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Why the MPC should consider a downward review of Monetary Policy Rate (MPR) this January

General sentiments support the need to commence the reversal of the two and a half year’s old monetary policy tightening programme in 2013. The tightening mode was initiated and has been sustained as a result of the high inflation in Nigeria which the monetary authority believed was largely a monetary phenomenon. However key indicators relevant to monetary policy actions supports a reduction in the MPR at the monetary policy committee meeting scheduled for Monday 21, 2013. And that a little reflation of the economy now would show the readiness of the monetary authority to use the monetary policy in an appropriate manner- short term, quick response and sharp on focus.

Global growth prospect expected to improve later in the year but not earlier

The Economic Intelligence Unit (EIU) sees improving fundamentals in many economies, supported in part by a heavy dose of stimulus, mainly from central banks. In this regard, it is worthy of note that the Nigerian monetary authority have pursued the opposite path consistently to fight inflation. Coupled with rising demand in many economies and the slow but steady resolution of banking and debt overhangs from the recession, the outlook for global growth is improving. These gains will, however, take some months to fully materialise, and in any case, will come against the backdrop of several risks early in the year. To sustain this trend in 2013, the combination of monetary easing and buffer building has been advocated by the Word Bank. More importantly, emerging and developing countries must avoid policies that are pro-cyclical at this time.

Nigeria’s monetary policy has been pro-cyclical, arguably compounding growth challenges

Amidst sustained impacts of economic downturn and domestic structural challenges on economic growth in the last two years, the monetary policy stance has been rather pro-cyclical. It may have added to the challenges of the productive sectors’ recovery from the economic downturn by promoting sustained deleveraging, pushing corporate hurdle rates higher and making it less attractive for banks to lend to the private sector, especially reducing the small amount of lending that erstwhile goes to the small and medium scale enterprises (SMEs) and consumers. The implication on the employment of human and material is depressing with unemployment rate for 2012 estimated at 25.6% from 23.9% in 2011. In this regard, the monetary authority agreed there is the need to support the economy with appropriate monetary policy actions as soon as possible.

Inflationary outcomes and threat are expected to be lower in 2013

Although inflation resurged in November 2012 when the year on year headline inflation surged to 12.3% from 11.7% in October, the slowdown to 12% in December 2012 however highlights the argument that the surge was significantly caused by base effect. This is shown by the dynamics of the monthly change in the CPI during the period, in addition to the unpredictably volatile dynamics of the year on year core and food inflation in recent times.

Despite the underlying inflationary tendencies that the dynamics of core inflation rates presents, we agree with the CBN research team, that inflation rate would slow down significantly in the first quarter of 2013 starting from January. This is expected to be caused largely by base effect as the base for 2013 monthly inflation rate estimation shifts to 2012, a year with high CPIs. In this regard, among other factors, the outlook for inflationary pressure in the short term is downward; thus providing substantial reason for the commencement of the reversal of monetary tightening.

Stronger and perhaps sustainable exchange rate has been achieved

The interbank and BDC rates moderated between the last MPC meeting in November and currently from N157.96/US$ and N159.00/US$ to N157.29/US$ and N159.00/US$. The official rate was largely flat at N155.75/US$ on the average during the period. Sales at the weekly wDAS market did not exceed US$300m and averaged only US$142m per sale. The stability of the foreign exchange market is also reflected in the growth of the nation’s foreign exchange reserve to US$44.6 billion on January 10, 2013 compared to US$36.8 billion at the end of June 2012. The outlook for the Naira exchange rate in 2013 is stable, on the back of the institutionalised market actions, import prohibition measures and perhaps positive outlook for FPI.

Systemic liquidity was well managed barring the surge in hot monies inflow

Money market liquidity, which provides a reasonable gauge of the dynamics of the systemic liquidity in lieu of the delayed monetary aggregate data, ended the month of December with a total net outflow of N211.23 billion. Characteristically, the liquidity squeeze was largely driven largely higher outflows through the CBN treasury operation and bond issues than the inflow from maturing bills and bonds. However, the mild moderation in short term interest rate during the month suggests that foreign portfolio inflows (FPI) perhaps sustained systemic liquidity higher than captured by the money market liquidity gauge above. The CBN utilised the OMO tool appreciably well to manage liquidity during the year.

