Welcome to the new normal!
Worldwide, countries have experienced the impact of COVID-19 in varying degrees, politically, economically and socially; thus, the odds of sliding into economic downturn for most developed and developing countries is on the rise.
For an Emerging Market like Nigeria that has barely recovered from the 2016 economic recession, the odds are not just higher, this pandemic may just be the catalyst to propel it into another brutal and painful recession.
Like most oil dependent economies already saddled with dwindling oil revenues as a result of the slowdown in global economic activity, additional debt incurred on COVID-19 relief most probably aggravate Nigeria’s unhealthy debt service to revenue ratios compared with pre-pandemic levels.
Urgent and aggressive policy action is therefore required to be taken at averting the potential debt crisis that may arise as a fallout of Covid-19 pandemic.
The Global Economic Impact
The tumultuous effect of the pandemic in Nigeria is heightened by the country’s over dependence on oil for its export earnings. It is in view of the country’s dependence on oil revenues, that the 2020 budget was prepared on the assumption of a relatively stable market and increased global oil demand, with oil price and oil output benchmarked respectively at $57 per barrel with productions levels set at 2.18 million barrels per day.
The drastic decline in global economic activities due to the pandemic has however led to a steep drop in Nigeria’s crude oil revenues, which accounts for one-third of the public revenue in 2020. With uncertainty in oil prices during the global lockdown and resultant impact of supply and demand shocks on non-oil revenues, the Nigerian Government is now compelled to rely on additional debt to finance its fiscal deficit which was revised to N5.2 trillion in April 2020.
As of March 2020, the Senate put Nigeria’s total debt profile at N33 trillion. Figures emerging from the Debt Management Office (DMO) indicate that as of December 2019, the Federal Government’s domestic debt stood at N14.2 trillion, while external debt was $27,676.14 or circa N10 trillion. The DMO has stated in addition that between January and December 2019, the Federal Government paid N480.4 billion on servicing external debts alone. Given the decline in net private capital flows as a result of the pandemic, the International Monetary Fund (IMF) approved Nigeria’s request for emergency financial assistance in the sum of SDR 2,454.5 million (US$ 3.4 billion, 100 percent of quota) under the Rapid Financing Instrument (RFI) to meet Nigeria’s urgent balance of payment needs. An additional $3.5 billion is also expected from other multilateral lenders.
According to the Medium-Term Expenditure Framework and Fiscal Strategy (MTEF/FSP) report recently released by the Federal Ministry of Finance, Budget and National Planning, Nigeria incurred a total sum of N943.12 billion in debt service in Q1 of 2020 whilst the Federal Government retained revenue was put at N950.56 billion. This implies Nigeria’s debt service to revenue is estimated to be 99% during the period. Whereas, according to the Joint World Bank-IMF Debt Sustainability Framework for Low-Income Countries released in 2020, a country’s debt service to revenue threshold should not exceed 23%. As a consequence, subnationals that rely heavily on the Federal Government’s allocation will likely struggle to cover their overheads and meet their existing debt obligations.
The onset of the COVID 19 pandemic has thus led to a dire review of the country’s revenue expectations and a downward revision of the 2020 fiscal budget. Furthermore, the antecedent effect of the pandemic will include a deficit in fiscal funding, debt sustainability issues, capital flows and revenue pressures.
Government and Corporate Bonds: Debt Sustainability
A Bond is a debt security in which the authorized issuer owes the holders a debt and depending on the terms of the bond, is obliged to pay interest (the coupon) and/or to repay the principal at a later date, termed maturity. A Corporate Bond is a bond issued by a corporation to raise money for capital and operating cash flow purposes. Any bond not issued by a government body is a corporate bond.
These debt instruments are actively used in Nigeria for funding by the federal government, subnationals and corporates to raise capital to finance infrastructure projects and plug fiscal deficits.
Federal Government Bonds are currently the largest component of the Nigerian domestic bond market – representing about 87% of the market whilst Subnational and Corporate Bonds represent about 13% of the market which incidentally accounts for the illiquid Subnational bonds market.
Sovereign and Subnational Bonds
On 30 March, the Debt Management Office of Nigeria (“DMO”) released a press statement to inform the general public that the Federal Government Savings Bond offer for the month of April was suspended.
The DMO further stated that arrangements had been made to ensure that all coupon payments and redemptions of FGN securities are made as and when due to investors designated accounts. Nevertheless, on 7th April, 2020, it was announced that President Buhari had approved the suspension of the payment of interest on debts owed by state governments in order to reduce their debt burden. According to the Minister of Finance, Budget and National Planning, a moratorium would be granted on the Federal Government and CBN-funded loans in order to create fiscal space for the states, given the projected shortfalls in FAAC allocations. According to the DMO, as soon as monthly average FAAC receipts fell below a specific threshold, interest and capital payments by states would be suspended till monthly average FAAC receipts exceeded the threshold.
