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EFFECT OF INTEREST RATE DEREGULATION ON THE NIGERIAN ECONOMY, 1987 -2013
- BACKGROUND TO THE STUDY
The Structural Adjustment Programme (SAP) was implemented in 1986 against the background of the global oil market crashes and the subsequent worsening economic conditions in the country. It is intended to achieve fiscal balance and balance of payments viability by changing and rearranging the production and consumption patterns of the economy, eliminating price distortions, reducing the heavy reliance on crude oil exports and consumer goods imports, enhancing the non-oil export base and achieving justifiable economic growth. Additionally, it is aimed at justifying the role of the public sector while fast-tracking the growth potentials of the private sector. The focal policies of the programme were:
- The deregulation of the external trade and payment arrangements,
- The adoption of a market determined exchange rate for the Naira, and
c.Considerable reduction in complex price and administrative controls and more reliance on
market forces as a major determinant of economic activity (Adebiyi, 2005).
With the switch to indirect instruments came the change of the goal of monetary policy to the reduction of inflation. This change was encouraged by the belief that monetary policy has only temporal effects on real variables and long run effects on prices. Pragmatic evidence over the years has shown that low inflation is a precondition for economic growth. Given the high levels of inflation in the country at the time particularly after the implementation of the reforms policy, there was the need to bring inflation under control before a continued path to growth could be attained. Using the implementation of policy in line with the IMF financial programme framework, control of growth in money supply became a very significant factor in the fight against rampant inflation target were set each year for growth in broad money and inflation rate. The implementation of the policy has involved monitoring the deviation of growth in money from target. Controlling the growth of money supply proved to be a difficult task particularly in the years just after interest rate deregulation (Adebiyi, 2005 & Ojo, 2001).
On July 31 1987 the Central Bank of Nigeria, as part of SAP, announced the deregulation of interest rate. It also abolished (with effect from August 1, 1987) all controls on interest rates, which are now determined by the forces of demand and supply. To prop up interest rates the Central Bank has since then interfered with the rediscount rate and the liquidity ratio, upwards, thus setting the peace for commercial and merchant banks. Banks have over-reacted by pushing up interest rates (especially prime lending rates, now more than 40% in some banks) like they did in the bidding sessions under the Second-Tier-Foreign-Exchange-Market (SFEM). It has been observed that there is a misalignment of the various interest rates, especially the widening gap between deposit and lending rates, hence the belated though ineffective Central Bank directive that the margins be narrowed within stipulated percentages. The swift rise in interest rates has rendered many enterprises insolvent, which is nothing but a rebound on the banks. This has resulted in a dramatic increase in the level of investment, and hence a fall in output level, resulting in inflation (Anyanwu, 1987d). The most seriously hit are the agriculture and small-scale and building construction sectors. They are unable to stand the levels of competition of interest rates because of the long lag time before profits are reaped, and their inability to provide the needed collateral. The result is the softening of small-scale and agricultural enterprises, without encouraging savings. Thus, the Governor of the Central Bank of Nigeria, Ahmed, (1989), acknowledged that, lending rates have been pushed to a height that threatens the life of the non-bank corporate sector and ultimately the financial sector as well. Ironically, the banks have paid relatively low rates on saving deposits, implying that the liquid banks are employing some collective market power to their immediate advantage.
Prior to the deregulation of interest rates in Nigeria in 1987, the financial sector’s operating rates then were said to be repressed. According to Mackinnon (1973) and Shaw (1973), financial repression arises mostly where a country imposes a ceiling on deposit and lending nominal interest rates at a low level relative to inflation. The resulting low or negative interest rates discourage the mobilizing of savings through the financial system. This has a negative impact on the quantity and quality of investment and hence economic growth in view of the empirical link between savings, investment and economic growth. In realization of these, the Nigerian government took bold steps to deregulate interest rates as part of the reform of the entire financial system (Gibson and Tsakalotos,1994), Based on this hypothesis, many governments in the developing nations deregulated their interest rate with some achieving significant spurts in economic growth rates but in some cases the policy was associated with excessively high and unstable real interest rates as well as stagflation (Grabel, 1993). Van Wijinbergen (1983) differentiates his hypothesis to those of Mackinnon, (1973) and Kapur, (1976). He expresses the view that the outcome of Mackinnon-Kapur depends significantly on one implicit assumption on asset market structures, an assumption that is never stated explicitly: that the portfolio shift into bank deposit is coming out of “unproductive” assets like gold, cash or investment. Van Wijinbergen, (1983) further argues that it is not at all obvious that bank deposits are closer substitute to cash or gold rather to loan extended on the informal sector.
