IMPACT OF INTEREST RATE LIBERALISATION ON SELECTED MACROCONOMIC INDICATORS IN NIGERIA

ABSTRACT

This research examines the impact of interest rate liberalisation on selected macro-economic indicators in Nigeria.   Employing ex-post factor  design and using GDP per capita as growth indicator, Total Financial Savings (TFS) as a proxy for savings and Credit to Private Sector as a proxy for investment.  The research established a negative relationship between interest rate liberalisation on economic growth, savings and investment which were represented by indices calculated using ordinary Least Square. This research finds that interest rate liberalisation  have  negative  and  insignificant  effect  on  economic  growth, savings and investment in Nigeria.   This supports the numerous past studies which have reported negative results regarding the effects of interest rate liberalisation on economic growth. The research concludes that interest rate liberalisation have negative  and  insignificant effect on credit to private sector, saving and economic growth in Nigeria.

CHAPTER ONE

1.1      Background of the Study

INTRODUCTION

Interest rate liberalisation can be viewed as a policy response encompassing a package  of measures  to remove  all undesirable  state imposed  constraints on the free working  of the financial market. The measure includes the removal of interest rate ceilings,  loosening of deposit and credit control (Killick and Martin 1990). Schmidt Hebbel  and Serven (2002) observe  that  interest  rate  liberalization  grants  market  forces  a  dominant  role  in  setting financial assets prices and returns, allocating credit and developing a wider array of financial instruments and intermediaries. Bandiera  et-al (2000)  notes that the wave of liberalization in many developing countries in the1980 was characterised by more attention given to market forces in allocating credit through market determined interest rate. The financial liberalisation hypothesis  holds that  allowing  the market to determine real interest rates would mobilise savings and  increase deposit (Fry1997). Several authors suggest that financial liberalisation spurs GDP growth by fostering productivity growth, not only by raising the funds available for  capital accumulation.  Theoretical  research by Acemoglu  and Zilibotti  (1997),  Soyibo (1992) and Aghion et-al (2005) among others show that financial liberalisation may relieve risky  innovators   from  credit  constraints,   thereby  fostering   economic   growth  through technological change.

According to McKinnon (1973) and Shaw (1973) financial repression largely manifested through indiscriminate distortion of prices including interest rate, has  tended  to reduce the real   rate   of   growth.   Undoubtedly,   government’s   past   efforts   to   promote   economic development by controlling interest rates and securing ‘‘inexpensive’’ funding for their own activities  have undermined  financial development  (Demetriades  and Luitel 1997). Prior to August 1987, interest rate in Nigeria was generally fixed by the Central Bank of Nigeria with periodic adjustments depending on the government’s sectoral priorities (Uchendu 1993).

The  Nigerian  economy  witnessed  such  financial  repression  in  the  early  80s.  The  pre liberalization period was associated with administrative control of interest rate. In  such an environment,  retail lending and deposit rates were set below their market  clearing levels (Scholnick 1999). Okpara (2010) is of the opinion that retail interest  rigidity is caused by either market concentration or size of the customer base. This low or negative interest rate discourages  savings  mobilization  and  channelling  of  the  mobilized  savings  through  the

financial system (Obamuyi 2009). According to McKinnon (1973) and Shaw (1973) financial repression by forcing financial institution to pay low and often negative real  interest rate reduces private financial savings thereby decreasing the resources available to finance capital projects. 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 interest rate. (Ogwuma 1993 and Ojo 1993).

In response to these developments,  government  liberalized interest rate in August 1987  as part of the structural adjustment  programme (SAP) policy package (IKhide and  Alawode,

2001).  The official position then was that  interest  rate liberalization  would  among  other things achieve efficiency in the financial sector by increasing the levels of savings and hence investment and ultimately leading to economic growth as well as bringing inflation down. Liberalizing interest rate is an attempt to deepen the financial market and widen the range of financial  instrument  offered  (Gibson and Tsakalotos  1994).  McKinnon  (1973)  and Shaw (1973) argue that interest rate liberalization is likely to  lead to an increase in positive real interest rate. This tends to suggest a positive correlation between the overall financial depth and growth in GDP.

Accordingly, a policy that aims at increasing financial depth through expansion of  interest bearing  instruments  would  help  maximize  economic  growth  via increased  availability  of credit  to  finance  investment.  This  imply  that  positive  real  interest  rates,  by  promoting financial deepening helps to raise the level of investment hence, domestic capital formation. In theory, the premise  underlying  the preposition  that  interest rate liberalization  (a major component of financial development) promotes growth is fairly straightforward.   Given that investment is a primary determinant (factor) of growth, for investment to take place, firms (investors) and savers must be given incentives.

Moreover, savings have to be channeld to investors. Interest rate liberalization ensures that this  takes  place  efficiently  (efficient  financial  intermediation).  As  interest  rate  rises,  the quality  of  investment  is  enhanced,  since  financial  repression  is  often  associated  with mediocre quality investment. In addition, investment quality rises, since higher deposit rates increase the supply of funds.

