Nigeria: Central bank deficit financing dooms rate hikes to diminishing returns

The central bank on 24 January raised its benchmark lending rate to 17.5%. Interest rates alone will not be enough to get inflation under control, and “wider policy changes will be needed,” says Razia Khan, head of research for Africa and Middle East at Standard Chartered.

A better-functioning official foreign exchange market would reduce the importance of the parallel market in pricing, Kahn says.  The most important change would be an end to breaches of “Ways and Means” financing limits, she adds.

The “Ways and Means” legislative provision lets the government borrow from the central bank to plug fiscal deficits or make up for delayed cash receipts. The central bank has lent over $53bn to the federal government since 2015, though the constitution says borrowings should not exceed 5% of the previous year’s state revenues.

Such interventions “contradict and undermine the effectiveness of interest-rate increases,” says Abdulazeez Kuranga, an economist at Cordros in Lagos. The effects of the latest rate increase will be “limited” given that “monetary policy transmission through the interest rate channel is not very strong” he says.

Inflation in December stood at an annual 21.34%, whereas the central bank’s target range is between 6% and 9%. Energy prices, persistent premium motor spirit (PMS) scarcity, and rising security challenges will stoke price pressures in the near term, and interest-rate increases can’t address them, Kuranga says. Key challenges are “rampant” insecurity, the need to improve critical infrastructure and to strengthen agricultural value chains to bring down food prices, he adds.

Peak in sight?

Kuranga notes that the central bank minutes mentioned the possibility of future tightening being “moderate” for the first time since it began increasing interest rates in May 2022. More members voted for a hike of 50 basis points (bps) compared with prior meetings. Those signs suggest “we might be nearing the peak,” Kuranga says.

The odds favour cumulative hikes of a further 50 to 100 bps at the next two meetings with an end to increases at the May meeting of the monetary policy committee, says Kuranga. Cordros expects that the rate will then stay stable for the rest of the year.

Some argue that rates may go even higher. Getting inflation down would mean rates of above 20% being sustained for some time, combined with policy reforms, EFG Hermes managing director Simon Kitchen told a briefing on 25 January. Wider policy credibility including better scrutiny of public finances and the removal of fuel subsidies will be needed, and more credible policy would mean rates wouldn’t need to stay high for so long, he said.

The IMF expects Nigeria’s fiscal deficit to widen to 6.2% of GDP in 2022, mainly because of fuel subsidy costs. Finance minister Zainab Ahmed said in January that the cost of the fuel subsidy means that the government sometimes needs to borrow to buy petrol.

Rates alone won’t get inflation anywhere near the 6%-9% target range, says Ayodeji Dawodu, head of Africa sovereign and corporate credit research at BancTrust & Co in Lagos. Inflation has been “partly driven by the central bank’s part financing of the government’s fiscal deficit” and “structural changes” are needed, he argues.

“There needs to be an improvement in security and investments in infrastructure,” including for transportation and power, to support agricultural and manufacturing output, he says. The fiscal spending needed is made harder by “sub-optimal oil production” and the “unsustainable” fuel-subsidy regime, he adds.

Bottom line

Deficit lending has crippled the central bank’s ability to fight inflation.