July 27, 2016

On The Recent Rise In Nigerias Monetary Policy Rate: Deciphering Implications

By Precious Chukwuemelie Akanonu

The Monetary Policy Committee (MPC), on the 26th of June 2016, unexpectedly raised monetary policy rate (MPR) by 200 basis point, from 12 percent to 14 percent, while retaining other key policy decisions[i]. The Committees decisions were made against the backdrop of severe macroeconomic and financial challenges in the Nigerian economy: from rising double-digit inflation (16.48 percent)[ii], negative economic growth (-0.36 percent)[iii] and high exchange rate (N310/$)[iv] to setback in oil price and production, falling consumer demand, and declining corporate investment. The decision to raise interest rate signaled the effort of the CBN to rein on soaring inflation and itsadverse implications oncapital inflows, especially in the midst of grave depreciation in the value of Naira. While the 2 percent rise in interest rate may seem as a marginal change, it poses potential economic and financial implications; especially through its effects on borrowing costs.

With rise in benchmark interest rate, the MPR, banks are likely to transfer the higher rate to borrowers and savers in the near term; thus incentivizing saving and disincentivizing borrowing. Macroeconomic theories for monetary policy suggest that a higher interest rate raises the cost of borrowing and interests on loans; which effectively constricts money supply and inflation. Thus, it is expected that short-medium term borrowing rates will likely rise; that is, the interest rates on loans linked to prime rate, which typically co-moves with MPR, shouldadjust upward. However, the rise in interest rate shouldnot affect loans linked to longer term interest rates. On the part of savings, saversshould gain as interest rates on savings deposits rise on the account of higher MPR. However, the foregoing is dependent on whether banks pass down the higher interest rate to borrowers and savers.Where the rise in MPR does not reflect in borrowing and savings cost, banks become less profitable; thus, become less willing to lend to individuals and businesses. In both cases, borrowers are at a disadvantage with the rise in benchmark interest rate.

In effect, the net worth of companies and individuals, which is inversely related to interest rate, declines viaa balance sheet channel of impact. The balance sheet channel of monetary policy transmission suggests that the financial position of private economic agents are influenced by changes in interest rate. Particularly, a higher interest rate results in reduced cash flows, reduced net worth of companies and consumers, drop in loans, and decline in aggregate demand[v]. Thus, it should become relatively tougher for companies and individuals to qualify for loans. For larger companies, erstwhilefeasible projects should become relatively unprofitable as the weighted average cost of capital (WACC), the average rate a company is expected to pay its shareholders to finance its assets, co-moveswith interest rates. Especially, small-scale borrowers with less sophistication and collateral to back-up their loan demand should be most affected.

Despite the accuracy of the theory on which the rise in interest rate is grounded, i.e. to constrict money supply and check inflation, the present rise in interest rate may not be able to correct present inflation trend. Inflation will likely continue its upward trend sincethe main factors driving the trend have not been properly addressed. Pending issues with greater influence on the present inflation rate in Nigeria include; the exchange rate situation persistently driving up the prices of imported raw materials and finished goods, as well as the exorbitant rise in fuel price (from N85.5 to N145)[vi] driving upthe cost ofdoingbusiness, amongst other structural factors.

Furthermore, the MPC decision to raise interest rate mainly rests on the theoretical underpinning that a higher interest rates should supportan appreciation of the Naira via its inflation-compensating effect on real interest rates. Precisely, foreign investors seeking higher returns should intuitively retain or increase their demand for domestic assets with the higher interest rate compensating for potential losses from rising inflation. Thus, retaining (or increasing) capital inflows should contribute in preventing further depreciation of the naira (or support its appreciation). However, this may not be the case given the presence of other factors that raise Nigerias risk profile;such as the looming recession, sustained uncertainty in oil price which drives the Nigerian economy, and rising interest rates in developed countries (like the U.S) offering safer havens[vii]. The impact of these factors on investment decisions could outweigh the effect of the change in domestic interest rate; thus continue to deter foreign investments.

Lastly, with a negative economic growth rate and double-digit inflation, the Nigerian economy is currently in stagflation. While the CBNs recent policy decision of raising interest rate is a step in the right direction, economic and financial conditions could further worsen on the account of the rising interest rate as consumers cut down spending, business activities slowdown, and leading firms lay off workers to cut back on operational capacity etc. In this case, the looming recession scarescouldextend into the third quarter of 2016. However, the remedy would be a clear and constructive exchange rate policy; in particular steady sales of foreign exchange (FOREX) in the interbank market is required to help induce investments and pull the economy out of the stagflation.

[i] Central Bank of Nigeria Communique No 108 of the Monetary Policy Committee Meeting of Monday and Tuesday 25th and 26th July 2016.

[ii] Inflation Rates, Data & Statistics, Central Bank of Nigeria (CBN), June 2016.

[iii]Nigerias Gross Domestic Product, National Bureau of Statistics (NBS), 2016.

[iv] CBN Exchange Rates, Data & Statistics, CBN, 2016

[v] What is the Balance Sheet Channel of Monetary Policy Transmission, Educational Series, CBN,

[vi] NBS Monthly PMS Report

[vii] Investments that is expected to retain its value or even increase its value in times of market turbulence.



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