The spate of hot monies is however worrisome

The FPI is ‘hot monies’ whose likely sudden reversal could derail any form of economic stability it may have helped to achieve. According to the CBN External Sector Development report for the third quarter of 2012, FPI inflow accounted for 76.21% of the total US$6.07 billion foreign capital inflow during the quarter; growing by 75.9% in that quarter alone.

Truly, the continued dominance of FPI in aggregate foreign capital inflows suggests the need to put in place measures against capital reversal. Yet, at this point on the Nigerian growth and unemployment scale, reflation will be countercyclical and in favour of the economy in the short to medium term.  On a decision scale, the argument for a mild reflation tilts the balance in favour of, at least, 25 basis points cut in MPR.

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Creating more value through enforcement of compulsory insurances

At the end of the insurance sector consolidation and recapitalisation, part of the reform of the entire financial system in 2007, expectations were high that the sector would unlock the huge untapped value in the industry and deliver exponential growth similar to the experience of the banking sector post consolidation in 2005. Unfortunately, despite the huge market for insurance, growth in the industry has remained flat in the last four years, partly due to the global economic recession. To a large extent the industry has been unable to deploy the new capital to grow earnings and mobilise long term investible funds. Rather, a large portion of capital raised might have been lost to the financial market crisis through equity investment. The sector has therefore not been able to take over from banks in the provision of core services such as underwriting performance bonds and guarantees and credit bonds for large ticket transactions.

There is huge potential for the underwriting business in Nigeria

With a population in excess of 160 million, Nigeria offers one of the biggest insurance markets in the world. The potential of the insurance market is better appreciated when compared to South Africa which has a population of about 40 million but controls 78.13% of Africa’s insurance sector’s premium while the sector contributes about 16% to the country’s GDP. According to statistics for 2010, Nigeria controlled a mere 1.7% of the continent’s total premium of US$67 billion. Therefore, if South Africa with less than a third of Nigeria’s population could control a premium of US$52.6 billion (N7.88 trillion) in 2010, Nigeria’s insurance industry has the potential of reaching this landmark in the medium to long term.

The Nigerian Oil & Gas Local Content Development (NOGCD) Act 2010 is poised to open up huge capital investment underwriting business for the sector with the capacity to deliver an estimated premium income of N52 billion in 2011 and annual growth of 10% afterward.  The huge infrastructure gap, low manufacturing capacity, high agricultural production potential, expanding middle income group and rising per capita income of the nation suggests that Nigeria’s insurance sector is at least as big as the pre-crisis banking sector in gross premium potential.

Stiff competition from banks and pension funds is among the several challenges facing the sector

The industry is however bedevilled by a number of challenges which has contributed to its stunted growth. Following the recapitalisation of the industry, it has been faced with stiff competition from banks, the pension industry, the stock market and even the real estate market in attracting household and firms’ funds. On the back of the poor perception of insurance among the populace, the high return on investment being offered by these other channels depressed insurance penetration. The reform of the pension system and the strength of enforcement supported faster growth in the pension sector to the relative disadvantage of insurance- personal and life insurance. Hence, the most enforced compulsory insurance business, motor insurance, remained dominant, accounting for over 25% of total industry revenue.

Slow adoption of innovation and creativity contributed to sector underperformance

The failure of the industry to emerge stronger from the reforms of 2007-2008 with a view to overcoming many of the challenges of the past contributed to its underperformance. The industry’s product offerings remain largely unsophisticated with only few companies creating new opportunities and exploring ways of filling existing gaps in the market. Insurance operators also failed largely to acquire the requisite skill to participate in highly specialised transactions especially in high value risk segments such as aviation, oil & gas, construction and infrastructure. At the low end of the market, where insurance participation has been estimated at only 2.3%, the industry has failed to focus on developing innovative products that could capture the market segment while improving on the image of the insurance business. In addition to the low depth of the capital market, most insurance companies also have below average investment and asset management capabilities considering the passive investment strategy adopted by most of them and their level of exposure to the equity market at its peak. Industry skill is still largely limited to technical underwriting while regulatory oversight, although improving in recent times remains substantially reactionary.

