on shops and kiosks and daily marketing levies. The public officials that have responsibility for health and safety, sanitary inspection, veterinary services etc. and the police provide little service but demand payment. Disputes that cannot be resolved by the market associations are firstly referredto community leaders and traditional rulers and, only as a final measure, may be taken to the courts. 136A very good descriptionofhow commodity and food marketswork inNigeriamay be found in `Investigations on Building aFoodMarketingPolicyEvidence Base inNigeria, Briefing Report, by G.Porter, F. Lyon and the Nigeria MarketingNetwork, commissionedby DFID, 2005. 101 6.11 With no formal contracts, transactions are frequently carried out on the basis of trust. Trading i s frequentlycarried out by commission agents acting on behalf o f sellers and buyers and this involves trust, including the giving of credit. Formal insurance mechanisms are largely absent or unused because of a mix of reasons ranging from low level of awareness, negative perception of non redemption o f claims and cumbersome procedures. Thus, insurance is providedthrough a mutual support network amongst members of the association or union. 6.12 The issue of ownership or security o f tenure over the major commodity also need to be resolved to ensure that commerce is not constrained by the behavior o f a few local governments. Local governments housing the major commodity markets should be encouraged by state governments to given long term leasehold tenure or freehold ownership over the sites to the market associations. These associations should in turn submit plans for their development including expansion o f the market, either at the current site or a more suitable site ifcongestion is a problem. These plans should include transferable sub leases for market traders on their current sites. Once approved, the plans should be left to the market associations to implement and their rights over land withdrawn if plans are not implemented. The local governments would receive payment for the lease holds or sale but, only charge the usual tenement rates on the property not the rent and the range oftaxes and fees charged now. 6.13 Part of the contract with the market association would be that they be trained in and enforce weights and measures and standards, health and safety, sanitary safeguards, product standards and animal health and dispute resolution. The market associations should nominate memberswho can be trained inthese key function, publishbye-lawsthat cover them and stipulate fines and punishments that may be imposed for breaches. The role o f the local government inspectors and officials of government agencies should be to ensure that bye-laws conform to national regulations and should provide oversight over their implementation. This should improve both the functioning o f the market and reduce predationby officials. Formal wholesale and retail markets also need change o f tenure from the local government to the market association as suggested for commodity markets. Formal wholesale and retailing would benefit from improved market planning and development approvals process in local government and a reduction of the number of permits, licenses, inspections and fees payable. 11. Role of Regionaland International Trade Inthe Economy 6.14 In2004, the share oftrade (exports and imports of goods and services) inNigeria's GDP was 84 percent. This is remarkably high for a country o f Nigeria's size and exceeds corresponding trade shares in comparator countries. The prominent trade-to-GDP ratio is largely the result ofNigeria's characteristic o f beinga specialized commodity exporter. As production is concentrated on relatively few products, notably petroleum products, trade i s a means of validating domestic surpluses. Over the past decade, the value of goods and services exports from Nigeria has grown by about 20 percent inreal terms. However, this expansion falls short of the acceleration of the external sector in comparator countries, and the world overall (export growth o f more than 70 percent). Hence Nigeria has been losingworld market share. 6.15 Nearly half o f Nigeria's merchandise exports are destined for North America and almost another quarter for Western Europe. Sub-Saharan Africa accounts for only about 7 percent. For non-oil exports which account for about 4 per cent of the total, Western Europe i s by far the most important destination, accounting for 70 per cent of the total. Capital goods account for nearly 40 per cent of total imports, while intermediate products and consumer goods each have a share in imports of about 30 per cent. More than 40 per cent of all imported goods come from Western Europe and almost a quarter from East Asia. 102 6.16 As discussed in Chapter 1, Nigeria's merchandise exports are largely dominated by fuels. Indeed, if measured by widely-used indicators such as the Herfindahl index137,Nigeria has the most highly concentrated export structure in the In2003, the country had only 66 product groups139with export values exceeding US$lOO,OOO, while five comparator-countries had substantial exports in at least 175 product categories. On a per capita basis, only three countries inthe world have lower non-oil merchandise exports, namely Burundi, Ethiopia, and Rwanda'40. The dependence on fuels might even increase further in the medium term, as exports of natural gas, o f which Nigeria has very substantial reserves, are projected to double within the next four to five years. 6.17 Between 1999 and 2003, Nigeria's main non-oil merchandise exports141,i.e. cocoa beans, leather, and crustaceans expanded faster than the world market overall. But in other non-oil export categories the picture i s mixed and exports appear to be rather volatile (Figure 6-1). These strong variations seem to be related to the low absolute value o f exports in the respective categories, so that small increases or decreases in export volumes can generate large relative changes. Figure6-1: Non-fuel MerchandiseExport Growth by Product-Group, 1999-2003 (Change inUS$-value of exports, percent) World market export growth (YO) 4106 Goat leather 7404 Ferrous scrap 1801 Cocoa beans 0 -0,o, 1804 Cocoa bu 2302 BrmB sharps 843 1 Machneryparts 0 * , , 150 200 Nigeria's export growth (%) 2609 Tm ores -20 J Note: Product-groupsdefined at the HS 4-digit level. Export values derived from mirror data (import data in destination countries). The circle area is proportional to the value of exports. Source: World Bank staffbased on datafrom the International Trade Center. 137Calculatedas the sum o fthe squares o f product export-shares. 13'UNCTAD, 2005b. 139Up from 37 in2001, though 140Nielsen, 2005. 14'The following discussion uses mirror data whenever possible to analyze Nigeria's non-oil exports given weaknesses intrade statistics on non-oil exports. 103 6.18 Over time, fluctuations in non-fuel exports have largely been driven by changes in agriculturalcommodity exports. Overseas shipments of manufacturingproducts have been more stable, and shown some modest expansion recently. Manufacturingexports grew by an annual average of 2.8 percent in nominal US$-terms, and during 1999-2004 by an annual average of 4.2 percent. The biggest share of the expansionwas due to processed skins and leather products. The textiles and leather industry showedby far the highest exports per employee ratio within the manufacturingsector in2002 (Table 6-1). 6.19 Reflectingthe nature of economic activity, Nigerianexports are not very technologically sophisticated. Medium and hightechnology products accounts on average for about 20 per cent of non-fuel manufacturing exports. This share is lower than the corresponding ratio in comparator countries. Over time, the share of low technology products has grown at the expense of resource-based manufacturing, reflecting the expansion of exports of processed skins and leather products. As explained in Chapter 1, there seems indeed to be a deficit in Nigeriawith respectto the uptakeofnew productiveactivities. Table 6-1: Structure of non-fuelmanufacturingin Nigeria, 2002 million million million million US% US% US% US% `000 US% Food, beverages & tobacco 121 1374 -1 253 345 372 326 Textiles, apparel & leather 173 117 56 188 80 2 152 Wood & products 26 80 -53 234 166 160 Paper & publishing 2 296 -293 157 153 14 Chemicals & pharmaceuticals 39 1479 -1 440 28 143 272 Rubber & plastics 5 184 -179 57 94 54 Non-metallic minerals 3 376 -372 42 148 21 Metals & machinery 34 2 062 -2 028 234 76 448 Electrical & electronic products 23 979 -955 29 87 269 Vehicles & transport equipment 10 1224 -1 214 223 76 135 TotalManufacturing 438 8 169 -7 731 1537 1395 314 111.Nigeria's Trade Policies 6.20 Nigeria's trade policies are geared both towards promoting export growth and diversificationandprotectingthe domestic market. Export Promotion Policies 6.21 The Government is intent on diversifying the economy and promoting exports. The current NationalExport Strategy envisages annual growth rates for non-oil export earnings that accelerate stepwise from 25 percent in 2005 to 50 percent in 2010. By that time, the Government's target is that non-oilexportswill account for 38 percentofall merchandiseshipped abroadl42. Judging by past performance, these goals appear ambitious. 14' Nigerian ExportPromotionCouncil, 2004 104 6.22 A recent survey of 145manufacturingfirms in Nigeria143 found that the propensity of Nigerianfirms to export was substantiallylower than that of firms in countries such as Ghana, Kenya, South Africa, and Tanzania. But similar to these other countries, exporters tended to be more productiveinterms ofoutputor value-addedper employee than non-exporters andbe larger in terms of employment size and capital stock. In addition, exporting firms were on average established for a longer time and were more likely to have some foreign ownership. These findings suggest that export promotion policies should focus on measures to remove fiscal and regulatoryobstacles to enterprise growth and support investments in human and physical capital inorder to foster productivityincreases. 6.23 Nigeria has pursued a number of special initiativesto encourage non-oil exports in the past. Special Economic Zones have been devised to provide investors with a more favorable businessenvironment than is availableon the mainland, butthe uptake of the incentives provided has so far been rather disappointing(Box 6-1). Moreover, Nigeria used to operate duty draw- back systems, which made it possible for exporters to claim refunds on imports of production inputs, as well as manufacturing-under-bondand bonified-manufacturersschemes, whichallowed duty-free imports. But due to large-scale abuse, these systems were discontinuedin 2002 and 2005, respectively. 6.24 Other export incentiveprograms includethe export adjustment fund, which compensates companies for cost disadvantages relatedto infrastructuredeficiencies, the export development fund, which provides financial assistance for international marketing, and the NigerianExport- Import Bank, which offers commercialbank guarantees and direct lendingto facilitate exports. Yet, the most prominentexport incentivesystem that has been used inNigeriainevolvingforms since 1986 i s the export expansion grant (EEG) program. This program subsidizes exports of qualifying companies through the issuance by Customs of negotiated certificates that can be redeemed against duties on imports. Such export subsidy schemes are in conformity with provisions under the WTO Agreement on Subsidies and CountervailingMeasures for countries with per capitaincomesof less than US$ 1000. 6.25 Originally, the EEG accorded export subsidies of 10percent to producers of finished goods, but the subsidy was increased over time and reached 40 percent by 2002. At the same time, agriculturalexporters became entitledto a 5 percent export subsidy. Given the magnitude of these incentives, it is both surprising that there does not seem to have been a strong supply responsefrom actual and potentialexporters and that the effectiveness o fthe program apparently has never beenthoroughly assessed. No account of the totalvolume of exportexpansion grants is publicly available. But ifthe 40 percent rate is applied to the value of exports of textile articles and hides & leather and the 5 percent rate to agriculturalexports, the fiscal cost of the program can be estimatedas amountingto about N 15.6billion (US$117.8million) in2004 alone. This is likely to be a lower boundary for the cost of the program, because products in other categories mighthavequalifiedas finished goods andbenefitedfrom exportsubsidies. 