INTEREST RATE VOLATILITY AND ECONOMIC GROWTH IN NIGERIA (1980 – 2011)
Abstract
This study examines the relationship between interest rate volatility and economic growth in Nigeria. It seeks to find out the impact of interest rate volatility on economic growth in Nigeria. The data used for the study are from secondary sources: Central Bank of Nigeria (CBN) publications, statistical Bulletins and CBN Annual reports (various issues) spanning from 1980 to 2011. The dependent variable in the model is the level of real output while the explanatory variables are interest rate volatility, Exchange rate, Money Supply, Inflation, and Investment rate. The unit root test was performed on the variables to determine their stationarity, after which the Johanson Cointegration test was then performed to check out if there exist a long run stable equilibrium relationship between the variables before the error correction model was used to correct for the short run dynamics. Also, the granger causality test was performed to cheek out the causal relationship between the variables. The Forecast error variance Decomposition (FEVD) and Impulse Response Functions (IRFs) were also estimated to cheek out the dynamic behaviour of the variables and to trace out the reaction of each variable to a particular shock at time. This estimation was done using the VAR methodology. Estimation was facilitated by the use of E-views economic software package (version 7.0). The results showed that interest rate volatility negatively impact on economic growth. The study recommends that government should try and stabilize the interest rate in the country
TABLE OF CONTENTS
CHAPTER ONE: INTRODUCTION
1.1    Background to the Study                         
1.2    Statement of Problem                         
1.3    Objective of the Study                         
1.4    Research Hypothesis                         
1.5    Justification for the Study                     
1.6    The Scope of the Study                         
1.7    Organization of the Study                    
CHAPTER TWO: CONCEPTUAL FRAMEWORK
2.1    The Meaning of Economic Growth                
2.2    An Analysis of Interest Rate and Economic Growth in Nigeria    
2.3    Literature Review                         
2.3.1    Inflation and Economic Growth                    
2.3.2    Economic Growth and Exchange Rate                
2.3.3    Investment and Economic Growth                
2.3.4    Money Supply and Economic Growth            
2.3.4.1 Money Supply and Growth in the Short and Long Run        
CHAPTER THREE: THEORETICAL FRAMEWORK
3.1    Classical Theory of Interest Rate                
3.1.1    The Loanable Funds Theory of Interest             
3.1.2    Hawtrey’s Monetary Theory                    
3.1.3    Neo-Classical Theory of Economic Growth                
3.1.4    Interest Rate Volatility and Money Demand            
3.2    Model Specification                         
3.3    Nature and Sources of Data                    
3.4    Method of Data Analysis                     
CHAPTER FOUR:    PRESENTATION, INTERPRETATION OF RESULTS AND POLICY IMPLICATION
4.0    Introduction                                
4.1    Presentation of Results                         
4.2    Policy Implication                                
CHAPTER FIVE:    SUMMARY, RECOMMENDATION AND CONCLUSION
5.0    Summary                                
5.1    Findings                                 
5.2    Recommendation                             
5.3    Conclusion                                
5.4    Suggestions for Further Studies             
References                                
Appendix                                
CHAPTER ONE
INTRODUCTION
1.1    Background to the Study
Prior to 1993, a regime of Direct Control of Interest Rate was adopted in Nigeria, most especially between 1974 and 1985. In this period, Interest Rate Policy was driven by considerations of promoting overall investment and channeling credit to identified priority sectors (Nnana, 2001). However, many policy makers intended that this practice promotes inefficiency and corruption in the system as credit funds accessed for use in the priority sectors are often diverted to other sectors rendering the policy objective ineffective.  This provided the disincentives for investment. It was against this background that a new policy framework focused on the deregulation of Interest Rate was introduced. In the year 1993, Interest Rate was very volatile and unduly high to the extent that Monetary Policy Rate (MPR) was adopted towards the tail end. However, the 26% Treasury Bills Rate stood at 26.8% while other Saving Rates float between 28.2% and 23.6%. The force of Demand and Supply for fund was put in place and this has remained so since late 1990s to date. The problem has been that the market-based approach to Interest Rate Management in Nigeria has always been associated with substantial Interest Rate Volatility which creates fear in the mind of investors as a result of the market uncertainty there by impeding growth hence call to question the overall desirability of the strategy.
Traditional Theories define Interest Rate as the prices of savings determined by demand and supply of loan-able funds. It is the rate at which savings is equal to investment assuming the existence of the capital market. The loan-able funds theory argues that Interest Rate is determined by non monetary factors. It assigns no role to quantity of money or level of income on savings, or to institutional factors such as: Commercial Banks and the Government. The Liquidity Theory on the other hand look at Interest Rate as the token paid for abstinence and inconveniences experienced for having to path with an asset whose liquidity is very high. It is price that equilibrates the desire to hold wealth in the form of cash with the available quantity of cash and not a reward of savings. The primary role of Interest Rate is to help mobilize financial resources and ensure the efficient utilization of resources in the promotion of economic growth and development (Ngugi & Kabubo, 1998).
