The recent body language of the Central Bank of Nigeria (CBN) has signalled lower interest rates in the country in the near-term, causing yields on Nigeria’s fixed income instruments to fall in recent months. At its Primary Market Auction (PMA) in January, where the CBN sells government treasury bills to investors, 1-year government debt was sold at a rate of 18.68%; at the start of November, the CBN sold the same instrument for 15.60%.
Is Nigeria finally heading towards lower interest rates?
Each day, different groups lament over Nigeria’s interest rates. When the AfDB isn’t raising concerns over the high cost of borrowing, the Senate, House of Representatives, and even former President Olusegun Obasanjo are pushing the agenda for low interest rates. But the most prominent proponents are manufacturers and the Federal Government itself, usually the largest borrowers in an economy.
The calls are well-founded, Nigeria has a real credit market problem. Loans aren’t just highly priced, they are also difficult to access. In Zenith Bank, one of Nigeria’s biggest banks, the most favoured debtors in the ICT sector can get a loan at a rate of 23% per annum. In Wema Bank, a much smaller lender, this prime lending rate is as high as 29%. No surprise then that the least favoured prospective ICT debtors at another smaller bank, Fidelity Bank, would be charged a 36% interest rate!
At the same time, credit is skewed to a select group of industries. Nigeria’s agriculture sector constitutes 20% of the economy but receives only 3% of loans from commercial banks. The oil & gas sector, barely 9% of the economy, accounts for nearly 30% of commercial loans.
Why are interest rates so high in Nigeria?
A thorough analysis of Nigeria’s high-interest rates would account for our high-risk environment – severe asymmetric information making it difficult to ascertain worthy borrowers, underlying macroeconomic risk, low-trust economy, etc. Regardless of your monetary policy leaning, there are reasons that provide a basis (however contentious) for Nigeria’s high-interest rate regime, with the most recent being high inflation. Between 2013 and 2015, Nigeria’s annual inflation averaged 8.5%, but by the end of 2016, it had risen to 15.6%. The average so far in 2017? 16.8%.
The decisions taken by the CBN to tighten monetary policy in the country – raising interest rates from 11% from 14% in 6 months – reflect the need to rein in inflation, the apex bank’s core mandate. Furthermore, as the 2014 oil price crashed induced pressure on the naira, high-interest rates may have helped support the exchange rate by enticing foreign capital.
Beyond hiking the base interest rate, the CBN employed two lesser-known monetary tools – the Cash Reserve Ratio (CRR) and Open Market Operations (OMO). Both regulate the amount of naira liquidity in the system and market interest rates – the lower the naira liquidity, the less cash available, the higher the interest rate a creditor will charge to lend you naira. The CBN’s liquidity restrictions have been particularly aggressive, as the apex bank has regularly sold short-term government debt (receiving cash from the market in return) to “mop up” naira liquidity and push up short-term interest rates. The effects have been stark – at the end of August, a 1-year treasury bill had an effective interest rate of 22%! In an economy starved of cash, lending only occurs at exorbitant rates.
So, what has changed in recent months?
First, a brief note on short and long-term interest rates. When naira liquidity is low, and banks/investors are scrambling for cash, they most readily sell off their short-dated debt, e.g. 3-month treasury bill, as these are the most liquid and so would be the least costly to sell. Thus, aggressive naira mop up mostly affects short-term debt as when investors sell these assets, they push down their price and push up their interest rate. The final bit comes from the inverse relationship between the bond/bill prices and the yield on these instruments – the lower the price you pay to acquire them, the higher your return/yield from owning them.
The CBN has exploited this relationship. Its persistent mop ups have starved the system of naira liquidity and ensured that investors keep selling off their short-dated instruments to push up short-term interest rates – in October, a 1-month treasury bill had an interest rate of over 21%!
Though it persists with this higher short-term rates strategy, it has also been creative in attempting to lower long-term interest rates in the economy at the same time.
The most significant step it took was to stop selling the 1-year treasury bill at its regular OMO mop ups. Why? This would dry up supply for the bill, push up its price, and so reduce its yield. This is precisely what happened: at the start of November, at its most recent bi-monthly treasury bill auction, where the 1-year bill is still sold, the CBN fetched an interest rate of 15.60%, compared to 18.98% in mid-April.
This pattern has had a knock-on effect on even longer-dated debt: government bonds. At its January bond auction, the government sold its 10-year bond at a rate of 17%; in October, this had crashed to 15% – with even more people buying it.
Why does all of this matter?
By instigating a divergence between short-term and long-term interest rates, the CBN is trying to eat its cake i.e. tackle inflation right now, and have it, by lowering interest rates going forward to stimulate growth. In a way, the strategy makes sense, as long as they can get it right. Unfortunately, previous (and more aggressive) attempts at controlling the fixed income yield curve in this way have produced tepid results, most recently in Japan.
In any case, the CBN cannot signal forever. At some point, it would need to cut its base interest rate – currently at 14% – to follow through. To do so, inflation may have to come down significantly in the next 12 months.
Farmers, manufacturers, and MSMEs are unlikely to be interested in the CBN’s yield curve control. Yet it may just carry the message they have been waiting for: hang on for lower interest rates.