THE IMPACT OF OPEN MARKET OPERATION ON PRICE STABILITY IN NIGERIA

ABSTRACT

Results of monetary policy outcomes suggest that Nigeria does not enjoy ideal conditions for adopting a monetary policy regime aimed primarily at stabilizing prices under a freely floating exchange rate. The reasons often advocated is that Nigeria faces a very volatile macroeconomic environment and a more acute inflation-output  trade-off  than other emerging market economies  which have embraced price stabilization  programs and thereby abandoning their exchange rate anchors. Moreover, Nigeria has an intense exchange of goods and services with the rest of the world which is stronger than other emerging  market  economies,  thanks to its mainly  oil-exporting-oriented  economy.  This can make Nigeria  particularly   exposed  to  price  and   quantity-type   external   shocks,  which  renders  price stabilization all the more complicated. Open Market Operation is one of the monetary policy tools of the Central Bank of Nigeria which entails the sale or purchase of eligible bills or securities in the open market by the Central Bank of Nigeria for the purpose of influencing deposit money, banks’ reserve balances, and the level of base money which is effectively aimed at achieving the price objectives of the Central  Bank  of  Nigeria.  Thus,  this study  sought  to: examine the impact of Open market operation on the maintenance of Exchange rate price stability in Nigeria and determine the impact of Open market operation on the maintenance of consumer price stability in Nigeria. The  research  design  adopted  for this study is the ex post facto research  design.  This enabled  the researcher  make  use of secondary  data.  Annualized  data from  1993 to 2007  of proxies  from  the Central  Bank  of  Nigeria  statistical  bulletin  were  used.  The  Linear  Regression  Model  (LRM) estimation technique using SPSS statistical software was used to evaluate the stated objectives where rate values of Open Market Operation Rate (OMOR) as proxy for Open Market Operation (OMO) which  is the independent  variable  while  Nominal  Effective  Naira  Exchange  Rate  Indices  (EXR), Inflation Rate (INFR) and Gross Domestic Product Growth Rate (GDPGR) as a control variables. The result revealed that open market operation has a negative non-significant impact on exchange rate in Nigeria (t = -0.025, coefficient of OMOR = -0.003) and open market operation has positive non-significant impact on inflation rate in Nigeria (t = 1.604, coefficient of OMOR =0.047). As revealed from the findings in this research the use of open market operation as a monetary policy tool have actually influence consumer price stability in Nigeria hence  the study recommends among others that an increased use of open market operations as a tool for achieving price stability in Nigeria and a conscious effort monetary authorities in bring the informal sector into the main stream of the Nigeria economy. This will help to expand as well as capture the huge funds in the informal sector which is presently not captured.

CHAPTER ONE

INTRODUCTION

1.1      BACKGROUND OF THE STUDY

In general terms, monetary policy refers to a combination of measures designed to regulate the value, supply and cost of money in an economy, in consonance with the expected level of economic  activity.  For  most  economies,  the objectives  of monetary  policy  include  price stability, maintenance  of balance of payments equilibrium,  promotion of employment  and output  growth,  and  sustainable   development.   These   objectives  are  necessary  for  the attainment of internal and external balance, and the promotion of long-run economic growth (Nnanna, 2001).

The importance of price stability is derived from the harmful effects of price volatility, which undermines the ability of policy makers to achieve other laudable macroeconomic objectives. There is indeed a general consensus that domestic price fluctuation undermines the role of money as a store of value, and frustrates investments and growth. Empirical studies (Ajayi and Ojo, 1981) on inflation, growth and productivity have confirmed the long-term inverse relationship between inflation and growth. When  decomposed into its components, that is, growth due to capital accumulation, productivity growth, and the growth rate of the labour force, the negative association  between inflation and growth has been traced to the strong negative relationships  between it and capital accumulation as well as productivity growth, respectively.  The  import of these empirical  findings is that stable prices are essential for growth.

The  success  of  monetary  policy  depends  on  the  operating  economic  environment,  the institutional framework adopted, and the choice and mix of the instruments used. In Nigeria, the design and implementation of monetary policy is the responsibility of the Central Bank of Nigeria (CBN). The mandates of the CBN as specified in the CBN  Act of 1958 include; issuing of legal tender currency, maintaining external reserves to safeguard the international value of the currency, promoting monetary stability and a sound financial system and acting as banker and financial adviser to the Federal Government.

