Interest rate liberalisation and economic growth

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Chapter Five Financial Liberalisation in Nigeria


This chapter is the second of the three chapters that focus on the financial liberalisation policies as implemented in the selected ECOWAS countries. The experiences of these countries’ financial liberalisation policies, as mentioned, will serve as a basis for the empirical investigation presented in chapters seven and eight. This chapter is sub-divided into eight sections. The second section deals with the origins of financial repression and liberalisation in Nigeria. The third section is a discussion of the origin of interest rate liberalisation in Nigeria, whilst the section after that looks at the trends of the interest rates and financial savings in Nigeria before and after financial liberalisation. Section five looks at the challenges posed by interest rate liberalisation in the Nigerian economy. This section also looks at financial development such as financial deepening and investment. It also investigates the influence of interest rate liberalisation on the sectoral allocation of credit in the Nigerian economy as well as trends of financial depth, interest rates, interest rate spread and economic growth before and after financial liberalisation together with the prevalence of foreign currency deposits in the domestic banks. In section six, the origin of capital markets in Nigeria, trends of capital account liberalisation and economic growth before and after financial liberalisation are analysed, and also current developments in the Nigerian stock market as well as challenges of the capital market are presented. Section seven presents a chronology of financial policy reforms that have been implemented since 1980, whilst in section eight, some concluding remarks are presented.

The origins of Financial Liberalisation in Nigeria

After serious external debt and balance of payment crises in the middle of the 1980s, Nigeria changed its economic policy from direct to indirect market-determined through the Structural Adjustment Programmes (SAPs) in 1986. Since then several reforms have been carried out including liberalisation of capital account and financial reform by the governments. Following the financial reform of the 1980s, the financial system in Nigeria has changed. The removal of foreign exchange controls and deregulation of financial markets have substantially changed the environment in which monetary policy operates. Government securities and interbank market have deepened, interest rate are determined freely, and reflects market sentiments, and new indirect instruments of monetary controls are developed. At the initial period of the reform programme, inflation rose from 5.4% in 1986 to 40.9% in1989. With the withdrawal of government fund from commercial banks, inflation rate fell drastically to 7.5% in 1990 (Adebiyi, 2005).
However, with the increase of financial and banking crises at the beginning of 1990, inflation reached its highest level of 72.8% in 1995. A return to democracy in May 1999, with good policy programme, helped to reduce inflation to 6.9% in 2000. The main factor behind the inflationary pressure during this period was the lack of budgetary discipline combined with monetary financing and/or domestic debt financing of budget deficit (Adebiyi, 2005). This was mainly due to the lack of harmony between fiscal and monetary policies, which hindered the effectiveness of monetary policy between 1986 and 1998 (Adebiyi, 2005). There is a direct link between monetary policy and the fiscal operations of the government. When deficit fiscal policy is taken, there is a possibility that part of that deficit will be financed by the government through borrowing from the banking system. The portion to be financed from the domestic banking system is part of the aggregate bank credit to the economy. There are serious implications when that portion is exceeded and/or is partly or wholly accounted for by the Central Bank. In this connection, the magnitude and pattern of government fiscal operations have been a major source of ineffective monetary control in Nigeria (Ojo, 2001).
In response to these developments, the private sector has responded by requesting higher real interest rates on government securities and by increasing its foreign exchange holding of foreign currency. This has led to a situation where many Nigerian residents hold a considerable part of their financial wealth in US dollars or other foreign currencies as a hedge against inflation (Ojo, 2001).

