Interest rates on bank loans in Nigeria are well over 20 percent, presenting a major hindrance to household spending and firm growth. Yet, against the backdrop of a slowly contracting economy and sharply rising inflation, which now stands at 17.6 percent, the Monetary Policy Committee (MPC) of the Central Bank of Nigeria (CBN) raised the Monetary Policy Rate (MPR) by 200 basis points to 14 percent in July. This decision has been criticised by some, given the state of Nigeria’s shrinking economy and weak labour market.
However, Nigeria’s current episode of stagflation ties the hands of the MPC: interest rate adjustments cannot both contain inflation and stimulate economic growth at the same time. Since the MPC decided to raise rates, anyway, it seems fairly obvious that they may have prioritized curtailing inflation in the short term over stimulating growth. If this were their calculation, it would seem reasonable given that stable prices are needed for long-term growth.
Moreover, the potency of monetary policy in this crisis is debatable. The extent to which the MPR passes through to lending rates for households and firms is unclear. Indeed, the large spread between the MPR and lending rates implies that factors beyond the control of the CBN are definitely at play.
Most commentators and policymakers in Nigeria often view lending rates only from the perspective of the borrower. But, in order to understand why lending rates are so high in Nigeria, it may be more useful to consider the perspective of the lender. Let us therefore consider the case of a Nigerian Commercial Bank, for the sake of this article, called NBank Limited, as it chooses the interest rate on its loans.
First, in view of the time value of money, NBank Limited must set its lending rate to be greater than inflation. Since inflation currently stands at 17.6 percent, any lending below this rate would come at a loss to the bank. The rise in inflation has been driven mainly by rising energy prices from upward reviews of electricity and petroleum prices. More also, rising import costs, reflecting the Naira’s depreciation has contributed to much of this inflation. As we know, oil has constituted 90 percent of Nigeria’s exports, and so Nigeria’s terms of trade have deteriorated with collapsing oil prices. To worsen matters, our country’s dependence on imports for core foods, such as rice and fish, and manufactured goods has further fuelled the rise in prices. Given this analysis, one way to initiate a gradual reduction in lending rate may be to increase agricultural productivity and export much more high-value, processed foods, which would address this imbalance, and moderate inflation.
Next, let us consider NBank’s alternatives to household and firm lending. Yields on Federal Government Bonds are fetching up to 18 percent, given the government’s high appetite for debt due to its dependence on oil (75 percent of budgetary revenue). Government bonds are effectively risk-free, and so NBank would never lend to a risky customer or SME without receiving some premium over the government’s guaranteed 18 percent.
> However, this premium is not fixed, but rather reflects the structural costs of doing business for NBank Limited. Risk of default plays a significant role in this. Weak identification systems make it difficult for NBank to identify good borrowers, as credit histories are patchy, and tracking defaulting borrowers once loans have been given out can be a nightmare. Even if the issue of identification can be solved, contract enforcement through our court systems remains a huge challenge.
According to the World Bank’s Doing Business Survey, Nigeria ranks 25th out of the 47 countries in Sub-Saharan Africa (SSA) for contract enforceability. Because of this, NBank must take on additional costs to enforce repayments. In the case of borrower insolvency, NBank’s recovery rate will only be 28 percent, compared to 72 percent in OECD countries. In fact, it is easier to resolve insolvency in 27 other SSA countries than in Nigeria.
In addition to these, NBank Limited has to stay afloat and must consider ways to be profitable. In order to do so, it must cover some administration costs that her peers in other climes do not confront. A typical Nigerian Bank these days must have large numbers of policemen and other security people deployed constantly to protect its branches. So, NBank Limited must cover this cost. The bank must also provide a significant amount for reliable electricity to keep its systems running. It must also provide for its own broadband Internet services, a service it cannot survive without. These issues only further increase costs of doing business for NBank, a cost it must pass on to borrowers in the form of high lending rate.
Given these additional risks and costs that NBank must take on when lending to households and firms, it is understandable why such a high premium is charged over risk-free government bonds. Whilst the MPC might have some power to alter the rates that pass through to borrowers, the government has several other powerful instruments at its disposal. Tackling these structural issues will lower not only the cost of capital, but also the cost of doing business for banks and all other firms.
In general, therefore, it is important to reiterate that Nigeria’s high interest regime reflects not only the cost of capital but also the cots of doing business in the country. Therefore, in order for Nigerians to begin to see a systematic drop in lending rates, the government must tackle the aspects of lending rates that reflect the high cost of doing business in Nigeria.