The dynamics of short term Interest Rate is central to the pricing of all fixed income instruments and the derivatives. The factors that leads to the volatility of short term Interest Rate includes; the Monetary Policy, the Government Fiscal Policy, Taxation, Inflation, Demand for capital etc. When supply of money in the economy is low, then Interest Rate are expected to be high vice-versa. Volatility in money supply growth may lead to high Interest Rate. Under the fiscal policy the government is supposed to finance all expenditures for the economy. In case where expenditure exceeds revenue (Budget Deficit), the government is forced to borrow from the local market. This in turn affects the supply of money in the economy and the trend of Interest Rate. Inflation on the other hand causes long term Interest Rate to rise where investors sell of their bonds in fear of inflation eroding their capital gains. Demand for capital influences Interest Rate when the demand/supply of fund is below or above the equilibrium level. If there are fewer borrowers and the demand for fund is low then the rate of interest will be low vice-versa.
This behavior of Interest Rate to an extent determines the investment activities and hence economic growth of the country. Investment depends upon the rate of interest involved in getting funds from the market while growth to a large extent depends on the level of investment. According to Jhigan (2003), if Interest Rate is high, investment is at low level and when Interest Rate falls, investment will rise. There is therefore the need to promote an Interest Rate regime that will ensure inexpensive spending for investment and consequently enhancing economic growth at low financial cost.
McKinon and Shaw (1993) were the first to suggest theoretical argument against the policy of financial repression as against the structuralist school. They pointed out the important role of the financial sector in increasing the volume of savings as a result of creating appropriate incentives. In order to reach high savings and hence investment rate, they argue that government should abolish Interest Rate ceilings and allow real Interest Rate to be determined by the market force. They said this will lead to increase in saving and hence investment and ultimately lead to economic growth as well as bringing information down. Base on this hypothesis, many government in the developing countries liberalize their Interest Rate with some achieving significant accelerations in economic growth rate but in some cases the policy was associated with excessively high and volatile real Interest Rate as well as stagflation (Grabel, 1995) which is the case of Nigeria. Van Vijubergen (1983) contrasts his hypothesis to those of (Mckinon 1973 and Kapur 1976). He expressed the view that the outcome of Mckinon and Kapur depend crucially on one implicit assumption on asset market structure. This assumption is never stated explicitly that the portfolio shift into Bank deposit is coming out of all productive assets like Gold, Cash or Inventory. He further argues that it is not at all obvious that Bank deposit are closer substitute to cash or gold or rather to loan extended on the informal sector. Stightz (1989) also criticizes the policy of financial liberalization on the theoretical ground of market failure in the financial markets.
Moreso, it is imperative to note that the structure of the real sector is an important factor when considering whether to completely deregulate an economy or to regulate the economy through monetary transmission mechanism there by controlling the level of volatility. This was asserted by Sanusi (present CBN Governor) in a press briefing. He further stressed that the controlling of Interest Rate will have no significant impact on an economy if it does not have a well defined structural base.
1.2    Statement of Problem
The issue of volatility on economic growth and performance has gained importance in recent years. Various aspects of this issue have received both theoretical and empirical attention. Kormendi and Megire (1985) and Aizeman and Marion (1993) find that output growth is adversely affected by the volatility of monetary policy, while the latter, find the same applies for fiscal policy as well. Another extensive literature examines the relationship between external sources of volatility and growth. Variability or otherwise volatility of Interest Rates in Nigeria is trace-able to the deregulation era where inconsistency in the up and down swing of the rates of interest were mainly noticed.  The major objective of the deregulation exercise as proposed was to increase savings thereby making credit available for investment and economic growth. But despite this effort, economic growth is still in the dull drums. The deregulation exercise has been met with mixed fillings in Nigeria while some believes it will have economic importance in Nigeria, the others have a contrary opinion. Nwakwo (1989) believes that interest rate deregulation will definitely lead to more efficient allocation of financial market resources. This position is in line with the arguments of (Mackinon and Shaw, 1973). Abiodun (1988) on the other hand holds that the deregulation of Interest Rate is like a double edged sword which will either stimulate or mar the economic growth depending on the available playing ground. The continuous variability (volatility) of Interest Rate over periods has caused a relatively high degree of instability in the macro economic sector thereby having a negative influence on economic growth. This is seen on how it affects the decision to save and invest. Investors differ in their willingness to hold risky assets such as bonds and stocks. When the returns to holding stocks and bonds are highly volatile, investors who rely on these assets to provide their consumption face a relatively large chance of having low consumption at any given time. For example, before retirement people receive a steady flow of income that will enable them buffer the changes in wealth associated with changes in the returns of their investment portfolios. This steady return from work helps them maintain a relatively steady level of consumption. After retirement people no longer have a steady flow of income from working hence a less volatile investment portfolio is called for. The lower volatility of investment returns allows retirees to maintain a relatively even level of consumption overtime. This continuous instability as earlier mentioned impedes growth. This is contrary to the opinion about the effectiveness of the deregulation exercise. On this ground there is therefore the need to comprehensively evaluate the relationship between interest rate volatility and economic growth in Nigeria. This will equally involve determining the relationship between: gross domestic product and money supply; investment and economic growth; exchange rate and economic growth; inflation and economic growth. Finally, the dynamic inter-relationship of the variables of interest will be ascertained.