6.26 The generosity of the EEG program and the lack of controls gave rise to wide-spread fraud, such as the over-invoicingof exports. Inresponse, the Government reformedthe program at the beginningo f 2005 by reducingthe maximumsubsidy-rateto 30 percent for manufacturing exporters (15 percent for commodity exporters, 10percent for merchants) and tightening the eligibility criteria. In particular, the subsidy-rate has been made dependent on company characteristics, notably local value-added, local content, employment level, sector of activity, export growth, and investment rates. But still, there does not seem to be a regular mechanism in 143Rankin, SoderbomandTeal, 2004 105 place to evaluate the use of the EEG funds and to assess if and to what extent the program achieves its stated objective. More generally, a broader review of export incentive schemes would seem highly desirable in order to rationalize the government's support to exporters, improve its efficiency, andminimizethe risk ofabuse. Box 6-1: The Calabar Free Trade Zone After putting legislationon the establishment of special economic zones (SEZ) into place in 1992, Nigeria's first SEZ at Calabar, the southeasternport city and regionalcapitalof Cross River State, became operationalin 1999. Since then other States have started to establish similar zones to foster local and foreign investments by providing business- friendly environments in spatially confined areas. But by the end of 2005, only one other zone, namely Onne Free Zone near PortHarcourt, was operational. Enterprisesin the SEZs enjoy a number of administrativeand fiscal advantages. These include one-stop approvals for permits, operating licenses and incorporationpapers. Moreover,tax exemptions from Governmenttaxes and leviesare granted and SEZ-firms can import raw materials and components for goods destined for re-export tax and duty-free. After the initial uptake by companies remained unsatisfactory, the existing export processingzones were transformed into free trade zones in2001by abrogatingthe rule that companieslocatedinthe zone shouldexport at least75 per cent of their production (Nielsen, 2005). Since then, firms are allowed to sell up to 100per cent of manufactured, assembledor importedgoods into the Nigerian market, but ifthey are servingthe domestic market, they are subject to paymentofthe import duty onthe raw materialsor componentsusedinassemblyof the finishedproducts. The Onne Zone with about 100firms, which are employingabout 7 000 workers, is largely dedicatedto the facilitation o f liquefied natural gas exports. Activities in the Calabar Free Trade Zone are more diversified, including food processing, furniture production, packaging, rubber processing, and iron works. By the end of 2005, there were 23 companies operatingin the Zone. Half of these firms are wholly foreign-owned,while the remainingones have local capitalparticipationor are completedcontrolled by Nigerians. Total investmentamountedto about USD350 million and employment stood at about 2 000 workers, with the food, packaging and basic metal industries accountingfor three-quartersofthe total. In2003, Calabar exportedabout USD50 million ofproducts. It is difficult to assess the performance and impact of the Calabar Free Trade Zone to date, as the zone is still in its build-up phase and there are only very limited data on production and exports available. Looking at world-wide experiences, the potential role of SEZs as engines of growth indevelopingcountrieshas been a much discussedtopic. Individual countryexperiences with export processingzones have been mixed and the specific set-up and management o f the zones seems to be paramount to their success. In particular, good governance seems crucial for a country's success insetting up SEZs. Export processingzones can make a positive contributionto growth and employmentifthey manage to attract foreign direct investment that is accompanied by technological transfer, knowledge spillovers and backward linkages to suppliers in the mainland. Relatively successful examples in terms of the dynamics of economic activity and employment include Honduras, El Salvador, Mauritius, China, Indonesia, Malaysia, South Korea, and Sri Lanka. On the other hand, there are a number of failures, and the fact that inmost cases firms locating in SEZs enjoy tax breaks and subsidizedinfrastructurehas been proneto criticism. It is indeednot clear whether such incentivescan always be justified on a cost-benefit basis (Madani, 1999). For example, detailed analysis suggests that governmental infrastructureinvestments inthe SEZ inthe Philippineshave not beenjustified by the returnsinterms of employment, tax receiptsandforeign exchangeearnings (Jayanthakumaran,2003). InAfrica, manySEZs have sufferedfrom lackof socio-politicaland economic management skills that have not made it possibleto address the multiple challenges of SEZ-establishment, such as providing high quality infrastructure,government services, and human capital (Watson, 2001). 6.27 To ensure that public resources are used effectively to achieve Nigeria's growth objectives, it is importantthat Government put inplacea frameworkfor determiningsuch support and for assessing its impact. This should include a cost benefit analysis of the program and consideration of different options for achieving the particular objective. Programs should be designed to promote transparency and accountability in order to reduce vulnerability to capture andcorruption. Existingprograms needto bereviewedwith this inmind. 106 DomesticMarket Protection 6.28 Tariff Protection. InOctober 2005, Nigeria formally adoptedthe ECOWAS-CET, which implies a major change in the country's trade policy. By the beginning of 2006, the CET was fully operational and Government has repeatedly stated its intention to remove current exemptions from the CET and any remaining import bans by the end of 2007. It is unclear, though, whether the phase-out of special duties on sensitive products and of import prohibitions will be undertakenina single, or inseveral, more gradual steps. 6.29 The ECOWAS-CET consists of four bands (0 percent, 5 percent, 10percent, and 20 per cent), similar to those already being applied by members of the West African Economic and Monetary Union, which is composed of a sub-set of ECOWAS member countries. During the transition period until the end of 2007, Nigeria applies 50 percent duty rates to imports in 102 tariff lines, or 1.9 percent of all lines. The resulting tariff profile is significantly less dispersed and carries lower average duty ratesthan Nigeria's pre-CET schedule (Figure 6-2). Indeed, after having reached almost 30 percent in the recent past, the adoption of the CET is bringing simple average import duties down to 12.1 percent (11.6 percent once the CET is fully implemented in 2008). The liberalization is particularly marked for agricultural products, which used to receive very high protection, but similarly felt in manufacturing (Table 6-2). Yet, in addition to the MFN-duties, Nigeria continues to apply several levies to imports, including a port development levy (7 percent of duty payable), a comprehensive import supervision scheme charge (1 percent of customs value), the ECOWAS community levy (0.5 percent of customs value), as well as product-specific levies and excise dutiesl44. Also, many imports are subject to non-tariff barriers, notably import prohibitions, which adds significantly to the restrictivenessof the import regime. Table 6-2: MFNTariffs in Nigeria 1997/98 1999/00 2001 2002 2003 1 CET CET 2005/06 2008 Simple averagetariff rate 24.4 26.0 26.0 29.0 28.6 12.1 11.6 Agriculture (ISIC, Div. 1) 26.7 26.3 26.7 41.5 41.4 12.8 12.6 Mining andquarrying(ISIC, Div. 2) 18.3 18.4 18.4 18.4 17.9 5.2 5.2 Manufacturing(ISIC, Div. 3) 24.4 26.1 26.2 28.5 28.0 12.2 11.6 Domestictariff spikes (%of lines) 0.5 0.5 0.5 5.2 5.0 1.9 0.0 Internationaltariff spikes (YOof lines) 51.6 57.9 57.9 57.4 56.5 41.3 41.3 Overallstandarddeviation 18.0 14.6 14.5 22.0 22.3 9.1 7.5 6.30 Nigeria's old and new tariff structures are in general escalatory, such that import duties on raw materials are lower than those on semi-processed products, which in turn are lower than the tariffs on finished goods. Producershave access to inputs at low-tariffrates, while beingable to shield behind high import barriersfor their final products. The effects of suchtariff escalation on the protection of value-added of an activity can be measured through effective rates of protection (ERPs). The latter provide a better representation of tariff-generated transfers to producersthan nominal rates of protection, as they take protection on both inputsand outputs into account. 144Nielsen, 2005; WTO, 2005 107 Figure 6-2: Tariff Drofile in Nigeria hates in vercent) 150 - 140 - 130 ::I, 120 110 --- LOO - I 90 I 80 -. , , 70 - ,~ , Pre-CET MFNRate \ , , , , .;p ) ' , 30 20 I O - CET Rafo 2005l06 CET Rate 2008 0 0 l o w ZOW 3000 4000 5WO Number of IarlNllne. (cumuhUve) Source: World Bank staffbased on data from Nigeria CustomsService Figure 6-3: Nominal and effective rates of protection (per cenq Md.1 Non-metal Pla.tl.Z. Phnrmaocutwll. Chcmisals 2000/01 Paper. pnntmg S publi.hmg Wood Tcxf~lcs Food S bcvcmqc. 0 20 40 60 80 100 120 140 160 180 Source: Rajhi andMarchat(2004) 6.31 Based on a sample o f 77 firms in different manufacturing sub-sectors it is estimated that ERPs will fall in line with the reduced nominal protection, but remain considerable in some sectors, such as food processing and plastics, with rates still exceeding 40 per cent (Figure 6-3). Onthe other hand, textiles producers will experience large reductions in effective protection, and ERPsfor pharmaceuticals are projectedto fall below nominalprotectionrates'45. 6.32 The lower duty rates o f the CET will also affect tariff revenues. There are two countervailing effects. On the one hand, lower duties will translate into lower revenues on existing imports. On the other hand, the reduced tariff might foster additional imports or might lead to informal trade shifting to official channels, so that the import volume and with it tariff revenue increases. Which of the two effects eventually prevails i s difficult to say. In any case, Nigeria is in a fortunate position, since only a small and decreasing portion of its total governmental revenues is derived from trade taxes. The share of trade-related government revenue fell from more than 20 percent in the early 1980s to little more than 5 percent in 2004. Hence, potential shortfalls in tariff revenues should be relatively easy to accommodate given other revenue sources, including petroleumtaxes and royalties. 145Work by Rajhi and Marchat (2004) suggests that the direct costs associated with the change in the trade regime will be small. They find reductions in employment levels, wages and profits o f manufacturing firms within a 3 to 4 per cent rangeeach. 108 6.33 Import Prohibition. Nigeria has been making extensive use of non-tariff barriers, notablyimportbans. InNovember 2005,944 tariff lines (downfrom 1130lines in January 2004) were subject to import bans. In other words, nearly a fifth of all products in the tariff schedule can not be legally imported into Nigeria. In addition, there were partial bans in 76 tariff lines, which mostly relate to imports of consumer durables inused form or prescribe minimum import quantities or specific import locations. It has been estimated that banned products might in the absenceofthe prohibitionsaccountfor 5-10 percentoftotal imports'46. 