THE DETERMINANT OF INTEREST RATE IN NIGERIA

CHAPTER ONE

INTRODUCTION

1.1. BACKGROUND OF TH STUDY

Over the years, interest rate in Nigeria has been managed by the monetary authority as a monetary and credit policy tool aimed at inflation control, investment inducement and economic growth. Interest rate is the price paid for the use of money. It is the opportunity cost of borrowing money from a lender. It is an important economic price determined by various factors and useful in gauging financial market conditions. The direction and magnitude of changes in market interest rate are primarily important to policy makers as it determines the growth path of the economy. The role and effect of interest rate is possible due to the link between the financial sector and real sector of the economy, for example, the lending rate which translates into cost of capital has direct implications for investment. The behaviour of interest rate determines investment activities and hence economic growth of a country. Banks as intermediaries mobilize funds from surplus spending units to deficit spending units of the economy through deposit acceptance and in turn, channel them into productive economic activities. The extent to which this is done lies on the interest rate which in turn determines economic growth (Uchendu, 1993). According to Omole & Falokun, (1999), interest rate policy is among the emerging issues in current economic policy in Nigeria in view of the role it is expected to play in a deregulated economy by inducing savings which can be channel to investment and thereby increasing employment, output and efficient financial resource utilization. Also, interest rates can have a substantial influence on the rate and pattern of economic growth by influencing the volume and disposition of saving as well as the volume and productivity of investment (Tayor, 2004).

Interest rate in Nigeria could be examined under two regimes; the regulated period characterized by a fixed rate and the deregulated period (SAP era) where interest rate is freely determined by market forces of demand and supply. Before the deregulation era, the monetary authority (CBN) relied on the use of direct control mechanism to fix interest rate and other banking charges with periodic adjustments depending on the government sectoral priorities. This was done to obtain social optimum resource allocation, promote orderly growth of the financial market and combat inflation. In adjusting interest rate according to sectoral priorities, the government aimed at direct financial resources at concessionary low interest rate to the favored sectors for possible increase in productivity and subsequently, economic growth (Udoka, 2000). For instance, in 1984, banks were instructed to lend to agricultural sector at 7%. This had serious implication for the economy as the period was considered a financial repression period (McKinnon & Shaw) where government regulations, laws and other restrictions prevented financial intermediaries from functioning at full capacity. The prevailing rates at the time were unable to keep pace with inflation thereby resulting in negative real interest rates. This led to the demand for credit exceeding savings, inefficient resource allocation and pricing, starvation of funds to essential sectors of the economy and under development of the financial market (Obute, Asor & Idoko 2012) In July 1987, the CBN deregulated interest rate. Interest rate under this policy was to be determined by market forces. This was due to the economic disturbances experienced in the economy in the early 1980s due to world oil price fall and the financial repression. The objective of deregulating the interest rate was to promote investment through the linkage between interest rate and investment. Specifically, the CBN maintained a flexible interest rate stance, anchored on adjustment of minimum rediscount rate complemented by cash reserve and the use of moral suasion (CBN 2005). It is however observed that banks lending rate rose while deposit rates were low. This resulted in a wide gap between both rates threatening domestic price stability, savings and credit availability to the real sector of the economy. The monetary rediscounted rate (MRR) has been replaced with the monetary policy rate (MPR). In 1994-1995, the fixed interest rate was re-introduced to check the persistent increase in interest rate. The surge in the interest rate was high such that lending rate reached 21% while deposit rate was 13.6%, discouraged investment.

1.2. STATEMENT OF THE GENERAL PROBLEM

The primary role of interest rate is to help in the mobilization of financial resources and to ensure the efficient utilization of such resources in the production, promotion of economic growth and development. It thus affects the level of consumption on the one hand and the level of investment on the other hand, which in turn affects growth in the real world. The performance of the economy is thus, linked with the level of interest rate as it exerts pressure on the stock market capitalization rate, manufacturing sector performance, foreign exchange rate etc (Adebiyi & Babatope-Obasa 2004). High interest rate impedes economic activities and slow down growth. It discourages borrowing for investment thereby hampering output and affecting GDP. It adversely affects exports and threatens widespread problem in the international banking system. With the experience of the interest rate in Nigeria and its direct/indirect impact on the economy and with the operation of a deregulated economy in Nigeria, it becomes important to check for variables that determines the level and direction of interest rate under deregulated period.

1.3. AIMS AND OBJECTIVES OF THE STUDY

The major aims of this study are as follows

1. To examine the determinants of interest rate in Nigeria.
2. To evaluate the forecasting capability of the model derived.

1.4. RESEARCH HYPOTHESIS

HO: There is no positive significant impact of interest rate on savings in Nigeria.

Ha : There is a positive significant impact of interest rate on savings in Nigeria.

1.5. SIGNIFICANCE OF THE STUDY

The deterioration of the Nigeria economy calls for a scrutinization of the economic policies. This Nigeria like all other developing countries is faced with the problem of choosing the most appropriate policies, which will be employed to attain economic growth. An identification of the factors, which influence the economy, becomes necessary, the level of investment being a major influence of economic growth lead us to the study of interest rate which is one of the factors influencing investment as well as savings (which provides funds for investment). In order to avoid decisional myopia there is a need for efficient and proper economic planning. The need for undertaking this study stems from the important role the rate of interest plays in determining the growth of savings and investment. This shall be of immense benefit to commercial banks in general, the CBN, the general economy and to future researchers in the field of interest rate.

1.6. SCOPE OF THE STUDY

In order to carry out a comprehensive and meaningful research work on the critical effect of interest rate as a determining factor in the growth of savings and investments in Nigeria. This work was based mainly on Central Bank of Nigeria (CBN), which regulates the employment of interest rate, savings and investment. Data used covers a period of ten years (1980 – 2015) so that the impact of interest rate on savings and investment can be compared using the interest policies.