By Bola Tinubu
The economic fallout from the coronavirus may present the best, most pressing case for revising the CBN’s high interest rate policy. The undue rates penalise domestic investment and consumer borrowing. This reduces both aggregate domestic supply and, to a lesser degree, aggregate domestic demand. The chronic gap between domestic supply and demand has been filled by bloated levels of imports and encouraged an overvalued exchange rate that the high interests have helped produce. In normal times, the high interest rates also attract significant foreign financial speculation, the ever-ominous hot money. While in the short-term, the foreign speculation boosts financial inflows. Over time, as compound interest payments become due on these foreign investments, the nation will lose an ever-increasing amount of money to satisfy foreign debt obligations. In the short run, high rates seem to attract foreign capital and spur the economy while giving it discipline against inflation. In the longer-term, all of this is untrue. High rates give us the worst of both worlds. They stifle domestic investment and incomes while pushing up inflation and exposing an ever-increasing share of our financial system to foreign manipulation and dependence. Put another way, if you take a single picture early in the process, the high interest rate policy looks good at that moment in time. However, if you view the entire movie, you will see an ending that is both painful and unnecessary.
The Central Bank of Nigeria has demonstrated its financial agility by establishing a growing number of special financing programs for various industries and sectors of the economy. While these programs look good at first glance, they also expose important contradictions in the CBN’s position. The special schemes are an implicit admission that normal rates stifle investment borrowing and thus suppress the economy. The extraordinary schemes would not be required if the general interest rate was at a proper level. By establishing the special programs, the CBN attempts the impossible. On one hand it defends the general rate as prudent. On the other, it proliferates special exceptions in order to spur investment borrowing that the general rate has heretofore stifled.
This complex CBN rear-guard action does not serve the greater purpose. It merely prolongs the inevitable: We must retreat from high interest rates if we want investment borrowing to attain levels that actually increase private-sector growth and job creation.
This point bears repetition. If the financial sector functioned properly, servicing the needs of the economy in general, there would be no need to constantly resort to specialised sectoral plans (one for this industry, another for that industry and so on) for concessionary lending below regularly available rates of interest. Each such scheme is evidence that the overall financial system is fragmented in a manner that artificially reduces investment and the positive consequences increased investment has on growth, production and employment. The schemes are akin to a homeowner who, confronted with severe structural damage, commissions a fresh coat of paint to obscure the obvious structural flaws. Just as the homeowner should focus on fixing the core problem to prevent the house from crumbling, the Bank should do the one great thing it can do to free the economy from an unpayable burden. It should reduce interest rates.
The modern global economy is built on credit. Prosperous nations have built success based on the sustained ability to use credit to generate high levels of domestic investment as well as allow for significant consumer financing. Unlike two centuries ago, most business investment is not derived from the self-generated funds of the businessman or investor. Investment comes mainly from bank loans. However, the current rate of interest in Nigeria prohibits most normal business investment. Thus, the productive sector stagnates as innovation and creative endeavour are discouraged. Employment and aggregate demand are dragged down. The economy becomes a slave to a negative, impoverishing dynamic.
The Story Thus Far
The current form of our financial system is antithetical to growth. Our financial system was originally structured to serve the colonialists who wanted a highly centralised system that provided little chance of prosperity for indigenous business beyond that which the colonial master would allow. Though the years have passed since the end of the colonial era, the basic structure of that old financial system remains intact. The system has not kept pace with the needs and challenges of our evolving nation.
After national independence, the system was but slightly modified to fit the requirements of highly centralised military rule. Broad and diffused growth was not the goal. Such growth contravened the underlying tenet of military rule – tight, centralised control of political power and economic resources.
Only those allied to the power core were enabled to access credit and favoured to prosper in business. A high interest rate regime was integral to this centralised and closed system. High interest rates prevented the growth of independent business. One had to seek the alliance and friendship of the government of the day to overcome the strong impediments that high rates caused. This rendered business an appendage of government, dependent on government favour to survive. There were no nodes of power truly independent from the centre. Nor did this situation foster creative and innovative economic thinking leading to sufficient business start-ups that might have grown and diversified the economy.
All things were thus reliant on the goodwill of those at the core of national power. There were few successful businesses that did not have a patron seated in the high ranks of government. In many nations, prosperous businessmen can rightfully claim they know no one in government. In Nigeria, such claims were nigh impossible. Genius was declared upon those who could get close to the men in uniform and did not always depend on whether a person could efficiently organise an enterprise or invent a useful device.
Thus, the banking system became one intended to bar most businesses and people from access to sufficient commercial and consumer credit, a system constructed to suppress large-scale independent economic activity unless expressly sanctioned and approved by arbitrary power. Thus, it suppresses wealth and job creation. It keeps the economy on crutches so it cannot run too fast as to get beyond the grasp of whosoever wields that arbitrary power. As such, we are in a situation where the banking system is not sufficiently governed by the rational dynamics of economic maximisation. As a result, the system sputters and fails to reach full throttle. Without optimal financial sector support, the productive economy has failed to grow as it should. We all suffer, especially the poor man who would have been employed and earning enough money to take care of a family and contribute to national wealth if only sufficient levels of investment had been attained.