6.34 The incidence of import bans is highest in the textiles, apparel and leather sector, where morethan 70 percent of all tariff lines are subjectto importprohibitions(Table 6-3). Importbans are also prevalent in agriculture and wood & furniture production, with about a quarter of all tariff lines affected. The import duties that the bannedproducts would face inthe absence ofthe prohibitions are in general higher than the average for the sector, so that a lifting of the bans would still leave domestic producerswith considerableprotection. Table 6-3: Import bans and tariffs by sector, November 2005 (per cent) Share of Simple Tariff Simple tariff Simple tariff Simple tariff Sector (ISIC Rev. 2) tariff lines with import average in average, average in average, han sector banned items sector banned items CET-2005/06 CET-2008 Agriculture 23.3 13.5 18.8 13.3 18.8 Forestry 0.0 5.0 5.0 Fishing 0.0 13.5 13.5 Coal Mining 0.0 5.0 5.0 Crude Petroleum & Natural Gas 0.0 5.0 5.0 Metal Ore Mining 0.0 5.0 5.0 Other Mining 1.4 5.3 5.0 5.3 5.0 Food, Beverages & Tobacco 17.3 17.8 22.4 16.0 18.1 Textiles, Apparel & Leather 71.6 17.1 18.0 17.1 18.0 Wood & Furniture 29.6 19.0 19.6 19.0 19.6 Paper, Printing& Publishing 11.5 11.5 18.9 11.5 18.9 Chemicals, Rubber & Plastic 3.9 8.2 13.5 8.0 13.5 Non-Metallic Minerals 1.9 16.2 13.3 16.2 13.3 Basic Metals 0.0 12.6 9.5 FabricatedMetals & Machinery 1.4 8.9 14.5 8.4 14.5 Other Manufacturing 5.6 17.4 20.0 I 17.4 20.0 Source: World Bank staff based on data from Nigeria Customs Service and Ministry o f Finance 6.35 The bans have provento be difficult to enforce as they provide incentivesfor smuggling, so that many bannedimports are readilyavailable for purchase inthe country. The losses intariff revenuesdue to unofficial importsof bannedproducts havebeenestimatedto amount to 8-10 per cent of total tariff revenue.14' Moreover,the frequent and often non transparent regime changes of import bans increase policy uncertainty. Developing and adhering to a clearly outlined schedule of import prohibitionremoval would therefore improve the predictability of Nigeria's trade policy. 146Ruffer, 2004 14'Ruffer, 2004 109 6.36 Nigeria also implements export bans for several products with the aim of fostering the domestic downstream sectors (bans on exports of hides, timber, scrap metals and rubber) or to promotethe availability of sufficient food on the domestic market (bans on exports of maize and rice). Similar to import restrictions, export bans and taxes encourage inefficient productionand consumption patterns and a suboptimal resource allocation. Moreover, there are frequently adverse distributional impacts. If the export restrictions concern primary commodities, as in Nigeria, it is oftenpoor smallholders, who have to bear the bulk of the economic costs, as prices for their produce are beingdepressed. Institutional Constraints in TradePolicy 6.37 Responsibility for trade policy making and implementation in Nigeria is spread across different ministries, agencies and departments. Inpractice, there is a lack of communication and coordination between the different levels of government, or between Abuja and the Nigerian Trade Mission in Geneva. This results in frequent policy incoherence, as evidenced in policy pronouncementsmade by the Presidency, the policy reform vision reflectedinNEEDS, and the policies preparedand negotiatedby the government bureaucracy. There is also little integration betweenthe multilateral, regionaland bilateraltrade negotiations, or betweenthem and domestic pra~tice.'~' 6.38 The evidence base for policy making is in general limited. There is little research, analysis or evaluationand an absence of in-depthknowledge and understandingof the technical issues within the FederalMinistry of Commerce. Very few trade officials have basic training in trade economics or knowledge of internationaltrade law. Research institutes are isolated from the policy making process'49and engagement by the private sector seems to concentrate on obtaining access from the Presidency to special favors and privileges rather than pressing for broadimprovementsinthe policy envir~nmenf.'~~This minimalanalysisandnarrow consultation results in a trade policy that is reactionary and lacking coherence and predictability, rather than creatinga soundbasefor a strategic andforwardlookingplan. IV. Expanding Opportunities for Growththrough Regional Integration 6.39 Due to its large size and rich natural resource endowment, Nigeria is the pivotal economic player in West Africa. The country is a member o f the Economic Community of West African States (ECOWAS) and has renewed its commitment to regional integration with the adoption of the Common ExternalTariff in October 2005. Furtherregionalintegrationis also a prerequisite for a successful conclusion of the Economic Partnership Agreement (EPA) with the EU, inwhichNigeriaparticipatesas a member ofthe West Africa Group. Estimationof Regional trade 6.40 Regional production and trade networks are not very well developed in sub-Saharan Africa, so that intra-regionaltrade accountsfor merely 5 percentofGDP. Nigeriais no exception within sub-SaharanAfrica. Accordingto official statistics, the countrytrades relativelylittle with partners in the region. In 2004, the share of exports that went to its neighbors or West Africa 148Rufferet al, 2004 [Ruffer, T., V. Imber, J. Ibrahim(2004), The Political Economy of TradePolicy inNigeria. OPM 20041 149Jerome, 2005 [A. Jerome (2005), Institutional Framework and the Process of Trade Policy Making in Africa: The Case ofNigeria. National Institutefor Economic Policy (NIEP) paper for the International Conference "African Economic ResearchInstitutions and Policy Development: Opportunities and Challenges" 150Ruffer et al, 2004 110 Group partners amounted to just 5.6 percent of total shipments and its imports from countries in the region to merely 2.4 per cent. Nigeria has a substantial trade surplus with regional partners, as its exports o f almost US$2 billion amount to more than five times its imports (Table 6-4). 6.4 1 However, regional trade is substantially underestimated due to informal cross-border links. These transactions are particularly important with the four countries with which Nigeria shares land borders, i.e. Benin, Chad, Niger, and Cameroon. With these countries strong traditional trade routes exist, and the natural conditions permit transactions outside official channels. While by its nature no exact valuation of unofficial cross-border flows is available, the general consensus i s that informal activities account for a significant share of total trade within the regi~n"~Some observers even estimate that 50 to 60 percent of cross-border transactions between Niger and Nigeria are informal, and that 75 to 80percent of Benin's exports go to Nigeria via unofficial channels'52. 6.42 Deeper regional integration will shift the balance in favor o f formal transactions. In particular, the harmonization o f trade policies and regulations between Nigeria and its neighbors and the phasing out of intra-regional trade barriers will lower formal trade transactions costs and reduce the incentives to use unofficial channels. The implementation o f the common external tariff will also eliminate the gains that can currently be obtained fiom world market imports into low protection countries, such as Benin, and subsequent informal transshipment into high protectioncountries, such as Nigeria. Table 6-4: Nigeria's officially recorded trade with partners in the region, 2004 (`000 US$) Exports Imports Net-exports Benin 22 109 14 919 - 71699 190 BurkinaFaso 145 1844 Cameroon 223 970 21 637 202 333 CapeVerde 24 38 - 14 Chad 9 832 527 9 305 Cote d'Ivoire 671 550 213 590 457 960 Gambia, The 0 2 - 2 Ghana 661 450 26 465 634 985 Guinea 4 013 46 3 967 Guinea-Bissau 0 15 253 - 15 253 Liberia 0 916 - 916 Mali 4 958 614 4 344 Mauritania 517 14681 - 14 164 Niger 45 735 49 899 - 4 164 Senegal 338 430 4 416 334 014 Sierra Leone 0 522 - 522 Togo 7 875 7 693 182 ECOWAS members 1756 288 336 215 1 420 073 WestAfrica Group 1 756 805 350 896 1 405 909 WestAfrica Groupplus neighbors 1 990 607 373 060 1 617 547 Note: West Africa Groupis ECOWAS plusMauritania; neighborsrefer to Cameroonand Chad Source: IMF Direction ofTrade database 15'Page and Bilal, 2001 15*SoulB, 2001; Meagher, 2003 111 6.43 Nigeria's adoptionof the CET is an importantfirst step towards expanding its trade with the ECOWAS zone. Full implementationof the CET is critical to achieving this. In addition further work with neighboringcountries to simplify and modernize border customs procedures is important. V. Integrating into Global Markets 6.44 Nigeriawill needto harness global markets more effectivelyto sustainrapidgrowththat will create jobs and help reducepoverty. Its ability to do this will be determined by progress in addressing the constraints to the economy's efficiency and productivity discussed in earlier chapters as well as on progress inbuildingskills andhumancapital. This will positionNigeriato take advantage of multilateraltrade integration initiatives. It will also require further reform of the global trading system to ensure that countries like Nigeriahave greater access to developed country marketsfor their exports. 6.45 Nigeria is a member of the WTO and grants its trading partners at least most favored nation treatment. As a developing country, Nigeria is not subject to the same disciplines and obligations as developed WTO members, and the country benefits from special and differential treatment and preferentialmarket access conditions in high-income countries. The multilateral trade negotiations in the Doha Development Round were indefinitely suspended in June 2006, due to differences ontariff and subsidy cuts. Market AccessPreference Schemes 6.46 Nigeria benefits from market access preferences under the GSP, the EU's Cotonou Agreement with African, Caribbean and Pacific Countries, and the USA's African Growth and Opportunity Act. The extent of duty reductions, product coverage, and rules of origin specifications differ across the various arrangements. The potential advantages for Nigeria of these preferentialarrangements are considerable, since the country ships most of its exports to preferencegrantingpartners. 6.47 The actualvalue ofthe preferenceschemesto individualdevelopingcountries depends on several factors. Obviously, preferencesare valuable only ifthere is a positivepreferencemargin over non-eligiblecountries' supplies, that is ifthe importingcountryhas non-zero MFN-dutiesin the tariff lines of interest. Moreover,the value of preferences depends on the costs involved in showing compliance with rules of origin requirements. If these costs exceed the MFN-duty, exporter will not bother to ask for preferentialtreatment, but pay the tariff. Finally, the extent of benefits from preferentialmarket access are a function of the volume of goods the country is allowedto export to the target market, for example under preferentialtariff rate quotas. Hence, three factors play a crucial role: the available preference margin, the costs of showing compliance with rules of origin requirements, and quantitative supply limits, including those originatingfrom insufficientsupply capacities inthe exportingcountry. 6.48 In 2003, the value of Nigeria's goods-exports to the EU amounted to EUR6.1billion. More than 96 percent of these exports, mostly fuels, entered the European market at zero-duty MFN rates. Of the remainder, about EUR218 million were eligible for preferential market access, i.e. were entitled to get zero or reduced duty access in cases where the MFN-rateswere non-zero. For 80 percent ofthe eligibleexports,Nigeriantraders madeuse ofthese preferences. 6.49 Several reasons have been put forward to explain the less than full utilization of preference schemes by developingcountries. In the case of Nigeria, analysis by product group reveals that preference utilization for agri-food, textiles, and leather products is higher than the 112 80 percent average. The relatively high preference utilization level for agri-food products is confirmed incross-country comparisons, where Nigeria with a utilization rate of more than 94 per cent ranks above the average for all ACP countries (Figure 6-5). Incontrast, Nigerian exporters of computers & machinery, optical & medical instruments, and iron & steel products could not take advantage of the existing market access preferences. Some o f the explanations for under- utilization o f preferences mentioned earlier might apply. But given that the product categories are rather untypical for Nigeria's exports, the non-attribution of preferences might alsojust reflect statistical mis-classification. 