The financial sector reforms began with the deregulation of interest rates in August 1987 according Ikhinde, (2001). However, in a 1994, a policy reversal, the Nigerian government, introduced measures of regulation into the interest rates management. It was claimed that there were wide variations and unnecessarily high rates’’ under the total deregulation of interest rates regime. The deposit rates were once again set at 12%-15% per annum while a ceiling of 21% per annum was fixed for the lending rate. By the end of 1994, the weighted average lending and deposit rates were 21% and 13.5% respectively (Source: CBN Annual Financial Bulletin,1996). The lid on interest rate was retained in 1995 with minor modifications to allow for flexibility and the lid was maintained until it was lifted in 1996. This made possible a flexible interest rate regime in which bank lending and deposit rates were largely determined by the forces of demand and supply of funds.
The primary role of interest rates is to help in the mobilization of financial resources and to ensure the efficient utilization of such resources in the promotion of economic growth and development. According to Jhingan (2000), if interest rate is high, investment is at low level and when interest rate falls, investment will rise. There is therefore, a need to promote an interest rate regime that will ensure ‘’inexpensive’’ spending for investment and consequently enhance economic growth at low financial cost. The financial system of most developing countries came under immense stress as a result of economic shocks of the 1980s. Additionally, financial repression largely manifested through indiscriminate distraction of financial prices including interest rates which tended to reduce the real rate of growth and the real size of the financial system. More importantly, financial repression has retarded the development process as envisaged by Shaw (1973). Undoubtedly, government’s past efforts to promote economic development by controlling interest rate and security, inexpensive fund for their own activities have undermined financial development.
1.2 STATEMENTOF THE PROBLEM
The upsurge in real interest rate observed in the early 1980’s raised a widespread concern about its possible detrimental economic effect. Numerous studies were carried out to measure the impact of high interest rates on key economic variables such as savings, growth of output, investment factor productivity and relative factor returns in response to these concerns. An empirical regularity observed in several cross-country studies such as by World Bank (1989) and Galbis in 1992 that countries with high real interest rate generally tend to exhibit faster output growth without correspondingly higher investment. This encourages a more efficient allocation of resources which raises overall productivity such that the net impact on growth becomes positive.Studies like (Kharkate, 1998) have questioned the empirical robustness of these findings. A basic lesson from this literature holds that the impact of higher interest rate on investment and growth mainly depends on what has caused interest rate rise in the first place.
Before 1986 in Nigeria, interest rate was extensively controlled prior to the adoption to SAP. The economic rationale behind this extensive control of interest rate and other elements of financial market have been motivated by a variety of factors including the desire to influence the flow of credit to preferred sectors of the economy and the concern that market determined interest rate could result in a serious imperfection in lending rate that would increase the rate cost of capital and thereby discourage investment.
Moreover, such high normal investment rate would also increase the cost of servicing the public debt. Thus, interest rate policy should be used to increase the availability of credit in order to encourage the accumulation of domestic financial assets by offering holders of these assets sufficiently attractive rates. The deregulation of interest rate during the SAP period seems to be justified by this consideration.
The market determined interest rate is meant to mobilize financial savings and for efficient channeling of such savings into productive investment. This deregulation which result to concurrent increase in interest rate and savings seem to lay credence to Mackinnon and Shaw interest rate, saving and investment hypothesis.
Furthermore, the importance of the financial sector in the economic development of developing countries has attracted a lot of attention in recent years. The adverse effects of interest rate controls, overvalued exchange rate, controlled lending and other controls have led to a large extent of research relating to financial reform. An open and well-deregulated interest rate promotes economic growth and stability. In the current setting with a rapidly globalising economy, efficient interest rate deregulations are essential for productive gains from the world market and to protect the domestic economy against foreign shocks. For most developing economies this became very evident during the oil crises of the 1970s (era of regulation).
In Nigeria, research efforts in the area of interest rate deregulation have been minimal when compared with the efforts into the other components of the programme in the financial sector such as exchange rate and trade liberalization reforms. Even where research is available, usually the emphasis has been placed on the fiscal structures.
Conducting interest rate deregulation policy is a difficult task since it affects most of monetary decisions. Achieving goals require some ability to peep into the future. Consequently, decision makers must take forecasts to assist in policy formulation. To conduct these forecasts, most central banks take a number of variables into account. The exclusive focus on one or a few selected variables, as is done in interest rate programming framework, implies that the policy makers believe these variables must contain enough information about movements in the target variables. An aspect of this thesis attempts to evaluate the information content of interest rate used by the Central Bank of Nigeria (CBN) to target, economy, and other key variables such as savings, foreign direct investment and domestic investment level, which have the potential of being useful indicator for economic growth.
Prior to the deregulation of interest rates in Nigeria, the prevailing rates of interest were regulated by government through the Central Bank of Nigeria-(FGN Financial Bulletin, 1989).
