The nyakumi Impact of Interest Rate Liberalization on Investment in Nigeria
The importance of investment in economic growth cannot be overemphasized. This has led to an upsurge in the study of its determinants. This research therefore, seeks to investigate the impact of interest rate liberalization on investment in Nigeria from 1970-2012. Using the Error Correction Model (ECM), the result indicates that a long run relationship exists among the variables. The result further reveals that all the variables have significant impact on investment. The study equally shows that there is no differential impact of interest rate liberalization on investment in Nigeria during the pre and post-liberalization regimes. Also, the impulse responses of these variables to shocks in the extraneous variables were verified; using the Multiple-Equation VAR models. In addition, the variance decomposition result shows thatPeriod 2 shows a standard deviation value of 97.23 in investment resulting from own shock, 2.44 to a response to a shock from interest rate, 0.0186 to a response from market capitalization rate,0.205900 to a response to public expenditure and 0.101933 to response to trade openness. In period 10, investment responds positively with a standard deviation of 18.77 originated from own shock and standard deviation values of 8.05, 7.94, 12.43 and 15.59 arising from a shock from interest rate, market capitalization rate, public expenditure and trade openness respectively. It is recommended that polices to make interest rate attractive to investors as well as improve trade should be encouraged. Also broadening the capital market and improving infrastructure through increased capital expenditure should be pursued. In addition to these, there should be consistency in policies so that policy summersaults does not affect investment.
Background of the Study
The Nigerian economy has at different times witnessed enormous interest rate swings in different sectors of the economy since the 1970s and mid 1980s under a regulated regime. The preferential interest rates were based on the premise that the market, if freely applied would exclude some priority sectors. Thus, interest rates were adjusted through the market forces in order to promote increased level of investment in the various preferred sectors of the economy. Prominent among the preferred sectors were the agricultural, manufacturing and solid mineral sectors which were accorded priority and deposit money banks were directed to charge preferential interest rates on all loans to encourage the upsurge of small-scale industrialization which is a catalyst for economic development (Udoka, 2000). According to Mckinnon (1973) and Shaw (1973), this situation can ignite financial repression which occurs mostly when a country imposes ceiling on deposit and lending nominal interest rate at a low level relative to inflation. The resulting low or negative interest rates discourage savings mobilization and the channelling of mobilized savings through the financial system. This has a negative effect on the quantity and quality of investment and hence economic growth.
Closely followed by the regulated interest rate regime was the interest rate reform, a policy evolved under the financial sector liberalization. The policy was put in place to achieve efficiency in the financial sector, thus, engendering financial deepening. In Nigeria, financial sector reforms started with the deregulation of interest rate in August, 1987 (Ikhide & Alawade, 2001). Since then, the Nigerian government has been pursuing a market determined interest rate which does not permit a direct state intervention in the general direction of the economy (Nyong, 2007).
Since the introduction of the interest rate liberalization concept in the 1980s, many countries such as Angola, Burundi, Congo, Ivory Coast, Ghana, Malawi, Nigeria, China, India etc. have made attempts at liberalizing their financial sectors by deregulating interest rate, eliminating or reducing credit controls, allowing free entry into the banking sector, giving autonomy to commercial banks, permitting private ownership of banks and liberalizing international capital flows financial repression has retarded the development process as envisaged by Shaw (1973). Undoubtedly, government past efforts to promote economic development by controlling interest rate and securing inexpensive funding for their own activities have undermined financial development. (Arturo, Fabio, & Andrew, 2003).
The liberalization of the interest rate system, mainly by raising interest rates, was a policy measure adopted by the Nigerian Government to increase private saving. The objective was to make and maintain positively in real terms as the upsurge in inflation in the 1970s had rendered them negative and there were rigid exchange and interest rate controls resulting in low direct investment. Funds were inadequate as there was a general lull in the economy. Monetary and credit aggregates moved rather sluggishly. Consequently, there was a persistent pressure on the financial sector, which in turn necessitated a liberalization of the financial system (Soyibo & Olayiwola, 2000).