Insurance penetration in Nigeria is very low

At 0.05%, the insurance contribution to national value added has remained low in the last five years compared to other markets, globally. Industry gross premium dropped below N200 billion in 2010 translating to a penetration rate of 0.8%. Besides the surge in gross premium by 49% in 2008, the immediate post-consolidation year, the average industry growth declined to 33% in 2009 and was even lower in 2010. In our opinion the industry might have lost significant premium income in 2010 as a result of the drastic fall in consumer spending following the protracted financial markets slowdown which began in 2008.  

The high exposure of the sector to the capital market during the protracted crisis eroded the value of investments and eventually the capital base of the industry at a period when the demand for insurance products was shrinking. The total market capitalisation of the industry grew from N200 billion (US$1.36 billion) in 2006 to N550 billion (US$3.74 billion) in 2008 but today the market capitalisation of the industry is less than N140 billion.  Unfortunately, the performance of the quoted insurance companies in terms of profitability, valuation, corporate governance, timely and reasonable rendition of returns and brand visibility has been below expectation.

Despite the enactment of the enabling law, compulsory insurances are not being enforced

Insurance is strategic to the development and economic prosperity of any nation because it serves as the custodian of the nation’s wealth through the process of indemnification. Insurance also mobilises small savings from millions of policy holders to create more wealth through long term investment in the productive sector of economy. It is in recognition of this that the government, in the Insurance Act 2003, made six classes of insurance compulsory.  Unfortunately, with the exception of the third party motor insurance which is a part of vehicle registration requirement, and the group life insurance as part of the new Pension Reform Act 2004, the others have existed merely as legal pronouncements.

In 2009, the National Insurance Commission (NAICOM) instituted the Market Development and Restructuring Initiative (MDRI), the centre point of which is the enforcement of the compulsory insurance and growing the industry gross premium to N1 trillion by 2012. In furthering the implementation, NAICOM pronounced March 1, 2011 as the deadline for the commencement of strict enforcement of these compulsory insurances. Unfortunately the non-existence of the institutional framework for enforcement has made it impossible to achieve. The enforcement of the third party motor insurance was easy because it is entrenched in the vehicle registration process and enforced by the police and traffic agencies.

The industry may not benefit from the opportunities until key challenges are addressed

Enforcing the compliance of the 6 compulsory insurance alongside the effectiveness of the provision of the Local Content Act are key success factors to the growth of the industry. The adoption of the model for enforcing motor insurance would be more effective at enforcing the other classes of insurance. A substantial body of evidence suggests that a robust and efficient insurance market will go a long way towards improving the country’s financial sector depth and efficiency. The sector can leverage on its institutional investor role in offering important services for which it has comparative advantage. The hurdles however appear numerous but they are not insurmountable if the regulators and players are willing to play by the rules and focus on the identified key issues.

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Sustained monetary tightening may be hurting the economy

In macroeconomics, the modern view of credit channel rather than the cost of capital channel as the key link in the transmission mechanism has been gaining ground. A former Chairman of the US Federal Reserve Bank, Paul Volcker stated that the relationship between inflation and interest rate is rather obscured; but it is easy to explain the control of money supply to check inflation. He however warns that the structural imbalances in the system could make either mechanism not to work at any point in time since when you control one variable, people can work their ways round it.

Then the question is why is the Central Bank of Nigeria through its Monetary Policy Committee sustaining the monetary tightening stance despite the appealing case for  easing especially when it inflationary pressure is rather structural than monetary? In addition, why does the CBN use interest rate as its instrument of monetary policy despite its being less effective at managing inflation than the money supply mechanism?