In decades past, this model could survive because our economic situation was more benign than it now is. Oil prices were such that the nation gained enough revenue given its then existing population. The nation could stay afloat and even record modest growth rates when oil prices climbed to their highest levels. Yet, this economic model was never meant to last as it risked all based on the price of one commodity.
This model led to an overvalued currency, which has caused Nigeria long-term harm. It undermined the global competitiveness of local producers. It also made imports cheaper. We became an import-reliant nation with a dwindling productive capacity. Over the long haul, such a position is high risk. Underlying economic fundamentals have become more adverse over time. Oil revenues, in real terms, have not and cannot keep apace population growth.
As oil revenues lose their potency to carry the economy, this financial model becomes an increasingly heavier albatross impeding economic growth. We remain too import reliant even though our supply of funds to buy imports dwindle. We seek to maintain a strong currency because of this import reliance and because of national pride. However, this reliance drains funds to support the exchange rate that could be better invested in strengthening our productive capacity. Moreover, pride is fleeting for who can maintain pride in a weakening economy with a stubbornly high incidence of abject poverty.
At this moment, we need business and industry to take up the slack generated by the weakening of the oil sector. However, the productive economy is barred from this needed increase in activity because the high interest rates, along with an unreliable power supply, combine to form a steep obstacle to sufficient real-sector investment, growth and productivity.
The high interest rate financial model runs contrary to the ideals of a progressive democracy to which Nigeria aspires. A nation cannot become a genuine democracy while access to credit remains under a semblance of authoritarian lock-and-key. Lending schemes under which a central bank has sole authority to prescribe lower interest rates may appear to open the system. In truth, they do no such thing. Instead, they merely move the discretionary power to give financial concessions from where it formerly resided (the military in times past) to the central bank.
Long Term Positive Relationship Between High Rates and Inflation
Over time, high rates cause more inflation than they prevent. In the initial phase, high rates might lower inflation. However, an economy is dynamic not static. Feedback loops created by the initial high rates will eventually encourage inflation. First, the suppressed levels of private sector activity will result in higher levels of government borrowing than otherwise would be the case had private sector incomes and productivity been unhindered by the high rates. This means that government must spend an increasing sum merely on interest charges. This places more naira in circulation without a corresponding increase in goods and services. This is inflationary.
Second, to the extent domestic firms can borrow, they must charge high prices in order to achieve profit levels sufficient to repay their high interest loans. This too is inflationary.
Third, we attract initial dollar inflows as private loans or investments in government bonds because of the high rates. Yet, the interest payments on the underlying bond, being computed as compound interest, compels us to pay an increasing percentage of our dollar intake through oil sales just to service the interest charge on the foreign debt. Consequently, we must engage in all manner of tricks to cover the widening gap between ever increasing foreign debt calculated at compound rates and foreign currency revenues which tend to remain flat and linear, if not decline during times of economic weakness. Debt servicing as a percentage of overall public and private sector spending will increase, causing more naira to be misdirected; exchanged into dollars instead of being used for productive economic discourse that would create wealth and jobs on these shores. This not only is an unproductive way to use the extra naira, such practices are historic drivers of inflation in any nation that measures inflation. Such practices are avoided by the best central bankers because their abuse courts ruin. This is why the best managed developing economies shy from heavy borrowing of foreign currency.
However, we have become too reliant on foreign borrowing. In our case, we have created a highly imbalanced and imperfect economy. On one hand, high rates are used to scare domestic investment borrowing thus undermining income, production and consumption. On the other hand, high interest rates are used to attract foreign creditors who must be repaid with an increasing percentage of our intake of dollars. This indifference to domestic investment yet open encouragement of foreign financial speculation is a rather odd mis-arrangement that makes little sense if the true objective is to grow the overall economy.
Given the inescapable dynamics of compound interest, a dollar borrowed today will have to be repaid with 2 dollars some point in the future. This drains our reserves to the benefit of foreign creditors. If we must borrow dollars better to first borrow from our own people, then the DFIs (World Bank, etc.) at concessional rates. We should only borrow from the foreign private sector as a very last resort.
Exchange Rate and the Economy
If we went to a freely floating exchange rate, the naira would devalue. This means our currency is overvalued in terms of our trade with the outside world.
This overvalued exchange rate is buoyed by high interest rates. Yet to maintain both interest rate and exchange rate levels simultaneously over time requires that money be siphoned from use in the productive economy in order to prop up both rates. High rates drain liquidity from the system. However, here the multiplier effect works terribly against us. For every naira drained from the system, we lose more than one naira of productive wealth, activity and income.