The origins of interest rate liberalisation in Nigeria

The Structural Adjustment Programme (SAP) was adopted in 1986 against the background of international oil market crashes and the resultant deteriorating economic conditions in the country. It was designed to achieve fiscal balance and balance of payments viability by altering and restructuring the production and consumption patterns of the economy, eliminating price distortions, reducing the heavy dependence on crude oil exports and consumer goods imports, enhancing the non-oil export base and achieving growth (Central Bank of Nigeria (CBN), 2008). Other aims were to rationalise the role of the public sector and accelerate the growth potentials of the private sector. The main strategies of the programme were the deregulation of external trade and payments arrangements, the adoption of a market determined exchange rate for the Naira, substantial 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 prompted by the belief that monetary policy has only temporal effects on real variables and long run effects on prices. Empirical evidence over the years has shown that low inflation is a prerequisite for economic growth. Given the high levels of inflation in the country at the time, especially after the implementation of the reforms policy, there was the need to bring inflation under control before a sustained path to growth could be attained. Using the implementation of policy in line with the IMF financial programming framework, control of growth in money supply became a very important factor in the fight against rampant inflation (CBN, 2008). Targets were set each year for growth in broad money and inflation rate. According to Adebiyi (2005) and Ojo (2001), 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, especially in the years just after financial deregulation. The almost simultaneous deregulation of both the domestic and foreign sectors led to problems from different sources.
The channels through which the reform would have led to improved growth have been shown to have worsened during the reform. Real deposit and lending rates were negative and savers became poorer during the reform. The rate of inflation also worsened. The growth in real GDP was slowed down due to high inflation rate. Although interest rates responded positively to financial liberalisation, real interest rates behaved differently. For most of the reform years, real deposit rate was negative. The high rates of inflation during the reform period, coupled with the re-imposition of interest rate ceilings brought about the negative real deposit rate (Adebiyi, 2005).
According to Hanson and Neal (1985), « negative real interest rates are generally not a problem, in and of themselves, but a symptom of much larger problems: that the whole macroeconomic framework – monetary, fiscal, exchange rate and tariff policies, as well as the interest rate – are out of line ». The strongly negative real interest rate in the Nigerian economy leaves much to be desired as it retards growth by the relative attractiveness of holding money as an asset instead of productive capital thereby depriving the economy investment capital.
According to Oresotu (1992), retail lending rates were reviewed upward and the minimum rediscount rate was also allowed to change. As observed by Aziakpono and Babatope-Obasa (2003), the minimum rediscount rate was fixed at 15% in August 1987 but was reduced to 12.75% in December 1987 as a result of the negative real rates. Subsequent to the initial measure of interest rate deregulation, the spread between deposit and lending rates began to widen. For example, in 1989, average savings rate was at 16.4% while prime-lending rate was at 26.8% representing a spread of about 10.4%. The monetary authorities intervened by limiting the spread between deposit, and lending rates. Sanusi (2002a) notes that widening of interest rate spread in the 1990s was due to the oligopolistic nature of the banking system. The reform of the financial system led to changes in the sector in an effort to foster competition, strengthen the supervisory role of the regulatory authority and streamline the relationship between the public and financial sectors of the economy. To foster competition, new financial institutions were granted licenses.
For example, Oresotu (1992) noted that 79 new banks with 824 nationwide branches began operations between 1986 and 1991.
Odife (1988) contains a more comprehensive account of the motivation and design of the structural adjustment program in Nigeria. The power of the Central Bank of Nigeria (CBN) was strengthened through the following two new Decrees: the Central Bank of Nigeria Decree 24 and the Banks and Other Financial Institutions Decree 25 (BOFID). The new laws facilitated the introduction of new financial instruments for the purpose of enhancing the ability of the CBN to manage the monetary system and also led to financial deepening of the economy. Moreover, according to Sanusi (2002a, 2002b), interest rate deregulation de-emphasised the use of credit allocation and control policies. It paved the way for the use of indirect controls such as open market operations (OMO), reserve requirements, and moral suasion in monetary management (Nnanna, 2001).
The financial liberalisation in the context of the Nigerian economy, poses many interesting questions. This is not only because the financial liberalisation policy was implemented on the background of international oil market crashes and the resultant deteriorating economic conditions in the country, it was also implemented in a period of high inflation and government deficit. The policy was designed to achieve fiscal balance and balance of payments viability by altering and restructuring the production and consumption patterns of the economy, eliminating price distortions, reducing the heavy dependence on crude oil exports and consumer goods imports, enhancing the non-oil export base and achieving sustainable growth. Other aims were also to rationalise the role of the public sector and accelerate the growth potential of the private sector as well as to correct the government deficit. Furthermore, the policy was implemented under conditions of unsatisfactory resource mobilisation, low financial deepening, high unemployment, high inflation, and fast depreciating domestic currency. A simple methodology used to assess the impact of the financial liberalisation on the economy of Nigeria in this chapter is a before-and-after test which compares the average figures30 pre and post the implementation of the financial liberalisation policy.

