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Effect Of
Interest Rate On Investment Determination In Nigeria
ABSTRACT
This study
examines the effect of interest rate on investment determination in Nigeria.
The study is necessitated by the fact that the behavior of interest rates to a
large extent determines investment activities and economic growth of any
country. Investment decision is seen as demand for credit in an economy and
this study calculated the annual variance of interest rate and its effects on
investment determination. This research made use of OLS technique in estimating
the model and also extracted data with regards to the period 1970-2010 from the
Central Bank of Nigeria (CBN) annual report and statistical bulletin of 2008.
The research showed that interest rate played a negative role in investment
determination in the economy. It also deduced that other variable such as
economic stability, debt burden, shortage and lack of infrastructure, foreign
exchange affect domestic investment. Improvement in these key macroeconomic variables
is a necessary condition towards facilitating investment in Nigeria. This
research work is above all a forward looking exercise intended to draw lessons
for the strategic positioning of the economy as the government of Nigeria
consolidates its transition to democracy.
CHAPTER ONE
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 the 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:
(a) 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.
(b) What are the causes of low investment
and fluctuating interest rate in Nigeria?
(c) 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:
(a) To critically examine the
relationship between investment and interest rate in Nigeria.
(b) To empirically investigate the effect
of interest rate on investment determination in Nigeria.
(c) To make recommendations based on the
results of the research.
1.4 HYPOTHESIS OF THE STUDY
(a) H0:
Interest rate has no effect on investment in Nigeria.
(b) H0:
Income has no effect on investment in Nigeria.
(c) 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.
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