Benign inflation, MPR set to decline, what next?

 The National Bureau of Statistics (NBS) recently reported that the January inflation rate reached a record low of 9 percent, from the 12 percent recorded in December 2012. The significant 3 percent fall in the rate of inflation was attributed to high base effects, which implies that the impact of any price increase in January 2013 was felt less as a result of a high commodity price in January 2012. After all, the partial removal of fuel subsidy in January 2012 resulted in an increase in the general price level. In February 2013, we also expect the inflation rate to remain relatively flat at 9.1 percent (±0.25 percent) due to a minimal impact of the base period (February 2012).

The indirect relationship that exists between the inflation rate and rate of interest has enabled central banks to use the latter to control the former. A low interest rate implies lower borrowing costs. Hence, more people can borrow money to spend more causing the economy to grow and inflation to rise. In the same way, high interest rates result in less spending, economic slowdown and a decline in the inflation rate.

Against this backdrop, the Monetary Policy Committee (MPC) in Nigeria has unwaveringly maintained a contractionary monetary stance since October 2011 due to persistent inflationary pressures. As a result, the benchmark interest rates (MPR) and other monetary policy rates have been left unchanged to date, except in July 2012 when the MPC altered the Cash Reserve Ratio (CRR) and Net Open Position (NOP) to further minimise liquidity in the banking sector.

The high interest rate environment has slowed down business activities and frustrated growth in the Nigerian economy. Thus, it is with much delight that Nigerians welcome this period of declining inflationary pressures as it is believed that the MPC would succumb and bring down the monetary policy rate (MPR) at its next meeting in March. Presently, there is a disconnect between the policy rate and market rates. That is, market rates are currently falling, though the monetary policy rate remains high at 12 percent. The Open Buy Back (OBB) rate fell by 38bps to 10.25 percent p.a. as at the end of February, from 10.63 percent p.a. recorded in the previous month. Similarly, the Overnight (ON) call rate declined by 58bps to 10.42 percent p.a. while the 91-day rate declined by 164bps to 9.20 percent p.a. from 10.84 percent p.a. in the period under review. As a result, we expect market rates to decline further, in tandem with the MPR.

In our opinion, the MPC has limited choices in its current conservative stance; hence, we expect a marginal cut in the benchmark interest rate by 100bps at its next meeting.

Effects of lower rates on the economy

Lower interest rates imply that the cost of borrowing has declined; thus, consumers and/or firms would be encouraged to take loans to finance spending and investment that boost growth. However, the anticipated increase in spending is dependent on the assumption that banks would lend when rates go down.

Are banks willing to lend?

In our opinion, there are two main reasons why bank lending is not likely to improve much if the MPR declines in March.

First, Nigerian banks are still on the path of recovery from the crisis that rocked the banking system in 2008/09. As such, banks are averse to giving out loans except to large companies which prove to be credit worthy. Besides, the existing low level of confidence in the economy discourages lending as there is no certainty that banks would recoup the expected returns from a sponsored project.

Second, consumers may not be motivated to borrow despite a reduction in MPR. The reason is that the MPC is not likely to cut the MPR by a large margin in March. Thus, interest rates may remain relatively high, especially for individuals and small businesses. Consequently, we expect to see only a slight increase in lending for individuals and small businesses while larger companies would get a fairly decent amount of loans from banks.

Bond market

Bond prices have an inverse relationship with interest rates. At a lower interest rate (or lower bond yield), investors who hold older bonds (at a higher market rate) are better off than those who hold bonds at the current market rate. Consequently, the prices of existing bonds rise because the bonds are now worth more. Nevertheless, an investor who intends to keep his bonds till maturity need not be concerned about changing market 

values. He will still receive his promised coupon payments and repayment of the principal at maturity.

The size of the Federal Government bonds rose by 15.22 percent to N4.08trn at the end of 2012 as against N3.54trn in the corresponding period of 2011. Currently, bond yields are falling as a result of an increase in demand. A further decline in interest rates in response to the MPC’s decision in March is likely to cause more people to shift their investment portfolio to government bonds since these bonds have a low risk of default.

Stock market

Similar to the bond market, the stock market is also inversely related to interest rates. Lower interest rates imply that companies pay less to borrow in order to finance their spending. It also implies that companies’ profits do not shrink, unlike high interest payments where companies may need to take out of their profits to finance the interest from borrowing. Thus, a decline in interest rates would boost stock market activities because investors would be willing to pay higher prices for companies’ stock since they believe that companies’ profits are not depleting. In addition, a drop in interest rates boosts stock prices of companies that have high debt in their balance sheet. This is because a decline in interest rates implies a reduction in the interest paid on the debt, which raises the earnings per share (EPS), improves investors’ sentiments for those companies’ stock and then boosts stock prices.

The Nigerian stock market capitalisation increased by 17.95 percent from N8.97trn as at the end of 2012 to N10.58trn in February 2013. Factors that led to increased activities in the stock market include the declining yields of the fixed income instruments which made investors shift to equities market, and increasing foreign portfolio investments due to poor performance of securities in developed markets when compared to Nigeria’s stock market. Nigeria’s interest rate would still be relatively higher and attractive when compared to its peers despite the anticipated decline in interest rates. Thus, we expect a further boost to stock market activities in the coming month.

What really matters?

To obtain the desired level of growth, some other critical factors, apart from a cut in interest rates, need to be taken into consideration as well. Availability of good infrastructure is an important factor for growth because it alleviates the cost of doing business and increases productivity. It is no news that many firms incur high costs in running their businesses because the necessary infrastructure (power, roads, etc) is not in place. If the government provides basic amenities, firms would spend less money providing for those services, thereby resulting in increased profits. Higher profits imply that firms are less likely to default on loans, which would motivate banks to extend credit at a lower interest rate.

Furthermore, the government needs to hasten ongoing reforms in various sectors (Power, PIB, etc). This would build up confidence in the economy, thereby facilitating spending and investment.

In conclusion, we believe that a decline in MPR is a catalyst for growth, but should be combined with quality infrastructure and positive progress from sector reforms in order to achieve the desired level of growth needed in the Nigerian economy.

 

Analysis by Financial Derivatives Limited.