INTEREST RATE AND DOMESTIC INVESTMENT IN NIGERIA (A CASE STUDY OF SELECTED BANKS IN EBONYI STATE)

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Changes in interest rates can reflect the basic situation of the operation of macro economy; it also affects all the macroeconomic variables such as GDP, price level, the level of employment, international balance of payments, the rate of economic growth, etc. Obviously the interest rate is an important economic variable that plays an important role in both macro and micro economy activity. Therefore, a change in interest rates is one of the main factors to judge the macroeconomic situation and the interest rate trend analysis is the main method to predict the macroscopic economic situation. Western economists believe that the market rate of interest, the total social savings and investment are closely linked. Therefore, the current interest rates affect the investment activities. At the same time, current interest rates also affect the scale of investment in the future by adjusting the savings. If the interest rate rises, bond prices fall, if the interest rate falls, bond prices rise. The influence of interest rate on investment scale is operate as the opportunity cost of investment on total investment, Under the condition of unchanged in investment income, the rising interest rates increase the cost of investment and then inevitably cause lower income investors to withdraw from the area of investment, so that the demand for investment is reduced. However, falling interest rates means that investment costs decline, thereby stimulating investment and the total social investments increase. The interest rate policy in Nigeria is perhaps one of the most controversial of all financial policies.

The reason for this may not be farfetched because interest rate policy has direct link to many other macroeconomic variables most especially investment decision. Interest rates play a crucial role in the efficient allocation of resources aimed at facilitating growth and development of an economy and as a demand management technique for achieving both internal and external balance. The term cyclical volatility of interest rates refers to the variability of interest rates over periods that correspond to the length of the typical business cycle, the variation of interest rates affects decisions about how to save and invest. Interest rate policy in Nigeria lacked consistency during the Structural Adjustment Program (SAP) as periods of liberalization were intertwined with impositions of some credit controls (IMF, 2013).

The business environment, in general, is very risky and uncertain so firms may not be able to service debt. Apart from this, the judicial system is reportedly inefficient and banks cannot easily enforce contracts, consequently, banks charge high interest rates and request for high levels of collateral. In addition to the above, high interest rate in the Nigerian financial system is a reflection of the extremely poor infrastructural facilities and inefficient institutional framework necessary to bring about substantial reduction in the risk associated with financing an extremely traumatized economy (World Bank, 2002).The administration of low interest rate which was intended to encourage investment before the SAP era and during SAP era of 1986 ushered in a dynamic interest rate regime where rates were more influenced by market forces and it failed to yield desired result of stimulating investment growth in Nigeria. All these problems highlighted persist due to the inconsistency of monetary policy and inability to formulate interest rate reform that will be a component of the broad policy package aimed at facilitating financial intermediation and monetary management that can induce investment spending through low interest rate.

Against this background, this paper attempts to establish an empirical relationship between investment and other macroeconomic variables, including interest rates in Nigeria. The Nigerian macro-economy witnessed different interest rates for different sectors in 1970s through the mid 1980s under regulation between 1960-1985 .The preferential interest rates were based on the assumption that the market rate, if universally applied, would exclude some of the priority sectors. Interest rates were, therefore, adjusted periodically with „invisible hands‟ to promote increase in the level of investment in the different sectors of the economy. The factors influencing interest rates would obviously vary with the extent of openness of the economy since forces of demand and supply determine it, for a highly opened economy with dynamic and sophisticated financial markets, the uncovered interest parity theory states that the differential between the domestic and foreign interest ratio equals the expected rate of depreciation/appreciation of domestic currency (Horobet, Dumitrescu & Dumitrescu, 2009).

The effect of real interest rates on private investment spending was first formalized in an investment equation by Jorgenson (2012) in his paper capital theory and investment behaviour, who derived the desired stock of capital as a function of real output and the opportunity cost of capital. In this approach, known as the neoclassical approach, a representative firm maximizes the present value of its future cash flows. The desired capital stock is directly related to output and inversely related to the cost of capital a decrease in the real interest rate lowers the opportunity cost of capital and, therefore, raises the desired capital stock and investment spending. The role of financial markets on capital formation (McKinnon, 2013; Shaw, 2013; Fry, 1989), includes suggestions that an increase in the real interest rates has a positive effect on the volume and quality of investment in those financially repressed economies like Nigeria. The former effect is given because self finance is important and investment is lumpy. Then, the economic agents must accumulate resources before any investment project is executed.

