This year, the CBN has introduced some unconventional policies in a bid to stimulate Nigeria’s slow growing economy. The GDP only grew 2.28 percent in the third quarter of 2019.
The major drivers of economic growth in the long term are: Labour, innovation and capital.
Economic growth is an increase in the value of goods and services in an economy over a period. An economy will grow, if:
1. There is an increase in the amount of labour participating in economic activities
2. There is an increase in the level of technology used by labour for production, thereby increasing productivity
3. There is an increase in the amount of capital spent for 1 and 2.
Based on the policies introduced by the CBN this year, there is a concerted effort to stimulate the growth of the economy by increasing capital spending (3 above). This year, the apex bank introduced 2 policies for this purpose; minimum level of Loan to Deposit ratio for commercial banks and restricting participation in Open Market Operation (OMO) bills to commercial banks and foreign portfolio investors.
We will be looking at the possible reasoning of the CBN in enacting these policies, as well as their potential impact on the economy.
First of all however, lets take a further look at the components of economic growth and how they interact.
Let us assume there is a pure water manufacturer. This entrepreneur has 20 staff, 5 sealing and bagging machines, and production capacity of 100 bags per day. The staff are the labour, capital includes everything used to produce the finished product such as the equipment and money available to the entrepreneur (financial capital).
There are several ways the entrepreneur can go about increasing production levels. One way could be increasing the amount of labour, another could be investing in staff training, thereby increasing the quality of labour and production level per unit staff. A third way could be investing financial capital to buy newer models of sealing and bagging machines which operate at a faster speed. By investing in this way, the capital per worker has been increased by increasing the level of technology used in the factory. From this we can see that if the controller of the factors of production chooses not to invest, it would be very difficult for any growth in production to be experienced. In this analogy, the government and financial institutions would be the entrepreneur, and production capacity would be the GDP.
The major determiners of the level and direction of financial capital in the economy are the government and financial institutions (in particular, commercial banks). By investing in education, a government is able to improve the quality of its labour force, while through investing in infrastructure, the government is able to increase productivity and technology levels. The role of commercial banks is to convert savings from citizens into investments, serving as the financial intermediary channeling financial capital from the savers (surplus segment) to investment projects (deficit segment) through loans. This role of commercial banks is very important as collectively, they can determine the direction in which financial capital flows in the economy, this is done by the banks’ decisions on where/with whom they decide to invest/loan the funds under their control. For instance, if an entrepreneur needs external capital in order to expand, he could seek these funds from the bank, and an aggregate increase in productivity of businesses such as this leads to an increase in the GDP of the country.
Next, lets take a look at the contributors to GDP and employment in Nigeria. According to the National Bureau of Statistics (NBS), Micro, Small and Medium Enterprises (MSMEs) account for 48% of the country’s GDP and employ 84% of the labour force. These are huge numbers and mean that growth in the economy would be closely tied to growth in this segment.
Let’s next examine how banks in Nigeria have performed in their role of financial intermediation. In the past few years, banks have chosen to loan out funds mostly to the public sector (government), oil and gas sector and other big corporates, and less to MSMEs. According to the latest banking sector data from the NBS, 22.9% of all commercial banking loans are held by oil and gas industry and services, while 8.75% is held by government and 15.32% by manufacturing. On the other hand, Agriculture, Trading and commerce, Education, and General sectors received only 4.02%, 6.57%, 0.40%, and 6.71% respectively.
The CBN defines MSMEs broadly as businesses which have a turnover of less than N100 million per year, and employ less than 300 people. So while I was unable get more specific data on the lending to MSMEs vs large businesses and government (Banks’ financial statements also only segment loan data by industry), it would be fair to assume majority of businesses involved in Agriculture, Trading and commerce, and General sectors are MSMEs, and that there is a very low number of MSMEs involved in Oil and gas considering the capital required. This assumption is corroborated by NBS data which shows 54% of Micro enterprise are involved in trade, while 35% of SMEs are businesses involved in education.
It can also be assumed that the 15.32% share of the Manufacturing sector in banking sector credit would have a mix of both MSMEs and large corporates, although the precise nature of this mix cannot be deduced, so due to limited available data, we’re working with approximations here. However, one thing is obvious from this data; that lending to MSMEs, which employ 84% of Nigerians and account for nearly half the GDP has been very low.
The modus operandi of banks in the last few years has been to grant loans to big corporates, especially oil and gas companies, first, and other sectors secondary. The banks would invest funds in high yielding government securities rather than give those funds out as loans to smaller companies. Commercial banks are not altruistic entities, their main goal is to turn a profit, not to develop the economy, they believe they have found an easier way of doing so. Would you rather invest in government T-bills at 15% risk free or would you rather loan those funds to a business at 23% knowing there is some probability of default? You see even as an individual the answer is not so straight forward and would depend on several factors including your risk appetite and the credit quality of the business asking for the loan. But then again, how do you determine the credit quality of a company? Data, a track record of the business performing and consistently making returns. This information is more readily available for bigger companies than it is for MSMEs, which is the reason banks tend to demand a much higher interest rate and other stringent conditions, covenants and collateral. Banks have found a formula that allows them to play things relatively safe and still make billions in profit, and for that, they really can’t be blamed.