However,  the  current  monetary  policy  framework  focuses  on  the  maintenance  of  price stability while the promotion of growth and employment are the secondary goals of monetary policy (see, Nnanna, 2001). In Nigeria, the overriding objective of monetary policy is price

and exchange rate stability (see, CBN, 2001). The monetary authority’s strategy for inflation management  is based  on  the  view  that  inflation  is essentially  a monetary  phenomenon. Because targeting money supply growth is considered as an appropriate method of targeting inflation in the Nigerian economy,  the Central Bank of Nigeria  (CBN) chose a monetary targeting policy framework to achieve its objective of price stability. With the broad measure of money (M2) as the intermediate target, and the monetary base as the operating target, the CBN  utilized  a  mix  of  indirect  (market-determined)  instruments  to achieve  it  monetary objectives.  These  instruments  included  reserve  requirements,  open  market  operations  on Nigerian  Treasury  Bills  (NTBs),  liquid  asset  ratios  and  the  discount  window  (see  IMF Country Report No. 03/60, 2003).

Onafowora (2007 say the CBN’s focus on the price stability objective was a major departure from past objectives in which the emphasis was on the promotion of rapid and sustainable economic growth and employment. Prior to 1986, the CBN relied on the use of direct (non- market)  monetary  instruments  such  as  credit  ceilings  on  the  deposit  money  of  banks, administered  interest  and  exchange  rates,  as  well  as  the  prescription  of  cash  reserves requirements in order to achieve its objective of sustainable growth and employment. During this period, the most popular instruments of monetary policy involved the setting of targets for aggregate credit to the domestic economy and the prescription of low interest rates. With these  instruments,  the  CBN  hoped  to direct  the  flow  of  loanable  funds  with  a  view  to promoting  rapid  economic development  through  the provision  of finance to the preferred sectors of the economy such as the agricultural sector, manufacturing, and residential housing (see, Onafowora, 2007).

During the 1970s, the Nigerian economy experienced major structural changes that made it increasingly difficult to achieve the aims of monetary policy. The dominance  of oil in the country’s  export  basket  began  in the  1970s.  Furthermore,  the  rapid  monetization  of  the increased crude oil receipts resulted in large injections of liquidity into the economy, induced rapid monetary growth. Between 1970 and 1973,  government  spending averaged about 13 percent of gross domestic product (GDP), and this increased to 25 percent between 1974 and

1980. This rapid growth in government spending came not from increased tax revenues but the absorption of oil earnings into the fiscal sector, which moved the fiscal balance from a surplus to a deficit that averaged about 2.5% of GDP a year. This new era of deficit spending led the government  to borrow from the banking system in order to  finance the domestic

deficits. At the same time, the government was saddled with foreign deficits, which had to be financed through massive foreign borrowing and the drawing down of external reserves. To reverse  the  deteriorating  macroeconomic  imbalances  (declining  GDP  growth,  worsening balance  of  payment  conditions,  high  inflation,  debilitating  debt  burden,  increasing  fiscal deficits, rising unemployment rate, and high incidence of poverty), the government embarked on austerity measures in 1982. The austerity measures was successful judging by the fall in inflation rate to a single digit, the significant improvement in the external current account to positions of balance. However, these improvements were transitory because the economy did not establish a strong base for sustained economic growth (see, Onafowora, 2007).

Having examined the objectives of monetary policy in Nigeria, this study intends to find out the  impact  of  monetary  policy  through  the  use  of  open  market  operation  in  enhancing economic stability in Nigeria.

1.2      STATEMENT OF THE PROBLEM

Results  of  monetary  policy  outcomes  suggest  that  Nigeria  does  not  often  enjoy  ideal conditions to adopting a monetary policy regime aimed primarily at stabilizing prices under a freely  floating  exchange  rate.  There  could  be  possible  reasons  for  this.  The  Nigerian macroeconomics environment often do faces a very volatile macroeconomic environment and a more acute inflation-output  trade-off than other  emerging market economies which have embraced price stabilization programs and  thereby abandoned their exchange rate anchors. Moreover, it could often observed that Nigeria has an intense exchange of goods and services with the rest of the world, and one that is stronger than other emerging market economies, thanks to its mainly oil-exporting-oriented economy. This can make it particularly exposed to price  and  quantity-type  external  shocks,  which  renders  price  stabilization  all  the  more complicated.  Although  Nigerian  consumer  price index is not that sensitive  to  commodity price shocks notably shocks to the price of oil changes in the Nigerian  exchange rate are passed through sizably and significantly (Batini and Morsink, 2004). Thus, given the above, the problems associated with the use of open market operation as monetary policy tools given the objectives of monetary policy in an economy of maintaining stability are: price instability and exchange rate instability in Nigeria.