6.50 Despite the relatively high preference utilization rate in the western European market, Nigeria's share in total preferential trade with the EU i s tiny. In 2003, Nigeria's accounted only for 0.13 percent of all preferential imports into the EU. On first sight, the situation looks fundamentally different for Nigeria's trade with the USA under AGOA (Table 6-5). Intrade flow terms, Nigeria i s the biggest beneficiary of AGOA and accounts for more than halfo f US imports under this preferential scheme. However, almost all ofNigeria's exports to the U S are petroleum, the MFNtariff for which is 5.25 UScents per barrel. Hence, the preference margin is miniscule and does not provide any significant incentive effect. Yet, the high volume o f shipments means that the value o f preferences is non-negligible. For 2002, it amounted to nearly USD22 million, which put Nigeriainto fourth place interms of total benefitsderived from AGOA'53. Concerning non-energy exports, Nigeria's shipments to the U S amounted to a mere USD 700 000 in2005, or 0.006 percent o f all U S non-energy imports under AGOA. So again, Nigeria has not been able to use its preferential market access to foster economic diversification. 6.51 The flip slide o fthe low use o f preferences inthe EUand US markets is that Nigeria has little to lose from negotiated tariff reductions in the Doha Round in terms of preferential trade income. Unlike some other developing countries, notably small island economies that rely heavily on sugar, banana and textile exports'54 the reduction of MFN tariffs and, hence, preference margins would not lead to major economic impacts on Nigeria. As a result, the country could take an active position inthe negotiations with the aim o f bringing down tariffs and opening up new potential markets for its exporters, in particular in middle-income developing countries. 153Brentonand Ikezuki,2004 154Alexandraki and Lankes, 2004 113 Figure 6-4: Nigeria exports to the EUeligiblefor preference,2003 (millionEuro) - Other HS-ohapters IPreferencesused 0Preference8not used - Iron & steel (HS-73)3 Anmal or vegetable fats (HS-15) 0 Optioel & madioal lnsmments (HS-90) -- 3 Manmade staple fibers (HS-55) Computers & machmery (HS-84) I Cotton (HS-52) Cocoa & preparations (HS-18) Energy (HS-27) Fish & crustacean(HS-03) Raw hides, skins & leather (HS-41) I 0 10 20 30 40 50 60 70 Source: EuropeanCommission Figure 6-5: Use of ACP preferencesfor agri-food products in the EUmarket, 2002 (per cent) Sierra Leone Average for all ACP countries Guinea I Niger I I Gambia ! NIGERlA Mall Cote dIvo1re Benm Senegal Cape Verde Ghana Tog0 Liberia BurkrnaFaso Gulnea Bissau 0 20 40 60 80 100 Source: OECD (2005) Table 6-5: US Imports from Nigeria, 2003-2005 ('000 US$) 2003 2004 2005 Total USImportsfrom Nigeria -- Non-AGOA 10 113 618 16295 101 23 875 179 757 606 878 497 1 414 562 AGOA (including GSP) --- Agriculture 9 356 012 15 416 604 22 460 617 Energy 9 353 913 15 415 912 22 459 913 1767 226 633 Other 332 466 71 Source: United StatesDepartment of Commerce 114 6.52 While preferentialtrade relations can be advantageous, some objectives can be better achieved at the multilaterallevel. Inparticular, adverse effects from trade diversionare avoided, the complexity of trade regulations is reduced, and better market access can be achieved in countries that are unwilling to engage in preferential agreements. Moreover, highly sensitive issues, such as agricultural subsidy reductions in industrializedcountries, can only be effectively addressedina multilateralform. The multilateraltrading systemalso providesa legal framework that treats all members equally, irrespectiveof their economic status. Nigeria has recognized these advantages and has beenparticipatingin multilateralnegotiationsas a founding member of the WTO. Shaping the EPA negotiations with theEU 6.53 As a developing country, Nigeria benefits from preferential market access in industrializedcountries. Yet, many of the preference granting programs are limited in duration and are subject to periodic review (). As a result of such a review, the EU's preferences for its partners inAfrica, the Caribbean, andthe Pacific (ACP) were renewed inthe CotonouAgreement of 2000. At the same time, it was decided to amend the relationshipbetween the EU and ACP countries and change the existingtrade preferences from non-reciprocalto reciprocalin order to ensure full compliance with provisions under the WTO agreement. The conclusion of the intended economic partnershipagreements (EPAs) is likely to have major impacts on the ACP co~ntries.'~~ 6.54 The prospective EPA agreement will not improve the preference margins that least developedcountries (LDCs), which are eligible for duty and quota free access to the EUmarket under the Everything-But-Arms initiative, already enjoy in the EU market. In contrast, non- LDCs, such as Nigeria, have higher stakes at play. Ifno agreement is reached, they would lose their current preferencesunderthe CotonouAgreement in2008 andwould only be eligiblefor the less generous Generalized System of Preferences (GSP). On the other hand, they could improve somewhattheir terms of market access through a successfulEPA outcome. In2005, the EUtariff schedule for imports under Cotonou preferences included 451 tariff lines with non-zero duty rates, out of a total of 8310lines. Some of the products concerned, such as processedmangos or poultry meat, might be of export interest to producers in West Africais6Yet overall, the benefits from lower importtariffs would likely remainlimited. ~~ Hinkleand Schiff, 2004 Price Waterhouse Coopers, 2005 115 Box 6-2: Major Preferential Market Access Programs The Generalized System of Preferences is based on the 1979 Enabling Clause that created a permanent waiver to the most-favored-nation provision in the General Agreement on Tariffs and Trade. Under GSP, selected products originating in developingcountries are granted non-reciprocalpreferences in the form of reduced or zero tariff rates. Least developed countries receivepreferentialtreatment for a wider coverage of productsand deeper tariff cuts. GSP schemes represent unilateral preferences that differ in their design and duration across preference granting countries. The following entities currently operate GSP schemes: Australia, Belarus, Bulgaria, Canada, the European Community, Japan, New Zealand, Norway, the Russian Federation, Switzerland, Turkey and the United States of America. The Cotonou Agreement of 2000 betweenthe EU and77 Mican, CaribbeanandPacific countries providespreferential access to the EU market in addition to and beyond GSP. The Agreement grew out of the Lomt Convention that governed the relations between the EU and its former colonies in the ACP region from 1975 until 2000. It grants comprehensive market access preferences and allows partners to count the value-added in imports from other ACP countries as local input when determiningthe origin of a product("full cumulation"). However, the EU has exempted bananas, beef, and sugar from the preferential access arrangements. The Agreement has been concluded for twenty years, with aclauseallowing for revisionevery five years. In2008, the presentmarketaccess preferences are supposed to be replacedby arrangementsto be agreeduponinEconomicPartnershipnegotiations. The EU's Everything but Arms initiative of2001grants duty-freeaccess to importsof all products from leastdeveloped countries, except to arms and munitions. Only imports of bananas, rice and sugar were not fully liberalized immediately. Duties on those products will be graduallyreduceduntil duty free access will be granted for bananas in January 2006, for sugar in July 2009 and for rice in September 2009. Inthe meantime, there are duty free tariff quotas for rice and sugar. The EBA provisionshave beenincorporatedinto the EU's GSP scheme. The rules of origin of the latter allow in four regionsin the Caribbean, East Asia, Latin America, and South Asia that intermediateinputs from regional partners are counted as local value-added, if the degree of prior transformation of the inputs would have conferred origin inthe regionalpartner country ("diagonal cumulation") . Outside these regions, only importedinputs from the EU can be counted towards local value-added("bilateral cumulation"). The regulationon EBA foresees thal the special arrangementsfor LDC's are to be maintainedfor an unlimited periodoftime. The African Growth and Opportunities Act of 2000 extends the GSP scheme of the United States to additional products, notablygarments, from African countries that satisfy certaineconomic, social andpolitical criteria. A special programfor countries with a gross nationalproductper capita of less than USD 1500 relaxesthe otherwise strict rules of origin for apparel and allows qualifying countries to count yam and fabric from anywhere in the world as local the usCongress, The specialtextile benefitsexpire inSeptember 2007, while the overallprogramis scheduledto content in apparel assembled in their countries. AGOA is a time-bound programthat requires periodic renewal by rununtil2015. 6.55 Larger benefits seem to be possibly on offer with respect to rules of origin requirements. In particular, the Government might aim in the EPA negotiations to obtain rules of origin provisions that are more favorable than the current Cotonouregulations. For example, if it were possible to negotiate specifications that confer origin based on a simple change of tariff heading or a lower value-added rule, additional market access opportunities for Nigerian exporters could open up. 6.56 On the imports side, reciprocity means that over a twelve year transition period from 2008 to 2020, Nigeria would have to open its market to supplies from EU members by phasing out existing trade barriers. This market openingwill have the typical effects of preferential trade liberalization, bringing benefits from trade creation and lower consumer prices at the expense of costs related to trade diversion and loss of tariff revenue. Producers will benefit from lower prices on inputs from Europe, but will have to adjust to the more intense competition from EU suppliers. 6.57 Quantitative analysis of a prospectiveEPA in West Africa15' suggests that imports from the EU would increase by 5-20percent once the agreement is fully implemented. The trade 157Busse and GroBmann(2004) 116 effects are most pronounced in Nigeria, reflecting the high level o f tariff protection in the base period and, hence, the bigger impact o f liberalization. Any reductions in external tariffs that Nigeria is undertaking before EPA implementation, including the adoption o f the ECOWAS CET, are attenuating the impacts o fthe EPA itself. 6.58 It is estimated that 60 percent of the additional imports from the EU represent newly created trade between Nigeria and western European countries, while the remaining 40 percent are due to the diversion of imports away from other partners and towards EU exporters due to the differential tariff treatment. Trade creation implies the availability o f a greater variety of intermediate inputs and final consumer goods from the EU at lower prices. Hence the Nigerian consumers and users of imported inputs would benefit. Trade diversion, on the other hand, is welfare decreasing because higher cost producers from EU countries displace in this case more efficient sources of imports. 