1.3    Objective of the Study
As implied from the statement of the problem, the primary objective of this study is to examine interest rate volatility and economic growth in Nigeria. Specifically, the following objectives were also considered. To:
1.    examine the relationship between money supply and economic growth in Nigeria;
2.    describe the behaviour of exchange rate on economic  growth in Nigeria;
3.    identify the relationship between inflation and economic growth in Nigeria;
4.    explain the relationship between investment and economic growth in Nigeria;
5.    explain and examine the dynamic interrelationship between the variables of interest related causality test,  innovations and shocks among variables overtime and
6.    make policy recommendation.
1.4    Research Hypothesis
In the course of this research work, the following hypothesis will be tested. These are thus presented in a Null form. That:
1.    the relationship between interest rate volatility and economic growth is not statistically significant;
2.    money supply does not significantly affect growth of the Nigeria’s economy;
3.    the relationship between exchange rate and economic growth is not statistically significant;
4.    inflation does not significantly affect economic growth in Nigeria;
5.    investment does not significantly affect economic growth in Nigeria;
6.    the variables of interest are not causally related and significantly affected by variations and shocks of the considered exogenous variables in relation to the specified endogenous variable overtime;
1.5    Justification for the Study
Base on the fact that interest rate volatility surfaced as a result of mainly the deregulation of the financial sector as proved by statistical evidence,   differs from the regulatory regime. The instability captured by volatility have a vigorous effect on the level of investment and hence economic growth in Nigeria using real Gross Domestic Product (GDP) as proxy. Previous studies have been carried out on the determinant of Interest Rate, impact of Interest Rate deregulation on economic growth in Nigeria, Interest Rate liberalization and economic growth in Nigeria, using different methodology and that of exchange rate volatility and economic growth in Nigeria.
In addition, (Eregha, 2010) did a study on interest rate variation and investment determinants in Nigeria. Moreso, Stephen and Pradip,(1998) did a work on volatility and growth in developing economies. Also, Joseph and Robert (2013) examined interest rates and the volatility and correlation of commodity price, a panel Garch model. Petra and Babara,(2010) presented a paper on macroeconomic and interest rate volatility under alternative monetary operating procedures.  None of them have investigated the volatility of interest rate and economic growth in Nigeria as captured by using the General Autoregressive Conditional Heteroscedacity (GARCH 1,1) Technique to generate the volatility series over the stipulated intervals .The application of cointegration and error correction mechanism, Granger causality test and a further application of the VAR technique to determine the impulse response and forecast error variance decomposition for each of the variables of interest. A minor focus on the relationship between money supply, inflation, exchange rate, investment and economic growth will equally be examined. This will provide an additional justification for this study.  Consequently, the work will be useful to Government, Monetary Policy Makers and Future Researchers since it will show the effect of volatility clustering of interest rate (level of interest rate instability) on the growth of Nigeria’s economy. Equally, this will require the use of the prime lending rate as a proxy for Interest Rate variable.
1.6    The Scope of the Study
This study is restricted to the examining of the relationship between Interest Rate volatility and economic growth in Nigeria which covers a yearly data of the variables of interest from 1980 to 2011.
Following the background structure of this study, the analysis is equally restricted to the statistical content of Nigeria’s economy.
1.7    Organization of the Study
This research work is proposed to be structured into Five (5) Chapters. Chapter One (1) is the Introduction which comprises of the Background of the Study, Statement of the Problem, Objectives of the Study, Research Hypothesis, Justification for the Study, Scope of the Study and Organization of the Study. Chapter Two (2) consist of the conceptual frame work and Literature Review. Chapter Three (3) will consider the theoretical frame work of the subject matter, Methodology and Model Specification. Chapter Four (4) will be the Presentation and Interpretation of Results and finally Chapter Five (5) will give the full summary of the major findings, Policy Implication, Recommendation, Conclusion and Suggestion for further studies.