FINANCE - 21 NOV 2017

The dangers of high interest rates in Nigeria

The dangers of high interest rates in Nigeria
CBN Governor Godwin Emefiele (Left) has expressed his desire to achieve a single-digit interest rate during his tenur.

The news cycle is still dissecting Nigeria's latest economic data which shows that the economy is on a recovery path after the 2016 recession, and inflation continues to trend downwards. 

In older news, commercial banks in the country are still under fire for failing to lend to many individuals and businesses. 

What ties all these together? Monetary policy. 

In a nutshell, monetary policy describes the activities through which a central bank regulates the financial and economic system, usually by setting interest rates. In Nigeria, this function lies with the Monetary Policy Committee (MPC) of the Central Bank of Nigeria (CBN).

 

Nigeria’s Monetary Policy

Since July 2016, Nigeria's national interest rate – known as the base rate or monetary policy rate – has been held at 14%. In contrast, the interest rate in South Africa, Nigeria’s perennial economic rival, is currently 6.75%. Unsurprisingly, many groups bemoan the high-interest rate environment, arguing that it restricts bank lending, which, in turn, impedes economic growth. 

Notwithstanding the truth in that statement, high interest rates serve multiple purposes. Primarily, as is the case in Nigeria at present, they are used to tackle inflation.

The national interest rate determines how Nigerians typically spend and consume. On the consumption front, the lower the national interest rate, the more willing people are to borrow money. When people borrow more and pay less interest on their debts, there is more money available for spending and consumption, which influences national output. However, at higher rates, people are unwilling to borrow. When higher interest rates are coupled with asymmetric information, banks provide fewer loans. The tighter lending standards mean that consumers will cut back on spending and consumption, which affect national spending. This has been the situation in Nigeria over the last few years. 

The effects of such a policy decision could be dangerous if not well-managed. A consistent slump in national spending and investment results in a shrinking economy, and ultimately, economic stagnation or a recession. Many economists would point to Nigeria's high interest rate environment as a factor impeding the country's economic recovery. 

 

Where Commercial Banks Come In

The danger of too-high interest rates does not stop there. When the CBN fixes a high base rate, the rate at which commercial banks lend to and borrow from themselves, the interbank lending rate, also becomes high. This, in turn, pushes up the cost of an individual or business obtaining a loan from a commercial bank (or similar financial institution). Effectively, banks transfer the high cost of borrowing from the CBN unto their retail and institutional customers, making loans expensive and less accessible. 

Furthermore, when interest rates are high, investors and banks are often only willing to invest in government securities which pay high returns – a phenomenon known as crowding out. How come? Well, if I can buy a risk-free 180-day treasury bill that pays me a 20% interest rate, I see little incentive in lending to a risky individual or institution, and if I do, I would definitely charge an exorbitant rate. Similarly, if I could get such a risk-free 20% return in half a year, why should I invest in the stock market or your business? In short, high interest rates on government securities draw investment away from other areas of the economy. 

Interestingly, the government does not particularly like this situation, either. High interest rates make the cost of government borrowing and debt servicing high. Again, Nigeria has experienced this recently – rising interest rates in the country have bloated the country's debt bill to the point that debt repayments now constitute as much as 60% of federal revenues, according to the International Monetary Fund. Unsurprisingly, wary of a debt crisis, Moody's recently reduced Nigeria's credit rating. 

Clearly, the CBN's interest decision has a significant effect on the economy. 

 

No Cause for Legislative Alarm

So should we be worried about Nigeria's high interest rates? Many key stakeholders believe so, with some calling for a cap on interest rates, similar to what Kenya implemented in 2016. However, this will only worsen the nation’s monetary equilibrium. Although the CBN can alter its base rate, actual interest rates are determined by forces subject to the national and global markets, thus cannot be regulated by fiat. Therefore, there is a need for restraint and an adherence to market principles for the management of the nation’s monetary policy.  

Just a year after the Kenyan parliament enacted its interest rate cap, the Central Bank of Kenya (CBK) is already pushing for a repeal of the law because of the negative effect it has had on the Kenyan economy. Caution must be applied to ensure that mistakes made in other countries are not replicated in Nigeria. 

Moreover, the biggest determinant of interest rates in Nigeria will always be the level of inflation. Until the CBN is able to arrest inflation, perhaps through its interventions in the agriculture sector, high interest rates will be Nigeria's norm. 

 

Follow this Writer on Twitter @LanreRufai_. Subscribe to read more articles here.

Olanrewaju Rufai

Olanrewaju Rufai

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