Understanding monetary policy nigeria by Mohamed Rahumathulla Mohamed

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

FACTORS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA1 Olubanjo T. Ajilore 2

SECTION ONE Introduction Interest rates rank among the most important variables in macroeconomics and in the functioning of financial markets. It plays a crucial role in the determination of the value of financial instruments, and generally affects economic agentsâ&#x20AC;&#x; decision or behavior on whether to consume, save and invest. It also affects the way wealth is distributed between borrowers and lenders. Interest rates influence the prices of key financial assets such as stocks, bonds, and foreign currencies. For individuals, interest rates are of interest as it determines monthly payments on car loans and home mortgages. It also determines the income earned on savings account, term deposits and other forms of market instruments.

1.1

Definition and Typologies of Interest Rates

Bannock et al (1998) defined interest rate as the price that a borrower has to pay in order to have access to the use of cash, which he or she does not own, and the return that a lender enjoys for foregoing consumption or liquidity in the current period. This definition connotes interest rate as both a cost and a reward. Interest rate is a cost of capital, which influences the demand for loanable funds by borrowers in need of such. When conceived in this way, interest rates are seen as lending rates on different forms of loans and advances in the financial market. On the other hand, interest rate could be conceived as a reward for accumulating financial assets and foregoing current consumption, which influences the willingness to save. In this way, interest rate denotes deposit rates on various forms of deposits and savings instruments in the financial market.

This publication is not a product of vigorous empirical research. It is designed specifically as an educational material for enlightenment on the monetary policy of the Bank. Consequently, the Central Bank of Nigeria (CBN) does not take responsibility for the accuracy of the contents of this publication as it does not represent the official views or position of the Bank on the subject matter. 2

Olubanjo T. Ajilore is a Principal Manager in the Monetary Policy Department, Central Bank of Nigeria.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

It is important to distinguish between the nominal and real interest rates at the outset, as well as identify the many variants of rates of interest in its deposit and lending rates forms:

1.2

Nominal Interest Rate

This is the interest rate paid for the use of money or credit before taking into consideration the inflation rate over the rental period. In other words it embeds both the effects of inflation and uncertainty. That is, the interest rates were not adjusted for changes in purchasing power caused by changes in the price level. In fact, inflation can reduce the purchasing power of returns on any investment. For example, suppose that an investor buys a N 1,000 bond that pays N50 in interest each year for 20 years. If the purchasing power of the currency that is received declines over time, the investor is, in effect, losing part of his interest income to inflation. In addition, inflation causes the purchasing power of the principal to decline. For example, if inflation is 5% per year, the purchasing power of the N 1,000 principal falls by N 50 each year.

1.3

Real Interest Rate

This is the nominal interest rate adjusted for expected inflation. To encourage savings, real interest rate is expected to be positive. Lenders and borrowers know that inflation reduces the purchasing power of interest income, so they base their investment decisions on interest rates adjusted for changes in purchasing power. Such adjusted interest rates are called real interest rates. Lending and borrowing parties are actually not sure of what the real interest rate will be over the tenor of the loan, they have to base their decisions concerning savings and investments on their expectations about the real interest rate. Savers and borrowers must decide what they expect the inflation rate to be in order to estimate the expected real interest rate. The expected real interest rate, r, equals the nominal interest rate, i, minus the expected rate of inflation, i.e., πe. i.e r  i   . e

Note that this equation also means that the nominal interest rate equals the real interest rate plus the expected inflation rate: i  r   . We can generalize by noting that the actual real interest rate equals the nominal interest rate minus the actual inflation rate. If the actual inflation rate is greater than the expected inflation rate, the actual real interest rate will be less than the expected real interest rate; in this case, borrowers will gain and lenders will lose. If the actual inflation rate is less than the expected inflation rate, the actual real interest rate will be greater than the expected real interest rate; in this case, borrowers will lose and lenders will gain. e

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

1.4

Savings Deposit Rate

The savings deposit rate is the interest rates paid by banks and other deposit taking institutions for cash deposited by savings deposit account holders. The payment of interest on the account is subject to the restriction that funds could only be withdrawn from the account after seven daysâ&#x20AC;&#x; notice. This restriction is however, seldom applied by banks nowadays, probably to gain competitive advantage in deposits mobilisation.

