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VELOCITY OF MONEY AND FINANCIAL DEVELOPMENT IN NIGERIA
1.1 Background to the Study
The income velocity of money plays an important role in both economic stabilization and development programmes. According to Akinlo (2012), the study of the behavior of the velocity of money has intrigued many researchers. The study contended that the increasing research works on the behavior of money velocity is as a result of its importance in setting credible monetary policy programmes. The volume of money supply and its speed of circulation link money to the economic activity in a country. Therefore, the velocity of money is very crucial in the design and implementation of monetary policy. Indeed, the numerical value of money and its determining factors play a major role in ensuring the effectiveness of monetary policy for purpose of ensuring price stability and rapid economic growth in any country.
In a similar vein, Gill (2010) noted that the total money supply in an economy is determined by the quantity of money and the rate of circulation of money, i.e. the velocity of money (VM). It is the contention of the study that to determine the optimal amount of money in an economy, the numerical value of VM and its determining factors is as vital as the total quantity of money. For the setting of credible monetary policy programs, understanding the behavior of VM and its determining factors is very crucial to developing countries such as Nigeria where yearly economic growth fluctuates frequently. For the conduct of efficient monetary policy, a reliable estimate of VM and its forecast is very crucial. If VM is not predictable, the demand for money is also unstable and that makes the standard relationship between GDP, inflation, and money supply uncertain and the result is weak monetary policy. The critical concern of the monetary authority is to ensure adequate supply of money to spur economic growth without causing inflation. This goal cannot be achieved if VM is not stable.
Traditionally, the velocity of money (VM), is the average frequency which a unit of money is spent on new goods and services produced domestically in a specific period of time. Velocity has to do with the amount of economic activity associated with a given money supply. When the period is understood, the velocity may be presented as a pure number otherwise it should be given as a pure number per time. Here, the relationship between money, output and prices is the cynosure of monetary theory and policy alike. Analytically, what lies at the heart of this relationship is the velocity of money, that is, the ratio of nominal income to the stock of money (Jadhav, 1994). The monetary authorities in the developed and developing countries strive to control money supply not for its own sake, but for regulating the flow of spending in the economy with a view of containing inflationary pressures. However, the flow of spending depends not only on money supply but also its turnover, or the velocity of money, which is not under the direct control of the monetary authorities.
On the other hand, financial development has attracted the interest and attention of economists and financial experts over the years. According to Adekunle, Salami and Adedipe (2013), the financial sector of any economy in the world plays a vital role in the development and growth of the economy. The development of this sector determines how it will be able to effectively and efficiently discharge its major role of mobilizing fund from the surplus sector to the deficit sector of the economy. The study noted that a well developed financial system performs several critical functions to enhance the efficiency of intermediation by reducing information, transaction and monitoring costs. If a financial system is well developed, it will enhance investment by identifying and funding good business opportunities, mobilizes savings, enables the trading, hedging and diversification of risk and facilitates the exchange of goods and services.
The link between financial development and velocity of money has been stressed by many researchers. As Short (1973) cited in Hassan, Khan and Haque (1993) noted, the behavior of the velocity is an important determinant of how much financial resources an economy can generate through the operations of its financial system without eroding it through higher inflation. According to Judd and Scadding (1982) as cited in Akinlo (2012), in the mid-80s several developing countries embarked on far reaching financial reforms. The basic objectives of these reforms are to enhance the efficiency of the financial sector and promote the development of the economy as a whole. The study concluded that the introduction of the financial reforms and innovation would have implications for stability or instability of the money demand and therefore the velocity of money function. Financial reforms could alter or cause shifts in money velocity; and in particular, where the velocity is variable, the relationship between money and income becomes uncertain and less predictable. The variability in velocity breaks the rigid link between money and income, since changes in money supply, however induced, may result in pushing velocity up or down rather than produce the desired effects on spending and income (Akinlo, 2012).
Prior to 1986, government had sufficient financial resources to finance a reasonable proportion of each development plan. The implication of this stranglehold on the economy became glaring by the middle of the 1990s as the country grappled with an excruciating external debt burden and other economic problems such as falling terms of trade in the international market place, decline in growth of output, high rate unemployment etc. For the financial system, Nigeria operated a highly regulated and under-developed financial system prior to the introduction of the structural adjustment programme (SAP) in the mid-eighties. For example, in the early seventies, as a result of the prevailing economic paradigm at that time, the sector was highly regulated with government holding controlling shares in most of the banks, Odeniran and Udeaja (2010). The paper maintained that in 1986, the liberalization of the banking industry was a major component of SAP put in place to drive the economy from austerity to prosperity.