6.59 There would be significant adverse impacts on tariff revenues in west Africa, with duty collection inmost countries dropping by 40-60 percent. These duty losses consist both of the lost revenueson pre-EPA imports from the EUand on the imports from other countries that are being replaced by duty-free EU supplies. The revenue losses would be attenuated if certain "sensitive" products were to be exempted from the liberalization process. Since Nigeria i s not very dependent on trade taxes, the tariff revenue loss would correspond only to 2.5 percent of total government revenues, while in some other West African countries, such as Cape Verde and Gambia, more than a fifth of all public revenuescould be lost. 6.60 Nigeria seems to have been less actively involved in the EPA services negotiations than other ECOWAS members, such as Ghana or Senegal. Also, the exchange o f information between Nigeria, other member countries, and the ECOWAS Secretariat concerning the definition of negotiating priorities and strategies seems to be minimal. This lack o f dialogue i s surprising, given the importance o f Nigeria's relations with the EU- about 60 percent o f the country's FDI inflows originate in western European countries. The marginal involvement o f Nigerian trade policy makers presentsthe risk that the outcome of the EPA negotiations might not correspond to the specific needs and interests of Nigeria. There are both Nigeria-specific issues at stake, such as the treatment o f oil industry related services, as well as interests that would benefit from the active support of the biggest ECOWAS member, such as attempts to ease EU restrictions on temporary migration. The Government might also use the EPA negotiations to lock in and advance reforms of its domestic services sector. Market access barriers inforeign markets 6.61 How important are the tariffs and regulatory obstacles that Nigerian exporters face overseas and that could possibly be reduced as a result of the Doha Round? The Market Access Overall Trade Restrictiveness Index (MA-OTRI) provides an aggregate measure of foreign barriers. It corresponds to the uniformtariff that ifimposed by all trading partners on exports of a particular country (instead of the actually applied tariffs and non-tariff impediments) would leave overall exports of that country ~nchanged'~~.For Nigeria in the early 2000s, the MA-OTRI amounted to 15.1 percent on agricultural exports and to 2.2 percent on manufactured products. For all merchandise trade, the indicator value was estimated at 5.9 percent. Among the 91 countries for which data are available, Nigeria thereby ranks among the countries that are facing relatively low tariff and non-tariff barrier obstaclesto their exports. 158Kee, Nicita, and Olarreaga, 2005 117 6.62 Nevertheless, in some cases Nigerian exporters encounter significant policy-generated trade barriers that mightpartly explaintheir low export intensity(Table 6-6). The duties claimed on imports of fish & crustaceans, cocoa & cocoa preparations, and hides & leather, which are amongNigeria's most important non-oilexports, tend to be particularlyhigh in medium income countries. For example, Taiwan levies a 26 percenttariff on fish & crustaceans, Ukraine charges import duties of 19percent on cocoa and cocoa preparations, and Tunisia asks hides & leather importers to pay duties of 25 percent. Tariffs on these products in industrializedcountries are generally much lower and of a single digit magnitude. Given preferential market access arrangements, Nigerianexporters only pay the full MFN-dutiesiftheir shipments do not qualify for preferentialtreatment, perhaps due to problems of showing compliance with rules of origin requirements. 6.63 Inany case, one impedimentto improvedexport performancethat low-incomecountries like Nigeria face despite relativelylow average export barriersis relatedto the tariff structure in partner countries. Many countries have escalatory tariff regimes, with low duties on raw materials, but higherones on semi-processedandprocessedproducts. This encourages imports of unprocessed goods, often from low-income countries, which are then transformed in the importing country under high protection. For the raw material exporter this tariff escalation means that value-additionbefore exports is discouraged, as processed products face high tariff barriers in foreignmarkets. Hence, the diversificationprocess intohighervalue-addedproduction activitiesis impeded. 6.64 It should be noted that preferential access for developing countries to high-income country markets will tend to neutralize the effects of escalatory MFN-tariff regimes in these countries. However, in many cases, rules of origin provisions on processed goods are more complicated or more difficult to meet than the rules on raw materials of unfinishedproducts.'59 For example, it has been estimated that the costs of compliance for food products are more than twice as highas those for agriculturalcommodities.'60 Such"rules of originescalation" will tend to have qualitativelythe same adverse effects on developing countries' effortsto shift into higher value-addedproductionas tariff escalation. 6.65 There are other non-tariffimpediments to developing country exports, notablyinthe area of sanitary and phyto-sanitary (SPS) and other technical standards. In response to heightened consumer and agro-industry concerns about food safety and agricultural health, industrialized countries have adopted more stringent SPS import requirements over time. As a result, agricultureand food producers from developing countries may experience increasing difficulty of entering export markets if they do not comply with international trading rules or voluntary, privatestandards, suchas supermarkets' assuranceschemes. 6.66 In2004, theEU's RapidAlert Systemfor FoodandFeedissued17alertandinformation notices concerning products from Nigeria, which corresponded to 0.7 percent of all notices. The available information for 2005 indicates that both the absolute number of notices concerning Nigerian products and their relative share of the total have risen. Many of the recent alerts concerned elevated aflatoxin levels inmelon seed or the presence of unauthorized Sudan4 color in palm oil. These indications point to quality assurance problems in the processing of agriculturalproductsfor export. 159 (Carrere and de Melo, 2003) I 6 OOECD, 2005 118 Table 6-6: Average of MFNbarriers in potential partner countries for major non-oil exports from Nigeria (per cent) Fish & crustacean Cocoa & preparations Hides, skins & leather Simple Weighted Simple Weighted Simple Weighted Average Average Average Average Average Average Argentina 15.1 14.0 Australia 0.0 0.0 2.3 2.5 Brazil 9.3 7.2 15.1 12.7 7.5 8.4 Bulgaria 3.1 4.9 Canada 0.4 0.3 3.0 3.0 1.3 1.9 China 11.7 10.5 11.0 10.4 10.0 6.8 Croatia 1.4 0.0 EuropeanUnion 9.3 10.3 6.1 2.2 2.3 2.4 Ghana 9.5 5.0 India 11.1 12.3 Indonesia 4.9 5.0 Israel 5.6 2.3 0.4 1.5 1.1 0.7 Korea, Republic 16.0 13.6 7.2 8.4 4.5 3.7 Malaysia 1.2 0.4 13.0 1.6 0.8 0.0 Mauritius 9.0 1.8 Mexico 16.4 16.8 16.8 19.7 8.4 9.4 New Zealand 3.0 4.5 Norway 0.0 0.0 0.0 0.0 Romania 8.8 5.3 RussianFederation 10.1 10.0 5.6 6.8 8.8 5.3 Saudi Arabia 10.1 17.3 Singapore 0.0 0.0 0.0 0.0 0.0 0.0 South Africa 3.7 5.9 Switzerland 0.0 0.0 0.0 0.0 Taiwan, China 25.7 21.8 0.8 0.5 Thailand 8.3 5.2 12.6 20.7 3.6 3.3 Tunisia 24.8 23.8 Turkey 9.0 1.3 Ukraine 18.8 9.0 United States 0.6 0.4 3.3 2.9 2.2 2.8 Vietnam 29.5 29.7 4.8 7.7 Note: (..) meansthat the country is not among the world's top-twenty importers of the respective products Averages across all tariff lines inthe respective HS-chapter. Data for 2005 or latest year available. Japan not included, as the country charges non ad-valoremduties on imports inthe three HS-chapters Source: World Bank staff based on UNCTAD Trains database 6.67 With respect to the North American market, the US Food and Drug Administration rejected 36 shipments from Nigeria over the period from April 2005 to March 2006. Many of the rejections concerned pharmaceutical products that were not authorized for sale in the USA. In addition, there were a number of cases in which shipments were not accepted due to filth or incorrect or incomplete labeling. Hence, exporters do not always seem to be aware of the formal technical requirements for imports into the USA, or do not always process and handle their produce ina way that ensures that it arrives in good condition inthe destination country. 119 6.68 While SPS and other technical requirements might in some cases be excessive and represent non-tariff barriers aimed at shielding industrialized country producers from international competition, most food safety standards are based on legitimate domestic policy objectives and do not discriminate between domestic producers and imports from developing countries. The possibilitiesfor developingcountries of negotiatingmore lenient standards seem, therefore, limited, and developing country exporters will have to comply with the destination country standards, if they want to supply the respective rnarkets.l6' In cases where SPS requirements are not based on internationalstandards or scientific risk assessments, the WTO Agreement on Sanitary and Phyto-sanitaryMeasures provides a framework to address pertinent trade concerns, includingdispute settlement procedures. Complementarity of DohaRound with domestic reforms 6.69 Ifachieved, multilateralreductions intariffs and non-tariffbarriers, as under discussion inthe DohaRoundof WTO negotiations, will tendto erodeNigeria's (modest) tariff preferences, while reducing(modest) trade barriersin overseas markets. What will the overall impact on the country be? Full liberalizationof merchandisetrade has been estimated to result in world-wide real income gains o f almost USD 300 billion.'62 About 70 percent of these income increases would be realizedin high-income countries, and about 30 percent in developingcountries. The exact impact of the Doha Round on Nigeria will, of course, depend on the outcome of the negotiations. Recent model-based analysis of the economic effects of alternative Doha trade liberalization scenarios suggests that Sub-SaharanAfrica (SSA) could more than proportionally gain from multilateral reform, but that countries will need to take a proactive stance in the negotiations to secure a positive outcome.163 Opening agricultural markets in industrialized countries is projected to result in large benefits for poor African countries, but the reductions in agriculturaltariffs, domestic support and export subsidies needto be ambitious. Exemptingeven just a few "sensitive" or "special" products could considerably reduce the gains from reform, since these products are likely to be the tariff peak items. Expanding non-agriculturalmarket access at the same time as reformingagriculturei s equally importantfor SSA. 6.70 Howwould Nigeria's owntrade regimebe affectedby an ambitiousoutcome ofthe Doha round? Nigeria currently has tariff bindings in 19.2percent of all of its tariff lines.'64 All agricultural lines are bound, while bindings exist only for 7 percent of non-agricultural lines. Finalboundtariffs rangefrom 40 per cent to 150per cent. Nigeria's boundrates, as well as those of its ECOWAS partners, are thereby generally well above the corresponding applied tariffs (Table 6-7), so that significant binding overhang exists. Should the Doha negotiations restart, Nigeriacould offer to significantlyexpand its bindingcoverage and reduce existingbound rates, without necessarily facing major adjustments in its trade regime and domestic economy. This would increase the predictability of Nigeria's trade policy and enhance the credibility of the country's commitment to international integration vis-a-vis its trade partners. As a result, potential trade partners might be more willing to engage in commercial transactions with Nigeriancounterparts. 6.71 Similarnegotiatingspace exists with respectto services. In line with commitmentsmade at the end of the UruguayRound negotiations in 1994, the government has engaged in a number of importantreforms in the services sectors, includingprivatizationsand revisions of some legal 161World Bank, 200%. 162Anderson, Martin and van der Mensbrugghe, 2005a 163Anderson, Martin, and van der Mensbrugghe,2005b 164WTO, 2005 120 and regulatory frameworks. As a result, Nigeriahas liberalizedfurther than it was legally bound to do under the GATS. This 'under-commitment' is a common patternfor many countries, but Nigeriacoulduse the resultingmarginof maneuver to its best interest inthe current DohaRound. Since the beginningof the Round, Nigeria has received GATS requests from nine other WTO members(Australia, Canada, China, Egypt, the EuropeanUnion,Norway, Panama, South Korea, and the United States), but has itself not made any offer yet. Once again, this is a common pattern for developingcountries, which tend to try to free-ride on the offers of the major trading countries. Table 6-7: WTO Tariff Bindingsof ECOWASMembers Country Number of Minimum Simple average Maximum boundtariff binding o f bindings binding lines (HS-6) ("/I ("/I ("/I Benin 2053 0 28 100 BurkinaFaso 2046 0 41 100 CBte d'Ivoire 1880 0 11 64 Gambia 684 20 101 110 Ghana 717 30 92 99 Guinea-Bissau 4902 40 49 50 Guinea 2036 0 20 75 Mali 2370 0 29 75 Niger 5030 0 44 200 Senegal 5115 15 30 30 SierraLeone 5113 30 47 80 Togo 715 80 80 80 Note: The ECOWASmembers Cape Verde andLiberiaare not membersofthe WTO Source: World Bank staffbased on WTO ConsolidatedTariff Schedulesdatabase 6.72 Yet Nigeria could use some GATS commitments as free bargaining chips. Further commitments could be made at no or very little cost to Nigeria. Many requests addressedto the country actually seek no more than the preservation of the status quo and the clarification of existingcommitments. In some cases, Nigeriacommitmentsjust needto be reviewedinorder to reflect the conditions already prevailing on the domestic market. For example, in the telecommunications sector, the Nigeriascheduleof commitmentsgives NITEL privilegesthat are now obsolete. Also, inthe maritimetransport sector, the inadequate number of national shipping companiesmakesit impossiblefor Nigeriato make full useof its scheduled shippingrights. 