Project – EFFECT OF INTEREST RATE ON DOMESTIC INVESTMENT IN NIGERIA

CHAPTER ONE

INTRODUCTION

1.1 Background To the Study

The behaviour of interest rates, to a large extent, determines the investment activities and hence economic growth of a country. Investment depends upon the rate of interest involved in getting funds from the market, while economic growth to a large extent depends on the level investment. According to Jhingan (2003), if the rate is high investment is at low level. A low rate of interest leads to an increase in investment. There is therefore a need to promote an interest rate regime that will ensure “inexpensive” spending for investment and consequently enhancing economic growth at low financial cost.

Interest rate is a critical variable in the loanable funds market, given its role in the mobilization and efficient allocation of financial resources. Prior to the adoption of the Structural Adjustment Programme (SAP) in 1986, the authorities in Nigeria fixed the level and structure of interest rate. The major reasons for regulating interest rates were the desire to obtain the social optimum in resource flow to the preferred sector; promote an orderly growth of the financial markets; combat inflation and lessen government’s debt service burden. In order to facilitate the flow of domestic credit to the priority sectors, discriminatory and below market interest rates were fixed for credit to agriculture, manufacturing and residential housing construction. This policy generally led to the unintended consequences of moral hazard and adverse selection.

The financial sector reforms, which commenced in July 1986, relied on market forces. Its objective was the elimination of financial repression in order to improve the incentive structure and ensure allocative efficiency. The policy stance of the regulatory authorities has been guided by the general economic conditions and developments in the financial markets. At various times, there had been policy shifts induced by the need to deal with emerging problems. However, by October 1996, all forms of control on interest rates had been removed, following further liberalization of the financial sector, thus the Central Bank of Nigeria’s minimum rediscount rate became the nominal anchor of its interest rate in the flow of banks credit, which averaged 19.8 percent in 1980 – 1986, 28.6 percent in 1987 – 1996 and averagely 42.9 percent in 1997 – 2000s respectively. However, the unintended consequence of the policy shift from controls to liberalization has been the rise in interest rates, especially between 1986 and 1993. Interest rate was relatively stable between 1994 and 1997 and, thereafter, became volatile (CBN, 2015).

An understanding of the nature of interest rate behavior on domestic investment is critical and crucial in designing policies to promote economic growth. Its importance is hinged on its equilibrating influence on supply and demand in the financial sector. Banks as intermediaries move fund from surplus units of the economy to deficit units by accepting deposits and channelling them into ending activities. The extent to which this could be done depend upon the rate of interest and level of development of financial sector as well as the saving and investment habit of the people. Hence, the availability of investible fund is therefore necessary for all investment in the economy which eventually translates to economic growth and development (Uremadu, 2006).

Davis and Emerenini (2015) explained that the basic functions of interest rate in an economy in which individual economic agents take decisions as to whether they should borrow, invest, save and/or consume, are summarized by International Monetary Fund (IMF) under three aspect; namely: a) interest rates as return on financial assets serve as incentive to savers, making them defer present consumption to a future date; b) interest rates being a component of cost of capital affect the demand for and allocation of loanable funds and c) the domestic interest rate in conjunction with the rate of return on foreign financial assets and goods are hedged against inflation.

The behaviour of interest rate to a large extent, determines the investment activities and hence economic growth of a country. Investment depends upon the rate of interest involved in getting funds from the market by investors, while economic growth to a large extent depends on the level of investment. If the prime lending interest rate is high, investment is at low level and when prime lending interest rate falls, investment will rise (George-Anokwuru, 2017). The need to promote an interest rate that will ensure increase in investment and consequently enhancing economic growth cannot be over emphasized. Deposit rates, lending rates, Treasury bill rate, interbank rate and Minimum Rediscount rate are all examples of interest rates (Davis & Emerenini, 2015). Therefore, the deposit money banks volume of customer deposits ranging from savings to demand deposits determines the quantity of loans, advances, overdrafts that the banks gives as credits to customers for investment purpose. Many studies have pointed to the fact that increasing the credit granted by deposit money banks due to the prevailing lending rate leads to economic growth (Aliyu & Yusuf, 2013).