In another vein, according to Adegbite (2005), the result of all the economic woes occasioned by pre-SAP economic policies was a shift in the economic development paradigm from government-led to private sector-led development. In line with this paradigm shift, according to Adegbite, was the need to relieve every sector of all strangulating regulations that had hitherto characterized it. Consequently, by 1986 a programme was fashioned out for the nation called the Structural Adjustment Programme (SAP). The SAP attempted to move the country away from government direct-control of economic activities to indirect control, (i.e. control of economic activities-through the market forces).
With the introduction of SAP, the impediments on the financial sector operations were reduced thus enhancing major financial reforms. According to Nnanna et al. as cited in Iganiga (2010), the major financial sector policies implemented were the establishment of the Nigerian Deposit Insurance Corporation (NDIC) in June 15 1988 by decree NO 22 OF 1988 with outlined procedure on the provision of deposit insurance and related services to banks. Its main importance was brought to focus in 1994 and 2006 when most of Nigerian banks and other financial institutions were submerged in distress and banks consolidation exercise of 2004 and 2005 respectively. In June 1989, privatization which is a tenant of the program was enacted to improve management, efficiency and performance of affected enterprises; reduce government debt, increase funds for infrastructure, enhance economic growth and development and instil market discipline. It was expected that this method will enhance capital market development by increasing the quality and quantity of financial instruments traded in the country. In the same year, Bureau De Change was licensed to enhance access to foreign exchange rate to small users and to enlarge the foreign exchange market in Nigeria.
In 1987, the financial liberalization policy was introduced as part of economic blueprint under SAP. The key reforms that were implemented as part of the policy include; liberalization of interest rate, changing the concept of a credit ceiling with open market operation (OMO), decontrolling exchange rates, developing the capital market, promoting competition and efficiency by liberalizing bank licensing/entry barriers which increased the number of banks from 34 in 1987 to 90 in 2003 and decreased to 20 in 2012. Other measures implemented included, strengthen the regulatory and supervisory institutions, upward review of capital adequacy standard and the introduction of direct monetary policy instruments.
Under the financial sector liberalization, certain measures were taken which involved interest rate deregulation, the introduction of an auction market for treasury bills, the identification of insolvent banks for restructuring, the introduction of more stringent prudential guidelines for banks, increases in banks’ minimum capital requirement, and the upgrading and standardization of accounting procedures. (Bakare 2011). In all these measures, the study maintained that interest rate deregulation was the first step. Thereafter the policy makers embarked on further financial liberalization measures. The legal reserve requirements were relaxed, credit controls were removed, and the capital account was liberalized. The financial sector liberalization i.e. the removal of restrictions on international financial transactions, was expected to boost the non-oil export and attract foreign investment while the relaxation of constraints and granting of licensing to new banks were to increase competition; interest rate liberalization and the abolition of credit rationing should provide incentive for economic agents to increase their rate of savings, investment and output growth. Financial liberalization, was also expected to directly generate international competition for funds, foster specialization and thereby drives capital towards the most productive projects. Indirectly, it should foster financial development which in turn could positively affect productivity.
As a result of the key role played by interest rate in stimulating the economy, the monetary authorities, even after the deregulation, keep fine-tuning the interest rate. In a bid to ensure a reduced interest rate, Kolawole (2012) argued that the CBN guaranteed inter-bank transactions as part of its quantitative easing policy. This has contributed to a downward slide in interest rates. For example, the weighted average inter-bank call rate, which stood at 2.89 per cent at the end of 2009, declined to 1.50 per cent at the end of 2010, compared with the monetary policy rate (MPR) of 6.00 per cent. The low and declining inter-bank rate was evidence of surplus of funds in the banking system. The paper contended that notwithstanding the declining inter-bank rates, the interest-rate structure of commercial banks showed high lending rates. The average lending rate increased slightly to 23.3 per cent at the end of 2010 from 23.1 per cent at the end of 2009. In addition, deposit rates declined from an average 6.13 per cent in 2009 to an average 5.53 per cent in 2010. Thus, the spread between the average lending rate and the average deposit rate widened in 2010 reflecting inefficiencies in cost management, and unrealistic profit expectations and targets in commercial banks. The most popular instruments of monetary policy were the setting of targets for aggregate credit to the domestic economy and the prescription of low interest rates. With these instruments, the CBN hoped to direct the flow of loanable funds with a view to promoting rapid development through the provision of finance to preferred sectors of the economy (agriculture, manufacturing and residential housing) (Onafowora and Owoye,2007).