6.73 Nigeriawould itselfbenefitfrom new commitments, that allowthe government to anchor its ongoing reform process into the GATS framework and protect its achievements against politicalinstabilityor interest group pressure. Froma business perspective,the set of new GATS commitments would improvethe investmentclimate by reinforcingpredictabilityandthe stability of the regulatory environment. This can be a significant advantage in a world where many countries compete for foreign investment. 6.74 Nigeria also has offensive interests in services trade, in particular in sectors where it performs relatively well ( e g banking, telecoms, transport). Considering that the ECOWAS Treaty does not ask member states to suppress barriers to trade in services, the GATS negotiations couldbe a tool to gain access to regionalmarkets. Finally, since Nigeriahas a large 121 and relatively well qualified labor force, it has a strategic interest in the horizontal liberalization o f the movement o f natural persons, inparticular vis-a-vis the U S and the EU. VI. MainRecommendations 6.75 To enhancethe functioning o f domestic markets the following actions are needed: 0 property rights over commodity markets need to be resolved; police check points and state taxes along the main highways of the country need to be removed; licenses and permitsrequiredto trade and manufacture need simplification; the tenure of formal wholesale and retail markets needs to be changed from the local government to the market association and the latter given incentives to manage these markets well; the approval process for formal wholesale and retail market planning and development inlocal government needsto be further simplifiedand improved. 6.76 To enhance their effectiveness, government could consider a systematic review of existingprograms to promote exports. Programs could then be redesignedto reduce distortionary impact, introduce greater accountability and results orientation. 6.77 To better exploit opportunities for regional trade, the Government needs to outline and implement a strategy for phasing out special tariffs on sensitive products and for the elimination of import bans by the end of the transitional CET period in2007 6.78 To promote the economy's integration into global markets, Nigeria needs to 0 Take an active role in shaping the outcome of the Economic Partnership Agreement negotiations with the EU and the WTO Doha Round. This will help maintain and possibly improve the terms of goods and services market access in Western Europe, including with respect to rules of origin provisions and trade standards, and bring down existingbarriers to Nigeria's exports inmiddleincome countries 0 Make new commitments that allow the government to anchor its ongoing reform process into the GATS framework and protect its achievements against political instability or interest group pressure. 122 7. POLICYCONCLUSIONS Introduction 7.1 Nigeria can effectively leverage the large resources generated by the ongoing oil boom, to build a firm foundation for a competitive and diversified economy. A strong start has been made in the last few years yet a considerable amount remains to be done. Countries like Indonesia that successfully managed to diversify their economies away from oil and achieve sustained growth and development did this over a long period. Nigeria cannot expect to be different. NeverthelessNigeria is at a criticaljuncture and policy choices over the next few years will determine whether the economy does fully reverse course or whether the recent progress turns out to be a short lived growth spurt as has happened inthe past. The key objective should beto raise investmentreturns andthereby promoteinvestmentand sustainedgrowth. I.Nigeria'sCompetitivenessandGrowthChallenge 7.2 Nigeria has made gains on both competitivenessand growth inthe recent past. However, at the current pace (average of about 5 percent over the last five years) and patternof growth the country will not achieve the MDG of reducingthe poverty level to about 28 percent. With low rates of formal job creation, the majority of the work force is employed in low productivity, poorly remunerated activities (in agriculture and the informal economy) that limit their contribution to growth and prevent an escape from poverty. 7.3 Whilst there are pockets of competitiveness, the non-oil economy is still largely uncompetitive. Rankings on both composite and individual sector competitiveness indicators are still low. Faster growth and the creation of productive jobs will not be possible unless this competitiveness gap is closed. Moreover, the economy has a dualistic nature with a large informal economy that has little to do with the formal economy. This hinders efficient resource allocation and reduces the competitive pressure to drive up productivity inthe economy. 7.4 Raising productivity and efficiency both at the firm level and economy- wide including through shifting the structure of production towards higher valued added activities should be at the heartofNigeria's non-oil growth strategy. This cannot be achievedwithout a strongerhuman capital base and improved use of technology. Long-term strategies are urgently needed in both areas to guide action. The Government is alreadypreparinga ten year plan for education. 7.5 The most immediate constraints that need to be addressed include infrastructure - notably power and roads-and the business environment in that order. Enhancing access to finance will allow the economy's considerableresources to be intermediatedmore effectively for private sector growth. All of these are areas where considerable progress can be made in the short to mediumterm. Policy action in each area will have to pay special attention to addressing the challenge of helping firms transition from informality to the formal sector. Appreciable improvements economy-wide are likely to take a while to achieve. The Government could therefore strategically focus attention initially on relieving constraints in specific high potential growth areas (specific value chains and growth poles). This could deliver quick wins and good demonstrationeffects for expanding reformsto other areas. 123 7.6 Government is already carrying out reforms to tackle some o f the economy's competitiveness constraints. What is needed is (i)a more strategic approach including through greater attention to prioritization and targeting areas for early wins; (ii)greater attention to consolidating and embedding reforms that have already been put in place to prevent reversal;(iii) further work to refine some of the policies and actions to ensure that they enhance productivity and to define and adopt new measures to achieve greater impact. Several of the areas of action are under the purview of the federal government but considerable action i s also needed at the level of states. Greater coordination and collaboration is therefore required between the federal and state governments in the context of a framework for reforms to achieve competitiveness and growth. 11.EmbeddingReformsfor Growthand Competitiveness 7.7 In the last few years Nigeria has made excellent progress on a broad reform agenda. Going forward it is important that Government embeds the reform achievements in a manner that enhances their irreversibility. There are four key ways though which reforms could be embedded and consolidated. The first is to build institutions and processes for policy making to support the current reform thrust; the second is to introduce legislation to reinforce the policy changes; the third i s to make public information on government policy and performance routinely available; and the fourth is to facilitate the creation of new and well-informed coalitions o f interest groups insupport ofthe reforms. 7.8 Reforming institutions to align institutional incentives with reform objectives and build institutional capacity to articulate and implement reforms i s critical. Nigeria's reforms have so far tended to be imposed from the top down. There was little alternative in a complex country with deep social divisions, weak institutions and strong vested interests against reforms including in public institutions. This approach has succeeded in kick starting many reforms, but will not suffice to extend and sustain them. Reform of public service institutions i s proceeding and needs to be speeded up particularly in the key ministries such as the Ministry of Finance and the National Planning Commission leadingthe reforms. This should help create new institutionsthat are in tune with the new policy thrust of government and where staff understand and are committed to the new policy shift. Considerable capacity building around policy making, implementationand monitoring will also be needed. 7.9 Efforts to strengthen institutional and organisational capacities at the Federal level must be replicated at the State and Local Government levels if the reforms are to be embedded. To date, most institutional reforms have taken place at the Federal level, complemented by actions in only a few States, and with little apparent improvement in the great majority o f local government areas, As long as this is the case, distortions to economic activity will not be adequately addressed and competitiveness and growth will be elusive. Extendingthe momentum of reform across Federal, State and Local government levels will reduce probability o f reversibility. An appreciable change at all three tiers of government will ensure that the reforms are meaningful to the great majority o f citizens, in the form of either better publicly-provided services or of broader growth. Some o f the reforms at the federal level provide a starting point with opportunity to learn lessons, and to reach out increasingly to those States in which conditions are conducive to improved economic governance and management. Federal government could help by assessing impact of its own reforms and drawing lessons, sharing information with states and local governments and identifying incentives for state and local governments to take on similar reforms at their level. A mechanism for performance based grants from the federal level to states that show commitment and action on reforms could be designed and implemented. Nigeria could draw on experiences from other federal countries inthis regard. 124 7.10 Second, Government needs to institutionalize the fundamental reforms that have been introducedover the past few years on the basis o f "political agreementshnderstanding"through the passageof a number of key bills, currentlypendingapproval. Critical legislationthat needsto be passed include:the FiscalResponsibilityBill; The Tax Policy and AdministrationBills, The Public Procurement Bill; The NEITI Bill; The Auditor General's Bill; The Statistical Act and other key regulatorybills. 7.11 Third, mechanisms of public accountability that create pressure on government and leaders for improved performance need to be strengthened. This should create a dynamic of highercitizenexpectations, so that improvedperformanceis widely seen as the norm, generating pressure for further improvement. To achieve durable accountability systems, government must make quality and timely informationroutinely available on a wide range of government actions, in particular relatingto financial management, but also on the performanceand impact of public bodies and on key competitiveness indicators. A good start has been made in a number of areas, however the process needs to be institutionalized and widened. Improved transparency will create greater scope for `intermediaries,' including the media and non-governmental organizationsto help createa more informedpublicopinion. 