Nigeria: Technically in Recession?


Monday, July 25, 2016 3:15pm /DLM Research

Nigeria is technically in recession…a direct reflection of the lull in economic activities. We are of the view that several factors have contributed to the contraction in economic growth which we split into: demand side factors and supply side factors. Demand side factors influence growth of aggregate demand while the supply side incorporates factors such as the cost of doing business. We note that the cost of doing business in Nigeria is relatively high, perhaps one of the highest in Africa which supports our argument for a low interest rate regime. This argument is based on the fact that the cost of capital is a key component of the total cost of product or service delivery. Hence, the overall high cost of production translates to high consumer prices as these costs are passed on to the final consumers as firms strive to, at the minimum, break-even.

We believe that lower interest rates will have a positive effect on investment, productivity, employment, export and foreign exchange in the medium to long term. This is based on the fact that lower interest rates would encourage firms to access loans to expand production capacities. In addition, inflationary pressures would eventually ease as cost of capital reduces and competition improves given the boost in overall national production.

Presently, firms are reluctant to take on debt due to high interest rates leading to significant reliance on self-financing which is inadequate to meet working capital needs and expansion. We are of the view that the country’s investment climate needs to be robust for business to thrive given that consumer and business confidence are key determinants for economic growth. The tough operating environment and rising cost of production have impacted on firms negatively evidenced by lower revenue growth and shrinking profit margins. With higher aggregate demand and strong economic growth, more firms will thrive, employment will be created, and non performing in banks’ balance sheet will be reduced.

‘‘In a market economy, resources tend to flow to activities that provide the greatest returns for the risks the lender bears. Interest rates serve as market signals of these rates of return. Although returns will differ across industries, the economy also has a natural rate of interest dependent on factors such as the nation’s rates of savings and investment. When economic activity weakens, monetary policymakers can push the interest rate target temporarily below the economy’s natural rate, which lowers the real cost of borrowing ’’

Headline inflation for June 2016 came in at 16.48 percent, representing an increase of 90bps from 15.58 percent recorded in the preceding month. This is the fifth consecutive month of a faster rise in the nation’s inflation rate which signals resurgence in inflationary pressures. Given that the average lending rates from deposit money banks in Nigeria is ~29%, a minimum return of 50% is needed for a business/investment to be viable. We are of the opinion that the sole ‘inflation-targeting’ approach of the apex bank is largely limited as we believe that Nigeria’s inflation is essentially ‘cost-push’ rather than ‘demand-pull’. Hence, we re-iterate that the Central Bank of Nigeria focuses on policy formulation geared towards stimulating investment and growth.

For example, in December 2007, most economists realized that the global economy was slowing but initially underestimated the severity of the recession. The US Fed used a dual-track response to the financial crisis while the Federal Open Market Committee (FOMC) reduced its interest rate target to near zero in December 2008 and indicated its intent to maintain a low interest rate environment for an “extended period”.

The primary benefit of low interest rates is the ability to stimulate economic growth mainly through spurring spending on capital goods— which impacts on the economy’s long-term performance. In addition, low interest rate can improve bank balance sheets and banks’ capacity to lend. This can be seen in the case of the United Kingdom For example, in FY’15, the Loans and advances to customers of Lloyds Banking Group alone is £455.18billion which is 1223% more than 15 listed Nigerian banks with total Loans and advances of N14.80trillion (£34.41bn based on fx rate of £/N430).

By keeping short-term interest rates low, the CBN can indirectly increase the capitalization of the banking system. Higher loan growth would improve the industry’s net interest margin (NIM), retained earnings and, thus, capital position. Furthermore, low interest rates increase asset prices as the public finds itself with more money balances than it wants to hold. In response, people use these excess balances to increase their purchases of goods and services and of assets like mortgages, equities and other money market instruments.

Is the Nigeria economy strong enough to allow the value of naira to be freely determined by the market at a time when the economy is technically in recession? We are of the view that this is largely dependent on the demand for the naira which supports our argument for a diversification of the economy to improve exports. We note that the currencies of countries that play a major role in world trade can freely be determined by the market. They include: The US dollar, UK pound sterling, and the European Union Euro. Others include Canadian dollar, Japanese yen and china Renminbi. This is due largely to the level of export undertaken by these countries and the fact that international transactions are settled mostly with these currencies.

China is the world’s largest exporter and manufacturer as well as its second largest economy. Yet its currency, which is still carefully managed by the Chinese government, has a market share well behind the U.S. dollar and the euro, and is barely traded on foreign exchange markets. But volumes are climbing steadily and all signs point towards the RMB gaining greater stature as a stable reserve currency. The Nigeria naira would only effectively compete with these currencies if exports improve significantly. In December 2013, the RMB overtook the euro to become the second most used currency in global trade finance after the dollar.

The floating of the currency saw the naira trading between 346 and 348 on the parallel market before declining to 360 by the end of last week. It continued trading around 360 this week before falling to a low of 376 at the close of business on Thursday. We are of the view that the exchange rate depreciation will produce negative balance sheet effects on firms which will limit ability to undertake foreign borrowing.

No nation can achieve sustainable economic growth without growth in the level of its investment. The developed economies in Europe, America, Asia and the Pacific have all leveraged on the strength of their Small and Medium-Scale Enterprises (SMEs). We observed that a huge number of mega brands and conglomerates in the developed economies started as SMEs and the performance of SMEs in countries like Brazil and India also supported their placement among the BRICS (Brazil, Russia, India, China and South Africa).

The entrepreneurial spirit of the Chinese has seen them not only as the second largest economy in the world, but also the country with thriving international presence in foreign economies. South Korea was one of the worst hit economies by the Asian financial crises of 1997. As a result of improvement in SMEs, the country recovered from the crisis and in 1999, SMEs accounted for 81.9% of industrial employments and 74.3% of total manufacturing in South Korea.

With funds accessible from deposit money banks in Nigeria at a single digit interest rate, SMEs will be placed on a path of sustainable growth. Hence, concerted efforts should be directed towards increasing the capacities of SMEs given its inherent capacity to contribute significantly to gross domestic product (GDP) and employment.

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