Monetary Fallacy

 

Nigeria, the largest economy in Africa, has been struggling with high inflation and low growth rates for a decade or more. Inflationary pressures and low growth have resulted in significant economic instability, making it difficult for businesses and individuals to plan and invest for the future. The government has employed various monetary policies to combat inflation and stimulate growth, but the results have been far from satisfactory. In this article, we will explore the monetary policy regime in Nigeria and its effects on the economy.

Monetary policy refers to the actions taken by a central bank to regulate the money supply and interest rates in an economy. Think of monetary policy as a way for the government to influence how much money is being spent and borrowed, and how much it costs to borrow. The Central Bank of Nigeria (CBN) has employed various monetary policy tools, such as the adjustment of the cash reserve ratio (CRR), open market operations (OMO), loan to deposit ratio (LDR) and changes in the monetary policy rate (MPR), to manage inflation- and stimulate growth. However, despite these efforts, inflation has remained high, averaging 12.82% from 2010 to 2020. It currently stands at over 22% in Nigeria and keeps climbing. Full year GDP growth has barely been above 3% for almost a decade.

Explaining the monetary policy tools

• MPR: In more developed economies (with majority of the population that are financially included), interest rate (MPR) adjustments, have an impact on consumption i.e. If interest rates go up then disposable income reduces due to increased mortgage and loan interest payments, so businesses and consumers spend less, which brings down demand-pull inflation (lots of money chasing few goods). Increased interest rates also encourage more savings and fixed income investments. These investments are considered safer as the expected returns are fixed rather than more uncertain (volatile) returns in the stock market or directly investing in businesses. This is often more attractive for foreign institutional investors, who may prefer to invest in FGN (sovereign) Bonds. Foreign investors bring in foreign exchange (FX), which boosts the country's FX liquidity.
• OMO: This is not be confused with a popular detergent brand or an expression of surprise in Nigeria! OMO in this context refers to periodic interventions by the central bank to mop up or release system liquidity i.e. to reduce or increase the amount of money in circulation as a means of controlling the availability of money and credit in the economy. The CBN issues a note (essentially an IOU) to financial institutions, with an attractive rate to encourage investment in the instruments, thereby mopping up funds from the banking system. Conversely, it purchases the notes from the financial institutions, which leads to a release of funds to the institutions for lending/investment purposes. Using this policy tool, it can impact on both inflation reduction (through issuances) or stimulating growth (through purchases).
• CRR: The cash reserve ratio refers to another tool used by the CBN to control money and credit supply in the economy. In this intervention, commercial banks are required to keep a certain percentage of their total deposits as liquid cash with the CBN. The current CRR in Nigeria is set at 32.5%. This means that if a bank has a deposit base of N1 billion, then N325 million must be kept aside in cash with the CBN. The bank cannot use that money for lending or investments. The higher the CRR, then the less banks have funds to lend/invest. The lower it is, the more funds banks have in their treasuries for lending/investments.
• LDR: The loan to deposit ratio is a monetary policy tool used by the central bank to control commercial banks' lending to the real sector of the economy. Banks are required to lend out a percentage of all deposits they attract. In Nigeria, the LDR is currently set at 65%. This means that for every N1,000 a bank receives as customer deposits, they are supposed to lend out N650 to businesses in key sectors of the economy. With this tool, money supply is controlled. To reduce system liquidity and tackle inflation, LDR is reduced so that banks lend less. Conversely, LDR is increased to stimulate growth by mandating banks to lend more to the real sector.

Highlights of key monetary policy decisions

Despite the various monetary policy tools at its disposal, the CBN's monetary policies have certainly struggled to positively affect the economy by containing inflation and stimulating growth. Although, it could be argued that it has reached the limits of its effectiveness given the challenging fiscal environment. However, let us analyze some of the policy directives using a five year timespan between 2018 to 2023.

Key events in the timespan:

• OMO restrictions in 2019. Only foreign investors and Nigerian commercial banks were permitted to invest.
• LDR increased to 65% in March 2020.
• CBN bans FX sales to Bureau de change (BDC) operators and channels to commercial banks.
• CRR increased to 32.5% from 27.5% in September 2022.
• CBN introduced Naira redesign and "cash swap" policy, which took effect in January 2023.
• MPR steadily increased to 18%, with the latest increase of 50bp in May 2023.

All these events were supposedly directed at reducing the money supply and taming inflation (or so we were told). However, statistics show that broad money supply steadily increased over the same period and coincidentally, so has private sector credit!

Nigerian Money Supply (M3) & Private Sector Credit

Inflation has not been left behind in mocking monetary policy either. In fact, it has shown particular disdain to all the monetary policy tools thrown at it by the CBN.

Nigerian Inflation Rate (2018 to 2023)

The only metric that seems to have cowered in fear of the all mighty monetary policy has been the country's foreign reserves. This is not positive by any means!

Nigerian Foreign Reserves (2018 to 2023)

Ineffective Monetary Policy

Structural Challenges: One of the reasons for the ineffectiveness of monetary policy in Nigeria is the high level of structural challenges in the economy. These challenges, such as a lack of infrastructure, weak institutions, and corruption, have created a situation where monetary policy has limited impact on the economy. For instance, even if the CBN raises interest rates to reduce inflation, it might not translate to a reduction in inflationary pressures because structural challenges limit the effectiveness of monetary policy. In layman's terms, due to bad roads, erratic power supply, systemic corruption etc., the cost of doing business goes up, which then means that prices of goods and services also go up (cost-push inflation).