Notwithstanding the assurances of the federal government, there is the looming apprehension that the economic fallout of the pandemic may very well trigger Subnational and Sovereign Bond defaults in the very near future.
In the case of States and Federal Government agencies, S. 256 of the Investment and Securities Act, 2007 provides that:
“upon a default by a body to meet its obligations under a bond issuance, and after the expiration of six months therefrom, the trustees of the bond shall present the copy of the irrevocable letter of authority/guarantee for repayment issued by the Accountant General of the State/Federal Government to the Accountant General of the Federation to deduct at source from the statutory allocation due to the issuer, for the purpose of redeeming any outstanding obligations.”
Given the uncertainties around revenue generation, a pending fiscal deficit and the country’s inability to fund its monthly allocations to state governments, the likelihood of a default in state and federal government bonds is imminent. The Irrevocable Standing Payment Order issued by the Accountant General of the State/the Federal Government is therefore of no consequence where the revenue generation is insufficient to meet the debt obligations. Nigeria is therefore seeking to raise $6.9 billion in the form of concessional funding through external borrowing from the World Bank, the International Monetary Fund and the African Development Bank in a bid to support the implementation of the 2020 budget. It is important to note that Nigeria’s Eurobonds alone account for $10.86 billion or 39% of external debt as of April 7, 2020
In the absence of a specific legal framework to address a sovereign’s debt default, commercial terms and arrangements are often undertaken with bondholders in order to restructure the debt obligations. The COVID-19 pandemic crisis makes a default on sovereign debt more likely than not and it is on account of this prospect that Nigeria’s finance minister has started talks with multilateral lenders to suspend debt repayments for this year. Where this is unsuccessful and a default is declared by the bondholders, Nigeria may face the same debt crisis experienced by Greece in 2015, when it almost declared bankrupt because it failed to pay the sum of €1.5bn to the International Monetary Fund when it was due. The debacle left Greece on the brink of collapse.
In the event of a default by the Federal Government on its Eurobonds, bondholders will either have to give up future profits or enter into decades-long litigation that is costly and undesirable. The key Bonds terms relating to enforcement and renegotiation matters that will have to be critically examined in order to address the extent by which the Nigerian government can seek a suspension of interest payments and restructure the debt are:-
The Argentine debt crisis of 2011 and its aftermath depicts the major shift in the legal framework of international sovereign debt markets. Prior to the Argentine crisis, defaulting governments were protected by the principle of sovereign immunity and the absence of a supranational legal authority to enforce payment. However, following the default in Argentina, a suit was filed by dozens of hedge funds in New York against the Argentine government. 15 years later, these holdout creditors obtained a favorable court ruling that compelled the government to pay over $10 billion as settlement. In other words, the veil of sovereign immunity has been pierced and cannot be relied upon to prevent enforcement by the courts.
Furthermore, debtors frequently waive sovereign immunity in the commercial documents governing the bonds. Thus, creditors will be able to obtain foreign judgements against them. While this means that creditors can institute a lawsuit, it does not mean that creditors can collect on their debts.
In the event of a default, the creditors can as a group increase their collective welfare by giving the sovereign a partial relief. The contract terms that facilitate the ability of creditors to grant sovereign partial relief in dire times are referred to as Collective Action Clauses (CACs) and classified below. The CACs permit bondholders to modify the terms of the bond through collective action:
- Non-payment modification
This provision governs the modification of non-payment term. i.e terms other than principal, interest, and time of payment. Typically, some fraction of bondholders between 50 and 75 percent can vote to alter the terms and bind all of the bondholders to the revised terms.
- Payment modification.
This clause governs the modification of payment terms but it tends to vary based on whether the bonds are governed by New York or English law. Since the early 2000s, bonds issued under New York law allow that the payment terms can be modified by a vote of 75% of the bonds. In bonds under English law, there is frequently a requirement that there be physical meeting of the holders. Typically, 50% is the quorum for the first meeting and 75% of those holders have to vote for there to be a binding modification of the payment terms.
The typical modification clause operates within a single bond issue. Aggregation provisions operate across all of the sovereign’s bond issuances. The typical aggregation clause requires that a minimum percentage, typically 66.7% of the bonds of a particular issuance agree to a proposed modification of payment terms. The aggregation clause also requires agreement among the bondholders aggregated across all of the issuances of the sovereign (typically, at the 85% level in terms of monetary value of all issuances). If both conditions are met then the restructuring agreement becomes mandatory for all bondholders.