According to D’Alberto (2015) interest is the cost of hiring money or credit. Uzomba, Chukwu and Jumbo (2014) added that interest is the extra cost paid for taking credit or money from the bank. Hassan (2016) defined interest rate as the price paid for the use of money. It is the opportunity cost of borrowing money from a lender to finance investment project. It can also be seen as the return being paid to the provider of financial resources, for growing fund for future consumption. Interest rates are normally expressed as a percentage rate. The volatile nature of interest is determined by many factors, which include taxes, risk of investment, inflationary expectations, liquidity preference, market imperfections in an economy etc.

Fatoumata (2017) defined interest rate as the reward for not hoarding money. Over the years, interest rates have remain a subject for critical assessment with diverse implications for savings mobilization and investment promotion. Banks pay interest on deposits on one hand and on the other hand they charge interest on loans and advances lent to borrowers. The difference between these two interest rates defines the interest spread which constitutes a significant proportion of the profits of deposit money banks. Interest rate variables include minimum rediscount rate, lending rate, deposit rates, treasury bills rates, as well as interbank rates (Kihara & Mirie, 2017).

Okosodo (2009) defined investment as expenditure on physical assets which are not for immediate consumption but for the production of consumer and capital goods and services. Investment made by business firms is governed by the desire to maximize profits. The main motive for government investment on social capital is not necessarily to make profit but to improve the living conditions of its citizens. He added that the amount of income earned, savings, profits, the amount paid as tax and the rate of interest are factors that determines investment in Nigeria.

Obamuyi (2009) investigated the relationship between interest rates and economic growth in Nigeria, using time series analysis and annual data from 1970-2006. The co-integration and error correction model were used to capture both the long-run and short-run dynamics of the variables in the model. The empirical results indicated that real lending rates have significant effect on economic growth. Olubanjo, Atobatele and Akinwumi (2010) simulated the inter-relationships among interest rates, savings and investment in Nigeria between 1993 and 2010 using two stages least square method. Their result suggested that a marked decrease in the real lending rate would not result automatically into increased domestic investment.

Based on the foregoing, this study is aimed at carrying out an empirical analysis on the effect of interest rate on domestic investment in Nigeria covering the period 1986-2021.

1.2 Statement of the Problem

Prior to SAP in 1986, interest rate in Nigeria was generally fixed by the CBN with periodic adjustments depending on the government sectorial priorities. The monetary authority in promoting investment in key sectors in the economy (Agricultural, Manufacturing etc) charged special interest rates on loans taken by these sectors so as to encourage the growth in the output of the sectors for a possible improvement in economic growth (Udoka, 2000). The prevailing rates of interest were regulated by government through the Central Bank of Nigeria (CBN) so as to guide the economy towards economic growth through these key sectors. The period is considered as a financial repression period (government regulations, laws and other non-market restrictions preventing financial intermediaries from functioning at full capacity) as explained by Mckinnon and Shaw (1973), and was 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 exception (Soyibo & Olayiwola, 2000). Although the interest rate instruments remain fixed, there were increases. The deposit rate increased from 4% in 1975 to 9.5% in 1986, while the lending rate rose from 6 to 10.5% within the same period.

The influence of interest rate in determining the level of domestic investment in an economy cannot be overemphasized. However, over the years in Nigeria, interest rate has always been fluctuating and this has adversely affected the level of domestic and foreign investment in the economy. Various measures have been taken by the government to stabilize the level of interest rate in the economy but these steps and policy strategies were ineffective in the economy. Firstly, through the Central Bank of Nigeria (CBN), the interest rate has been pegged at various rates so as to prevent fluctuations and volatility movements. This was facilitated by the policy of interest rate deregulation in the economy in 1986. However, despite these policies, the level of interest rate has not been impressively stable and the level of domestic investment has not been optimally on the increase. This study is thus focused on the evaluation of the effect of interest rate on domestic investment in Nigeria.