Commercial banks don’t have a duty to grow the Nigerian economy, but you know which bank does? The Central Bank. This year they introduced 2 major policies to help stimulate a slow growing economy:
Minimum Loan to Deposit Ratio (LDR) for Banks
In July of this year, the CBN mandated all commercial banks to have a minimum loan to deposit ration of 60% by a deadline of 30th September. On October 2nd, the CBN further increased the minimum LDR to 65%, with 31st of December as the deadline for compliance. LDR tells us how much of customer’s deposits are given out by banks as loans. A bank having an LDR of 90% means for every 10 Naira deposited, 9 Naira of it is given out as loans. In a normal economy, the main source of income for banks would be loans, and LDRs would tend to be above 80%, as having a low LDR would reflect on your bottom line and reduce profits, but in Nigeria, the attractiveness of government securities has made so many banks comfortable with low LDRs as they can still make profits in spite of it, for instance, Unity bank in 2018 still managed to turn a small profit of N1.27 billion with an LDR less than 30%. The CBN was trying to buck this trend and a particular section of the circular was of note:
“To encourage SMEs, Retail, Mortgage and Consumer Lending, these sectors shall be assigned a weight of 150% in computing the LDR for this purpose. The CBN shall provide a framework for classification of enterprises/businesses that fall under these categories”
The CBN wants banks to lend more to the retail sector. It said in October that the policy had increased lending by 5.33%, it is yet to be seen how much of this increase has gone to MSMEs. Some have criticized the decision, stating that it would see non-performing loans (which dropped to 9% from a 7 year high of 15% in 2017) in banks’ books increase. Now this statement is somewhat disingenuous. NPL levels were at a low of 3% in 2014, before rising to the high of 2017. So, what happened to cause the spike from 2015–2017? The price of oil crashed, leading to Nigeria entering a recession in 2016. A recession would cause an increase in NPLs for any economy, but the banks’ overexposure to the oil and gas industry in particular exacerbated it. The reason NPL levels have dropped now is a combination of a few things: First, oil prices have somewhat stabilized and are up from 2015 lows; second, many of those NPLs have now been provisioned out of banks’ balance sheets and finally, banks became more cautious about lending (hence the decreased LDRs). One could still argue that banks are over-weighted in their exposure to the oil and gas sector, even if LDRs remained low, another sustained crash in oil price could once again greatly increase NPLs of the banks. Rather than say the Apex bank should not increase the minimum LDR, the emphasis should be on diversification in the loan books of banks along with better credit policies.
Exclusion of Local Investors from OMO Auctions
Also, in October, the CBN issued a circular excluding individuals and local corporates (except commercial banks) from participating in Open Market Operations (OMO) auctions, foreign portfolio investors (FPIs) were also allowed continued participation in the auctions.
There has been some confusion on the distinction between OMO bills and Treasury bills and many believed that this ban applied to T-bills.
T-bills are issued by Federal Government as a tool to meet its funding needs.
OMO bills on the other hand are issued by the Central Bank and are used as an economic liquidity management tool. When the CBN perceives an excess degree of money supply, they issue (sell) more OMO bills to mop up the excess. When there is low level of liquidity, the Central Bank buys back OMO bills, thereby supplying liquidity to the financial system. This is of course, how it is supposed to work in a normal economy, but it seems we must once again, make a distinction when it comes to the Nigeria. The CBN has been using OMO bills less as a tool for liquidity management, and more as a tool for currency management. This is seen in the CBN’s encouragement of FPIs to participate in the auctions. If OMO bills were to be used solely for liquidity management, it would be unnecessary and counterproductive to invite foreign investors; for instance, if the purpose of issuing the OMO bills were to mop up excess liquidity, allowing foreign investors defeats that purpose because they would be buying up the bills with money from outside the Nigerian finance ecosystem, and might even crowd out local investors (whose money the Central Bank is trying to mop up). The CBN instead is using the OMO auctions as a means of attracting FX used to prop up the Naira. The capital importation report from the NBS reveals that 55.8% of imported capital into the country for Q3 of this year was from FPIs, a lot of which is invested in OMO bills to take advantage of carry-trade opportunities.
However, some good has come from the OMO ban. In its aftermath, the demand for T-bills skyrocketed as investors saw this as the alternative to OMO bills, this in turn led to a drop in the stop rate to 8.3% for a 1 year T-bill, this is below the national inflation rate of 11.6%. With this development, there’s now a dearth of risk free investments available to investors which have yields above inflation. Money market yields are also dropping to rates close to inflation. It will be good for the economy if participants in financial markets start to move away from investments in government issued securities and towards investing in the economy. The ban was made with two intentions; the first to free up room for FPIs to participate in OMO auctions (and continue propping up the Naira), and the second, to push investments locally away from government securities to the real economy. The policy has given the Nigerian stock market (which is the 3rd worst performing market in the world this year), a much needed boost. Banking stocks in particular have been a target of pension fund administrators (PFAs) and local investors, and the Banking Sector Index is up 15% for the month of November.
The early signs show these rather unconventional policies are having a positive effect. The positions of FPIs in propping up the Naira could however put the CBN in a precarious position. The moment they sense uncertainty about the Naira or see a devaluation coming (this could happen if there is a crash in oil price for an extended period), they will pull out all their funds and this would mount further pressure on the Naira.
