Wrong recipe for curbing inflation
Nigeria hikes interest rate
The policy of influencing the direction of the economy through interest rates and money supply is not the best strategy for fostering inclusive, employment-generating and poverty-alleviating economic growth in Nigeria, argues Prof Stephen Onyeiwu.
Stephen Onyeiwu
The Central Bank of Nigeria recently announced an increase in the interest rate, from 11.5% to 13%, a 1.5 percentage point hike that took effect immediately.
Whenever the central bank changes the monetary policy rate, otherwise known as the discount or interest rate, deposit and other financial institutions follow suit. Banks will therefore be raising their lending rates, which will increase the cost of borrowing and reduce the demand for money.
The accepted logic is that this will lead to a reduction in consumption and investment, thereby cooling off the overheated economy.
According to the central bank, the interest rate was raised to reduce inflationary pressure, narrow the negative real interest rate margin, restore investor confidence and boost remittances.
Nigeria’s inflation rate was about 16.8% as of April 2022. The rate was at an all-time high of about 18% a year ago, but dropped to 15% in November 2021. It has been on an upward trend since then, which explains why the central bank took a pre-emptive measure to tame it.
EFFECTIVENESS
But in my view, we shouldn’t assume that monetary policy will work in Nigeria the way it works in other countries.
Firstly, its effectiveness in curtailing inflation in Nigeria is blunted because price increases are caused mainly by supply constraints. These include insecurity in food-producing areas of the country, poor infrastructure, the war in Ukraine which has pushed up the price of commodities such as wheat, and falling imports due to currency depreciation.
In addition, Nigeria’s large informal sector has very weak linkages with the formal financial sector. About 80% of Nigerians are employed in the informal sector. Unlike households in developed countries, many Nigerians will not change their economic decision-making because of the interest rate increase.
There are also concerns about the timing of the increase. Nigeria is facing high levels of unemployment and poverty. Higher rates will have knock-on effects in the broader economy. For example, the manufacturers association of Nigeria’s big worry is that the rate hike would increase input costs and weaken the demand for manufactured goods.
How compelling are these concerns? Should the poor and working class in Nigeria be perturbed by the central bank’s decision?
WHO SHOULDN’T BE WORRIED?
The rate increase will not have significant effects on most low-income Nigerians for a few reasons.
First, domestic credit to the private sector in Nigeria is very low. It was just 12% of gross domestic product (GPD) in 2020, compared with an average of 40% for Sub-Saharan Africa.
Nigeria is one of the 20 or so countries in the world with a domestic credit to private sector ratio of below 15% of GDP.
Credit allocation to individuals and households is also low. This is because banks usually impose onerous conditions that make it nearly impossible for many Nigerians to obtain loans.
As of May 2021, for instance, consumer credit accounted for only 10.2% of total credit to the private sector.
Unable to obtain credit from financial institutions, many Nigerians use loan sharks.
The inability of many Nigerians to access loans from banks means they will not have to worry about paying higher rates on mortgages, credit cards, autos, and student loans.
Additionally, the rate hike will not have an impact on the prices of goods and services typically consumed by low-income Nigerians. Hikes in the prices of these basic food stuffs are driven by factors such as insecurity concerns as well as poor infrastructure that makes getting food to markets expensive.
EMPLOYMENT
What about growth and employment? An increase in interest rate raises borrowing costs. This, in turn, reduces investment, production, and employment.
But Nigeria does not fit this narrative. Much of its economic growth is driven, not by the production of goods, but by the export of oil and gas. Though a small percentage of the GDP, oil generates much of the foreign exchange and government revenue needed to support other sectors of the economy.
Because credit to the private sector in Nigeria is very low relative to GDP, the impact of the rate increase on real-sector production and employment will not be substantial.
Nigerians in the public sector in some states of the federation should be wary of the rate hike.
The state governments routinely borrow from banks to cover their huge budget deficits, and government debt has been on the increase over the years. Some have accumulated several months of unpaid salaries, gratuities, and pensions.
The interest rate increase will raise the borrowing costs of the government and result in the allocation of a higher proportion of revenue to debt servicing. This will affect the ability of the government to meet its capital and recurrent expenditures. In turn, this could exacerbate the delays in, or non-payment of, salaries, gratuities and pensions.