Monetary policy objectives are generally inflation control and output stability

Monetary policy has been operated with a variety of objectives in mind over the years. However, it appears that the objectives generally boil down to adjusting the supply of money in the economy to achieve some combination of inflation control and  output stability. Economists generally agree that in the long run, when the resources of the economy are in full use, the level of output is fixed and any adjustment to money supply will only cause prices to change. However in the short run, a period during which excess capacity exists and companies have room to increase production as demand rises, changes in money supply do affect the actual production of goods and services. This is because prices and wages usually do not adjust immediately. For this reason, monetary policy is a meaningful tool for achieving both inflation and economic growth objectives.

This might be the reason why the policy objective of the Central Bank of Nigeria (CBN) and its monetary policy thrusts are essentially the attainment of price stability and sustainable economic growth. Associated objectives are those of full employment, stable long-term interest rates and real exchange rates. Although the focus of monetary policy has shifted largely in favour of price stability- especially with the adoption of inflation targeting in 2008, the monetary authority acknowledges the need to create a balance with the other macroeconomic objectives of the Government.

However, considering the recent slowdown in economic growth, the price stability objective of the CBN and the consequent high benchmark interest rate over the last 3 years may have started to hurt the Nigerian economy. While monetary policy may have been forced to become reactionary, frontloading the liquidity impact of fiscal policy excesses, economic growth is being compromised in the process. In addition, given the level of resource unemployment- human and material, monetary surpluses/excesses that are channelled to productive use are unlikely to cause inflation.  Therefore , the perceived structural disconnect in the economy can  be helped by balanced monetary policy actions among which a single digit lending rate is central.

Monetary tightening and high interest rates ultimately result in declining GDP growth and lower inflation

Sustained sharp and/or miscalculated monetary policy tightening could push the economy into a recession where consumers tend to cut down on spending to as low as subsistence; business production declines, leading firms to lay off workers and stop investing in new capacity; and foreign appetite for the country’s exports may fall. The recent slowdown in the GDP growth is indicative in this regard.

Although it has been argued in certain quarters that a combination of structural constraints which could not be addressed with monetary policy actions and supply side shocks- flooding for instance- are largely responsible for the slowdown, denying the huge small and medium scale subsector access to finance through high interest rates and loan policies robs the nation of substantial complementary growth that could cushion the effects of the structural constraints. All sectors currently depend largely on natural factors to survive, for instance climate and increased land use in agricultural sector. And many of them will perform better, grow faster and provide mass employment with sound financial inclusion premised on affordable credit.

Within the parlance of the quantity theory of money, monetary tightening pushes the economy towards the point where less money chases more goods. This happens when consumers are broke and firms cut back on hiring and spending; leading to a decline in the general price level as we have seen in recent times. Monetary policy also achieves this through expectations—the self-fulfilling component of inflation.

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Placing the Capital Market on Nigeria’s economic agenda

In a recent article by the Economist proffering “sensible ideas for reviving America’s entrepreneurial spirit” the magazine argued that the country’s growth machine was in trouble because the three most powerful pistons of the machine had been malfunctioning for over a decade. The capital market was listed as the first of these pistons along with innovation and a knowledge economy. The Economist puts the capital market as the root of America’s economic prowess saying that the “United States once boasted of the world’s most friendly capital markets”. Buttressing the importance of the capital markets, Robert Litan and Carl Schramm point out in a new book, “Better Capitalism” that the lull in America’s initial public offerings (IPOs) is down from an average of 547 a year in the 1990s to 192 since then. This IPO drought has cut the supply of new high growth companies. According to the authors, given that companies less than five years old may have provided almost all the 40m net jobs the American economy added between 1980 and the financial crisis that could represent dismal news for the unemployed.

If the capital market is this important to economic growth owing to its multiplier effects on job and wealth creation it is quite worrisome that economic planners have chosen to snub the market even to the point of derision. Policy makers who have snubbed the capital market could be pardoned for oversight especially when weighed against the pronouncements of the hawks who have boasted in public forum that they would adopt policy measures to “squeeze the equity markets”. For a country that boasts of its ambitions to be among the top 20 economies by 2020, it would remain a global marvel how this grandiose ambition can be achieved without carrying the markets along.