It is also important to note that the concept of “force majeure”, “state of necessity” and “fundamental change of circumstances” are inscribed in the 1969 Vienna Convention on the Law of Treaties as well as in several national legislation, mainly regarding contracts. These legal principles also form part of international common law and are therefore applicable to all debtors and creditors without it being necessary to prove their consent to be bound by them or the illegality of the debt.
The United Nations International Law Commission defines force majeure as follows:
“The impossibility to act legally (…) is the situation that arises when unforeseen circumstances beyond the control of the person or persons concerned absolutely prevent them from respecting their international obligation, by virtue of the principle that one cannot do the impossible.”
The Preparatory Committee of the Conference for Codification (The Hague, 1930) accepts the applicability of the force majeure argument to the debt, because, according to the Committee,
“the State is held responsible if, through a legislative provision […] it suspends or modifies total or partial service [of the debt], unless it is forced to do so by financial necessities”
International jurisprudence explicitly recognizes this argument, which legitimizes a suspension of debt repayment to both private and public creditors such as States, the IMF and the World Bank.
As of December 2019, subnationals owe approximately N4.1trillion and $4.5billion in domestic and external debt respectively. About N109billion of public domestic debt is expected to mature by Q4 2020. Despite expecting marginal economic recovery from the last quarter of 2020, the expected impact of economic shocks is likely to send panic signals to bondholders who apprehend a credit default.
This is due to the fact that the pandemic and subsequent lock down has increased unexpected expenses amidst revenue shortfalls across all states; potentially leading to a fiscal crisis. Payment of salaries and servicing debt obligations as they come due may be impacted.
During the 2015 and 2016 economic recession, there was a similar situation of potential defaults on bank loans by State Governments but the Federal Government launched a debt-restructuring programme for about 23 states through the issuance of N574.78 billion in bonds aimed at reducing their debt service obligations. Also States like Bauchi and Niger opted for restructuring of their bonds at that time.
Unlike municipals in developed markets with robust rainy-day funds, most States in Nigeria have low internal revenue generating capacity and therefore rely on the debt markets to finance projects. This implies that a default will hurt their credit quality perception as well as increase borrowing costs should they consider accessing the debt markets in future. It is worth noting that only a marginal 1.5% of N10.5 trillion assets under management is currently allocated to state government bonds and therefore retirement funds will be impacted to this extent.
Once investors begin to perceive uncertainty in the ability of the states to repay bondholders, there will be more investors scrambling to pull money from the subnational secondary market which is already considered relatively illiquid, and causing spreads to widen. This may further result in an increase in market yields thereby making any delayed attempt at restructuring costlier for the states. Since debt markets are a source of financing projects, planned infrastructure projects in states may experience a slowdown.
In Nigeria, the issuance prospectus in defining default events also often stipulates the remedies and enforcement of remedies. Besides, the engagement of Trustees to the Issue ensures the Attorney General of the Federation deducts from the statutory allocation of the State such amounts as are specified by the Trustees as required to be paid into the Sinking Fund for the purpose of redeeming any outstanding obligations. The Investment and Securities Act, 2007 also permits suits, actions or proceedings as may be expedient. The State Government will also have to file such default with the Securities and Exchange Commission.
However, it should be noted that subnational bond defaults are rare. According to Moody’s in its 2019 report, in the past 48 years, there have been only 113 defaults in the total amount of a little over $72 billion across all sectors in the United States of America. Of this figure, Jefferson County, Alabama and the city of Detroit, Michigan accounted for approximately $11 billion and Puerto Rico some $55.5 billion (combined $66.5 billion) while there are more than 50,000 different state and local governments and other issuing authorities.
To moderate the impact of the crisis and avert credit events, developed markets such as Canada, USA and the United Kingdom, as part of their government stimulus programmes have launched quantitative easing which includes the purchase of municipal and corporate bonds. This has helped to re-stabilize the market and put investors’ minds at ease.
Further, a combination of grants and low interest loans that can be used to refinance private sector debts held by subnationals may also be considered.
Similar to renegotiations exercise in the 2008 economic crisis, it is advisable that subnationals immediately commence plans to restructure existing loans in order to create more fiscal space. Consideration should therefore be made to negotiate debt service moratoriums for subnational issuers on foreign currency loans owed to bilateral and multilateral lenders in order to ease debt service costs and fiscal burden on the states.
Simi Eyisanmi is a Senior Associate in the Finance Practice Group in the law firm of Chris Ogunbanjo LP