In response to these developments, the government deregulated interest rate in 1987 as part of the Structural Adjustment Program (SAP). The official position then was that interest rate liberalization would, among other things, enhance the provision of sufficient funds for investors, especially manufacturers (a priority sector), who are considered to be the prime agents of investment, and by implication, promotes economic growth (Odhiambo, 2009). However, in a dramatic policy reversal, the government in January, 1994 out-rightly introduces some measures of regulation into interest rate management. It was claimed that there are more wide variations and unnecessarily high interest rate under the complete deregulation of interest rate immediately, deposit rate were once again set at 12% – 15% per annum while a ceiling of 21% per annum was fixed for lending (CBN 2012).
The high interest rate observed in Nigeria during the era of interest rates deregulation has been frequently blamed for the country‟s slow growth and pointed out as a major failing of the Adjustment Program initiated in August, 1986. The believe is premised on the assumption that the demand for funds is for the purpose of investment and that investment demand will be larger at a lower lending rate. This study regards that such blame is largely for obvious reasons. First interest rate deregulation lead to an increase in saving mobilization in Nigeria (Chuba, 1997). While it is impossible to achieve economic growth without adequate investment, saving generates investment.
Secondly, investment does not depend upon interest rate alone, for instance investors may be prepared to borrow more and invest more, even if interest rate are high provided they anticipate a higher margin of profits. On the other hand, investors are not tempted to borrow even if interest rate are very low, or even zero if they are afraid that they may lose even their capital. In other words, investment depends upon risk and the prospects of profits in a particular industry-or what Keynes (1936) calls the marginal efficiency of capital rather than upon interest rates. Thirdly, interest rate is just one among many factors that have negative effects on investment. For example, the deregulation of Nigerian economy went beyond interest rates reform policies rather than interest rate deregulation to be the major obstacle to investment expansion in Nigeria.
The policy on interest rate introduced in 1994 was retained in 1995 with a minor modification to allow for flexibility. The policy stayed in place until it was lifted in October 1996. The lifting remained in force till date, thus enabling the pursuit of a flexible interest rate regime in which bank deposit and lending rate were largely determined by the forces of demand and supply for funds (Omole & Falokun, 1999).
Statement of the problems
Prior to the deregulation of interest rate in Nigeria, the prevailing rates of interest were regulated by government through the Central Bank of Nigeria (CBN). This was meant to guide the economy to follow the desired direction. However, it was soon realized that, the low rates of interest that prevailed could not be sustained (for example the real lending rates were 3.60, -4.40,-13.20,-9.40,-6.93,-2.63,-1.40 and -11.73 percent in 1973, 1974, 1977, 1978, 1979, 1980 and 1981 respectively (Chuba, 2005). This 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 interest rate system was deregulated in the second half of the 1980. A major objective of the deregulation exercise was to increase savings for investment and economic growth. But despite this effort, investment is still in the doldrums because the deposit rate is low and that discouraged savings which translate into higher interest rate and therefore low investment. The deregulation exercise has been met with mixed feelings in Nigeria, while some believe it would enhance economic performance, others have contrary opinion. Nwankwo (1989) opine that interest rate deregulation will definitely lead to more efficient allocation of financial market resources. His position is in line with the arguments of Mckinnon (1973) and Shaw (1973). Abiodun (1988), on the other hand holds that deregulation of interest rate is like a double-edged sword, which will either stimulate or mar the economy. He asserts that the deregulation of interest rate will lead to an increase in interest rate, which will increase savings. This high cost of borrowing might bring about cost-push inflation as borrowers of funds will pass the high cost of borrowing to the customers by pushing up prices.
Ojo (1988) & Ani (1988) are both of the opinion that interest rate deregulation would mar the Nigerian economy. In their separate studies, they flawed the deregulation exercise, claiming it would discourage investment and hence economic growth, by pushing up interest rates. They believe that since domestic financial markets are to some extent structurally oligopolistic, if interest rate is left uncontrolled, it might lead to a sharp increase in lending rate which will translate to increase in cost of capital and discourages investment. This position is supported by Soyibo & Olayiwola (2000) and Akpan (2004) who all pointed out the low positive impact of deposit rate on investment after interest rate liberalization in Nigeria.
