The monetary policy committee [MPC] at its last meeting on 21st and 22nd July, left the benchmark interest rate unchanged at 12%. The decision seems to be in line with the cautious approach of central banks globally on monetary policy at the moment. It however left business operators here wondering when the promise of the new governor of the Central Bank of Nigeria to reduce interest rates gradually will begin to take effect.
The committee felt that the relative stability of financial markets does not yet warrant interest rate reduction but the increase in the stock of external reserve represents a step forward in this direction. The nation’s gross official reserve has risen from $37.31 billion at end-June to $40.20 billion by 18th July
The increase is attributed mainly to increased accretion and moderation in the rate of depletion. Rebuilding foreign reserve is an appropriate step preparatory to lowering interest rates in order to avoid undue pressure on the naira exchange rate. The value of any currency draws significantly from the strength of the reserve back up.
Interest and exchange rates are inversely related: high interest rates are needed to defend the exchange rate – which makes politically sensitive reading. The inability of the MPC to begin the gradual reduction in interest rates appears to reflect a practical consideration of fundamental factors that the governor of the CBN might have overlooked initially.
The promise of low interest rates at a time that the naira is under pressure is apparently a tall order. Market fundamentals need to be altered first and the adjustment process can take some years to accomplish. The good news is that the process has begun with the effort by the CBN to sanitise the foreign exchange market and rebuild foreign reserve.
There is no doubt that the foreign exchange market stands in the way of low interest rate policy for now. It is therefore appropriate for the apex bank to take every step necessary to strengthen the market first to pave the way for a low interest rate regime. The steps being taken by the bank to this effect are quite commendable and will amount to a major accomplishment by the new governor of the bank when finally achieved. The task ahead is to change the unhealthy relationship between interest and exchange rates.
The inverse relationship between interest and exchange rates means that we have lost interest rate policy as a tool for stimulating productive activity. In order to defend exchange rate, interest rates will have to be held significantly high, which is the reason why financial markets stability is at the expense of employment growth. This unfavourable relationship is what the CBN is now promising to change, which will readmit interest rate as a tool for stimulating economic activity.
For the CBN to fulfill the promise of reducing interest rates without letting exchange rate deteriorate, it has to sustain and reinforce the current efforts to rebuild external reserve and block the leakages in the foreign exchange market. It has to take steps also to reduce the level of speculative demand in the foreign exchange market.
If the level of speculative demand is reduced and capital flight-induced foreign exchange demand is also checked, the link between liquidity injection into the system and demand pressure in the foreign exchange market will be broken. When this happens, the need to mop up liquidity to keep pressure off the foreign exchange market will be curtailed. This will consequently reduce the extreme dependence on interest rate for liquidity control and free it for use in inducing economic growth with employment creation.
One area of concern over the low interest rate expectation is inflow of portfolio investments, which has provided the strength to defend the naira exchange rate so far. High interest rates have attracted foreign portfolio investors, as rates of return dived in the advanced financial markets due to monetary policy easing. The prospects for portfolio flow reversal have however continued to grow, meaning that it offers nothing better than a temporary relief, which leaves financial markets potentially volatile.
While interest rate reduction might hurt foreign portfolio inflow, it will encourage the preferred foreign direct investments. Nigeria is therefore in a position to gradually replace the highly volatile portfolio investments with the more stable and job-creating foreign direct investments. The various arms of government responsible for courting foreign investment inflow should therefore join forces with the CBN to make this happen as soon as possible.
While the promise by the CBN governor to reduce interest rates looks more like a medium- to long-term objective, we believe that it is achievable without destabilising financial markets. Fundamental changes in the market structure need to take place to create the necessary conditions for reducing interest rates. Some of these changes are already in process and need to be sustained.
If the CBN succeeds in achieving a low interest rate regime that attracts both local and foreign direct investments, which deliver new jobs without hurting the foreign exchange market, this will position the economy to add employment creation to economic growth. That will be the type of financial markets that the Jonathan administration needs to transform the economy.