An increase in real interest rates thus stimulates both total and financial savings and consequently investment. The latter effect, improvement in the quality of investment, occurs because a higher interest rate will rule out investment projects with low productivity. At the same time, higher rates move resources from less efficient (e.g. goods facing some depreciation) to more efficient forms of accumulation (e.g. bank deposits with a more favourable return).In particular, McKinnon (2013), when explaining the link between interest rates, money and investment, suggests a nonlinear relationship between the real interest rates on deposits and the rate of private investment. 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 the deregulated economy in inducing savings which can be channelled to investment and thereby increasing employment, output and efficient financial resource utilization (Uchendu 2012). 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 (Leahy, 2012 as cited in Lensink 2010).There is yet no detailed conclusion on the actual link between interest rate and investment whether negative or positive but there is actual link between them. Though, most of the study has been inconclusive, hence this study will tend to examine and establish the past researchers claim. The long run objective of deregulating the interest rate to promote investment in the agricultural and manufacturing sector of Nigeria was to achieve positive linkage between interest rate and investment in Nigeria in order to foster economic growth and development. The linkage between interest rate and investment in Nigeria by economic scholars call for the need to embark on this study, this study intends to examine what happens to investment with variation in interest rate.

1.2 STATEMENT OF THE PROBLEM

Prior to SAP in 1986, interest rate in Nigeria was generally fixed by the CBN with periodic adjustments depending on the government sectoral priorities. The monetary authority in promoting investment in key sectors in the economy (Agricultural, Manufacturing etc) charged special interest rates on loans taken by these sectors so as to encourage the growth in the output of the sectors for a possible improvement in economic growth (Udoka, 2010). The prevailing rates of interest were regulated by government through the Central Bank of Nigeria (CBN) so as to guide the economy towards economic growth through these key sectors. The period is considered as a financial repression period (government regulations, laws, and other non-market restrictions preventing financial intermediaries from functioning at full capacity) as explained by Mckinnon& Shaw (2013), and was characterized by a highly regulated monetary policy environment in which policies of directed credits, interest rate ceiling and restrictive monetary expansion were the rule rather than exception (Soyibo and Olayiwola, 2010). Although the interest rate instruments remain fixed, there were increases. The deposit rate increased from 4% in 1975 to 9.5% in 1986, while the lending rate rose from 6 to 10.5% within the same period. However, the low rates of interest that prevailed could not be sustained. The low and sometimes negative real interest rates discouraged savings, increased the demand for loan able funds. The demand for credit soon exceeded the supply of funds while essential sectors of the economy were starved of funds (Obute, Asor and Idoko 2012) On 31st July 1987, the CBN deregulated interest rate. Interest rate became market driven where the forces of demand and supply determined interest rate level. This came about as a result of economic shocks of the 1980s and the financial repression which manifested through indiscriminate distortions of financial prices interest rate inclusive, reduced the real rate of growth. The position of the deregulated interest rate among other things was to enhance the provision of sufficient funds for investors, especially manufacturers who were considered prime agents and by implication promoters of economic growth so as to stimulate exports, correct price distortion. In a policy reversal 1994, measures of regulation of interest rate management was re-introduced. A claim of variation and high rate under the regulation of interest rate led to the reversal. Deposits rate were set at 12% to 15% per annum while a ceiling of 21% per annum was fixed for lending. A minor modification to allow for flexibility was seen in 2014, in which flexible interest rate were bank deposits and lending rate were determined by forces of supply and demand for fund (Udoka&Anyingang, 2012), (Omole&Falokun, 1999). Since 2004, the monetary policy committee of the Central Bank of Nigeria fixed the rates depending on performance of the economy. In 2013, the lending rate was 17.10% while the monetary policy rate was 12% while saving rate 2.39% (CBN, 2012). The role and effect of interest rate is possible due to the link between the financial sector and real sector of the economy, for instance the lending rate which translates into cost of capital has direct implications for investment. High lending rate discourages borrowing for investment. Also, high saving rate encourages savings which means more lendable funds for investments. As such the directional flow of interest rate has a linkage to the investment in an economy. This relationship calls for the need to examine the impact of interest rate on domestic investment in Nigeria, hence the need for this research work.

