The critical questions, therefore, are: Does interest rate reform has any positive effect on economic growth in Nigeria? Will deregulation of the financial system speed up capital accumulation and economic growth in the country? The study tests whether there is any significant relationship between interest rate reforms and financial deepening in Nigeria. The paper is relevant in view of the pivotal role played by interest rates in the saving-investment and growth relationship, as well as the need to provide capital for the private sector.
The private sector is a catalyst in the development process. The motivation for this study is to provide both theoretical and empirical evidence on the relationship between interest rate reforms and financial deepening in Nigeria. The findings will provoke financial policies that will promote economic growth in the country. The paper is organized as follows.
Section 2 discusses the literature on the link between interest rate reforms and financial deepening. Section 3 presents the data and methodology used in the study. Section 4 is presents the results of the analysis, and Section 5 provides concluding comments. McKinnon-Shaw argued that financial repression reduces the real rate of growth of the economy.
Financial repression refers to government fixing interest rates and its adverse consequences on the financial sector and economy. One of the basic arguments of the McKinnon-Shaw model is an investment function that responds negatively to the effective real rate of interest and positively to the growth rate.
The McKinnon-Shaw school of thought is financial liberalization exerts a positive effect on the rate of economic growth in both the short and medium term. This implies that interest rate reforms resulting from financial liberalization, as opposed to financial repression, increase savings into the banking system and investment through credit availability Agenor and Montiel, As Ucer argues , positive real interest rates resulting from financial liberalization lead to financial deepening, or a higher level of intermediation, as demand for money, defined as savings and term deposits as well as checking accounts and other currency increases as the proportion to national income, which in turn, promotes growth.
According to Ucer , the important role played by interest rates in savings, investment and economic growth makes the removal of interest rate controls a centrepiece of the liberalization process.
Interest rates policy in Nigeria is discussed along the dividing period of pre-reform and post- reform periods. In order to compare the structure of interest rates between the sub-periods, Table 1 showed savings rate, maximum lending rate, savings-lending rate spread and the minimum rediscount rate to demonstrate the relationship among these four rates as the reform process progresses.
The period before was a period of financial repression, 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 the exception Soyibo and Olayiwola, Although interest rate policy instruments remained fixed there were marginal increases. For the reform period, savings and maximum lending rates were determined by market forces.
During this time interest rates increased as envisaged. For instance, following the reform, the nominal savings and maximum lending rates rose from 9. By , the savings and maximum lending rates have rose to This process gives rise to competitive interest rates, which are higher than pre-liberalization interest rate. Lending Rate Redis-count Rate 3. Redis-count Rate This will in turn affect the amount of funds available for investment with a retarded influence on economic growth.
On the other hand high lending rates are detrimental to productive investment and hence economic growth. As Soyibo and Olayiwola observe, borrowers with worthwhile investments may be discouraged from seeking loans and the quality of applicants could change adversely.
Again, high lending interest rates could create a moral hazard where loan seekers borrow to escape bankruptcy rather than invest or finance working capital. Generally, behavior of the interest rate structure is such that there is a wide margin between savings and maximum lending rates, which may encourage speculative financial transactions.
As Edirisuriya suggested, a commonly used measure to evaluate benefit from financial sector reforms is the interest spread or interest margin of banking institutions. The interest spread is the difference between interest income and interest expenditure.
Theoretically, interest margins decline with competition among banks. Figure 1 reveals the interest margin of Nigerian banks, which marginally declined in , then increased until , before nose-diving to very low level of 1. The major reason for the decline in was competition among banks in the country.
The number of banks in the country increased from a low level of 40 in to about by Implication of the situation depicted by the interest rate spread is that interest rate reform has not improved bank efficiency. This is because the efficiency of a financial system is gauged by how quickly and cheaply the financial system is able to channel funds from surplus economic agents to the deficit agents for productive investments, while ensuring reasonable returns for the financial intermediaries.
Figure 1: Savings-Lending Rate in Nigeria, 30 25 20 Percentage 15 10 Interest Spread 5 0 Year Interest margin of Nigerian banks, which marginally declined in , then increased until , before nose-diving to very low level of 1.
Outreville reported that the readily available traditional measures of financial deepening in developing countries are quantity indicators based on monetary and credit aggregates. For instance, Outreville, observes that savings deposits increase as the financial system expands.
As Nanna and Dogo argue, freeing the financial system from repression through interest rate reforms, contributes to financial deepening, which Odhiambo and Akinboade postulate will increase the relative size and role of the financial system in the economy.
Figure 2 reveals that financial deepening and interest rates exhibited downward trends, especially between and as a result of the government policy of guided deregulation. This policy of financial repression has the tendency to discourage savings and inhibit financial development in a country.