However, in a policy reversal, the government in January, 1994 outrightly introduced some measures   of  regulation   into  interest  rate  management   owing  to  wide   variation   and

unnecessarily high rates under the complete deregulation of interest rates ( Bakare 2011). By re imposing controls on interest rate, maximum spread between deposit and lending rate were imposed. In the light of this, deposit rate was once again set at 12-15 % per  annum while ceiling of 21% per annum was fixed for lending. The cap on interest rate introduced in 1994 was retained in 1995 with a minor modification to allow for  flexibility. The cap stayed in place until it was lifted in October, 1996. The lifting remained in force in 1997 thus enabling the pursuit of a flexible interest rate regime in  which bank deposit and lending rates were largely determined by the forces of demand and supply of fund (Omole and Folokun 1999).

In view of the perceived benefits of liberalized interest rate, Van WijinBergan (1983b) and Taylor (1983) contrast their model to those of McKinnon- Shaw’s hypothesis. Using Tobin’s portfolio framework for household, household choice of investment includes time deposit, loan to businesses  through the informal sector and gold  or currency.  They argue that  in response to increase in interest rate on deposits, household will substitute these for gold or cash and loan in the informal sector.

Van Wijnbergan (1983a) expresses his view that the outcome of McKinnon- Kapur  model depends crucially on one implicit assumption on asset market structure. He  further argued that it is not at all obvious that bank deposit are close substitute to cash, gold, inventories and other commodities but  rather to loan extended to the informal sector. So many people have conducted research on interest rate liberalisation in Nigeria but their studies were limited to its effect on economic growth. The main objective of this study was to determine empirically the impact of interest rate liberalisation on selected micro-economic indicators in Nigeria.

1.2      Statement of the Problem

In view of the perceived benefit of liberalized interest rate, evidence in Nigeria suggests that neither the domestic savings nor investment has significantly increased since the introduction of  the  reform  programme.  The  domestic  economy  has  failed  to  experience  impressive performance. (Akpan 2004) and (Bakare 2011).

The criticism has been that interest rate liberalization in Nigeria is capable of discouraging savings and retarding  growth (Ojo 1976). In view of the empirical link  between savings, investment and economic growth, Van Wijnbergan, (1983a) contracts his hypothesis to those of McKinnon  (1973)  and  Kapur  (1976).  He  argues  that the  existence  of informal  credit market can reverse the effect of increase in interest rates on the total amount of savings. The effect of an increase in deposit rate on the amount of  loanable funds depends on whether

household substitute one of informal market loan or cash to increase their holdings for time deposits. If time deposits are closer substitutes for informal market loans than for cash, then the  supply  of funds  could  fall  given  that  banks  are  subject  to  reserve  requirement  and informal  markets  are not. He expresses  his view  that the outcome  of  McKinnon-  Kapur depends crucially on one implicit assumption on asset market structure.

With these features, the hope of achieving a sustainable economic growth through interest rate  liberalization  continues  to  diminish.  The  purpose  of  this  research  is  to  empirically investigate and provide an insight into the impact of interest rate liberalisation on Savings, Investment and Economic growth in Nigeria.

1.3      Objectives of the Study.

The general objective of this study is to investigate the impact of interest rate liberalization on selected  macroeconomic  indicators in Nigeria. However,  the specific  objectives are to investigate the effect of interest rate liberalisation on

1.  Savings.

2.  Investment

3. Economic growth

1.4      Research Questions

The questions that arise for which this study provided answers were:

1.  How does interest rate liberalization have positive and significant  effect on savings  in

Nigeria?

2. How does interest rate liberalization have positive and significant effect on investment in

Nigeria?

3. How does interest  rate liberalization  have positive  and  significant  effect on  economic growth in Nigeria?

1.5      Hypotheses of the Study.

The following hypothetical statements arise in this research. These are;

1. Interest  rate  liberalisation  does not  have  positive  and  significant  effect  on savings  in

Nigeria.

2. Interest rate liberalisation does not have positive and significant effect on investment  in

Nigeria

3. Interest  rate  liberaliation  does  not  have  positive  and  significant  effect  on  economic growth in Nigeria.

1.6      Scope of the Study.

This study used data from 1987– 2013.This  is to ensure that all the various interest  rate liberalization policies implemented toward the attainment of full financial liberalization status are taken into account for Nigeria. This also help to solve the problem of quantification of the effect of interest rate liberalization  which is usually one of the  problems associated  with empirical studies in this era (Caprio, et-al. 2001, Leaven  2003.)

1.7      Significance of the Study.

So far in Nigeria,  studies conducted on interest rate liberalisation is only limited to its effect on economic growth .This research seeks to empirically investigate and provide an insight into  the  impact  of  interest  rate  liberalisation  on  selected  macroeconomics  indicators  in Nigeria

This research will be of immence significance to the following groups. These groups are:

1          Policy makers. This is important because the behaviour of interest rate to a  large extent determines the investment activities and hence economic growth of a country. The findings will guide the policy makers in designing and  implementing financial policy that will enhance private and public investment friendly interest rate which is crucial for economic growth.

2          Academia.     The  empirical  finding  to  date  about  the  effects  of  interest   rate liberalization and economic growth in Nigeria has been inconclusive. The  result of this work may act as the spring board for other researchers  to do  more empirical studies on the impact of interest rate liberalization on economic growth in Nigeria.

3          General Public. The general public may also find the result of the work interesting and possibly extend their frontiers  of knowledge  of interest rate  liberalization  and investment nexus.

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