Nigeria's Bond-less States
On the 14th of August 2017, Lagos State issued the third tranche of its ₦500 billion debt programme, fetching an impressive ₦85 billion from investors to fund infrastructure projects.
The state’s ability to raise large sums from the capital markets is a privilege it has earned via its status as Nigeria’s number one revenue generating state. While Lagos’ internally generated revenues (IGR) cover 55% of its 2017 Budget, Rivers State, the number two revenue generating state, would be able to fund less than 20% of its 2017 Budget with 2015 IGR, according to the most recently available data.
Historically, states have struggled with IGR, leaving them reliant on federal transfers, but also constraining their ability to borrow. Today, state borrowing could prove a useful complement to efforts to boost IGR.
The FAAC problem
In an ideal world, other states would be able to boast the same level of internal revenue as Lagos. In reality, most states receive more in Federal allocations than they generate by themselves. This centre-dependency is often cited as a reason for weak state revenues and poor fiscal discipline in Nigeria.
Perhaps, like in privatisation, the invisible hand of the market can promote efficiency where our federal structure has failed. Tapping into the market, by issuing bonds, could provide the funding states need to undergo future revenue generating projects, and subsequently become self-sufficient.
Who Bonds help?
Bonds are a debt instrument with an agreed level of interest (coupon rate) and repayment date. They differ from standard loans in that they can be traded freely between investors after they have been issued. State Bonds are often tied to specific revenue streams such as tax receipts from the increased water supply in India. These bonds are attractive to investors as they typically provide steady streams of income and some level of tax exemption. But while Federal Government bonds have grown in appeal over the years, Sub-National bonds are yet to take off in the country, totalling less than 1% of the country’s GDP, compared to 20% in the United States.
To see just how effective market support can be, take the recent uproar over the cities excluded in the Ministry of Transportation’s rail expansion plans. The exclusion would have been less significant if the likes of Rivers and Enugu could implement large-scale transport projects funded with state bonds. The interest payments on the bond could be covered by the revenue generated from the train stations, which could be demarcated from other state income to reduce the perceived risk of default for the bonds. Lower default risk means lower interest rates and a lower cost of borrowing for states. State bonds also enable investors to pick out particular states they want to back directly, as opposed to buying Federal bonds where their investment could be used to support underperforming states.
Encouraging states to source for finance in the domestic debt market would also ensure greater transparency than with standard loans or federal allocations. Bond-holders would scrutinise and appraise the performance of each state and project, ultimately relaying their thoughts through the ratings and pricing of the bond. Conscious of this, state governors would work harder to ensure funds are used judiciously, especially when the state intends to revisit the market – as was the case with recent Lagos State issues. They would find that, unlike federal handouts, the bond market can be very unforgiving.
All in all, through state bonds, rail infrastructure can be financed, built, and monitored effectively, all the while keeping the state on a path of fiscal responsibility.
Revenue vs Debt
In reality, debt financing is not that rosy, and Etisalat’s default is the most recent example of “debt-gone-wrong” in Nigeria. Yet, late last year, the Minister of Finance relaxed the regulations around state bond-raising; the requirement that states’ borrowing cannot surpass 50% of their 12-month revenue was scrapped, and instead, they must simply ensure that IGR is not “less than 60% of consolidated revenues for three years.”
While the old restrictions would have prevented the likes of Kano State from raising bonds, the new rules give them more freedom. So, why don’t they?
Ironically, permitting states to borrow more is like giving them a torchlight without batteries. As most – if not all – state bonds are illiquid, they are much less appealing to prospective investors as they may be forced to hold the bond to maturity or take a sizable haircut on their investment. Pension Fund Administrators (PFAs), the largest investor group in the market, could provide this liquidity but, as it stands, there are restrictions to what they can invest in. Today, PFAs are unlikely to be able to invest in many state bonds outside of Lagos.
So, are the PFAs unpatriotic or just rational investors? Looking at the historically poor revenue generation of our states would suggest the latter. And because states struggle with IGR, their bonds are priced at a sizable risk premium to Federal Government bonds, making them more expensive. Some respite could be achieved if states are able to isolate bond-financed projects from their wider spending portfolio if only to foster confidence and encourage investors to judge those bonds on their individual revenue merits, and not just of the state. The recent Federal Government Sukuk shows that this can be done in Nigeria. Similarly, the perception of fiscal indiscipline can be overcome by reducing the flexibility states have on the revenue generated from bond-financed projects. In theory, this should be happening right now as any state with an Irrevocable Standing Payment Order (ISPO) has the funds deducted as a first-line charge on their federal allocations.
With many states still struggling under their current debt servicing burdens, this proposal of bond financing for state projects cannot work for all. Nonetheless, reducing Federal allocation dependency requires investing in the right revenue-generating projects. If states can shake hands with the bond market – rather than stretch their hands to the Federal Government – perhaps they will finally be able to exit the negative spiral of debt and revenue.
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