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Interest rate liberalisation, financial savings and Interest rate trends

Interest rate liberalisation in Nigeria started in 1987 when controls on interest rates were completely abolished and licensing of banks was fully liberalised. However, it was not until 1989 that money deposit banks were allowed to pay interest demand deposit accounts. As observed from Table 5.1, the total deposits with banks as a percentage of GDP increased steadily from 8.5% in 1969 to a high of 75.6% in 1984 then dropping to 27.0% in 1987 (the years of the policy). This trend continued after the implementation of the policy, dropping to a low of 17.0% in 1989. Three years after the policy, financial savings started to increase, reaching a high of 49.7% in 1999 before falling to 12.9% in 2001. Since 2001, financial savings have been increasing steadily, reaching 26.2% in 2008. On average, the financial savings in Nigeria have decreased by 4.9% points post liberalisation period compared to the pre liberalisation period.
As can be seen from Table 5.1, interest rates have been increasing since liberalisation. Deposits rate started from 3.0% in 1969 but ended up at 13.1% before the policy in 1987 with a yearly average of 5.3%. Even the full interest rate liberalisation in 1987 could not reverse the trend. The rate rose to a high of 23.2% in 1993 then dropped to as low as 7.2% in 1996, then to 12.0% in 2008. The average for the post liberalisation period is therefore 13.7%. This is about 8% points over the pre liberalisation average. Furthermore, the discount and lending rates followed the same trend as the deposit rate, for example, the lending rate started at 7.0% in 1969, but in 1987 stood at 14.0% with a pre liberalisation average of 8.2%. After the full interest rate liberalisation, the trend continued to increase reaching 31.7% in 1993 but dropping to 15.5% in 2008 with an average of 20.6% showing an increase on about 12% points. Comparing the real interest rates, it was found that while the average real deposit rate pre financial liberalisation was negative 9.0%; the figure was negative 11.2% after the implementation of the interest rate liberalisation policy, showing a decrease of negative 2% points.
The real discount rate followed similar trends. On average, the real discount rate was negative 1.9% by 2008 with a post liberalisation average of negative 9.8%. This shows a fall of negative 1.7% points31 compared with the pre liberalisation average. However, the lending rate did not follow a similar trend. The average real lending rate before interest rate liberalisation was negative 6.1% but increased to negative 4.3% post liberalisation. This shows an increase of about 2.0% points. This is contrary to the McKinnon-Shaw hypothesis that removal of interest rate ceilings will lead to an increase in the real deposit rates. The hypothesis therefore is not fully verified in the case of Nigeria. On the other hand, total financial savings have started increasing, but with an increasing portion being held in foreign currency deposits. The policy outcome in Nigeria is therefore mixed on the above basis32.
However, it is also worth noting that, following the adoption of the unification of flexible exchange rate and the establishment of foreign exchange bureaus in 1986, black market dealings in foreign exchange virtually disappeared. One could therefore argue that the foreign exchange resources of the black market were almost completely absorbed by the formal sector as the citizens were allowed to open foreign currency accounts with the banks. This was reflected in the rapid increase in the proportion of foreign currency deposit in the domestic banks (see Table 5.1, col. 2). Related to this is the decline in the size of the underground market economy as measured by the decrease in the ratio of currency outside banks to narrow money (M1). The average of the ratio of currency to M1 pre financial liberalisation was 43.0% and the post financial liberalisation average was 40.0%. The slight decrease of 3.0% points may suggest the magnitude of the reduction in the underground economy. But it can be seen from Figure 5.1 that since 1997, the ratio has been decreasing, reaching 18.4% in 2008. The financial liberalisation policy was able to reverse the rapid declining total savings, as was anticipated, but rather aggravated the problem of the foreign currency deposit in the Nigerian banking system. It also reduced the activities of the informal financial sector, by implication, as a result of the implementation of flexible exchange rate and banking penetration.