1.5

Fixed Deposit Rate

Fixed deposit account is an investment account with a specified amount invested at an agreed and specified interest rate and term to maturity. In Nigeria, fixed deposits have tenor of 30, 90 or 180 days. The interest rates paid on this form of account are called fixed deposit rates. They normally attract higher interest rates than the savings deposit rates.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

SECTION TWO Understanding the Concept of Factors that Influence Interest Rate in Nigeria 2.1

Minimum Rediscount Rate

This refers to the minimum lending rate of the central bank, at which it rediscounts bills of exchange and government securities held by the commercial banks in the performance of its function of lender of last resort. The rate serves as a signal of the liquidity conditions in the economy, and also as a signal of the desired direction of monetary policy.

2.2

Prime Lending Rate

This is the interest charged by banks to their most creditworthy, least risky and secured customers on short-term loans. In other words, this is the rate applied to loans made to customers with the highest credit risk rating. For each bank, this rate also represents the minimum lending rate. It is a good indicator of the cost of business borrowing from banks.

2.3

Maximum Lending Rate

This refers to the rate charged by banks for lending to customers with a low credit rating

2.4

Inter-Bank Interest Rate

Banks have cause to borrow and lend money among themselves in the interbank market. This is necessary for them to manage liquidity and meet the regulatory requirements placed on them. The inter-bank rate is the rate of interest charged on short-term loans made between banks. The interest rate charged depends on the availability of money in the market, on prevailing rates and on the specific terms of the contract.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

SECTION THREE Theoretical Perspectives on Interest Rate Determination There is a general lack of theoretical consensus on how interest rate is determined, and no single theory of interest rate determination is completely determinate. The classical interest-rate theory for instance, posits that the interest rate is determined by the supply of and demand for capital. On the contrary, the neo-classical or the loanable funds theory explains the determination of interest rate in terms of demand and supply of loanable funds. Keynesian theoretical framework opined that the interest rate is determined by liquidity preferences, which incorporate the impact of expansionary and contractionary monetary policies of Central Banks on the interest rates as a key policy variable, in pursuit of its monetary policy objectives. In what follows, we expatiate on each of these theoretical standpoints on interest rate determination. This is intended to put in perspectives subsequent discussions on the factors that influence the determination of interest rates in Nigeria.

3.1

The Classical theory of Interest rate

According to the classical theory, the rate of interest is determined by the supply and demand of capital. The supply of capital is governed by time preference while the demand for capital is governed by the expected productivity of capital. The theory is regarded a real theory of interest since explains the determination of the rate of interest by real forces such as thriftiness, time pref-erence and productivity of capital. On the demand side, the demand for capital comprises mainly of the demand for productive purposes, thus capital is demanded by the investors because it is productive. However, the law of variable proportions governs productivity of capital. This means productivity of capital diminishes with additional units of capital demanded by investors, up to a stage when the employment of an additional unit of capital is no more worthwhile. This implies that the rate of interest must at least equal to the marginal productivity of capital for the investor to demand capital. It shows that at a higher rate of interest the demand for capital is low and it is high at a lower rate of interest. Thus, the demand for capital is inversely related to the rate of interest and the demand schedule for investment curve slopes downward from left to right.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

Figure 1. Investment Demand Curve The supply of capital depends on savings on the supply side, and the rate of interest remains the most potent incentive to savings. Savings involves a sacrifice, abstinence or waiting when present consumption is foregone in order to earn interest. The higher the rate of interest, the higher will be the propensity to save and more will be the supply of funds. The supply curve of capital or the saving curve, thus moves upward to the right. As enunciated above, the rate of interest is determined by the interaction of the investment demand curve and the supply of savings curves. This is shown in Figure 2 below. SS is the supply of savings curve while II is the investment demand curve. Point E denotes the point of intersection of Investment demand curve and the supply of savings curve SS. Or is determined as the equilibrium rate of interest, at which point, the demand for investment and supply of savings equilibrate at quantity ON.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

Figure 2. Classical Theory: Determination of Interest Rate.