That is why the parley between the capital market community and the Minister of Finance (who also doubles as the Co-ordinating Minister of the Economy) which held in Lagos in July came as a welcome relief. The Nigerian equities market was heavily deflated by what started off as a price correction in March 2008 but later snowballed into a full blown market crash. Despite the bullish rally of the last three months, the benchmark index is still less than half of what it was at its peak. Some doomsday analysts even argue that owing to the losses suffered by investors (especially at the retail end) that it will take collective amnesia of a new generation to ignite interest in the equities market once again. 

The higher than expected yields in government debts even gave local institutional investors a compelling reason to shun the equities market. Despite the high yields on government debts, as long as the truism that equities offer higher returns on the long term than bonds still stands, then even institutional investors especially pension funds who think long term will still need to keep equities on the radar. This insight may have informed the keen interest of foreign portfolio investors in the Nigerian equities market. Despite the exposure of these FPIs to foreign exchange risks and double digit inflation, 80% of the total trades on the Nigerian bourse in the last year were driven by the FPIs.

When will the Nigerian companies start raising equity capital again?

We must appreciate that a capital market in its simplest of definitions is a place where the government and business enterprises can raise long-term funds. However, the current market downturn has sapped the market of capital raisingactivities especially when adjudged against the 2007 era when First Bank alone raised over N600 billion in one swoop. Capital raising by firms last year from equity offerings was roughly below N5 billion at a time companies are still in dire need of capital. Firms that seek listing on the exchange must see commercial sense behind the decision. It is not a decision that can be entirely driven by emotion. The ability of Nigerian capital market operators to serve as intermediaries steering long term funds to fill capital investment needs could just be the silver lining into the exchange.

But the Nigerian equity market is currently an inaccurate mirror of the economy

It is quite true that the Nigerian equities market is not a true representation of the broader economy. The market capitalisation of the NSE at $52.83 billion pales into insignificance for instance when it is compared to South Africa’s market value of over $600 billion. The Nigerian economy has corporations that can truly help with catching up. If press reports are anything to go by, the listing of the telecoms firms alone can add another $45 billion to the market’s value. It is baffling that with agriculture’s contributions to GDP, it only represents a minute fraction of the value of the equities market. Even at its five year peak in 2007 when agriculture contributed 42.2% to GDP, the market capitalisation of the quoted agriculture companies contributed a miserly 0.36% to the market value. That the sector has only five companies listed is even a more damning commentary.  In order to attract more interest to the capital market,  the country need to put the capital market on the economic agenda.

Government should start the process by listing state-owned companies 

Following the government’s decision to liquidate NITEL, perhaps one should ponder if this exercise would have been necessary had the firm’s shares been listed ab-initio.  Every round of sale of NITEL attracted criticisms especially on the transparency levels being adopted around the sale. When there was no transparency issues around the sales process, preferred bidders failed to muster the cash resources to execute the deal. However, with the benefit of hindsight one might wonder if NITEL would have been the contraption it is today if the government had sold off some of its stake through an offer for sale on the exchange. Our suggestion especially at this times when the government plan to privatise some of its assets is that while the government seeks for core investors, the divestment process should also include giving other Nigerians a chance to retain a portion of this commonwealth by offering minority stakes on the exchange. With this we will avoid the asset stripping that has bedevilled some of the privatised enterprises in the past.

Why it is important to list government owned corporations?

According to Hans Christiansen and Alissa Koldertsova in an OECD article on Corporate Governance, the main direct contribution of exchanges to corporate governance has been listing and disclosure standards and monitoring compliance. According to them, “stock exchanges have established themselves as promoters of corporate governance recommendations for listed companies”. It has been allegedthat Nigeria’s age old problem of cronyism and patronage affected the performance of some of the privatised entities especially since some of the new core investors were not able to deploy sufficient capital and expertise to achieve the intended turn-around effects. Listing a portion of some of the government’s shares would have helped safeguard disclosure levels and transparency standards in these entities post privatisation. And it is pertinent that the government must not follow this same path when selling its stake in the PHCN entities. The NSE must become the guardian angel of privatised entities to avoid the pitfalls of the past.