Challenges of interest rate liberalisation policy in Nigeria

Nigeria, like the other ECOWAS countries, especially those depending on single commodity for their export revenue, has faced a number of challenges since the implementation of interest rate liberalisation as part of the SAP in the 1986. Apart from high and increasing interest rates as discussed in the above section, some of the challenges that Nigeria has experienced since the implementation of financial liberalisation policy relate to the mixed savings, investment and financial deepening trends, changes in the sectoral allocation of credits, low economic growth rate in relation to financial depth, the relatively wide spread between lending and deposit rates and foreign currency deposits. These sets of challenges are discussed separately below.

Interest rate liberalisation, Investments and Financial Deepening

The McKinnon-Shaw hypothesis postulates that financial liberalisation will lead to an increase in savings, an increase in investment and hence rapid economic growth. Whilst in the pre financial liberalisation period, the average proportion of the GDP invested was 19.6%, the proportion decreased to 15.5% after the financial liberalisation policy reaching as low as 9.5% in 1996. However, the proportion of GDP that is invested by Nigeria has been increasing since 1996 reaching 33.8% in 2008. On the other hand, the savings ratio which began on almost the same level as investments pre the financial liberalisation rate increased to about 27.3% in 1980 then tumbled to low of 5.0% in 1996 but recovered to 10.3% in 2001 then to 17.3% in 2008 (see figure 5.1). At the same time foreign direct investments (FDI) flow into the country increased from an average of 1.3% of GDP pre the policy to an average of 3.7% of GDP after the policy (see Table 5.1 above). One other positive outcome of the financial liberalisation is the increase in the capital flow and the consequent augmentation of the country’s foreign exchange reserves. Prior to the policy, the stock of total reserves (minus gold) was $1,165m in 1987; this figure increased to $53,002m by the end of 2008. The increase in FDI could be attributed to several factors. One factor relates to the increase of investment in the oil industry, and especially the communication sectors of the economy and the flexible exchange rate regime following the implementation of the SAP.
Financial deepening, as measured by the ratio of M2 ( money and quasi-money) to GDP as it could be observed from figure 5.2, started to increase in 1974 from 12.5% through to 39.6% in 1986, then dropped to as low as 13.7% in 1996 but stood at 38.4% in 2008. The pre liberalisation average stood at about 27.0% but decreased to about 24.0% after the policy. The reduction of 3.0% points may suggest that there has been a worsening of financial deepening post the financial liberalisation period. It is hoped that as the interest rate liberalisation programme stayed on course and the financial system matures, financial assets such as stocks and bonds (issued by both government and firms) will appear on the financial market and with growth in income and stability in the economy associated with the reduction in the countries risk premium, financial deepening may also increase. This is because (ceteris paribus), with increase in the real rate of return on financial assets, assets held previously in the form of say, large inventories, gold and livestock, will find their way into the formal financial system33.