3.2

The Loanable Funds Theory

The neo-classical or the loanable funds theory explains the determination of interest rates in terms of demand and supply of loanable funds. The theory posits that the rate of interest is the price of credit, which is determined by the demand and supply of loanable funds. There are three main sources of demand for loanable funds. The first is government, which borrows funds for constructing public works or to prosecute wars. Second are the businessmen who borrow for the purchase of capital goods and for starting investment projects. Such borrowings are interest elastic and depend mostly on the expected rate of profit relative to the rate of interest. Finally, is the demand for loanable funds on the part of consumers for the purchase of durable consumer goods like houses. Individual borrowings are also interest elastic. The tendency to borrow is more at a lower rate of interest than at a higher rate in order to enjoy their consumption soon. Since demand for funds for consumption is mostly met out of past savings or dis-saving, it is denoted by the curve Ds in Figure 3. The demand curve for investment funds, both for the government and the businessmen, is as curve I. The downward slope of the curves indicates that fewer funds are borrowed at a higher rate and more at a lower rate of interest. Lastly, funds are demanded for the purpose of hoarding them in liquid form or as idle cash. They are also interest elastic and are shown by the curve H. The horizontal summation of the investment demand curve I, consumption or dissavings demand curve DS, and the hoarding demand curve H, gives us DL as the total demand curve for loanable funds.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

Figure 3: Determination of Rate of Interest. The supply of loanable funds comes from savings, dishoarding and bank credit. Private individuals and corporate savings are the main sources of savings. Although personal savings depend upon the income level, yet taking the income level as given, they are regarded as interest elastic. The higher the rate of interest, the greater will be the inducement to save and vice versa. Undistributed profits of corporate firms represent corporate savings. It also to some extent, depends on the current rate of interest. The second source of supply of loanable funds is the volume of funds coming out of hoards or being added to them. Dishoarding represents both purchase of old assets or securities from others, out of idle cash balances of one‟s own funds for net investment, or for consumption in purchases in excess of net disposable income. The higher the interest rate, the larger the funds that will be coming out of hoards and vice versa. Lastly, there is the bank credit as an important source of the supply of loanable funds. More funds are lent at a higher than at a lower rate of interest. In Figure 3, savings are indicated as curve S. Funds coming out of dis-hoarding are indicated by the curve DH. Bank credit is shown as the curve DM. The lateral summation of the foregoing, yields the aggregate supply curve SL of loanable funds. The total demand curve for loanable funds, DL, and the total supply curve of loanable funds, SL, intersects each other at E, and give Or rate of interest, and OM amount of funds are borrowed and lent.

3.3

Keynesian’s Liquidity Preference Approach

Keynes defined the rate of interest as the reward of not hoarding, but the reward for parting with liquidity for a specified period. It is the „price‟ which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

In the Keynesian sense, the rate of interest is determined by the demand for and the supply of money. This theory is, therefore, characterised as the monetary theory of interest rate, as distinct from the real theory of the classicals. The supply of money refers to the total quantity of money in the country for all purposes at any time. Though the supply of money is a function of the rate of interest to a degree, it is considered to be fixed by the monetary authorities, that is, the supply curve of money is taken as perfectly inelastic. Keynes coined the term „liquidity preference‟ for the demand for money. Liquidity preference is the desire to hold cash. In the words of Keynes, the rate of interest is the “premium which has to be offered to induce people to hold their wealth in some form other than hoarded money”. The higher the liquidity preference, the higher will be the rate of interest that will have to be paid to the holders of cash to induce them to part with their liquid assets. The lower the liquidity preference, the lower will be the rate of interest that will be paid to the cash-holders. Keynes identified three motives behind the desire of the people to hold liquid cash: (1) the transactions motive, (2) the precautionary motive, and (3) the speculative motive. The transactions motive relates to the “need of cash for the current transactions of personal and business exchanges.” The transactions motive is divided into the income and business motives. The income motive is meant to bridge the interval between the receipt of income and its disbursement, while the business motive is meant to bridge the gap of the interval between the time of incurring business costs and that of receipt of sale proceeds. If the time between the incurring of expenditure and receipt of income is small, less cash will be held by the people for current transactions and vice-versa. There will, however, be changes in the transactions demand for money depending upon the expectations of the income recipients and businessmen. The precautionary motive relates to the desire to provide for contingencies requiring sudden expenditures, and for unforeseen opportunities of advantageous purchases. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies. Businessmen similarly, keep cash in reserve to meet unexpected profitable deals. The precautionary demand for money depends upon the level of income. Keynes holds that the transactions and precautionary motive are relatively interest inelastic, but highly income elastic. The amount of money held under

