Africa’s growing subsidy bill

from This Is Africa..

May 23, 2013, By ADAM ROBERT GREEN

With deficits creeping up and import prices high, African governments review growing energy and food subsidies.

Africa’s growing subsidy bill T

African government deficits, while low by historical standards, has been creeping up as aid and remittances dip, and counter-cyclical interventions rack up in response to the effects of the financial crisis. Combined with a rising food and fuel import bill, governments are now looking for savings. Energy and food subsidies are increasingly being reviewed.

“The need to cut fiscal deficits is often the trigger for subsidy reform,” says Shanta Devarajan, chief economist for Africa at the World Bank. “Ghana, for instance, has a deficit of about 12 percent of GDP, and subsidy reform is high on the agenda. Even without high deficits, the size of the expenditures on subsidies can prompt calls for reform. In Nigeria, it was shown that the expenditure on subsidies exceeded debt service payments before debt relief.”

Of all the subsidies in play in Africa, food and fuel are attracting the most attention. Fuel costs for most countries are only going to increase over time, given the world’s continuing reliance on non-renewable fuel resources and Africa’s lack of capacity to deliver finished fuel products. Politicians have not failed to notice the growing challenge. But the effects of subsidy removal on all segments of society mean few have the stomach to tackle the issue head on.

Power out(r)age

Fuel prices are on a long-run upwards trend. Between the end of 2003 and mid-2008, nominal international fuel prices increased more than fourfold, with most of the increase occurring during 2007 and the first half of 2008. Prices remained high through the recession due to geopolitical shocks in North Africa and the Middle East.

African governments with high fuel subsidy outlays have been slow to act, creating fiscal burdens. Egypt’s government is in a drawn-out dispute with the International Monetary Fund over a fuel subsidy scheme estimated to have cost as much as $4.7bn over the first three months of this year.

Egypt’s subsidy system started in 2001, when the country moved from being a net exporter of energy to a net importer. After 2001, energy consumption started to rise in accordance with growth and population expansion. “Prior to 2001, all inefficiencies were masked because you can mask inefficiencies when you are an exporter,” says Ahmed Heikal, CEO of Citadel Capital. Nigeria’s energy subsidies, meanwhile, have grown at a frightening pace.

Governments’ reluctance to cut subsidies is understandable. Populations are directly affected by subsidy withdrawal through higher prices for fuels consumed for cooking, heating, lighting and private transport. The indirect impact hits the poorest, through higher prices for all goods and services for which higher input costs are passed on. IMF estimates suggest that a $0.25 per litre increase in fuel prices equates to a 5.9 percent decline in household real incomes – hardly a popular move, whatever the long-term economic merits might be.

But energy subsidies can be regressive, with more than 80 percent of the total benefits accruing to the richest 40 percent of households, according to one global analysis by the IMF. “Fuel subsidies are a costly approach to protecting the poor due to substantial benefit leakage to higher income groups,” the IMF report argues. “In absolute terms, the top income quintile captures six times more in subsidies than the bottom.”

They can generate perverse incentives too. “Smuggling of subsidised fuel from Nigeria to Benin and Togo is big business,” says Patrick Raleigh, Africa analyst at Standard & Poor’s, who also cites anecdotal evidence of subsidised fuel from Mozambique ending up in South African SUVs – representing a loss both to the Mozambican government as well as the South African revenue service.

The opportunity cost is a vital consideration, as evidenced by Senegal. Subsidies for electricity consumption, as measured by the annual budgetary transfer to the power utility Société National d’Éléctricité du Sénégal to compensate for the tariff gap, amounted to about 1.4 percent of GDP last year. This means SENELEC now soaks up more funds than are allocated for new capital expenditure on health or education. And even with this expensive scheme in place, power is expensive and unreliable due to the dearth in private investment – itself a response to the flaws in the subsidy payment framework. A restructuring of SENELEC is imminent, and would allow the government to widen its currently limited safety net programme.

Nigeria’s fuel subsidy, meanwhile, has mushroomed of late. But reforms last year – which led to the highest price jump in fuel in the country’s history, rising from $0.42 to $0.89 – led to eight days of nationwide strikes supported by a range of groups, including the Nigerian Labour Congress and the Trade Union Congress. In the end, the government reduced the subsidy increase to $0.63. Many of the gains from the initial subsidy were lost through the economic shutdown resulting from the strikes, and corruption in the subsidy reform procedure. A bigger public policy flop is hard to imagine. Little more will happen now, as Nigeria re-enters election season in mid-2014.

Other African countries have fared better, drawing down subsidy schemes while implementing compensation mechanisms. “The main way is by accompanying the reform with some form of targeted transfer to poor people,” says Mr Devarajan. He acknowledges that most of the subsidies accrue to the non-poor. “Yet, an increase in fuel prices will affect the poor. So cash transfers that enable the poor to pay for the higher cost fuel can cushion the shock.”

Communication is also key, says Mr Raleigh at S&P, but it is easier said than done. “It may not be as simple as saying ‘On X date we are going to raise prices, everyone get ready’. That can lead to panic buying, or hoarding by merchants. It is not an easy process,” he observes.

Ghana has pursued a more successful approach than its neighbour. In 2004, policymakers saw that fuel prices were on an upward trend. Realising the subsidy scheme was unsustainable, the government announced plans to raise fuel prices by 50 percent. But crucially, the raise was pursued in parallel with a targeted anti-poverty programme, including the elimination of primary and junior-secondary school fees, extra funds for primary health programmes, rural electrification and urban transport. There was still resistance – notably from trade unions – but a thorough debate led to a smoother reform process overall.