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Interest rate liberalisation and sectoral credit allocation

As observed in Figure 5.2, there has been a tremendous change in the structure of credit allocated to the various sectors by the banks after the financial liberation policy. While before the policy, Agriculture, Forestry and Fishing (AFF), Manufacturing (M), Construction (C) and Trade and Commerce (T&C) were allocated on the average 6.0%, 25.2%, 16.5% and 24.6% of the total credit respectively, the post financial liberalisation period saw an average of 10.9%, 28.7%, 3.7% and 14.5% for Agriculture, Manufacturing, Construction and Trade and Commerce respectively. The data seems to suggest that the sector that has benefited most as a result of the interest rate liberalisation is the Miscellaneous (MIS) sectors from an average of 8.8% to 31.8%. The worse-off sector is the Construction sector with a fall of 12.8% points. Like the case of Ghana, the question that may follow is, “Does this change in the composition of the credit allocation and reflect an increase in the efficiency in credit allocation?”
According to the World Bank (2002), the bulk of the credit that was channelled to the private sector was mainly directed towards short-term investment. Long-term finance was very rare and only the most creditworthy have access to it (World Bank, 2002). The private sector, especially the small and medium enterprises (SMEs) are yet to feel the impact of the financial liberalisation policy. As Ajayi (2007) observed, the anticipated flow of funds from the banking sector to the real sector, which was one of the thrusts of the government policy, is yet to manifest on the economy, especially on SMEs, with the current tendencies of the financial sector reflecting high preferences for large enterprises. The banks were reluctant to give loans to the private sector, especially SMEs, not because the sector is not viable, but due to the perceived risky nature and lack of government guarantee schemes (Obamuyi, 2009).
According to Obamuyi (2009), in 1992 the proportion of total bank credits that were extended to the SME was 48.8%. The proportion has been falling drastically since then reaching 2.7% in 2005. Since 2005, it has fallen further to a low of 0.2% as at 2008. The implication is that the financial liberalisation policy has not generated enough funds for the development of private sector-led economy. This means that government objective of using private sector as a catalyst of development may not be easily achieved.
Like in Ghana, the allocative efficiency of credit in an economy can be measured in several ways; the best is probably to compare marginal returns on capital investment across different sectors of the economy. If the marginal returns in different sectors are equal, then one may say that the economy allocates credits efficiency on the assumption that risk, uncertainty and transaction cost are kept constant. Due to data non-availability, it was difficult to obtain accurate estimates of marginal return on credits in different sectors of the Nigerian economy. One alternative was to compare the cost of credit in different sectors on the assumption that firms, in order to maximise profit equate their marginal cost of capital and marginal rate of return on investment. It is hypothesised that credit allocation in an economy has become efficient (or at least more efficient), if borrowing costs in different sectors of the economy are equalised (or differences in borrowing costs are reduced).
Following this conceptual framework, the following calculations on the Nigeria sectoral borrowing cost were made. The borrowing cost of each sector was calculated between 1971 and 2008, by dividing total interest and discount payments by the total amount of debt in each sector, which included all sources of borrowing34. The variation in the borrowing cost reflects the differential borrowing cost for different sectors offered by the banks. Under the assumption that with an increase in efficiency in credit allocation, the variance of borrowing costs of the sectors should reduce, the following results, as shown in Table 5.2, were obtained. The results from Table 5.2 show that the variances before interest rate liberalisation were relatively smaller between 0 and 2.83 with an average of 1.7. The situation after the financial liberalisation, however, shows a relatively wide variation, reaching a high of 11.86 in 1993 with an average of 2.4 for the period. This may suggest that credit allocation post the financial liberalisation is less efficient than before the policy. Like Ghana, the results obtained must be interpreted with caution, since the underlying assumptions of the concept used in the analysis are strong35. One should also note that it is not clear whether a lower variance of cost of borrowing between sectors is indicative of allocative efficiency and also no adjustment for sectoral risks were made in the calculations.
An additional contributing factor could be that the presence of moral hazard cost of borrowing is likely to expand, leading to increased distress borrowing, increased probability of default and bank failure (McKinnon 1989). This refers to a situation where banks prefer to be risk lovers and provide risky loans with high interest rates in expectation that losses will be covered by the domestic government while gains would accrue to themselves (McKinnon, 1989). The above evidence and reasons may suggest that, even though the volatility of borrowing cost among different sectors of the economy has increased under the interest rate liberalisation policy relative to before the policy, leading to less efficiency in the allocation of credit, the cause cannot be put solely on the financial liberalisation policy per se, but also on some political and socio-economic problems inherent in the Nigerian financial system as a whole.
According to Obamuyi (2009), although the majority of SMEs36 are either very, or fairly, satisfied with the liquidity position of their banks, the stringent lending conditions, including various astronomical charges, have made banks’ finance unattractive to the private sector. About 80% and 69% of the private business operators are dissatisfied with the lending conditions and high cost of funds of the banks respectively. The issue, therefore, is that the banks are liquid and ready to lend, but the private sector is reluctant to borrow because of the high transaction costs and other lending bottlenecks. This has the implication of restraining private sector investment, and ultimately retarding economic growth.