1.3 AIMS OF THE STUDY

The major purpose of this study is to examine interest rate and domestic investment in Nigeria. Other general objectives of the study are:

1. To examine the role of investment in the economy.
2. To examine the determinants of interest rate and how they impact on investment in Nigeria.
3. To examine the impact of interest rate on domestic investment in Nigeria.
4. To examine the determinants of investment on the growth of Nigerian Economy.
5. To examine the relationship between interest rate and domestic investment in Nigeria.
6. To examine policies that will improve domestic investment in Nigeria.

1.4 RESEARCH QUESTIONS

1. What are the roles of investment in the economy?
2. What are the determinants of interest rate and how do they impact on investment in Nigeria?
3. What are the impacts of interest rate on domestic investment in Nigeria?
4. What are the determinants of investment on the growth of Nigerian Economy?
5. What is the relationship between interest rate and domestic investment in Nigeria?
6. What are policies that will improve domestic investment in Nigeria?

1.5 RESEARCH HYPOTHESES

Hypothesis 1

H₀: There is no significant impact of interest rate on domestic investment in Nigeria.

H₁: There is a significant impact of interest rate on domestic investment in Nigeria

Hypothesis 2

H₀: There is no significant relationship between interest rate and domestic investment in Nigeria.

H₁: There is a significant relationship between interest rate and domestic investment in Nigeria.

1.6 SIGNIFICANCE OF THE STUDY

This research work will benefit policy makers, students, businessmen, financial experts, the academic and researchers because it will help improve their general understanding of these concepts. The banking sector will also benefit from this by comparing their past mistakes with the present and devising better strategies to handle future operations on investment decisions. Thus, this study will be significant to policy makers to make appropriate policy which will go a long way toward alleviating investment problems and bring about the desired improvement in the nation’s economy since developing economy like Nigeria which is bedevilled by need to determine the appropriate policy mix to achieve stability. Finally, this research work will be useful to students and researchers who might wish to undertake study and research work on this area.

 1.7    SCOPE OF THE STUDY 

The study is based on interest rate and domestic investment in Nigeria, a case study of selected banks in Ebonyi state.

1.8 LIMITATION OF STUDY

Financial constraint– Insufficient fund tends to impede the efficiency of the researcher in sourcing for the relevant materials, literature or information and in the process of data collection (internet, questionnaire and interview).

Time constraint– The researcher will simultaneously engage in this study with other academic work. This consequently will cut down on the time devoted for the research work.

1.8 DEFINITION OF TERMS

Interest Rate: This is the rate at which the Central Bank of Nigeria lends to financial institution thus supply and demand for funds. The rate of interest is the reward of parting with liquidity for a special period. It is the inverse proportion between a sum of money and what can be obtained for parting with control overtime the money in exchange for a dust for a state period of time. In this sense, it is seen as a measure of the unwillingness of those who passes money to part with their liquid control over it. It is the “prince” which equilibrates the desire to hold wealth in the form of cash with the available quarterly of cash in the price for credit (J.C. Anyanwu 2014).

Interest Rate Policy: This is the policy Central Bank uses to control inflation in the economy. It also used to control the money supply by the monetary authorities, in order to achieve the stated or desired goals Ndulu (1990).

Investments: Investment is the addition to the existing stock real capital assets such as the purchase of bonds, equities (stocks) construction of new factories new office building or the acquisition of new capital assets like plants, equipment and machinery and addition to inventions. Investment can also mean the deposit of saving in a bank’s account (Iyoha 2009, Aigbokhn 2014). Investible Funds which are utilized to expand the growth in the economy Elliot(1984).