The creation of a vibrant OTC market for equities would also help

Nigeria is long overdue for an active over the counter (OTC) exchange in the mould of the American NASDAQ. This would serve as a platform for non-listed companies with a large number of shareholders to exchange their shares even without public listing. Thus firms like WAMCO and MTN will be able to expand their current OTC framework beyond registrar brokered deals. The OTC platform will also serve as an intermediary for firms that seek to test the markets prior to their full listings on the exchange in the route that Facebook adopted. Thus companies will have been able to test investors gauge for their shares and fully appreciate the impact of listing.

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Fighting high inflation rate at the expense of high unemployment and poverty rates is not approprate

On the one hand, recession hurts the ability of an economy to operate at its full potential. Firms are forced to operate below capacity as aggregate demand dwindles; pushing down the level of equilibrium aggregate production below full employment. A recessionary gap is thus created; a scenario in Keynesian Model, implying a contractionary business cycle. On the other hand, economies experience boom during expansionary business cycle. Expansionary cycle creates inflationary gap resulting from higher aggregate demand level above aggregate production and consequently overheating rapidly rising prices before leading to a ‘burst’. Due to these opposing circumstances, there is need for stabilization.  A counter-cyclical stabilization works to smoothen out business cycle fluctuations by expansionary public spending or tax cuts in recessions and/or contractionary policy in boom periods. These policies generally encompass both discretionary changes in monetary policy resulting from specific policy decisions and automatic stabilizers that occur when policy thrust automatically respond to changes in economic activity.

Some economists argue that the monetary policy should flexible enough so as to implement discretionary counter-cyclical policy when they are most needed.  A situation of  tight monetary regime where monetary easing is required will only lead to further growth contraction as high interest rate constrain local production capacity. The avoidable scarcity of these  domestic items will be created with serious consequences for inflation; in addition to defeating the domestic capacity development objectives of the government.

The Nigerian situation calls for a review of the tight monetary regime

Although the principal object of the Central Bank of Nigeria (CBN)  is to ensure monetary and price stability, it also has developmental functions in addition to providing economic and financial advice to the federal Government. In that case, the monetary authority has responsibility for economic growth as much as it has price stability  mandate. Declining growth rate, growing unemployment and poverty rate should be a concern as much as inflation is. The impact of the high interest is unfriendly to the situation of the economy.

Aggregate demand channel has been negatively impacted

Economic theory and research outcomes have identified a number of ways through which monetary actions are transmitted to the real economy by altering the amount of money in the economy; directly or indirectly. Directly through the sale and purchase of short term government securities in open market operations or indirectly through the use of the short term benchmark interest rate. The first channel of impact is through the aggregate demand on both the output and prices; a process called the demand channel. When monetary policy is contractionary or tight as is currently the case in Nigeria, borrowing costs increase, making it less likely for consumers to demand commodities they would normally finance such as houses or cars. And for businesses, they become less likely to invest in new equipment, projects, or buildings. Theoretically, the reduction in the level of economic activities will push inflation lower because lower demand usually leads to lower prices. 

The retail lending rate rose from an average of 18.36% in 2007 to 23.5% in 2012. During the same period, the monetary policy rate (MPR) rose from an average of 9.13% to 12%. However, the MPR declined to as low as 6.08% in 2010 before the commencement of the current spate of monetary tightening. The retail lending rate has however trended upward even at the low MPR in 2010; indicating a disconnect between the MPR and the retail lending rate at this point. This could be blamed partly on the curtailment of lending by banks during the global financial crisis as asset prices collapsed. The period was characterised by a sharp dry up of bank credit to both the corporate and retail consumers, as the regulator battled to sanitise the banking system. While the monetary policy approach to resolving these issues has worked to stabilise the industry, the punitive classification of risk assets may have raised the bar on credit evaluation thereby weeding out some classes of borrowers. An important parameter in that process is the dynamics of the retail lending rate in which the prime lending rate declined compared to an increase in the maximum lending rate between 2009 and 2012. The decline in prime lending rates indicates an increased preference to supply credit to select prime customers, usually corporates.

