In Africa's most populous country, the size of the informal sector and the low use of credit by households and businesses make an interest rate hike rather inappropriate.
The Central Bank of Nigeria recently announced a interest rate increase, from 11,5% to 13% which took effect immediately. Each time the Central Bank changes its monetary policy in this way, the financial institutions follow suit. Banks are raising their borrowers' rates, which will partly deter them from taking out a loan. In other words, the demand for money will shrink.
The accepted logic is that this will result in a reduction in consumption and investment, since there will be less recourse to credit. The idea: thus cooling an economy when it is overheated.
In Nigeria, according to the Central Bank, the interest rate was raised to reduce inflationary pressure, restore investor confidence and stimulate remittances.
Nigeria's inflation rate has fluctuated a lot over the past few months. It had reached a record high of around 18% a year ago, before falling back to 15% in November 2021. It then started to rise again, to 16,8% in April. And that is why the Central Bank took a preemptive measure to tame it and bring it back down.
In our view, however, to assume that monetary policy will work in Nigeria the way it works in other countries is misleading.
Sources of concern
Its effect on inflation remains uncertain first of all, since its main cause is supply problems: chronic insecurity in the country's food-producing areas, poor infrastructure and the war in Ukraine which is driving up the price of commodities such as wheat. Imports are also falling and, as a result, the currency is depreciating.
It should also be noted that the Nigerian economy is based on a large informal sector, a source of income for nearly 80% of the population. The latter has only weak links with the formal financial sector. Unlike households in developed countries, many Nigerians will therefore not change their economic decisions because of rising interest rates.
The timing of this decision also raises concerns. Nigeria is facing high levels of unemployment and poverty and a rise in the rates will have repercussions on the economy in general.
Outside the classic patterns
Are these fears justified? Let's first look at those who have nothing to worry about. The rate hike will not have significant effects on most low-income Nigerians for several reasons.
First, domestic credit contracted by the private sector in Nigeria remains very low: 12% of gross domestic product (GDP) in 2020, compared to an average of 40% for sub-Saharan Africa. This ratio is less than 15% only in some 20 countries in the world.
Individuals and households are not big borrowers either. In May 2021, for example, consumer credit represented only 10,2% of total credit to the private sector. The onerous conditions imposed by the banks make obtaining loans almost impossible for many Nigerians. Many are then those who have recourse to loan sharks.
The inability of many Nigerians to get loans from banks means they won't have to worry about paying higher rates on mortgages, credit cards, cars and student loans. Also, the rate hike will have no impact on the prices of goods and services typically consumed by low-income Nigerians. The rise in prices of these basic foodstuffs is due to other factors already mentioned.
What about growth and employment? Classically, a rise in the interest rate increases borrowing costs. This, in turn, reduces investment, production and employment.
Nigeria, however, does not fit this pattern. Much of its economic growth is driven, not by the production of goods, but by the export of oil and gas. Although it represents only a small percentage of GDP, oil generates much of the foreign exchange and government revenue needed to support other sectors of the economy.
Since credit to the private sector in Nigeria is very low relative to GDP, the impact of rising rates on output and employment in the real sector will not be substantial.
If the economy worked well...
However, mistrust must remain for other actors, starting with Nigerians in the public sector. State governments in this federal country routinely borrow from banks to cover their huge budget deficits, and the public debt has steadily increased over the years. Some have accumulated several months of unpaid wages, gratuities and pensions.
With rising interest rates, a larger share of revenues will be allocated to servicing the debt. This will affect the government's ability to meet its expenditures and could exacerbate problems with late payments or even non-payment.
On the other hand, if Nigeria were a well-functioning economy, the rate increase would attract investors and strengthen, according to the theory of purchasing power parity exchange rates, the value of the naira, its currency. There would also be a mechanism of "carry trade", investors who borrow where the rates are low, to invest where they are high, as in Nigeria.
But Nigeria is not a well-functioning economy. Insecurity, political uncertainty, and weak financial regulation make it unlikely that portfolio investors will jump on the bait of high interest rates. On the contrary, they then rather tend to withdraw their money because of these uncertainties, which partly explains why the naira depreciates inexorably.
Monetarism or Keynesianism?
Only middle- and upper-class Nigerians will actually benefit from the long-term benefits of rising interest rates. Therefore, in our view, monetary policy is not the best strategy to foster inclusive, job-creating and poverty-reducing economic growth in Nigeria.
The challenges of high rates of unemployment and poverty are more worrisome than inflation in contemporary Nigeria. Many observers believe that the high level of violence and insecurity in the country is a byproduct of economic disempowerment, especially among Nigeria's burgeoning youthful population.
What the country seems to need now is Keynesianism, that is, an economic policy regime that mobilizes funds for massive job-creating investments in infrastructure, agriculture, labour-intensive manufacturing and agribusiness.
The Central Bank is already doing this, albeit in a limited way. To stimulate production and employment in the real sector, it uses “intervention fund” to support strategic sectors of the economy. Some N385 billion (about $1,2 billion at the official exchange rate of 415 naira to $1) was earmarked for intervention projects in March 2022.
These funds are used to grant credit on preferential terms to sectors that strengthen the productive capacity of the economy. The objective is to ease supply constraints and mitigate inflationary pressures. Nigeria needs more of this approach.