Financial non-inclusion: Nigeria's large unbanked population can have a significant impact on the country's monetary policy too. The unbanked population in Nigeria refers to individuals and businesses that do not have access to formal financial services such as savings accounts, loans, and credit facilities. This group is estimated to be around 40% of the population, which is a significant number. The large unbanked population in Nigeria can make it difficult for the central bank to effectively implement monetary policy. For example, interest rate adjustments may have less of an impact on the unbanked population, as they may not be borrowing from formal financial institutions but from unregulated lenders, with exorbitant interest rates. The high loan cost is often passed on to the consumer via price mark ups leading to cost-push inflation. This can make it challenging to manage inflation, as interest rates are a key tool in controlling the money supply. The CBN has attempted to tackle this issue through direct development financing initiatives such as the Anchor borrowers scheme and other SME financing schemes but these have been largely fraught with fund diversion and inaccessible to those that need it most.

Shadow economy

Shadow Economy: The Nigerian economy operates under a large shadow economy. A shadow economy could be described simply as a "black market", where informal market activities take place without any government intervention, taxation or regulation. A black market exists in the foreign exchange market in Nigeria with USD($)1 currently selling for between N735 to N760, despite an official exchange rate of N460.36/$1. This has provided a massive arbitrage opportunity that encourages currency speculation and roundtripping, which some financial institutions have adopted as a perfect substitute to more risky lending activities (despite the LDR requirements). This puts pressure on the country's foreign reserves leading to currency devaluation, which ramps up Naira liquidity and ultimately increases prices of goods and services.

Fiscal Dominance: Another reason why monetary policy has been ineffective in Nigeria is the high level of fiscal dominance. Fiscal dominance occurs when fiscal policy decisions, such as government spending, taxation, and borrowing, influence monetary policy decisions. In Nigeria, the government has been borrowing heavily from the CBN to finance its budget deficits, which limits the effectiveness of monetary policy. For instance, the CBN might need to loosen monetary policy by reducing interest rates (MPR) to stimulate growth, but the government's need to borrow domestically could cause a tightening of monetary policy by increasing interest rates, which squeezes the money supply and stifles growth.

The Fallacy

It is evident from the statistics that monetary policy has been ineffective in tackling some of the major economic issues being faced in the country for a number of years. However, it must be put in context as monetary policy alone is not solely responsible for the country's economic management and its effects tend to have less of an impact in an inefficient market.

Interest rate & FDI

Nevertheless, the notion that cash in circulation is the major driver of inflation in Nigeria is fundamentally flawed and this was evident in the recent cash rationing that severely dented the economy and ultimately proved fatal for the most vulnerable at the base of the socioeconomic pyramid. Furthermore, a large percentage of the population are financially excluded with little access to formal credit from banks. Why then do we persist with this fallacy that monetary policy in Nigeria is able to tackle inflation? It does however, have a larger impact on growth.

While the CBN is responsible for monetary policy, the Ministry of Finance is responsible for fiscal policy. The lack of coordination between these policies has led to conflicting objectives, limiting the effectiveness of monetary policy in addressing inflation and spurring growth. With the FGN strapped for cash amidst multiple recurrent obligations and a revenue squeeze, it has resorted to borrowing from the CBN as a lender of last resort. It appears that the CBN in turn, has used hawkish policies to essentially focus on three areas:

• Squeezing liquidity from the system in order to lend to the Federal Government and provide development financing to FGN priority sectors;
• Maintaining high interest rates to attract foreign portfolio investors to boost FX liquidity and continue in its attempts to stabilize the official exchange rate;
• Allowing a multiple exchange rate system to provide an easier avenue for commercial banks to make profits amidst a riskier lending environment and increasing non-performing loans (NPLs).

The Legacy Impact

Overall, the recent monetary policy tools employed in Nigeria supposedly aimed to manage inflation, stabilize the currency, and promote economic growth. However, their effectiveness varied depending on external factors such as oil price volatility, structural challenges in the economy, and fiscal dominance. To put some context, these tools have contributed to some degree of stability amidst the Covid pandemic and more recently the Russia-Ukraine crisis, nevertheless high inflation rates still persist and economic activities have remained stagnant.

The impact of this has been felt in all aspects of the economy. Borrowing costs for businesses and individuals have continued to increase and have stifled economic growth, leading to more poverty. Disposable income has been eroded due to high inflation, unemployment has skyrocketed as businesses crumble under the weight of supply chain disruptions, reduced consumer spending, increased taxation and crippling interest rates. The affordability of housing for the average Nigerian has become dwindled as building costs and mortgage rates have gone through the roof. Lastly, the ill-fated attempt to redesign the currency and remove cash from the system, will undoubtedly be the recent monetary policy legacy that remains etched on the collective consciousness of the country.

Thanks for taking time out to read this article. Please feel free to send me a message or comment on the article. I am always happy to discuss other perspectives and explore different philosophies.