This was meant to guide the economy towards the desired direction. However, the government soon realised that the low rates of interest that prevailed could not be sustained. On the other hand, the very low and sometimes negative real interest rates discouraged savings. Also, the low rates did not only increase the demand for loanable funds but also misdirected credit. Consequently, the demand for credit soon exceeded the supply of funds while essential sectors of the economy were starved of funds. It was against this background that the Nigerian financial system was deregulated in the second half of the 1980s.
A major objective of the deregulation exercise was to increase savings for investment and economic growth. But despite this effort, economic growth is still in depression. The deregulation exercise has been met with mixed feelings in Nigeria. While some believe it would enhance economic performance in Nigeria, others have contrary views. Nwankwo (1989) believes that interest rate deregulation will definitely lead to more efficient allocation of financial market resources. His position is in line with the argument of Mackinnon (1973) and Shaw (1973). Furthermore, Abiodum (1988), posits that deregulation of interest rate is like a double-edged sword, which would either stimulate or stifle the economy. He maintains that deregulation would certainly lead to increases in the interest rate which would lead to increase in savings.
Ojo (1988) and Ani (1988) on the other hand argue that interest rates deregulation would certainly destroy the Nigerian economy. In separate contributions on interest rate and Nigeria’s economic development, they faulted the deregulation exercise positing that it would discourage investment and hence economic growth, by pushing up interest rates. Soyimbo and Olayiwola (2000) and Akpan (2004) support Ojo and Ani’s position pointing out the low positive impact of deposit rate on economic growth after interest rate liberalization in Nigeria. All the foregoing highlights the effectiveness or otherwise of the interest rate deregulation exercise in Nigeria whiles it illustrates a brighter path in the deregulation of the interest rate.
It has now been observed that there is a misalignment of the various interest rates, especially the widening gap between deposit and lending rates, hence the belated though ineffective Central Bank directive that the margins be narrowed within preset percentages. A major fallout of this policy is a dramatic decrease in the level of savings and investment, a fall in output level and a resultant inflationary pressure. The most seriously hit are the agricultural and building construction sectors (small and medium scale firms). They are now incapable of meeting with the rising interest rates regimes because of the long time lag before their investment and earnings. Though the resolve for deregulation was informed by the Keynesian investment theory; which lays emphasis on savings and investment hypothesis, the results do not seem to have favoured the Nigerian economic environment. Contradicting evidences on the impact of interest rate deregulation on economic growth in both developed and developing countries have largely been documented hence the need to study the Nigerian economic space against this backdrop.
There is therefore the need for a comprehensive evaluation of the role of interest rates deregulation and its effect on the Nigerian economy through savings and investment. It is against this backdrop that this research work seeks to evaluate the government’s interest rate deregulation and its effects on the Nigerian economy.
1.3 OBJECTIVES OF THE STUDY
The main objective of this study is to examine the effect of interest rate deregulation on the Nigerian economy. The specific objectives of the study are to:
- Assess the impact of deregulated interest rate on the growth of Nigerian economy
- Investigate the extent to which interest rate deregulation affects investment growthinthe Nigerian economy
- Appraise the impact of interest rate deregulation on investment level in Nigeria
- Evaluate how far interest rate deregulation impacts on foreign direct investment (FDI)
- Examine the extent to which interest rate deregulation affects savings in Nigeria.
1.4 RESEARCH QUESTIONS
The following research questions are formulated for the study:
- How far does deregulated interest rate impact on the growth of Nigerian economy
- To what extent has interest rate deregulation affected investment growth in the Nigerian economy.
- To what extent has interest rate deregulation affected investment level in Nigeria
- How far has interest rate deregulation impacted on foreign direct investment (FDI)
- To what extent has interest rate deregulation affected savings in Nigeria?
1.5 RESEARCH HYPOTHESES
The following hypotheses are formulated in a Null form for the study:
H01 Interest rates deregulation does not have a positive and significant effect on the growth of
H02Interest rate deregulation does not have a positive and significant effect on Investment
growth in Nigerian economy.
H03There is no positive and significant impact of deregulated interest rate andinvestment
level in Nigeria.
H04. Interest rate deregulation does not have a positive and significant effect onForeign Direct
H05. Interest rate deregulation does not have a positive and significant effect onthe savings in
1.6 SCOPE OF THE STUDY
Thescope of the research is on the effect of interest rate deregulation on the Nigerian economy. The study centred extensively on the interest rates deregulation, (represented by the various changes in interest rate regimes over the period under study) and determining factors in Nigeria and their effects over the years. Relevant interest rates deregulation theories ranging from classical to contemporary interest rates theories were reviewed and discussed in detail. Empirical analyses were used to examine the effect of the deregulation policies of the Nigerian government that was adopted as part of economic reforms (exchange rate policy, government economic reforms, real sector reforms and interest rate policy) and how it should be evaluated in relation to the country’s economic growth during the period. The Gross Domestic Topic (GDP) and its index served as a proxy to assess the Nigerian economy.