However, a full implementation of the liberalization policy thereafter led to rising deposit rates and increasing financial deepening in the country.
This implies that interest rate reform has contributed to financial deepening, which in turn, contributed to economic growth by improving the productivity of investment.
From the foregoing literature review we deduce that financial reform leads to financial deepening, which encourages competitive interest rates and economic growth. This goal of this study is to investigate empirically this relationship, using most recent data in Nigeria. Data were obtained mainly from publications of the Central Bank of Nigeria, the Statistical Bulletin, Annual Reports and Financial Statements, Banking Supervision and Annual Reports, and supplemented with data from other secondary sources.
Trend analysis was used to determine the relationship between interest rate reform and financial deepening. To assess the strength and robustness of the regression analyses, the study includes those variables that are associated with financial development Greenwood and Smith, ; Outreville, Drawing from the earlier work of Boyd et al. A priori expectation was that deposit rate, financial deepening lagged once, gross domestic product, savings to GDP, and financial reform are positively related to financial deepening, while inflation rate, exchange rate and liquidity reserve ratio are negatively related to financial deepening.
The deposit rate was included to capture the effect of interest rate reform on financial deepening. The inclusion of inflation was to capture the effect of inflation on the various components of money. The exchange rate variable was included because exchange rate regime constitutes a major issue regarding monetary stability, which is required for financial stability.
The liquidity reserve ratio measures the level of liquidity in banks. A declining liquidity reserve ratio is usually associated with increasing lending activities as a result of reform processes. Haslag and Koo investigated the relationship between financial repression measures and the level of financial development. They found that countries with high reserve ratios tend to be countries that have less developed financial systems.
A dummy variable was included to incidate the financial situation, in which 0 indicates a period of financial regulation and 1 for financial deregulation.
This implies the time series have to be detrended before any sensible regression analysis can be performed. The next step was to establish whether the non-stationary variables were cointegrated. The Johansen was used test to confirm the existence of a long run equilibrium relationship between variables. If cointegration is established, an Error Correction Model is specified to present short run dynamics while preserving the long run equilibrium relationship.
Dickey Fuller test and Phillips-Perron P-P tests were used to test the stationarity of each of the variables and its order of integration.
The tests examined the null hypothesis that the specified variable has a unit root against the alternative hypothesis that the variable is stationary. The tests were performed with various combinations of lag lengths up to 4 and inclusion and exclusion of a constant in the Autoregressive equations AR.
The findings will provoke financial policies that will promote economic growth in the country. The paper is organized as follows. Section 2 discusses the literature on the link between interest rate reforms and financial deepening.
Section 3 presents the data and methodology used in the study. Section 4 is presents the results of the analysis, and Section 5 provides concluding comments. McKinnon-Shaw argued that financial repression reduces the real rate of growth of the economy.
Financial repression refers to government fixing interest rates and its adverse consequences on the financial sector and economy. One of the basic arguments of the McKinnon-Shaw model is an investment function that responds negatively to the effective real rate of interest and positively to the growth rate. The McKinnon-Shaw school of thought is financial liberalization exerts a positive effect on the rate of economic growth in both the short and medium term.
This implies that interest rate reforms resulting from financial liberalization, as opposed to financial repression, increase savings into the banking system and investment through credit availability Agenor and Montiel, As Ucer argues , positive real interest rates resulting from financial liberalization lead to financial deepening, or a higher level of intermediation, as demand for money, defined as savings and term deposits as well as checking accounts and other currency increases as the proportion to national income, which in turn, promotes growth.
According to Ucer , the important role played by interest rates in savings, investment and economic growth makes the removal of interest rate controls a centrepiece of the liberalization process. Interest rates policy in Nigeria is discussed along the dividing period of pre-reform and post- reform periods. In order to compare the structure of interest rates between the sub-periods, Table 1 showed savings rate, maximum lending rate, savings-lending rate spread and the minimum rediscount rate to demonstrate the relationship among these four rates as the reform process progresses.
The period before was a period of financial repression, 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 the exception Soyibo and Olayiwola, Although interest rate policy instruments remained fixed there were marginal increases. For the reform period, savings and maximum lending rates were determined by market forces.
During this time interest rates increased as envisaged. For instance, following the reform, the nominal savings and maximum lending rates rose from 9. By , the savings and maximum lending rates have rose to This process gives rise to competitive interest rates, which are higher than pre-liberalization interest rate.
Lending Rate Redis-count Rate 3. Redis-count Rate This will in turn affect the amount of funds available for investment with a retarded influence on economic growth.
On the other hand high lending rates are detrimental to productive investment and hence economic growth. As Soyibo and Olayiwola observe, borrowers with worthwhile investments may be discouraged from seeking loans and the quality of applicants could change adversely.