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

these two motives (M1) is a function (L1) of the level of income (Y) and is expressed as M1=L1(Y). Money held under the speculative motive, in the words of Keynes, is â&#x20AC;&#x153;for securing profit from knowing better than the market what the future will bring forthâ&#x20AC;?. Individuals and businessmen that have funds, after keeping enough for transactions and precautionary purposes, like to gain by investing in bonds. Money held for speculative purposes is a liquid store of value, which can be invested at an opportune moment in interest-bearing bonds or security. Bond prices and the rate of interest are inversely related to each other. Low bond prices are indicative of high interest rates, and high bond prices reflect low interest rates. According to Keynes, it is expectations about changes in bond prices or in the current market rate of interest that determine the speculative demand for money. The speculative demand for money is a decreasing function of the rate of interest. The higher the rate of interest, the lower the speculative demand for money. Keynes denoted the speculative demand for money as M2=L2(r), where L2 is the speculative demand for money and r is the rate of interest. The total liquid money is denoted by M= M1+M2, which is the sum of the transactions plus the precautionary motives (M1) and the speculative motive for holding money (M2). Though M1 is a function of income and M2 of the rate of interest, the two are not in watertight compartments. Even M1 is interest elastic at high interest rates. If there is increased demand for M1, it can be met by transferring funds from idle balances, M2. Geometrically, as indicated in Figure 4, money held under the speculative motive is a decreasing function of the rate of interest. The X-axis is indicated the speculative demand for money, while the Y-axis represented the rate of interest. The liquidity preference curve LP, is downward sloping towards the right indicating that the higher the rate of interest, the lower the demand for speculative money demand motive, and vice versa. It is important to note in Figure 4 that the liquidity preference curve LP becomes quite flat i.e., perfectly elastic at a very low rate of interest. This perfectly elastic portion of liquidity preference curve indicates the position of absolute liquidity preference of economic agents. At a very low rate of interest, people will hold any amount of money as inactive balances. This portion of liquidity preference curve with absolute liquidity preference is called liquidity trap by economists.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

Figure 4. Demand for money

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

SECTION FOUR Interest Rate Determination in Nigeria The discussion of both the loanable funds and the liquidity preference theoretical underpinnings of interest rate determination have indicated that the equilibrium interest rate is only a temporary equilibrium. Changes in the underlying factors that determine the demand and supply of loanable funds and/or demand for liquidity preferences can cause continuous shifts (upwards or downwards) in the respective demand and supply curves. Market forces will react to the resulting disequilibrium with a change in the equilibrium interest rate and quantity of funds traded in the market. In what follows, we examine specific factors that underlie interest rate decisions across the range of real-world financial market, given the underlying level of interest rate.

4.1

Inflation Rate

The first factor that affects interest rates is the actual or expected inflation rate in the economy. Specifically, the higher the level of actual or expected inflation, the higher will be the level of interest rates. If inflation is expected to increase, the nominal interest rates need to adjust to induce positive real interest rates, which will not render savers worse-off. In other words, lenders/savers will want to be compensated for inflation (for loss of purchasing power) and will push the nominal interest rate up to get the desired real rate of interest. If the rate of inflation is expected to increase, the nominal interest rate needs to be sufficiently high to induce positive real interest rates, so that there is an incentive for savings.

