Bad recipe for curbing inflation
The Central Bank of Nigeria recently announced an increase in the interest rate, from 11.5% to 13%, a hike of 1.5 percentage points which took effect immediately.
Whenever the Central Bank changes the monetary policy rate, also known as the discount rate or interest rate, depository institutions and other financial institutions follow suit. Banks will therefore increase 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 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 around 16.8% in April 2022. The rate was at an all-time high of around 18% a year ago but fell to 15% in November 2021. It followed an upward trend since then, which is why the Central Bank took preemptive action to tame it.
But in my opinion, we should not assume that monetary policy will work in Nigeria as it works in other countries.
First, its effectiveness in reducing inflation in Nigeria is blunted because price increases are caused primarily by supply constraints. These include insecurity in the country’s food producing areas, poor infrastructure, the war in Ukraine which has driven up the price of basic commodities such as wheat, and falling imports due to to the depreciation of the currency.
In addition, Nigeria’s large informal sector has very weak linkages to 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 due to rising interest rates.
There are also concerns about the timing of the increase. Nigeria faces high levels of unemployment and poverty. Higher rates will have repercussions throughout the economy. For example, the big concern of the Manufacturers Association of Nigeria is that raising rates would increase input costs and weaken demand for manufactured goods.
How compelling are these concerns? Should Nigeria’s poor and working class be upset by the Central Bank’s decision?
Who shouldn’t worry
The increase in rates will not have significant effects on most low-income Nigerians for several reasons.
First, domestic credit to the private sector in Nigeria is very low. It represented only 12% of gross domestic product (GDP) in 2020, compared to an average of 40% for sub-Saharan Africa.
Nigeria is one of about 20 countries in the world whose domestic credit/private sector ratio is less than 15% of GDP.
Credit allocation to individuals and households is also low. Indeed, banks usually impose onerous conditions that make it almost impossible for many Nigerians to obtain loans.
In May 2021, for example, consumer credit represented only 10.2% of total credit to the private sector.
Unable to obtain credit from financial institutions, many Nigerians resort to loan sharks.
The inability of many Nigerians to access loans from banks means they won’t have to worry about paying higher rates on mortgages, credit cards, cars and student loans.
Moreover, the rate hike will have no impact on the prices of goods and services generally consumed by low-income Nigerians. Price hikes for these staple foods are driven by factors such as insecurity issues as well as poor infrastructure that make getting food to markets expensive.
What about growth and jobs? An increase in interest rates increases 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. Although it represents only a small percentage of GDP, oil generates much of the foreign exchange and government revenue needed to support other sectors of the economy.
Since credit to the private sector in Nigeria is very low relative to GDP, the impact of rate increases on real sector output and employment will not be substantial.
who should be worried
Nigerians in the public sector in some states of the federation should be wary of rising rates.
State governments regularly borrow from banks to cover their huge budget deficits, and public debt has increased over the years. Some have accumulated several months of unpaid salaries, bonuses and pensions.
Rising interest rates will increase the government’s borrowing costs and cause a greater proportion of revenues to be allocated to servicing the debt. This will affect the government’s ability to meet its capital and recurrent expenditures. This in turn could exacerbate late or non-payment of salaries, gratuities and pensions.
A dysfunctional system
If Nigeria were a well-functioning economy, rising rates would attract investors. According to the purchasing power parity theory of exchange rates, a decline in the rate of inflation would strengthen the value of the naira.
Also, the rise would cause the value of the naira to increase through what is known as the “carry trade” – when portfolio investors borrow money from countries with low interest rates and invest the proceeds to take advantage of the gap between Nigeria’s high interest rate and low rates in other countries.
But Nigeria is not a well-functioning country. It experiences high levels of insecurity and political uncertainty. In addition, financial regulation is weak and the financial sector is fragile. Portfolio investors are therefore unlikely to jump on the hook of high interest rates.
On the contrary, investors are withdrawing their money due to these uncertainties, which partly explains why the naira is inexorably depreciating.
The wrong approach
Only middle- and upper-class Nigerians would benefit from the long-term benefits of higher interest rates. Regardless of how one views the Central Bank of Nigeria’s rate hike, it’s hard to see how it would benefit most Nigerians.
In my view, the policy of influencing the direction of the economy through interest rates and the money supply – known as monetarism – is not the best strategy for fostering inclusive economic growth, generating employment and reducing poverty in Nigeria.
The challenges of high unemployment and poverty rates are more worrisome than inflation in contemporary Nigeria. Many observers believe that the high level of violence and insecurity in the country is a byproduct of economic disempowerment, especially among Nigeria’s burgeoning youthful population.
Prioritizing 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 mobilize funds for massive job-creating investments in infrastructure, agriculture, labor-intensive manufacturing and agribusiness.
The Central Bank is already doing this, albeit in a modest way. To stimulate real sector production and employment, it uses “intervention funds” to support strategic sectors of the economy. About 385 billion naira (about $1.2 billion at the official exchange rate of 415 naira = $1) was earmarked for intervention projects in March 2022.
The funds are used to provide concessional credit to sectors that strengthen the productive capacities of the economy. The aim is to ease supply constraints and ease inflationary pressures.
Nigeria needs more of this approach.
Stephen Onyeiwu, Andrew Wells Robertson Professor of Economics, Allegheny College
This article is republished from The Conversation under a Creative Commons license.