Again, high lending interest rates could create a moral hazard where loan seekers borrow to escape bankruptcy rather than invest or finance working capital. Generally, behavior of the interest rate structure is such that there is a wide margin between savings and maximum lending rates, which may encourage speculative financial transactions. As Edirisuriya suggested, a commonly used measure to evaluate benefit from financial sector reforms is the interest spread or interest margin of banking institutions.
The interest spread is the difference between interest income and interest expenditure. Theoretically, interest margins decline with competition among banks. Figure 1 reveals the interest margin of Nigerian banks, which marginally declined in , then increased until , before nose-diving to very low level of 1.
The major reason for the decline in was competition among banks in the country. The number of banks in the country increased from a low level of 40 in to about by Implication of the situation depicted by the interest rate spread is that interest rate reform has not improved bank efficiency.
This is because the efficiency of a financial system is gauged by how quickly and cheaply the financial system is able to channel funds from surplus economic agents to the deficit agents for productive investments, while ensuring reasonable returns for the financial intermediaries. Figure 1: Savings-Lending Rate in Nigeria, 30 25 20 Percentage 15 10 Interest Spread 5 0 Year Interest margin of Nigerian banks, which marginally declined in , then increased until , before nose-diving to very low level of 1.
Outreville reported that the readily available traditional measures of financial deepening in developing countries are quantity indicators based on monetary and credit aggregates. For instance, Outreville, observes that savings deposits increase as the financial system expands. As Nanna and Dogo argue, freeing the financial system from repression through interest rate reforms, contributes to financial deepening, which Odhiambo and Akinboade postulate will increase the relative size and role of the financial system in the economy.
Figure 2 reveals that financial deepening and interest rates exhibited downward trends, especially between and as a result of the government policy of guided deregulation.
This policy of financial repression has the tendency to discourage savings and inhibit financial development in a country. However, a full implementation of the liberalization policy thereafter led to rising deposit rates and increasing financial deepening in the country.
This implies that interest rate reform has contributed to financial deepening, which in turn, contributed to economic growth by improving the productivity of investment. From the foregoing literature review we deduce that financial reform leads to financial deepening, which encourages competitive interest rates and economic growth. This goal of this study is to investigate empirically this relationship, using most recent data in Nigeria. Data were obtained mainly from publications of the Central Bank of Nigeria, the Statistical Bulletin, Annual Reports and Financial Statements, Banking Supervision and Annual Reports, and supplemented with data from other secondary sources.
Trend analysis was used to determine the relationship between interest rate reform and financial deepening. To assess the strength and robustness of the regression analyses, the study includes those variables that are associated with financial development Greenwood and Smith, ; Outreville, Drawing from the earlier work of Boyd et al. A priori expectation was that deposit rate, financial deepening lagged once, gross domestic product, savings to GDP, and financial reform are positively related to financial deepening, while inflation rate, exchange rate and liquidity reserve ratio are negatively related to financial deepening.
The deposit rate was included to capture the effect of interest rate reform on financial deepening. The inclusion of inflation was to capture the effect of inflation on the various components of money. The exchange rate variable was included because exchange rate regime constitutes a major issue regarding monetary stability, which is required for financial stability. The liquidity reserve ratio measures the level of liquidity in banks. A declining liquidity reserve ratio is usually associated with increasing lending activities as a result of reform processes.
Haslag and Koo investigated the relationship between financial repression measures and the level of financial development. They found that countries with high reserve ratios tend to be countries that have less developed financial systems. A dummy variable was included to incidate the financial situation, in which 0 indicates a period of financial regulation and 1 for financial deregulation.
This implies the time series have to be detrended before any sensible regression analysis can be performed. The next step was to establish whether the non-stationary variables were cointegrated.
The Johansen was used test to confirm the existence of a long run equilibrium relationship between variables. If cointegration is established, an Error Correction Model is specified to present short run dynamics while preserving the long run equilibrium relationship.
Dickey Fuller test and Phillips-Perron P-P tests were used to test the stationarity of each of the variables and its order of integration. The tests examined the null hypothesis that the specified variable has a unit root against the alternative hypothesis that the variable is stationary. The tests were performed with various combinations of lag lengths up to 4 and inclusion and exclusion of a constant in the Autoregressive equations AR.
I 0 means stationary at levels, while I 1 means stationary at first difference. The results of the Augmented Dickey-Fuller ADF and Phillips-Perron P-P in Table 2 show that only the growth rate of gross domestic product, inflation rate and liquidity reserve ratio variables were stationary in their level forms. The study transformed of some of the variables to get a reasonable model. The VAR table is not presented since it has been established that there are variables that are integrated of order 1.
The decision for this study was made based on the Likelihood ratio LR test. From Table 3 the Likelihood Ratio test shows that the optimal lag length is 3.
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