The balance sheets, bank lending and exchange rate channels were also not spared

An increase in interest rates also tends to reduce the net worth of businesses and individuals. This is called the balance sheet channel of impact; that makes it tougher for them to qualify for loans at any interest rate, thus reducing spending and increasing price pressures. This occurs by making many erstwhile feasible projects unprofitable at a higher hurdle rate as the weighted average cost of capital (WACC) increases with each interest rate hike. It therefore introduces the problem of adverse selection to the lending process - a situation where the level of interest rate weeds out likely quality credits leaving only the potentially bad ones; a scenario that may be playing out in Nigeria.

An interest rate hike also makes banks less profitable in general and thus less willing to lend. This is called the bank lending channel. This is because the fall in credit demand accompanying a monetary contraction robs the bank of the credit margin which cannot always be substituted for by trading/holding of liquid assets, including government securities. However, where monetary tightening results in higher real yields on secured and liquid assets and is followed by widespread deleveraging, the fall in deposit rates could allow for a substantial spread which would enable banks remain profitable.

High rates normally lead to an appreciation of the currency, as foreign investors seek higher returns and increase their demand for domestic assets. The recent surge in foreign portfolio investment alludes to this. At over 12% yields on government securities, Nigeria appears to be the only country with a sovereign risk rating of BB- that offers such a significant return on risk free assets. This is in addition to the sustained positive real return over the last 2 years as the monetary authority keeps it so at every level of inflation. In return, the surge in FPI has resulted in an increase in the value of the naira in recent times. 

However, through the exchange rate channel, exports become less competitive with their volumes reduced as they become more expensive, and the level of imports rise as they become cheaper. While it can be argued that our non-oil export industry is small, the naira value of oil export earnings, the major source of government revenue, becomes lower with implications for fiscal expenditure profile and outlook. For instance, the adoption of a N160/US$ exchange rate for the budget 2013 revenue assumption may weaken the government revenue profile in 2013 if the current monetary policy stance sustains the exchange rate at N155/US$, a very strong possibility.

Inflation in Nigeria is structural and high interest rates appear to be compounding the problem

The debate on whether inflation is a structural or monetary phenomenon has been on-going for some time. The constrained business environment which continues to keep the economy well below its production possibility frontier is also worthy of note. Another factor is the structural disconnect that allows fiscal excesses to create systemic liquidity without any productive impact with strong implications for price stability. The resolution of these issues is at the heart of a balanced monetary policy framework.

The implications of this is that the proportion of and rise in costs caused by the myriads of supply side constraints, especially infrastructural challenges, in the prices of goods and services is very high. We believe that this effect is big enough to sustain inflation rate in the double digit region if the monetary contraction continue to add to the supply side problems. One argument that highlights this conclusion is the fact that inflation rate were at their lowest during the period of accommodating monetary policy in 2007-08. And in those periods, economic growth was also high.Since the monetary authority has recognised the structural nature of inflation and the improvement in fiscal policy, we believewhat the Nigerian economy requires at this crossroad of structural reforms, is a complementary interest rate environment that supports the reduction of retail lending rates to single digit levels.

Period of monetary easing has coincided with declining inflation suggesting productive use of liquidity

The 2007/08 period was preceded by strong institutional development and fiscal commitment to economic liberalisation. Investment in infrastructure was also modest with high expectations upon which long term productive investments could be made. And investment was growing alongside aggregate demand in an environment of both high liquidity and monetary accommodation. Monetary aggregates- broad money, net credit to the economy, and credit to the private sector grew at an average annual rate of 52.8%, 176.9% and 72.1% per month respectively between 2007 and 2008, while inflation, although rising remained in single digits for most of the period. The global recession which started in 2008 and the oil production shock caused by the Niger Delta insurgence arguably contributed to the volatile economic conditions afterward.