7.12 To optimize its effect on growth, Nigeria's ongoing democratic process needs to be accompanied by a set of measures that reward the political leadership for taking actions that promote economic growth, and that punish them for economic failure. This will include demonstratinghow political leadership may benefit from broad-basedeconomic growth (e.g. the political benefits associated with these would include increased employment and income opportunities, increased revenue and a reduction of poverty related conflict). To achieve this Government needs to address the political economy constraints that have hindered growth over the past four decades. At the heart of the vicious cycle that needs to be brokenis the needfor an economy that diversifies beyond oil. Government's efforts to achieve this must be deepened across the three tiers of government to ensure that vested interests that have been created around oil, protected and uncompetitiveindustries, and the inefficient public and private sectors can be broken. A more diversifiedeconomy comprisinga more vigorous, competitiveand less protected private sector will contributeto more sustainable and equitable growth, and generate a healthier configuration of interest groups, whose incentives would be better aligned with employment basedgrowth. 7.13 Fourth there is a cririerl need to widen the range of individuals and organizations that have an interest and commitmaat in taking the reforms forward. Whilst acknowledging that political leadership will continue to play a pivotal role in driving the reform process, a process must be initiatedwhich moves the policyprocess from beingdependent on individualleadersto becoming more firmly rootedin democratic institutions. The internationalcommunity can assist Government achieve its accountability objectives by helping to empower and strengthen the capacity of the elements of civil society and the private sector whose interests coincide with a growthand competitiveness agenda. This will facilitatethe establishment of coalitionsthat bring together groups and reformist elements of government around common interests. While the support of parts of Nigeria's elites has so far been sufficient to launch some of the reforms, sustaining change will require broader support. Jobs and improvedpublic services are critical. There is a needto work with a range of stakeholders, goingwell beyondthe state to includealso the more visionary parts of the formal private sector, as well as elements of civil society, especially those with soundly-basedadvocacyprograms. 125 111.Towards an Agenda For Competitivenessand Growth 7.14 The analysis of this report suggests the following broadthrusts of a competitivenessand growthstrategy for Nigeria: Strengthening actions to tackle the immediate or binding constraints to productivity and competitiveness of the economy presented by infrastructure and the business environment, focusing on early wins through successful pilots for competitiveness improvementsinselectedhighpotentialvalue chains andhighgrowthareas; Building the human capital and technologicalbase of the economy over the longer term. Ensuring that the poor can participate more fully in growth by placing urgent emphasis on (i) raisingagriculturalproductivity; (ii)encouragingthe transitionfrom windfall directlyto Nigeriansandparticularlyto poorNigerians . informality to the formal sector; and (iii)finding ways to give back some of oil 7.15 To succeed, this strategy must be underpinnedby further improvements inthe efficiency with whichNigeria's oil resourcesare used. 7.16 This report has discussed and presented policy options to address the infrastructureand business environment constraints to growth. Analysis of human capitaland technology are being handled in other ongoing analytical pieces. A detailed analysis of the agriculture sector and agriculturalproductivity issues was provided in a separate entitled GettingAgriculture Going In Nigeria" World Bank Report No.34618-NG. Annex 1-F provides an extract from this analysis. The issues surrounding efficient use of Nigeria's resources are addressed in the recently completed PEMFAR:NigeriaA FiscalAgenda for Change.Futureanalyticalwork will also need to consider in more detail, the issues of ensuring that growth is more pro-poor including the issues of informality and ensuring that Nigerians can benefit more directly from oil windfalls. The report has also included discussion of the issues of access to long term finance which although not a binding constraint is also important for promoting the longer term investment needed for growth. How trade (both domestic and external) can be used more effectively as a catalyst of Nigeria's growth has also been analyzed. The main policy conclusions from the analysesofthe different chapters is summarizedbelow Closing theInfrastructure Gap 7.17 Nigeria's ongoing infrastructure reforms aim to increase private participation in infrastructure, with government continuing to play an important role as both infrastructure provider and regulator. The thrust of government policies in this area is broadly sound. Inthe energy sector however, there are risks to the government's approachof embarkingon a massive investmentprogram at the same time as the sector is undergoingmajor institutionalchange. This i s of particular concern given that there i s no oversight or coordinatingentity'65. Additional actions that could further enhance the efficiencyof public infrastructureinvestments and provide an appropriate framework-including regulation-for private participation to close the infrastructuregap are summarizedbelow. 165This is discussed in greater detail inthe Nigeria PEMFAR 126 Short-term Medium-Term Long-Term Public Preparesoundmediumterm 1Investin power transmission 1Build infrastructureinvestment Investment infrastructureinvestment and and distributionalongside planning, selection, designand financing strategies expansionof generation oversightcapacity Adopt clear criteriafor prioritizing bReducetechnicaland non- and allocatingpublic resources technicallosses inpower betweendifferent infrastructure sector investment PPI Adopt a standardizedandtransparent 1Implementworkplanon 1Build capacity to implementPPI approachtowards offering outstandingSOE liabilities initiatives government support to PPPs. 1Address regulatoryand Carry out an electricity demandstudy governancerisks to PPI to form basisfor concludingPPAson around issues suchas IPPS. procurement, contract Reviewtariff ratesinthe power sector enforcement, board to ensure sector's financial membershipandpolicy sustainability direction bCarry out economic analysis of federal government funding of railway track rehabilitationandfuture improvementsas part of concessioning Carry out stock taking of SOE liabilities ininfrastructuresector and develop work out plans. Regulation Build capacityo fNERC for 1Secure alongtermfunding Build capacity for infrastructure implementationofthe new tariff order base for NERC regulation bDevelopmarketrules andadditional 1Developand adopttolling investmentsto guide unbundling regulationin preparationfor transmissiondistribution and concessioningtoll bridges and generationof power. roads 1Consolidateall transport regulatory 1Build and publishadatabase functions into asingle Transport of key performanceindicators RegulatoryAgency on each infrastructure concessionto stimulate performanceimprovements Institutional bMergethree ministriesinthe 1Adopt and implement transportsector into one Transport integratedframework for ministry federal and state level planned 1EstablishaPPP Unit within investmentsininfrastructure Government to provideoversightof PPI. Finance bRaise public financingof 1Apply open and competitive infrastructure tender processesfor 1 EstablishRoadFundfrom surcharge infrastructureinvestment on motor fuel supplementedby execution vehicle registrationfees andfines for overloading. 127 Providing the Business Conditionsfor Growth 7.18 The Doing Business surveys have demonstrated that an improvement in the institutions that guide businesses can result in increased growth performance of up to 2.3 percerP. Four aspects of the business environment provide considerable scope for government misuse of its monopoly and discretionary powers, inflicting some of the most severe constraints to business growth inNigeriaI6'. These are taxation, trade facilitation, business registration and licensing and contract enforcement. Butthey are also areas where relatively quick progress can be made which could, with parallel improvements in infrastructure and access to finance impact positively on enterprise performance and lay foundations for higher productivity and rapid growth. Three of these indicators - taxation, licensingkegistration and trade facilitation - also entail some o f the most direct exchange that the different levels of government have with businesses. As such, progress in these areas provides a real opportunity to build confidence in the facilitative role of government for private sector led growth. This could have a major positive impact on enterprise investment and formalization decisions. Excessive regulatory compliance places unnecessary burden on firms and is a major determinant in a firm's decision not to operate in the formal sector. Lowering the transaction cost of transitioning firms from informal can contribute significantly to Nigeria's growth goals. Inaddition, risksfrom macroeconomic instability needto be addressed. 7.19 Additional actions to strengthenthe conditions for business growth at both the micro and the macro level are summarized below: Short-term Medium-Term Long-Term Taxation Adopt and implementTax Increasetax 0Further simplify the tax Policy andAdministration administrationefficiency structureacross different Tax Structure ReformBills at federal andstate levels levelsofgovernment to Tax Administration Raisepublic awarenessof through computerization increasetransparency and Privatesector what taxes are payableand and staffskill eliminate opportunitiesfor awarenessand to whom strengthening arbitraryand predatory empowerment Address adverse effects of Identify specifictax practices "outsourcing" of tax concernsat LGA, State Strengthentax administration collectionto the private andFederallevel and capacityacross different sector work with selectedBMOs levelsof government Instituteprivatesector to develop strategiesto monitoring oftax agency intervene intax policy performancethrough dialogue annualperformance targets Trade Facilitation Simplify trade Introducepre-shipping 0Improve automationofport documentation and inspectionswith random services andupgrade training Port efficiency signaturerequirements or risk-basedsite support to staff PortProcedures andprovidepublic inspection Extendreformof customs CustomsAgency informationon procedures Enforcereductionof services beyondinitially reform agencieswith permanent selectedtargeted locationsto port presence entire country Implementcustoms reforms, including 166"Growth and Regulation" ,S. Djankov, CaroleeMcLeish and RitaRamalho, March 2006 167Inmanyways customsservices at the Lagosport providesthe mostgraphic exampleofhow costs-both in terms of time and money can spiral as a result ofthe poor exerciseby a government agency o f a monopoly role - and a set of discretionary powers The industry case studiesofthe "Nigeria Value and Supply Chain Study"; P. . Yee and M.Paludetto, Consilium International, March 2005 and the Doing Business 2006 assessmentadd further evidenceto the impact of poor government on enterprise sector development. 128 Short-term Medium-Term Long-Term streamliningcustoms proceduresin line with Kyoto Convention Guidelines Could start by privatecontractingof customs servicesin targeted business-intense locationssuchas Tinapa BusinessRegistration 1 Continueregistrationand Reviewand streamline and Licensing licensingcomputerization licensingrequirements improvements for key sectors across the I Streamline Federal three tiers of government Agency involvementin Establishbenchmarksfor registration official licenseprocessing ,withprivatesector oversight of performance Collaborate with BMOs to promote\enhance registration, especially outsidemainurban centres) Contract bExtendfast track courts Review\Revise\Repeal 1 Developaparalegal Enforcement modelbeing implemented key business legislation, profession in Lagos to other states combinewith major 1 Address structuralproblems bScale-up successful pilot public awareness of enforceability ADR programs program 1 Reformcourtjurisdictions Introducenew legislation (e.g. thresholds), civil includingCompetition procedures, practices(e.g. Act (currentlypendingat abuse ofadjournments) the NationalAssembly), anda SecuredLending Act Enhanceefficiency of case management Build capacity ofjudges, registrarsand court clerks to leadreformeffort Macroeconomic 1 PassFiscalResponsibility Continueeffortsto 1Build capacity for public Instability Bill increase exchange rate expenditureand financial 1 Issue guidelinesand flexibility managementat federal and implementationmanuals particularly state levels. effective implementation 1 Institute amore formal mechanismfor managing oil revenuesavings Enhancing Access to Long Term Finance 7.20 The lack of local currency term finance in Nigeria has historically been a bottleneck to growth in the non-oil economy. Limited access to debt finance for investmenthas resulted in a highdegree of self-financing among firms, increasingthe cost of doing business. The recent bank consolidation process has increased potential of the Nigerian banks to provide finance for productive investment. The actions summarized below could help ensure that this potential is fully seized. 