Nigerian consumer prices is so volatile, and more dramatic than in other emerging market economies countries, this have created problems for the conduct of a monetary policy aimed at price stability because optimal policy responding to exchange rate shocks depends on the source and duration of the shock, which are typically unknown and hard to decipher in an unstable macroeconomic environment. Judging by the risk premium on dollar-denominated Nigerian sovereign debt relative to same risk premia of other emerging market economies’ debt, the Nigerian fiscal policy appears extremely vulnerable a reflection of the fact that the Nigerian central bank is fiscally dominated in the sense of Masson et al (1997). The size and volatility of the Nigerian risk premium on government debt means that the Nigerian exchange rate, as well as short- and long-term  rates, may vary endogenously  with the debt-to-GDP ratio. Both facts indicate that it is hard, if not impossible, in the current circumstances to talk about active monetary policy  in Nigeria of whatever kind. As emphasized  in Favero and Giavazzi (2003), large and variable term premia and credit risks reinforce the possibility that a vicious circle might arise, making the fiscal constraint on monetary policy more stringent. Given  these  conditions,  it is reasonable  to expect  that aiming  for and adopting  a stable prices/free float regime in the long run in Nigeria may not lead to successful outcomes. In addition to not achieving the intended aims, it could be argued that pursuing unsuccessfully a price stabilization regime may harm the credibility of the central bank going forward. Sims (2003), for instance, emphasized  that when conditions are such  that an inflation targeting commitment has a high probability of proving unsustainable like when the necessary fiscal backup to monetary policy is not available embracing nevertheless explicit inflation targets can be unproductive or lead to an initial success that only amplifies a later failure.

Exchange rate target results in the loss of independent monetary policy. With open capital markets, an exchange-rate target causes domestic interest rates to be closely linked to those of the anchor country. The targeting country thus loses the ability to use  monetary policy to respond  to  domestic  shocks  that  are  independent  of  those  hitting  the  anchor  country. Furthermore, an exchange-rate target means that shocks to  the anchor country are directly transmitted to the targeting country because changes in interest rates in the anchor country lead to a corresponding change in interest rates in  the targeting country (Clarida, Gali and Gertler (1997). Exchange rate targets have been pointed out forcefully in Obstfeld and Rogoff (1995), where they say exchange rate targets leave countries open to speculative attacks on their currencies. An exchange rate target in emerging market countries that suggests that for them this monetary policy  regime is highly dangerous  and is best avoided except in rare

circumstances.  Exchange  rate targeting in emerging market countries is likely to  promote financial fragility and possibly a fully fledged financial crisis that can be highly destructive to the economy.  To see why exchange-rate  targets  in an emerging  market  country  make  a financial crisis more likely, we must first understand what a financial crisis is and why it is so damaging to the economy.

Studies evaluating the costs of inflation have long established the desirability of avoiding not only high but even moderate inflation (Fischer and Modigliani,  1978; Fischer,  1981; and more recently Driffill, et., al, 1990 and Fischer, 1994), However, there is still a serious debate on whether the optimal average rate of inflation is low and positive, zero, or even moderately negative (Tobin, 1965 and Friedman, 1969). An important issue in this debate concerns the reduced ability to conduct effective countercyclical monetary policy when inflation is low. As pointed out by Summers (1991), if the economy is faced with a recession when inflation is zero, the monetary authority is constrained in its ability to engineer a negative short-run real interest rate to damp the output loss. This constraint reflects the fact that the nominal short- term interest rate cannot be lowered below zero  the zero interest rate bound (Hicks, 1937 interpretation of the Keynesian liquidity trap and Hicks, 1967). This constraint would be of no relevance in the steady state of a non-stochastic economy. Stabilization of the economy in a stochastic environment, however, presupposes monetary control which leads to fluctuations in  the  short-run   nominal  interest  rate.  Under  these  circumstances,   the  non-negativity constraint on nominal interest rates may occasionally be binding and so may influence the performance of the Economy. Although inflation targeting does appear to be successful in moderating and controlling inflation, the likely effects of inflation targeting on the real side of the economy are more ambiguous. Economic theorizing often suggests that a commitment by a central bank to reduce and control inflation should improve its credibility and thereby reduce  both  inflation  expectations  and  the  output  losses   associated  with  disinflation. Experience and econometric evidence (see Almeida and Goodhart, 1998, Laubach and Posen,

1997,  Bernanke,  Laubach,  Mishkin  and  Posen,  1998)  does  not  support  this  prediction, however. Inflation expectations do not immediately adjust downward following the adoption of inflation targeting. Furthermore, there appears to be little if any reduction in the output loss associated with disinflation, the sacrifice ratio, among countries adopting inflation targeting.