The periods of monetary easing through 2009-2010 coincided with a peak in inflation; perhaps a lag effect of earlier monetary expansion and primarily due to the sharp depreciation of the naira. It was also the period of major moderation in inflation from the peak of 15.6% to 11.8% as the exchange rate stabilised and the adjustment was priced into costs; it might as well be a result of the global economic recession. This suggests that barring structural constraints, given the typically high the marginal propensity to consume in an economy with vast idle resources and high absorptive capacity, high liquidity will not necessarily cause inflation. In the presence of heavy structural constraints, what monetary tightening does is to simply add to the constraints and force down aggregate demand and prices with limited impact.

The credit channel of monetary policy transmission mechanism may be more effective at inflation management

Since the 1980s, the hitherto established view that the cost of capital is the key link in the transmission mechanism of monetary policy has come under intense challenge by the modern view which saw the supply of credit to firms as the key factor.The traditional Keynesian ISLM view of the monetary transmission mechanism indicates that an expansionary monetary policy will lead to a fall in real interest rates, which in turn lowers the cost of capital, causing a rise in investment spending, thereby leading to an increase in aggregate demand and a rise in output.

The simplified assumption that a firm’s cost of capital is determined by a single interest rate is consistent with the Modigliani and Miller theorem that a firm’s cost of capital is not affected by its leverage based on the assumptions of a perfect market and no transaction costs. The asymmetry of information due to market imperfection and thus the presence of agency and bankruptcy costs have led theorists to the consideration of the credit channel as an alternative transmission mechanism of monetary policy. The liquidity preference theory shifted monetary economists’ focus from interest rate to the money supply as the key link in the transmission mechanism.

We recognise the problem of unproductive liquidity injections from fiscal excesses which could compound systemic liquidity and pose a threat to exchange rate stability and hence price levels. It is a product of the structural disconnect in our economy which allocates the highest financial flows to the smallest contributor to growth. However, we are of the opinion that targeted market rules and regulations as well as quantitative monetary interventions and incentives, as proven by the positive outcomes of some of the recent rules around interbank and foreign exchange market activities would suffice at managing such liquidity.

We believe that a supply of money approach otherwise known as quantity based anchor, which regulates aggregate demand, may be more effective. This is because a monetary policy system that monitors the flow of liquidity and uses the open market operation to mop up any excessive and unproductive injections directly will do better than a generalised benchmark interest rate that punishes all sectors of the economy regardless of whether they benefit from the liquidity flow. While they tend to have the same effect on short term market rates, a targeted approach will have a more positive impact on economic activities as businesses can access longer term finances (through the capital market) at relatively cheap rates.

Nigeria needs monetary policy easing to prevent the economy from an economic cliff

Monetary policy has a strong role to play in expanding financial inclusion and ensuring that proper financial intermediation other than securities trading remains the hallmark of the banking system. An important task in this regard is working with the fiscal authority on the roles of the monetary authority in the development strategy of the government. The current weakness of that handshake is constraining the monetary authority to a reactive stance at the expense of a supportive monetary policy direction particularly in relation to interest rates.

We must note that the Nigerian economy faces its own economic cliff to which a commencement of monetary tightening reversal and a comprehensive review of the financial intermediation process and policy transmission channels is important. Such a review will increase access to finance for small scale businesses who are major employment creators. Other sectors, especially light manufacturing in food and beverages, housing, and construction would increase their share of GDP while the increasing aggregate supply is likely to create competition that would have a positive inflationary effect.

In our opinion, monetary policy dynamics are not static and the market understands this. More importantly, the positive edge which monetary policy has over fiscal policy is the short term flexibility and usefulness at providing cyclical and countercyclical solutions. Therefore to forestall pushing the economy down the growth slope, and to help boost economic activities going forward, we recommend that the monetary authority should limit the use of OMO for to support the short term rate at the current level. In addition, at the shortest possible  time, the Central Bank of Nigeria should signal the commencement of monetary easing so as to boost economic activities, save the economic from free-fall and reduce unemployment.

  • Written by The Analyst
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