129 Short-term Medium-Term Long-Term Banking I Strengthensupervisory capacity mStrengthenrisk managementand Review minimum capital System to implementrisk-based and projectfinancecapacity of requirementsand consolidated supervision commercialbanks geographic limitations I Strengthencreditor rights mEnhancecorporategovernance for microfinancebanks framework andenforcement framework and implementation Restructuredevelopment 1Initiate household survey to mDevelopframework for credit finance institutionsto close accessto Finance informationinfrastructure address specificmarket knowledgegap mStrengthenbank resolution failures andreducefiscal 1Enforcebank governance framework and integrationof burden guidelines CBN andNDIC mImplementNational Payment System Strategy Capital 1Strengthencoordinationof Reduce issuancecosts for Markets capitalmarket development securities marketsandfoster stakeholders anddevelop market awarenessof corporate nationalcapitalmarketsstrategy issuers mIncreasesupply of securitiesto extendthe fixed-income yield curve Infrastructure ~~~~ 1 Review tariff levelsto allow Improveaccess to private Finance cost recoveryin infrastructure finance for infrastructure investmentsandclarify tariff throughGovernment and IFI- regulation supportedrisk mitigation and financinginstruments (possibly consolidated inone InfrastructureFacility) Housing 1 Reformadministrationof mImproveefficiency of land Finance Governor's consentto lower registry and cadastral mapping transaction costs of registering systems mortgagetitles andtransfer of mIntroducetargetedsecondary landtitles mortgage market liquidity instrumentssupportedby FederalMortgageBank and reformofthe National Housing Fund HarnessingDomestic, RegionalandInternational TradeFor Growth 7.21 While the domestic market is relatively large, it is still small compared to even small Europeaneconomies like Belgium. Nigeria cannot rely on the domestic market alone to sustain rapid growth over the long term and will need to access regional and global markets as well. Domestictrade neverthelesscan andneedsto be usedmoreeffectivelythan inthe past to promote firm efficiency and productivity and provide a platform for the emergence of firms able to compete on global markets. Inthe short and medium term, domestic and regional trade can be importantdrivers of growth and help to build internationalcompetitiveness. Actions to improve the functioning of domestic markets will therefore be important. Over the medium and longer termNigeriawill needto increaseher integrationinto globalmarkets. 7.22 The adoption of the ECOWAS CET in October 2005, has substantially improved Nigeria's trade policy. The benefits from this improvementwill be felt over time as government addresses the constraints to competitiveness discussed above. Additional actions that could be put inplaceto maketrade a moreeffectivedriver ofgrowth inNigeriaincludethe following: 130 Short-term Medium-Term Lone-Term Domestic Address propertyright over Simplify licenses andpermits Trade commodity markets requiredto trade andmanufacture Removepolice check points and state taxes alongthe main highwaysofthe country Change tenure of formal wholesale andretail markets from local governmentsto market associations Export Undertake systematicreview Redesignspecial export Providequality of market Promotion of special programto promotionprogramson basisof information to potential enhanceexports. review findings exporters Trade Prepareexplicit schedulefor n Improvequality oftrade Policy phase out of special tariffs statisticsto better inform and importbans by 2007 and policy decisions implementit. n Finance port development from generalgovernment revenuesandsuppressthe port development levy Regional Fully implementECOWAS Integration trade liberalizationscheme as scheduled. Global Assumepro-activerole in Take active positioninDoha Extendbinding coverageand Trade EPA discussions to further roundto reduceexportbarriersin narrowthe binding overhang national interests MIC to augmentpolicy Pressfor more favourable predictability EUmarket access andrules of origin provisionsinEPA negotiations Makeoffer inGATS negotiationsto anchor domestic services sector reforms 131 BACKGROUNDPAPERS Adenikinju A. - Explaining Nigeria's growth Performance(May 2006) Bhaumik S, EstrinS - The PerformanceofNigerianFirms inLagos: a Report (May 2006) Budina N., Pang G. and Van Wijnbergen S. - Nigeria's Growth Record: DutchDisease or Debt Overhang?On the Sustainability and Growth impact of Nigeria's macroeconomic policies (first draft, April 2006) EdozienO.N., Abiola Z.W. -Power Sector Report (May 2006) Malik,A -The Nigerian Manufacturing Sector:Challengesand Constraints(March2006) Ojowu A, Gray J-Agriculture andAgribusiness(draft final report) (April 2006) Olsen, W. - Nigerian Local Content in the petroleum sector: opportunities and strategies (May 2006) Oyelaran-Oyeyinka B., Olokesusi A. and Abiola B. - Technology, Innovation and Skills Impact on Growth and Competitiveness(May 2006) Ogunsanya, A. A. -RoadFreight Transport inNigeria (March 2006) Salami, D. - The Manufacturing Sector in Nigeria's Economy (1990-2005): Characteristicsand Performance(April 2006) Sinah, S. - Nigeria's Domestic Economy: Opportunities for Improving Productivity and Competitiveness(May 2006) SondhiJ. -Review ofthe fiture ofNigeria's railways (March2006) Teryba A. -The Nigerian Service Sector (May 2006) Utomi P., Duncan A. and Williams G. - Strengthening Incentives for Economic Growth: The Political Economy of Reform (first dtaft, 20 April 2006) Tsigas M., Ehui S. - The Role of Agriculture in Nigeria's Economic Growth A General Equilibrium Analysis (Paper inprogress) (16 May2006) WalkenhorstP., Cattaneo 0.- Trade, Diversification and Growth inNigeria (April 2006) Willoughby C -Infrastructure and Economic Growth inNigeria (June 2006) World Bank, RPED-An Assessment ofPrivate Sector inNigeria (2002) World Bank, RPED-Nigeria Private Sector Assessment, TechnicalPapers(2002) 132 REFERENCES Aghion, Ph., Ph. Bacchetta and R. Ranciere (2006), Exchange Rate Volatility and Productivity Growth: the Role of Financial Development", NBERWP 12117 Akinlo, A.E., 2004. "Foreign Direct Investment and Growth in Nigeria: An Empirical Investigation." Journal of Policy Modelling 26(5): 627-39. Anderson, K., W. Martin, and D. van der Mensbrugghe, 2005a. Distortions to World Trade: Impacts on Agricultural Markets and Farm Incomes World Bank Policy Research Paper 3736. World Bank, Washington, DC. Arimah, B.C., 2001. "Nature and Determinants of the Linkages between Informal and Formal Sector Enterprises inNigeria." AJEicanDevelopmentReview 13(1): 114-144. Brenton, P., and H.Imagawa, 2004. "Rules of Origin, Trade and Customs." In De Wulf, L.,and J. Sokol (editors), CustomsModernization Handbook. World Bank, Washington, DC. Brenton, P., and T. Ikezuki, 2004. The Initial and Potential Impact of Preferential Access to the US. Market under the AJEican Growth and Opportunity Act. Policy Research Working Paper No. 3262. World Bank, Washington, DC. Busse, M., and H. GroBmann, 2004. Assessing the Impact of ACP/EU Economic Partnership Agreement on WestAJEican Countries. HWWA Discussion Paper 294. Hamburgisches Welt-Wirtschafts-Archiv,Hamburg. Centre for the Study of African Economies Oxford University. April 2003. Sources of Growth in Nigeria: An Initial Analysis. report Preparedfor DFIDNigeria. Corden, M. and J. P.Neary (1984), "Booming Sector and Deindustrialization in a Small Open Economy", Economic Journal, vo1.92 Federal Office of Statistics, 2005a. TheNigerian Statistical Fact Sheets on Economic and Social Development,Abuja and Lagos. Federal Office of Statistics, 2005b. Draft Poverty Profilefor Nigeria. Abuja and Lagos. GettingAgriculture GoingInNigeria" World Bank ReportNo.34618-NG. Hausmann, R. and R. Rigobon (2002), An Alternative Interpretation o f the Resource Curse: Theory and "Policy Implications", NBER WP 9424. 133 Hausmann, R., and D. Rodrik, 2003. "Economic Development as Self-Discovery." Journal of DevelopmentEconomics 72: pp. 603-633. Hausmann, R., J. Hwang, and D. Rodrik, 2003. "What You Export Matters." Working Paper. JohnF. Kennedy School of Government, Harvard University, CambridgeMass. Hinkle, L.E., and M. Schiff, 2004. "Economic Partnership Agreements Between Sub-Saharan Africa and the EU: A DevelopmentPerspective." WorldEconomy 27(9): 1321-1333. IMF(2005), Nigeria: 2005 Article IV Consultation - Staff report; Staff Supplement; and Public Information Notice on the Executive BoardDiscussion, IMF country report No. 051302. Jayanthakumaran, K., 2003. "Benefit-Cost Appraisals of Export ProcessingZones: A Survey of the Literature." DevelopmentPolicy Review 21: 51-65. Kee, H.L., A. Nicita, and M. Olareagga, 2005. "Estimating Trade Restrictiveness Indices." Working Paper. World Bank, Washington, DC. Klinger, B., and D.Lederman, 2004. Discovery and Development: An Empirical Exploration of `New' Products. World Bank Policy Research Working Paper No. 3450. The World Bank, Washington DC. Lane, Phillip R. and Aaron Tornell, "Power, Growth and the Voracity Effect," Journal of Economic Growth,Vol. 1(2), 1995. Manzano and Rigobon (2001), Resource Curse or Debt Overhang?, NBERWorking Paper 8390. Page, S. and S. Bilal, 2001. Regional Integration in Western Africa. Report prepared for the Ministry of Foreign Affairs, the Netherlands. Overseas DevelopmentInstitute, London. PriceWaterhouseCoopers, 2005. Sustainability Impact Assessment (SIA) of the EU-ACP Economic Partnership Agreements. Report prepared for the European Commission, Neuilly-sur-Seine. Rajhi, T. and J.M. Marchat, 2004. "Estimates of the Impact of a Common External Tariff on the Nigerian Manufacturing Sector: Some Simulation Results based on Firm Level Data." Working Paper. University of Paris-I and World Bank. Paris and WashingtonDC. Rankin N., M. SBderbom and F. Teal, 2004. "Exporting from Manufacturing Firms in Sub- Saharan Africa: Micro Evidence for Macro Outcomes." Working Paper. Centre for the Study ofAfrican Economies, Departmentof Economics, University of Oxford, Oxford. Ruffer,T., 2004. An Assessment of Nigeria's Import Prohibitions Policy. Study preparedfor the UnitedKingdom Department of InternationalDevelopment. Oxford Policy Management, Oxford. Salai-i-Martin X., and Arvind Subramanian 2006. Addressing the Natural Resource Curse: An Illustration fromNigeria. Study ofNigeria's Informal Sector, CBN/FOS/NIESR, 2001. 134 Wijnbergen, S. van, "Inflation, Employment andthe DutchDiseaseinOil Exporting Countries: A Short-Run Disequilibrium Analysis", Quarterly Journal of Economics, May 1984. Wijnbergen, S. van, "The DutchDisease: A DiseaseAfter All?"The Economic Journal, March 1984 Wijnbergen, S. van, "Trade Reform, Aggregate Investment and Capital Flight: on Credibility and the Value of Information", EconomicLetters, 1986. World Bank (2003), Nigeria: Policy Options for Growth and Stability, Report No. 26215-NGA, PREM3 Africa Region, WashingtonDC. World Bank (2004), Nigeria: Petroleum Revenue Management, Poverty Reduction and Economic ManagementSector Unit, Sub-SaharanAfrica region, WashingtonDC. World Bank (2005), Nigeria's Opportunity of A Generation: Meeting the MDGs, Reducing Indebtedness, PREMAnchor Report Prepared for the Africa Region, Washington DC. World Bank (2006), Debt SustainabilityAnalysis inOil-Rich Countries, PRMED Note, WashingtonDC. 135