One of the greatest financial challenge for businesses and even the federal government of Nigeria is the high cost of credit in the country. Prime lending rate which is the rate at which banks lend to the most credit worthy customers has remained persistently high in Nigeria since the late 1980s. In fact, the last time Nigeria ever enjoyed a single digit prime lending rate was in 1985 when the lending rate was 9.25 percent (according to financial statistics collated from the Central Bank of Nigeria). 34 years on, prime lending interest rate has stubbornly remained in double digit, averaging 18.79 percent during the period (double its 1985 level) despite several contractional monetary policy efforts to reduce interest rate in Nigeria. Two key questions then arise from this issue, how important is a single digit interest rate in Nigeria and why has it been difficult to achieve since 1985? I attempt to answer both questions in this article.
The importance of a single digit interest rate
- It could lead to rapid economic growth: The myth that only borrowers benefit from single digit interest rates is untrue. Indeed, single digit interest rates is desired by all financial markets’ stakeholders including borrowers, lenders and financial markets regulators. Single digit interest rate is considered healthy for economies around the world as it encourages borrowing for manufacturing and consumption. The lower the level of interest rate, the more producers will borrow from financial institutions to increase production of goods and services which leads to a faster growth in the national output. As economic growth quickens, the poverty level in a country typically declines. Asides increasing production on the supply side, low interest rate encourages borrowing by households for today’s consumption. Low level of interest rate can allow individuals take a loan to pay school fees, pay house rent, pay for hospital bills, buy a car, shop for loved ones and decide to pay in installments for items that they would not have ordinarily been able to afford without availability of cheap credit. Cheap credit encourages a debt financed consumption that typically drives economic growth. Little wonder, economic studies have shown that economic boom typically occurs in periods of low interest rate.
- It increases the value of financial assets and collateral: Investors also enjoy periods of low interest rate as the value of their assets typically rise rapidly during such periods through proper allocation of investments. Since the discount rate (interest rate) with which most financial assets including stocks and bonds is low, their worth and returns tend to be high. The reverse occurs when interest rate rises as the discount rate will also increase, thereby suppressing asset prices and leading to significant wealth loss for investors. Since assets are often used as collateral (for secured loans), lower interest rate could increase the value of the collateral and increase the amount of loan that can be assessed from a lender. Higher interest rate could cause this collateral to lose value and cause a panic in the financial market as collaterals may no longer be sufficiently valuable to secure the loan originally disbursed to the customer.
- It increases the amount of money you can access as loan from lenders at a given level of income: Since the interest on the loan is low, borrowers at the same level of income will be able to access more loans from lenders which can be invested in private businesses, acquisition of assets or for consumption. Any of these activities are positive for economic growth and the more money spent on them, the faster the economy will grow. However, if a borrower at the same level of income approached a lender to borrow funds in a double digit interest rate environment like we are currently experiencing in Nigeria, the borrower will not be able to access as much loans as he did when interest rate was lower because the interest payment is significantly higher and will prevent the borrower from easily covering repayment of loan principal and interest within the same agreed period using his fixed salary.
Why has single digit interest rate remained elusive after three decades?
For decades, a narrative from the Apex bank (i.e. Central Bank of Nigeria “CBN”) has been a mandate to make credit more affordable by reducing interest rate to single digit. While most Nigerians believe that the power to do so rests in the hands of the monetary authority and with one simple decision it could be done, the reality is that this decision is not as simple as many believe. Even though the monetary policy committee (a committee within the CBN that meets often to set interest rate for the country) have the power to make the decision to reduce the monetary policy rate (which is the anchor for all interest rate in the economy including treasury bill rate and prime lending rate) to single digit, there are restrictions to doing so because the country’s economic fundamentals currently does not support such low interest rate. Any attempt to do so forcibly will lead to financial instabilities that could bring our financial system grinding to a halt, thereby causing what could be the greatest economic disaster the economy has ever faced.
Essentially for the monetary policy committee to comfortably reduce interest rate to single digit, a single digit inflation rate must first be achieved. This is because interest rate is generally used by Apex Banks as a monetary policy tool to ensure price stability. If inflation rate is high, interest rate will be high not only to ensure that inflation declines (since they share a negative relationship) but to also ensure that suppliers of monies “investors” to the financial system get compensated above the rate of inflation. This compensation is referred to as real interest rate which makes investing in such an economy attractive. If real interest rate was to be negative such that the rate of inflation exceeded the prime lending rate in the country, banks will refuse to lend as there will be no real financial benefit to lending and this will starve the economy and customers of much needed credit required to survive and grow. This explains why anytime the National Bureau of Statistics announces that inflation is trending upwards in Nigeria, the expected monetary policy response from the CBN will be to adopt a contractionary monetary policy stance which includes increasing interest rate to bring down the rate of inflation and make investing and lending in the economy remain attractive.
Since we have now established that single digit interest rate is beneficial to most stakeholders in the financial system and that inflation is the single greatest influence of the direction of interest rate in a country, we must then turn our focus on inflation to understand why for three decades, interest rate in Nigeria has remained in double digit. In the last 34 years, average inflation rate was 19.69 percent, including 6 years when inflation level exceeded 40 percent. Single digit inflation rate in the country has been rare, occurring only 6 times in the last 3 and a half decades. If we agree that investors should earn a premium above inflation rate for taking investment risk and inflation has remained at double digit for 28 of the last 34 years, it should then be no surprise to Nigerians that lending interest rate in the country is persistently at double digit.
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