Table of Contents
Chapter Page
0. The Thesis Statement
1. Introduction to the Study
1.1. Background of the Study
1.2. Objectives and Hypothesis
1.3. Significant of the Study
1.4. Motivation for choosing the countries selected
1.5. Organisation of the Study
2. Interest rate liberalisation and economic growth
2.1. Introduction
2.2. Origins of interest rate liberalisation
2.3. Interest rate liberalisation and economic growth – A theoretical linkage
2.4. Empirical literature review
2.5. Conclusion
3. Capital Account Liberalisation and Economic growth
3.1. Introduction
3.2. Origins of capital account liberalisation
3.3. Theoretical arguments in favour of capital account liberalisation
3.4. Theoretical arguments against capital account liberalisation
3.5. Capital account liberalisation and Economic growth – A theoretical linkage
3.6. Empirical literature review
3.7. Conclusion
4. Financial liberalisation in Ghana
4.1. Introduction
4.2. The origins of financial repression and liberalisation in Ghana
4.3. The origins of interest rate liberalisation in Ghana
4.4. Interest rate liberalisation, financial savings and interest rate trends
4.5. Challenges of interest rates liberalisation policy in Ghana
4.6. Capital account liberalisation, stock market development and economic growth
4.7. Sequencing of financial liberalisation in Ghana
4.8. Conclusion
5. Financial liberalisation in Nigeria
5.1. Introduction
5.2. The origins of financial repression and liberalisation in Nigeria
5.3. The origins of interest rate liberalisation in Nigeria
5.4. Interest rate liberalisation, financial savings and interest rate trends
5.5. Challenges of interest rates liberalisation policy in Nigeria
5.6. Capital account liberalisation, stock market development and economic growth
5.7. Sequencing of financial liberalisation in Nigeria
5.8. Conclusion
6. Financial liberalisation in Ivory Coast
6.1. Introduction
6.2. Brief History of the banking sector of Ivory Coast
6.3. The origins of financial repression and liberalisation in Ivory Coast
6.4. The origins of interest rate liberalisation in Ivory Coast
6.5. Interest rate liberalisation, financial savings and interest rate trends
6.6. Challenges of interest rates liberalisation policy in Ivory Coast
6.7. Capital account liberalisation, stock market development and economic growth
6.8. Sequencing of financial liberalisation in Ivory Coast
6.9. Conclusion
7. Empirical Model Specification and Estimation Techniques
7.1. Introduction
7.2. Model Specification
7.3. Data and Construction of indices
7.4. Estimation Techniques
8. Econometric Analysis and Empirical Findings
8.1. Introduction
8.2. Empirical findings and analysis for Ghana
8.3. Empirical findings and analysis for Nigeria
8.4. Empirical findings and analysis for Ivory Coast
9. Conclusion and Policy Implications
9.1 Introduction
9.2 Summary of the study
9.3 Summary of the empirical findings
9.4 Conclusions and policy implications
9.5 Limitations of the study and areas for further research

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