EFFECT OF INTEREST RATE ON INVESTMENT DETERMINATION IN NIGERIA

Introduction

1.1. Background Of The Study

The role of interest rate in the determination of investment and hence economic growth in Nigeria has been a matter of controversy over a long period of time. Yet, what constitutes an appropriate interest rate policy still remains to be a puzzling question. Until the early 1970s, the main line of argument was that because the interest rate represents the cost of capital, low interest rates would encourage the acquisition of investment and promote economic growth, a notion consistent with the Keynesian and neo-classical analysis. This promoted many countries to impose interest rate ceilings at below market clearing levels.

Interest rate is a prominent feature of any economy. Interest rate change in response to a variety of economic events such as change in federal policy, crises in domestic and international financial market and changes in the prospects for long term economic growth and inflation. However, economic events such as these tend to be irregular (Keith, 1996).

Interest rate reform, a policy under financial sector liberalization, was to achieve efficiency in the financial sector and engendering financial deepening. In Nigeria, financial sector reforms began with the deregulation of interest rate in august 1987 (Ikhide and Alawode, 2001). Prior to this period, the financial system operated under financial regulation and interest rates were said to be repressed. According to McKinnon (1973) and Shaw (1973), financial repression arises mostly when a country imposes ceiling on deposit and lending nominal interest rates at a low level relative to inflation. The resulting low or negative interest rates discourage saving mobilization and channeling of the mobilized savings through the financial system. This has a negative impact on the quantity and quality of investment. Therefore, the expectation of interest rate reform was that it would encourage domestic savings and make loanable funds available in the banking institutions. But the criticism has been that the “tunnel-like” structure of interest rate (Ojo, 1976) in Nigeria is capable of discourage savings and retarding investment.

Because of the complementarily between savings and investment, positive real interest rates will encourage savings and the increased liabilities of the banking system will oblige financial institutions to lend more resources for productive investment in a more efficient way.

Therefore, the purpose of this research work concentrates on examining the effect of interest rates on investment in a theoretical frame work that mimics the financial sector prevailing in Nigeria. The study further sets out to examine empirically the pattern and direction of financial repression through controlled interest rates and the ensuing credit rationing that impedes economic growth by discouraging financial savings and fostering low, inefficient investment in Nigeria.

1.2 Statement Of The Problem

If the cost of capital as determined by the interest rate is not made available for investment that are capable of increasing production and productivity, the rate of the country’s expansion (growth) will be retarded. Investment enhances economic growth. The major obstacle to economic growth in developing countries such as Nigeria is the shortage of financial resources. Nigeria has the potentials to attract investment but has not been successful in attracting it despite the effort of the central bank of Nigeria (CBN) through its intensified monetary policies.

Although Nigeria has embarked on interest rate policies and structural reforms, liberalized her domestic financial market and removed restrictions on capital movement, investment has been mainly in the oil sector of her economy where the country derives over 90 percent of her Gross domestic product (GDP). In terms of diversification of domestic investment to other sectors of the economy, Nigeria has not benefitted commensurate to her potentials.

In the 1987 budget announcement of then president, General Ibrahim Babangida, it was observed that the pegging of interest rate contrary to expectation, has not achieved its desire goal of stipulating new investments nor did it result in an increased capacity utilization of industry and hence the resolve for deregulation.

According to Keynesian investment theory, which sees low interest rate as a component of cost administered detrimental to increased savings and hence investment demand. They argue that increase in the real interest rate would have strong positive effects on savings which can be utilized in investment because those with excess liquidity will be encouraged to save because of the high interest rate, thus banks would have excess money to lend to investors for investment purposes thereby raising the volume of product investment.

Most importantly successive government in Nigeria through the central bank has devised many strategies and means to control the unhealthy rise in interest rate and improve domestic investment. Despite these measures, investment continues to be the decline. It is based on these specifics that appreciated the following research problem:

1. What is the contribution of interest rate in determining investment in Nigeria following Keynesian argument that increased real interest rate could be efficiently in investment via savings.
2. What are the causes of low investment and fluctuating interest rate in Nigeria?
3. What are the measures to control interest rate and improve investment in Nigeria?

1.3 Objectives Of The Study

The general objective of this research work is to present an overview of Nigeria’s level of interest rate and its desired policy objective of enhancing investment and growth in the economy using time series analysis and annual data from 1970-2008.

The specific objectives of the study are:

1. To critically examine the relationship between investment and interest rate in Nigeria.
2. To empirically investigate the effect of interest rate on investment determination in Nigeria.
3. To make recommendations based on the results of the research.

1.4 Hypothesis Of The Study

1. H0: Interest rate has no effect on investment in Nigeria.
2. H0: Income has no effect on investment in Nigeria.
3. H0: Exchange rate has no effect on investment in Nigeria.

1.5 Significance Of The Study

The main thrust of this study is to investigate the effects of interest rate on investment determination in Nigeria. This is necessitated by fact that the behavior of interest rates to a large extent determines the investment activities and economic growth of any country. The finding would guide policy makers in designing and implementing financial policies that would enhance private and public investment friendly interest rates which are crucial to economic growth in Nigeria.

The research work implies that the behavior of interest rate is important for economic growth in view of the relationship between interest rates and investment and growth. Thus, the formation and implementation of financial policies that enhance investment friendly rate of interest is necessary for promoting economic growth in Nigeria;

1.6 Delimitations Of The Study

This study aims at discussing the various factors (macro-economic variables) that determines investment in the Nigeria economy and only few variable will be considered because of unavailability of data and also to avoid the violation of the ordinary least square (OLS) technique that would be used in analyzing the data. The study would also aim at analyzing the data collected from the CBN statistical bulletin and would be limited to cover the period of 1970-2008.

Interest rate as used in this research refers to lending rate of banks, and income is being proxied by GDP. Efforts will be made to ensure that despite all the impediments mentioned above, this research work will be relevant in serving the objectives for which it is intended.

1.7 Definition Of Terms

(A) Interest Rate:

It is seen as the reward for parting with liquidity for a specified period. It is the price which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash i.e. The price of credit. It could also be seen as the inverse proportion between a sum of money and what can be obtained for parting with control over the money in exchange for a debt for a stated period of time.

(B) Investment:

It refers to capital expenditures on consumer durables, residential construction (buildings) and plants and machinery. Thus, investment refers to the purchase of real tangible assets such as machines, factories or stocks of inventories which are used in the production of goods services for future use as oppose to present consumption. Investment can also be viewed as the sacrifice of certain present values of consumption for future value of consumption. It is the commitment of money in order to earn a financial return of the purchase of financial assets such as stocks or bonds with future end date in mind.

(C) Exchange Rate:

It refers to the price of one currency (domestic currency) in terms of another (foreign currency). It plays a key role in international economic transactions. The importance of exchange rate derives from the fact that it connects the price system of two different currencies, making it possible for international trade to make direct comparison of prices of traded goods.