4.2

Monetary Policy Actions

The Central Bankâ&#x20AC;&#x;s interest-rate policy most directly underlies the level and movement of interest rates that, in turn, affects financial institutionsâ&#x20AC;&#x; cost of funds. Since the Central Bank can control short-term interest rates by setting the Monetary Policy Rate that determines the rate at which banks can borrow overnight, it also controls the rate at which an investor can borrow. Through its daily open market operations, such as buying and selling treasury bills, the Central Bank seeks to influence the money supply, inflation, and the level of interest rates (particularly short-term interest rates). In turn, changing interest rates impact economic decisions, such as whether to consume or save.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

4.3

Fiscal Policy Stance

Other things being equal, an increase in the government budget deficit will raise interest rates. The loanable fund framework approximates increase in government borrowing to imply a rightward shift in the demand curve for loanable funds. Moreover, announcement of a larger budget deficit arouses inflation expectation, which stimulated inflation expectations, pulling up interest rates via the Fisher effect. Furthermore, government fiscal deficits financed by the banking system crowdout the private sector. Real interest rates rise as the government attracts funds away from the private sector.

4.4

Risk Profiles

Borrowersâ&#x20AC;&#x;(including sectoral) risk profile and the pricing of risks by the deposit money banks play an important role in determining the level of interest rates charged by banks. Where a borrower/sector or project is assessed to be high risk, a higher than â&#x20AC;&#x153;normalâ&#x20AC;? nominal interest rate is charged. This explains why some customers are charged a higher interest rate than others under similar conditions.

4.5

Term to Maturity

Another factor that could influence changes in interest rates is the maturity period of the financial instrument and perception of the risks associated with the instrument. Those with longer-term maturity and higher probability of incurring loss carry higher interest rates.

4.6

Domestic Savings Mobilization

Higher volumes of savings drive down interest rate and promote investment. Conversely, lower volume increases interest rate and lowers investment. The domestic interest rates and the rate of return on foreign financial assets, as well as the expected change in exchange rate determine the allocation of accumulated savings among domestic financial assets, foreign assets and goods that are hedged against inflation. Raising the levels of long-term savings is therefore, vital for achieving the desired level of interest rates as well as sustaining high investment and output growth.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

SECTION FIVE Conclusion Interest rates rank among the most important variables in macroeconomics and the functioning of the practical world of financial markets. The definition of interest rates connotes it as both a cost and a reward. Interest rate is a cost of capital, which is a determinant of the borrowersâ&#x20AC;&#x; decisions to demand loanable funds. On the other hand, interest rate could be conceived as a reward for foregoing current consumption for the purpose of accumulating financial assets, which influences the willingness to save. Consequent on the foregoing, this series espouses on the definitions of interest rates and the various forms of interest rates that derived from such definitions. Given the general lack of theoretical consensus on how interest rate is determined, the chapter expatiates on differing theoretical standpoints on interest rate determination. This is intended to put in perspectives subsequent discussions on the factors that influence the determination of interest rates in Nigeria. Financial market refers to a market where people and other entities trade financial securities, commodities and other fungible items of value in which prices reflect the interplay of demand and supply conditions. Financial markets source funds from investors and channel such funds to borrowers to finance their operations. Ordinarily, a borrower issues a receipt to the lender promising to pay back the principal. These receipts are usually referred to as securities, which may be freely traded.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA

Bibliography Bannock, G. et al (1998.) Dictionary of Economics, 6th Edition, Pengium. Charles P. Jones (2010). Investment: Principales and Concepts, International Students Version, 11th Edition, Wiley. Frederic S. Mishkin, (2012). The Economics of Money, Banking and Financial Markets, 10th Edition, Pearson. Lee, W. and Prasad, E. (1994). “Changes in the Relationship Between the Long Term Interest Rate and its Determinants”, IMF Working Paper 94/124, Washington DC, 1994.

FACTOTS THAT INFLUENCE INTEREST RATE DECISIONS IN NIGERIA