Similarly, Gabon raised petrol and diesel prices by 26 percent in March 2007. A cash payment scheme to the poor was resumed, and assistance to single mothers was increased, as was a microcredit program targeting disadvantaged women in rural areas. School enrollment fees were waived for public schools and investment in rural health, electricity and water supply were accelerated. The public transport network in Libreville was modestly expanded.

Finally, Guinea reduced its budget deficit from 14.3 percent in 2010 to 3.9 percent in 2011, in part due to a lowering of fuel subsidies. Yet social spending has been able to rise in step, including free malaria net distribution to vulnerable populations, immunisation campaigns and lowered healthcare costs. These cases show that subsidy reform can be pursued in a manner which protects the most vulnerable.

Food fight

Agricultural input subsidies are a second controversial outlay, in vogue in the likes of Malawi, Zambia, Ghana and Tanzania. While input subsidy systems were dismantled during the era of structural adjustment beginning in the 1980s, they returned in the late 1990s as countries tried to deal with plunging agricultural productivity. The Malawian government pioneered a return to large scale subsidies in 1998 when it began distributing free fertiliser to farmers, followed by Nigeria, Zambia, Tanzania, Kenya and Ghana.

The new paradigm emphasised ‘smart’ as opposed to universal subsidies – new programmes targeted farmers who did not apply inputs previously (thus reducing the risk of displacing non-subsidised input sales), were often market-friendly (based on vouchers rather than direct interventions), and – in the likes of Ghana and Tanzania – included an exit strategy (this was not the case in Malawi or Zambia).

Malawi proved the pace-setter in 2005, when – following a poor harvest – it launched a massive, state-managed maize input subsidy programme based on a voucher system. Maize production rose steeply. Official estimates suggest that national maize harvests increased by around 1m tonnes in 2005/6, rising to more than 2m tonnes in the 2008/9 season (increases of around 54 percent and 114 percent respectively) compared to the 2002/3 and 2003/4 seasons. Others in the region looked to copy the country’s success.

“There is no doubt [subsidies] have helped production – there is a clear increase in yield and this is associated with the increase in input,” says George Rapsomanikis, senior economist at the Food and Agriculture Organisation. These subsidies have not hindered the development of the private sector in the way some economists feared. “They are based on the distribution of vouchers, so farmers can take vouchers and buy their own fertiliser.”

But there are growing doubts over sustainability. Malawi’s subsidy cost 2.1 percent of GDP in 2005 rising to 6.6 percent in 2008/9, with budget overruns growing from 42 percent to 105 percent over the same period. The overall economic environment is deteriorating. Foreign exchange reserves are low, and the fiscal balance has been worsening for some time. Because Malawi is not exporting significantly, thus not replenishing its foreign reserves, this scheme is now more akin to a consumption rather than a production subsidy. Crucially, funding comes straight from the Malawian government’s budget since donors only cover 5 percent of total programme costs.

Beyond sustainability, input schemes –even ‘smart’ ones – often lack focus. “They don’t have a clear objective. If you go to the documents of Malawi’s government, and other countries in the area, the objectives are multiple: increased application of fertilisers, enhanced food security, strengthening supply chains,” says Mr Rapsomanikis.

Whether subsidies are the right way to go depends in part on the problem one is trying to solve, he says. “If the problem is technology adoption, you don’t subsidise inputs but you try to enhance knowledge of farmers. For one or two years you can deliver starter packs to farmers together with advice and extension and this solves technology adoption. If the problem is cash constraints, again you are probably not solving it with input subsidies. The problem is solved by providing credit, by helping credit markets to develop. Instead of having a surgical focus on solving problems, you get these market-smart input subsidy programmes that are very expensive.”

As with energy, agriculture subsidies risk being regressive. In 2011, Zambia’s government pursued a subsidy programme – subsidising the price of maize sold by the Food Reserve Agency (FRA) to maize millers. The government hoped that by receiving maize at subsidised prices, millers would pass along the discount to Zambian consumers in the form of lower retail maize meal prices.

The Zambian subsidy increased maize production by 146,000 tonnes in 2007/8, corresponding to an 89 percent growth in output. But very little of the costs incurred in providing maize below market prices actually benefited urban consumers. Instead, it boosted the profit margins of the selected millers.

As with Malawi, the costs of the programme were exorbitant. This could perhaps be justified if there were equity effects, but none are apparent. Most small-scale and informal sector maize millers had no access to the subsidy, and were pushed out of business. This undermined the diversity and competitiveness of the Zambian maize sector by benefiting only the well-connected millers who were able to entrench their market share, while pocketing the subsidy.

Subsidised fertiliser has also tended to benefit wealthier, better-connected farmers who could already afford inputs. The World Bank has called for a change of focus in government agricultural development programmes towards investment in appropriate technologies, such as legume rotations or conservation tillage, and labour-saving methods.

Arguments in favour of particular subsidies are easy enough to make. But policymakers must also look at the ways they shape incentives. In Malawi, for instance, there is a risk that farmers focus on maize at the expense of cassava, which may have food security implications given that cassava is a more drought-resistant crop.

The opportunity costs also matters: what investments are governments not able to make because funds are tied up supporting subsidy programmes? “This money could be utilised to build roads and feeder roads and connect small farmers to market with long-term benefits both for food security and development,” says Mr Rapsomanikis. “We have this narrow focus that is not helpful for agricultural development.”

Link to the article: http://www.thisisafricaonline.com/News/Africa-s-growing-subsidy-bill?ct=true

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