DYSFUNCTIONAL SYSTEM
If Nigeria was a well-functioning economy, the rate increase would attract investors. According to the purchasing power parity theory of exchange rates, a fall in the inflation rate would shore up the value of the Naira.
In addition, the hike would lead to an increase in the value of the Naira through what’s called “Carry Trade” – when portfolio investors borrow money from countries with low interest rates and invest the proceeds to take advantage of the spread between Nigeria’s high interest rate and low rates in other countries.
But Nigeria isn’t a well-functioning country. It has high levels of insecurity and political uncertainty. In addition, financial regulation is weak and the financial sector is fragile. It is therefore unlikely that portfolio investors would jump at the bait of high interest rates.
If anything, investors are pulling their money out because of these uncertainties, which partly explains why the Naira has been depreciating inexorably.
WRONG APPROACH
Only the middle and upper-class Nigerians would gain from any long-term positive payoffs from the interest rate hike. No matter how one views the Central Bank of Nigeria’s rate increase, it is hard to fathom how it would benefit most Nigerians.
In my view, the policy of influencing the direction of the economy through interest rates and money supply – known as monetarism – is not the best strategy for fostering inclusive, employment-generating and poverty-alleviating economic growth in Nigeria.
The challenges of high unemployment and poverty rates are more ominous than inflation in contemporary Nigeria. Many observers believe that the high level of violence and insecurity in the country is a by-product of economic dis-empowerment, especially among the burgeoning youth population in Nigeria.
Prioritising inflation over inclusive economic growth, unemployment and poverty is, in my view, the wrong decision.
What the country needs now is Keynesianism – an economic policy regime that would mobilise funds for massive job-creating investments in infrastructure, agriculture, labour-intensive manufacturing, and agro-processing.
The central bank already does this, albeit in a small way.
To boost real-sector production and employment, it has been using “intervention funds” to support strategic sectors of the economy. About 385 billion naira (approximately US$1.2 billion at the official exchange rate of 415 naira = US$1) was reserved for intervention projects as of March 2022.
The funds are used to provide concessionary credit to sectors that boost the productive capacities of the economy. The aim is to ease supply constraints and ameliorate inflationary pressures.
Nigeria needs more of this approach. – The Conversation
Stephen Onyeiwu is the Andrew Wells Robertson professor of economics at Allegheny College.
The Central Bank of Nigeria recently announced an increase in the interest rate, from 11.5% to 13%, a 1.5 percentage point hike that took effect immediately.
Whenever the central bank changes the monetary policy rate, otherwise known as the discount or interest rate, deposit and other financial institutions follow suit. Banks will therefore be raising their lending rates, which will increase the cost of borrowing and reduce the demand for money.
The accepted logic is that this will lead to a reduction in consumption and investment, thereby cooling off the overheated economy.
According to the central bank, the interest rate was raised to reduce inflationary pressure, narrow the negative real interest rate margin, restore investor confidence and boost remittances.
Nigeria’s inflation rate was about 16.8% as of April 2022. The rate was at an all-time high of about 18% a year ago, but dropped to 15% in November 2021. It has been on an upward trend since then, which explains why the central bank took a pre-emptive measure to tame it.
EFFECTIVENESS
But in my view, we shouldn’t assume that monetary policy will work in Nigeria the way it works in other countries.
Firstly, its effectiveness in curtailing inflation in Nigeria is blunted because price increases are caused mainly by supply constraints. These include insecurity in food-producing areas of the country, poor infrastructure, the war in Ukraine which has pushed up the price of commodities such as wheat, and falling imports due to currency depreciation.
In addition, Nigeria’s large informal sector has very weak linkages with the formal financial sector. About 80% of Nigerians are employed in the informal sector. Unlike households in developed countries, many Nigerians will not change their economic decision-making because of the interest rate increase.
There are also concerns about the timing of the increase. Nigeria is facing high levels of unemployment and poverty. Higher rates will have knock-on effects in the broader economy. For example, the manufacturers association of Nigeria’s big worry is that the rate hike would increase input costs and weaken the demand for manufactured goods.
How compelling are these concerns? Should the poor and working class in Nigeria be perturbed by the central bank’s decision?
WHO SHOULDN’T BE WORRIED?
The rate increase will not have significant effects on most low-income Nigerians for a few reasons.