In furtherance of the government’s efforts at improving the financial system, Odeniran and Udeaja (2010) contended that in 2004, the consolidation exercise in the banking industry took a leading role in the National Economic Empowerment and Development Strategy (NEEDS), which was in place at that time to drive the economic agenda of the government. In 2009, as part of the broad economic measures to respond to the adverse effects of the global financial and economic crises, the Central Bank of Nigeria in conjunction with the fiscal authorities engineered measures to avert a collapse of the financial system with a view to maintaining economic growth.
Despite all these financial reform measures, statistics on financial development in Nigeria do not paint an encouraging picture. The stylized facts on the comparison between the two main financial development indicators and economic growth as shown below reveal that financial development in Nigeria has not influenced GDP much. From figures 1.1,1.2 and1.3 below, it can be seen that while the ratio of broad money supply to GDP (M2/GDP) and credit to private sector as a ratio of GDP experienced increases (though in a fluctuating manner) from 1985 up till 2005, the GDP was almost flat within the same period. This shows that financial development may not have influenced economic growth within these periods.
Fig 1.1: Graph of GDP
Source: Compiled by the Researcher with Data from the CBN Bulletin (2013)
Fig 1.2: Ratio of Broad Money Supply to GDP (M2GDP)
Source: Compiled by the Researcher with Data from the CBN Bulletin (2013)
Fig 1.3: Ratio of Credit to Private Sector to GDP
Source: Compiled by the Researcher with Data from the CBN Bulletin (2013)
1.3 Statement of the Problem
Central banks of countries try to use monetary policies as tools to maintain relative price stability, maximum output and a healthy balance of payment position. The major tools used are the interest rates, special deposits, administered exchange rate, credit control and ceiling. However, using these tools to achieve the stated objectives is not feasible in most developing countries such as Nigeria due to the under developed nature of the financial system, inadequate supply of relevant debt instruments and deliberate restraint on interest rate. As a result, the economy of Nigeria still experiences high level of unemployment, inflation, instability in price level and high poverty level. One of the key reasons why the financial sector has not effectively transmitted to the real sector of the economy is the inability of the central bank indicators to reliably predict economic activities in the transmission mechanism. The transmission mechanism is portfolio adjustment which occurs when asset demand and supply differ.
A poorly specified money demand function and income velocity of money could yield spurious inference on the underlying stability of money demand and income velocity of money and needs a considerate attention in the formulation of monetary policy (Mehra, 1991). According to Anyanwu (1994), income velocity of money function is one of the economic indicators which is relied on for monetary policy. The designed implementations have been varying considerably in recent times which make the prediction of its behavior difficult. This implies that velocity function as earlier defined cannot be stable enough for one to reliably make quantitative predictions about monetary adjustments with acceptable accuracy. This means that deliberate policy intervention would have random and unpredictable effect.
It is among this reasons that led to the introduction of SAP during the eighties. The effects of these reforms are evidenced in the rapid growth of financial variables such as savings, deposits, lending, borrowing and money supply. The interest rate and other key rates experienced upward movement following the financial sector reforms in the 80s. Essentially, with the growth in financial transactions, advancement in loans distribution techniques, financial innovation and services automation among others, the velocity of money would have undergone significant changes (Akinlo, 2012). The velocity of money has been fluctuating in Nigeria. For instance, it was 5.4 in 1970, 2.5 in 1986, 4.6 in 2006, 2.6 in 2009 and 3.0 in 2011 respectively. This fluctuations in the VM poses big challenge to CBN in its monetary aggregate targeting in particular and monetary policy formulation in general. Again, it can be seen that the velocity of money in 1986 (2.3) and 2009 (2.6) was remarkable. These figures shows that there was structural change during the two periods. During the SAP in 1986 and the “bailing out” of commercial banks in 2009, lots of money was injected into the economy. This led to a decreased velocity of money and after then increased to 4.6 and 3.0 in 1989 and 20011, respectively.