1.3      OBJECTIVES OF THE STUDY

As a result of the problems stated above, the main objectives of this study are;

1.   To examine the impact of Open market operation on the maintenance of Exchange rate price stability in Nigeria

2.   To determine the impact of Open market operation on the maintenance of consumer price stability in Nigeria

1.4      RESEARCH QUESTIONS

As a result of the above objectives, the following research questions emanate:

1.   To what extent does Open market operation in Nigeria assist in the maintenance of exchange rate price stability? and

2.   To what extent does Open market operation impact on the maintenance of consumer price stability in Nigeria?

1.5      RESEARCH HYPOTHESES

Following the research questions raised above, the following hypotheses are stated;

1.         Open market operation does not have a significant positive impact on exchange rate price stability in Nigeria

2.         Open market operation does not have a significant positive impact on consumer price stability in Nigeria.

1.6      SCOPE OF THE STUDY

This study covers the period 1993 to 2008. OMO was introduced at the end of June 1993 and is conducted wholly on Nigerian Treasury Bills (NTBs), including repurchase  agreements (repos). OMO entails the sale or purchase of eligible bills or securities in the open market by the CBN for the purpose of influencing deposit money, banks’ reserve balances, and the level of base money and consequently the overall level of monetary and financial conditions. In this transaction, banks subscribing to the offer, through the discount houses, draw on their reserve balances at the CBN thereby reducing the overall liquidity of the banking system and the  banks’  ability  to create  money  via  credit.  In  implementing  the  OMO,  the  Research Department of the CBN advises the trading desk at the Banking Operations Department, also

of the CBN, on the level of excess or shortfall in bank reserves. Thereafter, the trading desk decides on the type, rate and tenor of the securities to be offered and notifies the discount houses 48 hours ahead of the bid date. The highest bid price lowest discount rate quoted) for sales and the lowest price offered (highest discount offer) for purchases, with the desired size or volume, is then accepted by the CBN (Nnanna, 2001).

1.7      SIGNIFICANCE OF THE STUDY

This study will be significant to the following groups;

1.   MONETARY POLICY MAKERS

Monetary policy decisions are made in real time and are based, by necessity, on preliminary data and estimates that contain considerable noise and are often substantially revised months or years after the event. While part of everyday life for policymakers,  this aspect of the monetary policy process is often neglected in theoretical  formulations of monetary policy, introducing  a  wedge  between  the  promise  of  macroeconomic  theory  and  the  reality  of macroeconomic  practice. Recognition  of the  complications  resulting from the presence of noise is important for the study of monetary policy for two reasons: First, the evaluation of past policy is incorrect when it is based on the wrong data. That is, our understanding of the past becomes distorted. Second, the evaluation of alternative policy strategies is unrealistic and likely to mislead if it is based on the assumption that policy can react to either data that are not really available to policymakers when policy must be set or that are only available with  substantial  noise.  That  is,  recommendations  for  better  policy  in the  future  become flawed, thus, this study will assist policy makers in formulating policies that conforms with the objectives of monetary policy.

2.   ACADEMIC PURPOSE

The  conduct  of  monetary  policy  in  Nigeria  under  the  colonial  government  was  largely dictated by the prevailing economic conditions in Britain. The instrument of monetary policy at that time was the exchange rate, which was fixed at par between the Nigerian pound and the British pound. This was very convenient, as fixing the  exchange rate provided a more effective mechanism for the maintenance  of balance of  payments viability and for control over inflation in the Nigerian economy. This study thus will trace the history of monetary

policy in Nigeria, especially the use of open market operation as a tool of monetary policy in Nigeria  since  1993.  There,  it will contribute  to the volume  of literatures  in  this area of finance.

3.   GENERAL AND INTERESTED PUBLIC

It is argued that if residents evaluate their asset portfolio in terms of the domestic currency, a depreciation  of the exchange rate that increases the value of their foreign  holdings would enhance wealth. To maintain a fixed share of the wealth invested in domestic assets, residents will shift parts of their foreign holdings to domestic assets, including domestic currency. The increase in the share of wealth held in domestic assets, including domestic currency, suggests a rise in the demand for the domestic currency.  Thus, this study will be significant to the general and interested public because it will help them to decide on how to increase economy wellbeing.

1.8      DEFINITION OF TERMS

The following terms as they relate to this study are defined:

Monetary Policy: a combination of measures designed to regulate the value, supply and cost of money in an economy, in consonance with the expected level of economic

activity (Nnanna, 2001).

Open Market Operation: OMO entails the sale or purchase of eligible bills or securities in the open market by the CBN for the purpose of influencing  deposit  money, banks’ reserve balances, and the level of base money and consequently  the overall level of monetary and financial conditions (Nnanna, 2001).

Inflation  Targeting:  Inflation  targeting  involves,  public  announcement  of  medium-term numerical  targets for inflation,  an institutional  commitment  to  price  stability as the primary  and  increased  accountability  of  the  central  bank  for  attaining  its  inflation objectives (Mishkin, 1998)

Exchange  rate  Targeting:  the  form  of  fixing  the  value  of  the  domestic  currency  to  a commodity such as gold (Mishkin, 1998).

Price  Stability:  measures  that  ensure  that  inflation  rate  is  in  a  single  digit  and  stable (Onafowora,  2007) or Price stability obtains when economic agents no  longer take account of the prospective change in the general price level in their economic decision making” (Greenspan, 1996).

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