Okogo & Osafo-Kwaako (2006), believe that, with the Structural Adjustment Programme in 1986, market based reforms were to ensure that true cost of capital would be achieved in Nigeria. However, the initial attempt at interest rate liberalization yielded poor results. A poorly supervised and inefficient financial sector, weak institutions and poor governance created opportunities for arbitrage, patronage and rent-seeking behaviour.
The high interest rate observed in Nigeria during the era of interest rate liberalization (17.5%, 26.8%, 20.18%, 24.85%, 17.59% and 16.79% in 1987, 1989, 1995, 2002, 2010 and 2012 respectively) have been frequently blamed for the country‟s slow growth and therefore a major failure of Structural Adjustment Programme (SAP) initiated in August 1987. This belief is premised on the assumption that, the demand for funds is for the purpose of investment and that investment demand will be lower at higher lending rate ( for example, investment was at 19.835%, 19.879%, 15.145%, 30.472%, 25.842% and 22.139% in 1987, 1989, 1995, 2002, 2010 and 2012). (CBN 2012).
This change of interest rate policy is a problem because of two main reasons, first, investment contraction in Nigeria may not have any connection with the increase in lending rate that accompanied interest rate liberalization. Just as it was in 1987 when interest rate is 17.5% and investment was 19.835%, an increase in interest rate in 1989 (i.e. from 17.5% to 26.8%) was also accompanied by increase in investment (i.e. from 19.835% to 19.879%). Secondly, low interest rate policy, which the regulation of interest rate implies could discourage saving mobilization. However, it is impossible to achieve economic growth without adequate investment, saving generates investment. (Chuba, 2005). These problems give raise to this study to find out the structural changes that have taken place in the economy during the pre-liberalization and the post-liberalization regime. Although many works have not compare the two periods to see how investment response to the changes in interest rate over time in Nigeria.
There is therefore the need for a comparative analysis of the impact of interest rate liberalization in promoting investment in Nigeria. This forms bedrock of the present study, in line with this therefore, the study will address the following question. Equally, answers to these questions would enable us to access the desirability or otherwise of the occasional resort to financial system regulation and control as practiced between 197 -2012.
i. To what extent has interest rate affected investment in Nigeria?
ii. What is the differential impact of interest rate liberalization on investment in Nigeria during the pre and post-liberalization regimes?
iii. What is the difference in the structural response of investment to changes in interest rate in Nigeria overtime?
Objectives of the Study
The major objective of this research is to analyze the impact of interest rate regulation and deregulation on investment in Nigeria. The specific objectives are:-
i. To examine the impact of interest rate on investment in Nigeria.
ii. To determine the differential impact of interest rate liberalization on investment in Nigeria during the pre and post-liberalization regimes
iii. To examine the structural responses of investment to changes in interest rate in Nigeria overtime.
Based on the objective of the study, the following null hypotheses are proposed.
Ho1: Interest rate has no significant impact on investment in Nigeria.
Ho2: There is no differential impact of interest rate liberalization on investment in Nigeria during the pre and post-liberalization regimes
Ho3: There are no structural responses of investment to changes in interest rate in Nigeria overtime.
Policy Relevance of the Study
This study will be helpful in analyzing how the impact of interest rate liberalization on investment in Nigeria has been before the regime of interest rate deregulation and after the regime. It also investigates the interest rate deregulation and investment relationship by taking
into consideration the transmission mechanism through which interest rate affect investment. The study is also relevant because it will make a comparative analysis between the impact of deregulated interest rate on investment and that of regulated interest rates on investment. As a result, the outcome of this study shed more light on the role of interest rate in economic development in Nigeria. Consequently, this work will be useful to Government and monetary policy makers in their quest to improve financial intermediation in the economy. Also, by raising specific issues concerning the link between interest rate and economic performance (investment) in Nigeria, this study provides a basis for further in-depth investigation in this area.
Scope of the Study
This study is a macro level analysis which will involve time series elements, thus the econometric analysis of the impact of interest rate liberalization on investment is based on the Nigeria economy for the period 1970-2012. These years are chosen owing to the availability of time series data for the variable of interest indicator. The main variables of interest in this study are investment which is proxy by Gross Domestic Investment (dependent variable); and interest rate, market capitalization rate, public expenditure, and trade openness as explanatory variables.
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