Exchange Rate And Interest Rate; Are They Mutually Exclusive? The Nigerian Experience

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The price of commodities, goods and services is influenced by exchange rate and interest rate in an economy. In the case of Nigeria inflation has increased from 8% to 20% over a 12-month period majorly because official exchange rate has increased by 55% from N197 to N305. The unofficial rate on the other hand has increased from N220 to N473 an increase of 115%.

With increase in exchange rate and itsirregular supply, expectations were that the Central Bank of Nigeria (CBN) will lower interest rates to assist manufacturers to reduce their costs however, the reverse has occurred. For businesses that require both foreign exchange and also some leverage it is a double edged sword.

Since this is a learning blog let’s take a break and look at what interest rate and exchange rate are and factors that influence them and then proffer suggestions

interest12What is Interest Rate?

An interest rate, or rate of interest, is the amount of interest due per period, as a proportion of the amount lent, deposited or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, the compounding frequency, and the length of time over which it is lent, deposited or borrowed.

Factors that influence Interest rate

The key to understanding the role of the interest rate is to see it in the context of management of the money supply. The CBN is chartered with managing the money supply in order to steer between the two perils of inflation and unemployment. The CBN manages the money supply, based on an analysis of all the data they look at, and does this by targeting a given interest rate. When the CBN says that they will increase interest rates by so many basis points, it means that they will decrease the money supply so as to cause interest rates to increase to the targeted value, given all of the other market factors.

What is an ‘Exchange Rate’?

The price of a nation’s currency in terms of another currency. An exchange rate thus has two components, the domestic currency and a foreign currency, and can be quoted either directly or indirectly. In a direct quotation, the price of a unit of foreign currency is expressed in terms of the domestic currency.

interest4Factors That Influence Exchange Rates

Floating rates are determined by the market forces of supply and demand. How much demand there is in relation to supply of a currency will determine that currency’s value in relation to another currency. For example, if the demand for U.S. dollars increases, the supply-demand relationship will cause an increase in price of the U.S. dollar in relation to the Naira. There are countless geopolitical and economic announcements that affect the exchange rates between two countries, but a few of the most popular include: interest rate decisions, unemployment rates, inflation reports, gross domestic productnumbers and manufacturing information. In the case of Nigeria, the reserves of the country tied to income from crude oil influences exchange rate.

Currency devaluation can occur in absolute and relative senses. A relative devaluation occurs when the foreign exchange value of one currency drops against the exchange value of other currenci

Interest Rate and Monetary Policy

Interest rates matter in many different ways and affect the economy. One way that interest rates matter is they influence borrowing costs. Lower interest rates, for example, would encourage more consumer loans to obtain a mortgage for a new home or to borrow money for an automobile or for home improvement. Lower rates also would encourage businesses to borrow funds to invest in expansion such as purchasing new equipment, updating plants, or hiring more workers. Higher interest rates would restrain such borrowing by consumers and businesses. The CBN seeks to set interest rates to help set the backdrop for promoting the conditions that achieve the mandate set by the Fiscal policy–namely, maximum sustainable employment, low and stable inflation, and moderate long-term interest rates.

interest5The Nigerian Experience – Problems

  • Exchange rate is high because demand is constant and supply is inadequate due to mono-product (crude oil income)
  • Interest rates have increased because liquidity in the banks has been reduced due to the TSA policy of all income accounts residing with the CBN.
  • Interest rates are also high due to government consistent local borrowing through Treasury Bills and Bonds

The Nigerian Experience – Suggested Solutions

I am not an economist but these are my two pence thoughts:

  • Government should stop local borrowings and focus on foreign loans. Local borrowings encourage banks to buy treasury bills at the expense of lending to the real sector and support SMEs. This creates lazy banks with little creativity. Government should stop issuing new Treasury Bills as old one mature. This will increase liquidity in the banks and force them to lend since they have responsibilities to shareholders, and also reduce interest rate. We can learn from the Japanese experience where the Central Bank has reduced interest rate to negative 1.5%. The implication is that banks that want to keep funds with the Central Bank pay for doing that rather than earn interest.
  • The TSA accounts should be returned to the commercial banks. In an economy that is mostly public sector driven, keeping these funds away from the banks has impact on liquidity. While the government wants to prevent corruption, there are ways to monitor activities on the TSA accounts. The government should centralize withdrawals from TSA accounts to only approvals by the Accountant General for control purposes and no new accounts can be opened by ministries and parastatals without approval from the presidency. This will increase liquidity and also reduce interest rate.
  • Government should consolidate assets. Government agencies should maximize space and share facilities. All idle assets should be sold and no government agencies should be in rented facilities. Do I support sale of national assets? Yes, some idle assets (The Refineries, Nigeria Railways, Privatize NNPC etc.).
  • Diversification of the economy is also important. Foreign exchange income from the agricultural sector is a long-term project as this requires planning and implementation and benefits may not be seen until after four years. The low hanging fruits and quick wins can come from the solid minerals sections and a working policy needs to be put in place as well as incentives to encourage investments in this sector.
  • Nigerian banks need to focus on growing the retail banking business. The CBN as per its March 2016 report indicated that “Currency Outside Banks” was N1.4 trillion. Guess the days of lazy banking and focus on Letters of Credit and corporate Banking are over. This is the time for creative banking. Every serious CEO in the banking sector should be asking the questions: (a) Where is this N1.4 trillion? (b) How Can I Trap at Least 10% of This Fund? What Resources Do I Need to Deploy?

Conclusion

Exchange rate and interest rate are not mutually exclusive. I am not an economist but they should move in opposite direction and not in the same direction. The purpose of increasing interest rate may be to attract foreign investors to the money market however, the flip side is local industries are dying. That’s my two pence for the next two weeks.

Forum Discussion

Let’s have your views on this issue. What should the CBN do?

References

https://www.globalcreditportal.com/ratingsdirect/renderArticle.do?articleId=1733110&SctArtId=403769&from=CM&nsl_code=LIME&sourceObjectId=9828349&sourceRevId=2&fee_ind=N&exp_date=20261011-21:00:03

https://en.wikipedia.org/wiki/Interest_rate

http://www.investopedia.com/terms/e/exchangerate.asp#ixzz4Myqfy1po

http://www.investopedia.com/ask/answers/forex/how-forex-exchange-rates-set.asp#ixzz4MyrqPGEh

http://www.investopedia.com/ask/answers/060115/what-are-key-economic-factors-can-cause-currency-depreciation-country.asp#ixzz4MysplYMo

https://www.quora.com/Why-is-the-Interest-rate-determined-by-Federal-Reserve-rather-that-the-free-market-Demand-Supply

https://www.federalreserve.gov/faqs/why-do-interest-rates-matter.htm

https://www.cbn.gov.ng/rates/mnycredit.asp

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