1.3 Objectives of the Study

The general aim of this study is to evaluate the interest rate and domestic investment in Nigeria; an empirical analysis (1986-2021). The specific objectives of the study include:

1. To ascertain the effect of interest rate on domestic investment in Nigeria.
2. To evaluate the effect of inflation on domestic investment in Nigeria.
3. To evaluate the effect of money supply on domestic investment in Nigeria.

1.4  Research Questions

In the course of this study, the following research questions will be addressed:

1. To what extent has interest rate affected the level of domestic investment in Nigeria?
2. To what extent has inflation effected on the level of domestic investment in Nigeria?
3. To what extent has money supply effected on the level of domestic investment in Nigeria?

1.5 Hypotheses of the Study

The following hypotheses of the study will be tested:

Ho: Interest rate has no significant effect on domestic investment in Nigeria

Ho: Inflation has no significant effect on domestic investment in Nigeria

Ho: Money supply has no significant effect on domestic investment in Nigeria

1.6 Significance of the Study

A research draws its relevance from the present and prospective beneficiaries and its contribution(s) to academia at large. The pertinence of this research is justified on the grounds that it will show the effect of interest rate on domestic investment in Nigeria for the years under review; and thus provides a framework for policy prescriptions and interventions. In furtherance to the above, this research will find its relevance as made evidence in the following:

The Banking Sector: The banking sector will benefit significantly from this study as it will reveal the effect of interest rate on domestic investment in Nigeria. This is because the banking sector use interest rate as an instrument of lending and this study will show the effect it has on domestic investment in Nigeria over the years.

Government: The federal government will find this study highly relevant as it will provide a picture of the relative effect of interest rate on domestic investment and thus motivate relevant policy reforms or sustenance. This research will also find its relevance in the coffers of financial variable analysts given that the subject under study is purely a monetary phenomenon.

Subsequent Analysts: This investigation will also serve as a stepping stone for researchers who develop interest in carrying an empirical analysis on the concept of interest rate and domestic investment.

Scholars: Students will find this piece highly relevant as it will undeniably increase their knowledge horizon on the concept of interest rate and domestic investment.

The Academia: The education sector is also considered as one of the significant beneficiaries because it is believed that this research will be an addition to the existing stock of knowledge.

1.7 Scope  of the Study

The primary focus of this study is to carry out an empirical analysis of the effect of interest rate on domestic investment in Nigeria between 1986 and 2021. It will utilize a time series data covering 35 years.

1.8 Limitations of the Study

In the course of carrying out this research, the researcher was confronted with a lot of limiting threats which amongst others included time constraint, dearth of data and some discouraging attitudes from the staff of some statistical agencies. However, despite these limitations, the researcher will ensure that the objectives of the study are duly met and actualized.

1.9 Definition of terms

Interest Rate: The interest rate is the amount lenders charge borrowers and is a percentage of the principal. It is also the amount earned from deposit accounts.

Domestic investment: investment in the companies and products of someone’s own country rather than in those of foreign countries.

Gross domestic product: Gross domestic product is a monetary measure of the market value of all the final goods and services produced in a specific time period by a country or countries. GDP is most often used by the government of a single country to measure its economic health.

1.10 Organization Of The Study

The study is categorized into five chapters. The first chapter presents the background of the study, statement of the problem, objective of the study, research questions and hypothesis, the significance of the study, scope/limitations of the study, and definition of terms. The chapter two covers the  review of literature with emphasis on conceptual framework, theoretical framework, and empirical review. Likewise, the chapter three which is the research methodology. The second to last chapter being the chapter four presents the data presentation and analysis, while the last chapter(chapter five) contains the summary, conclusion and recommendation.

Project – EFFECT OF INTEREST RATE ON DOMESTIC INVESTMENT IN NIGERIA