This provides a higher exchange rate but a shrunken domestic economic base. This combination of a high exchange rate and a diminished domestic productive base gives strong impetus to high import levels. In a well-functioning economy, import levels should shape the exchange rate. In our economy, the exchange rate determines import levels. Our demand for unnecessary imports is much too high. This unhealthy appetite drains or limited supply of foreign currency. We are again relegated to placing more and more naira in circulation in the futile chase of the dollar, the pound and the euro. Again, this is a most unproductive way to use our currency. Had or currency issuance power been used to fund domestic infrastructural development, the economy would be much improved.
To maintain the exchange rate, we must sacrifice both naira and dollars that could have been invested in strengthening our productive capacity and job creation. Instead of bolstering the economy, we give these financial resources to international finance arbitragers who care little for our well-being, who invest little in our productive economy and who gain too much influence over our national economy as insensitive creditors. We have to progressively pay them increasing amounts just to sate their demands while giving our population relatively less.
Coronavirus and Opportunity to Lower Interest Rates
To stimulate their economies, the central banks of all major economies have driven their prime interest rates below one per cent and nearer to zero percent. These central banks are lending vast amounts at low rates just to support to their industries and firms.
My position has always been one of reticence to foreign denominated debt due to repayment challenges. However, if we need foreign currency to buy items essential to protecting the nation from the coronavirus now is the time to borrow. The World Bank and other DFIs have said they will grant loans at concessionary rates. We should hold them to their word and demand a renegotiation of existing loans or debt relief.
While we are not yet inundated with the medical fallout of corona, we too suffer gravely from the economic and financial effects of the contagion. The rest of the world understands the imperative of lower interest rates. We should not pretend to be blind to that which every other major nation sees.
If this crisis is to have any positive economic aspect, let it be that we used this moment to drive down interest rates. To apply the rate reduction only to future loans would be prejudicial to current bank debtors. Thus, the financial authorities should consider formulating regulations that banks must reduce the high interest rates on existing business loans to the new lower general rate. This can be achieved through regulations requiring banks to automatically roll-over existing loans at the lower rate or regulations stating this must be done if the borrower so requests.
Any such change will alter the profit structure of most banks. To help moderate the change, government should provide generous tax relief to the banks. Additionally, government should institute a special bond-purchasing program where banks can purchase interest bearing government bonds at a significant discount or even on credit for a period of years. The central bank should give banks liberal access to its discount window in order to participate in such programs. These programs are intended to be transitional and thus will sunset in 3-5 years. During the transitional period, banks will have time to alter their lending practices. They must begin to earn profits from higher volumes of business and consumer lending at much lower profit margins per loan. In this way, our banking system will finally advance into the modern banking practices that have served as the linchpins for growth in any prosperous nation one can name.
There will be some initial jitters and anxiety. In the end, this will materially help us by sparking much needed private sector investment borrowing and encouraging suitable levels of consumer borrowing. Such borrowing will complement and thus lessen the amount of direct fiscal stimulus government must provide. The lower rates will be politically popular as well as economically benign at this time. Lower rates might dissuade some foreign speculators, but most speculative money has returned to its host nation at this point. So, the effects of lower rates will be muted. For those speculators still sensitive to arbitrage opportunities, our rates, albeit lower, will still be visibly above those obtained in any Western economy.
Yes, the lower rates will put pressure on the exchange rate. However, much of that pressure has already been priced into the exchange rate due to capital flight and lower oil prices caused by the viral outbreak. Moreover, shipping and the import-export business are at a minimum. With trade at a minimum, this is again an opportune moment to allow downward pressure on the exchange rate; the practical effects will be minimised since trade has already been materially reduced.
Another consideration we must weigh regarding interest rates is how lowering rates along with other innovations may unlock the potential for real estate to be catalyst for economic growth at this moment. The global economy will not rebound for several months if not longer. We must seek ways to inject liquidity into the economy and foster activity. Should the CBN lower rates as well as allow for longer-term mortgage notes, real estate would become a better functioning collateral for investment borrowing not only for the housing industry, but for the general economy. Reform of government mortgage agencies and policies will further allow us to deepen both the primary and secondary mortgage markets in ways that increase liquidity and spur economic activity independent of what may be happening in the outside world.
High interest rates are a fundamental drag on national economic growth. Only our unreliable power supply may loom as a bigger impediment to national prosperity.
Lower rates will spur domestic investment and production. This creates both jobs and wealth. High rates serve only to suppress these vital factors. Lower rates will have some negative short-term impact on inflation and the exchange rate. However, in a twist of irony, the economic dislocations caused by the coronavirus serve to mitigate those temporary negative consequences. If there is a time to reduce interest rates, that time is now.
Tinubu is the National Leader of the All Progressives Congress