First, domestic credit to the private sector in Nigeria is very low. It was just 12% of gross domestic product (GPD) in 2020, compared with an average of 40% for Sub-Saharan Africa.
Nigeria is one of the 20 or so countries in the world with a domestic credit to private sector ratio of below 15% of GDP.
Credit allocation to individuals and households is also low. This is because banks usually impose onerous conditions that make it nearly impossible for many Nigerians to obtain loans.
As of May 2021, for instance, consumer credit accounted for only 10.2% of total credit to the private sector.
Unable to obtain credit from financial institutions, many Nigerians use loan sharks.
The inability of many Nigerians to access loans from banks means they will not have to worry about paying higher rates on mortgages, credit cards, autos, and student loans.
Additionally, the rate hike will not have an impact on the prices of goods and services typically consumed by low-income Nigerians. Hikes in the prices of these basic food stuffs are driven by factors such as insecurity concerns as well as poor infrastructure that makes getting food to markets expensive.
EMPLOYMENT
What about growth and employment? An increase in interest rate raises borrowing costs. This, in turn, reduces investment, production, and employment.
But Nigeria does not fit this narrative. Much of its economic growth is driven, not by the production of goods, but by the export of oil and gas. Though a small percentage of the GDP, oil generates much of the foreign exchange and government revenue needed to support other sectors of the economy.
Because credit to the private sector in Nigeria is very low relative to GDP, the impact of the rate increase on real-sector production and employment will not be substantial.
Nigerians in the public sector in some states of the federation should be wary of the rate hike.
The state governments routinely borrow from banks to cover their huge budget deficits, and government debt has been on the increase over the years. Some have accumulated several months of unpaid salaries, gratuities, and pensions.
The interest rate increase will raise the borrowing costs of the government and result in the allocation of a higher proportion of revenue to debt servicing. This will affect the ability of the government to meet its capital and recurrent expenditures. In turn, this could exacerbate the delays in, or non-payment of, salaries, gratuities and pensions.
DYSFUNCTIONAL SYSTEM
If Nigeria was a well-functioning economy, the rate increase would attract investors. According to the purchasing power parity theory of exchange rates, a fall in the inflation rate would shore up the value of the Naira.
In addition, the hike would lead to an increase in the value of the Naira through what’s called “Carry Trade” – when portfolio investors borrow money from countries with low interest rates and invest the proceeds to take advantage of the spread between Nigeria’s high interest rate and low rates in other countries.
But Nigeria isn’t a well-functioning country. It has high levels of insecurity and political uncertainty. In addition, financial regulation is weak and the financial sector is fragile. It is therefore unlikely that portfolio investors would jump at the bait of high interest rates.
If anything, investors are pulling their money out because of these uncertainties, which partly explains why the Naira has been depreciating inexorably.
WRONG APPROACH
Only the middle and upper-class Nigerians would gain from any long-term positive payoffs from the interest rate hike. No matter how one views the Central Bank of Nigeria’s rate increase, it is hard to fathom how it would benefit most Nigerians.
In my view, the policy of influencing the direction of the economy through interest rates and money supply – known as monetarism – is not the best strategy for fostering inclusive, employment-generating and poverty-alleviating economic growth in Nigeria.
The challenges of high unemployment and poverty rates are more ominous than inflation in contemporary Nigeria. Many observers believe that the high level of violence and insecurity in the country is a by-product of economic dis-empowerment, especially among the burgeoning youth population in Nigeria.
Prioritising inflation over inclusive economic growth, unemployment and poverty is, in my view, the wrong decision.
What the country needs now is Keynesianism – an economic policy regime that would mobilise funds for massive job-creating investments in infrastructure, agriculture, labour-intensive manufacturing, and agro-processing.
The central bank already does this, albeit in a small way.
To boost real-sector production and employment, it has been using “intervention funds” to support strategic sectors of the economy. About 385 billion naira (approximately US$1.2 billion at the official exchange rate of 415 naira = US$1) was reserved for intervention projects as of March 2022.
The funds are used to provide concessionary credit to sectors that boost the productive capacities of the economy. The aim is to ease supply constraints and ameliorate inflationary pressures.
Nigeria needs more of this approach. – The Conversation
Stephen Onyeiwu is the Andrew Wells Robertson professor of economics at Allegheny College.
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