In addition to this, according to Okafor, Shitile, Osude, Ihediwa, Owolabi, Shomand, Agbadaola (2013) issues such as financial innovations, deepening of the financial sector, monetization policy, growth of GDP, among others, have contributed to the fluctuating behavior of velocity. Moreover, the reforms in the sector would have led to significant psychological, social and institutional changes in the lending-borrowing behaviors of individuals and businesses in the economy thereby making the assumption of constant velocity of money rather unrealistic. All these changes in the financial variables have equally led to changes in the velocity of money over the years as the figure below depicts.
Fig 1. 4
Plots of income velocity of narrow money (MV1) and velocity of broad money (MV2)
Source: Adapted from Akinlo (2012)
From the above figure, money velocity M1 to GDP and M2 to GDP experienced a sharp increase up to the middle of 80s, precisely during pre-SAP era. However, during post-SAP era, that is, from 1987 until 2010 they were relatively flat or constant. These variations call for deep investigation to identify the actual factors responsible for them. This study becomes necessary because velocity of money has implications for monetary policy particularly for central banks that use the monetary targeting framework. An unstable velocity makes the forecast of optimal monetary aggregates difficult; thereby affecting the basis of monetary policy decisions. Given the importance of money velocity in the setting up of credible monetary policy and the fact that several factors may have caused its fluctuations over the years, we have deemed it necessary to look at its relationship with financial development and other relevant control variables.
On the strength of this therefore, we seek to investigate this relationship during pre-liberalization period and post-liberalization period in order to inform a better understanding of how the reforms have impacted on velocity of money supply in relation to financial development as this forms our major departure from previous studies. Also, in line with this, the complexity of the link between financial development and velocity of money supply means that it is needful to conduct a study to investigate the causal relationship between the two for better policy formulation. A wrong inference could be made if there is no proper knowledge of the causal relationship between financial development and velocity of money supply. This lack of knowledge could also lead to an improper specification of the velocity of money function. On the basis of these, this paper takes up the challenge of finding how the financial sector development has affected the behavior of velocity of money in Nigeria over the years. Consequently, the study tends to address the following research questions.
1.4 Research Questions
- What is the impact of financial development on velocity of money supply in Nigeria?
- What is the differential impact of velocity of money on financial development in Nigeria during the pre and post-liberalization regimes?
- What is the direction of causality between velocity of money and financial development in Nigeria?
- Objective of the Study
The broad objective of this study is to investigate the relationship between financial development and velocity of money in Nigeria. However, the specific objectives are:
(i) To determine the impact of financial development on the velocity of money supply in Nigeria.
- (ii) To determine the differential impact of velocity of money on financial development in Nigeria during the pre and post-liberalization regimes.
- (iii) To establish the causal relationship between velocity of money and financial development in Nigeria.
- Research Hypotheses
With regard to the stated objectives, the hypotheses below will guide our study:
Ho1: Financial sector development has no significant impact on the velocity of money supply in Nigeria.
Ho2: There is no differential impact of velocity of money on financial development in Nigeria during the pre and post-liberalization regimes?
Ho3: Financial sector development does not Granger cause velocity of money in Nigeria.
- Significance of the Study
The most important challenge faced by the Nigerian economy today has been the provision and monitoring of capital for actors in the real sector, so as to reduce the growing level of unemployment and poverty. The leading role is velocity, which promotes economic growth and development through the real sector of the economy. The role of velocity of money in this regard will be appreciated by providing evidence of its interaction with financial development. In this study, effort is made to provide a good specification of the relationship between velocity of money and financial development and also to include relevant variables that affect velocity of money. On the basis of this, the study would be of immense benefit to policy makers in comprehending the impact of financial sector development on the velocity of money. It will also assist in the provision of a framework upon which further research in the financial sector can be carried out. In addition to this, the study would provide reliable information for CBN in the exercise of her monetary policy restraint without causing economic crisis in the course of designing and implementing monetary policy. It would also facilitate the functioning of efficient transmission of resources among competing needs.
- Scope of the Study
This work is a country-specific study concentrating on the impact of financial sector development on the velocity of money in Nigeria. Annual time series data shall be used and this shall cover a period of 1981 to 2013. The variables to be used in the study shall be the ratio of broad money supply to GDP as a proxy for velocity of money. We shall also use credit to the private sector as a ratio of GDP as a proxy for financial development. Other control variables to be used are: real exchange rate, inflation rate, real interest rate, treasury bills rate and real GDP. Data sources shall be from the World Development Index (2015) and the Central Bank of Nigeria Statistical Bulletin (2014).