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The interest rate dilemma around Nigeria to maintain the peg in the US Dollar

Dollar rises to N755 on increased demand

It is not arguable that inflation is caused by an increase in the amount of money in circulation in an economy given the presence of few goods available for purchase. Therefore, we can say that inflation is caused by the difference between the quantity of goods produced and the amount of money in circulation when the former is greater than the latter. An interest rate is also globally defined as the price paid for borrowing money as well as the reward received for saving money with formal financial institutions.

The US economy is said to be experiencing an out-turn of increasing inflation as an effect of the money pumped into the economy as a measure to ease the aftermath of the COVID-19 pandemic. The rate of inflation is, however, regarded as an all-time high within the last 40 years.
However, the United States has decided to raise interest rates by 0.75 percent for the third time in a row in order to reduce the rate of inflation in the economy. It might, thus, be expected that the Nigerian government as well as the apex bank, the Central Bank of Nigeria (CBN), follow suit by ensuring a simultaneous increase in the interest rate in the Nigerian economy to avoid jeopardising the current rate of exchange to the dollar.

However, it is important to note that the United States is one of the developed countries in the world characterised by economic conditions such as political stability, low corruption, high currency value, high per capita income, significant level of industrialisation, high governance accountability, amongst others. Nigeria, on the other hand, is a developing country characterized by the polar opposite of the aforementioned economic conditions, including a high level of corruption, political instability, low per-capita income, a low level of industrialization, extremely low government accountability, and insecurity, among other things.

Since inflation is not the only economic challenge Nigeria is faced with, increases in the interest rate do not necessarily offer a solution to the surging inflation rate in the country, as other sections of the economy tend to be affected when the interest rate is increased. Furthermore, the interest rate in Nigeria is already at a high rate and, despite this, the inflation rate of the country is still remarkably high at 20.52 percent as of August 2022, according to the CBN, as compared with that of the US, which is still at 8.3 percent according to the Bureau of Labour Statistics (BLS).

This implies that increases in interest rates cannot sufficiently act on the reduction of inflation in Nigeria. Also, it is difficult to give an answer to what extent the interest rate will be increased in Nigeria to ensure it matches up to the increase in the interest rate in the US given the difference in the economic status of both countries. The US interest rate, after the third consecutive increase, remains at 3.25 percent. In contrast, interest rates in Nigeria currently stand at 14.4 percent. So, a three-quarter increase in the interest rate in the US will leave it at 5.78 percent, but a three-quarter increase in the interest rate in Nigeria will make it 24.5 percent, which is very high.

Although, given the effect of an increase in interest rates on the value of the currency, an increase in the interest rate tends to influence not only the reduction of inflation but also the increase in the value of the US dollar. Since the value of the US dollar tends to go up when the interest rate goes up in the US, not raising the interest rate in Nigeria could mean that the exchange rate will go up anyway.

Currently, the exchange rate to the US dollar stands at 715/dollar. Although this is the unauthorised rate, it is still the working exchange rate in the Nigerian economy while the official exchange rate is 430.09/dollar. As a result, increases in US interest rates signal an increase in the value of the dollar, which may cause both the official and unofficial exchange rates to rise. However, increases in the interest rate do not translate into an increase in the value of a nation’s currency.

This is because increased interest rates are not a sole determinant of the increase in the value of an economy’s currency. Social, economic, and political stability must be present in such an economy alongside a moderate rate of inflation, which is expected to be in the single digits, and an increase in demand for the goods and services produced in such a country. These economic conditions are, however, found to be missing in developing countries such as Nigeria, as the country offers limited goods and services that can be demanded.

Read also: Dollar premium, annuity lift insurance sector growth to 19%

This, then, poses a hindrance to the increase in the value of the naira even if the interest rate is increased. This indicates that once the value of the US dollar increases, the exchange rate is expected to rise regardless of whether the interest rate in Nigeria has increased or not.
Some scholars may also argue that an increased interest rate would attract foreign investors and investments and that the failure to increase the interest rate would therefore push the available foreign investors to countries with higher interest rates. However, it is important to note that increased interest rates are not the sole determinant in attracting foreign investments and investors into an economy.

Foreign investors would not bring investments to countries with little or no social infrastructure to aid foreign investments, countries with an unconducive business environment, as well as countries where their lives are endangered because of the challenge of insecurity. Nigeria is one of the countries that is faced with the economic challenges of insecurity, an unconducive business environment, as well as a lack of both soft and hard social infrastructure that can aid the running of a business. Therefore, even if the rate of interest is increased, other economic challenges make the country unattractive to foreign investment.

Furthermore, it is sufficient to say that an increase in interest rates appears to cause more harm than good. This is because of the impediment to economic growth that it poses. For example, an increase in interest rates signifies a reduction in loan accessibility, which means that the accessibility to loans by citizens and business owners is limited given a higher rate of interest. It is also important to note that loans in any developing country contribute massively towards the development of the industrial sector and the business sub-sector.

This is because most businesses use loans as their major source of capital acquisition to start as well as expand their businesses. Therefore, increases in the rate of interest have a negative relationship with domestic investment. This implies that increases in interest rates would discourage investments from internal sources because of a lack of access to capital from formal institutions.

In posing an alternative solution, it would be better if the government considered the increment of interest on savings deposits to attract citizens and entities with tangible money. The Nigerian government has recently increased the minimum interest rate on savings to 4.2 percent with effect from the 1st of August 2022.

This shows the understanding of the Nigerian government concerning the effect of increases in savings deposit interest rates rather than the lending interest rate. An increase in the interest rate on savings deposits would encourage more savings rather than the hoarding of money by people. This is expected to have a positive effect on the rate of inflation in an economy as money is withdrawn from circulation within the economy but not by detrimental means that pose a disadvantage to other sections of the economy, such as an increase in the general interest rate.

Also, since inflation occurs when goods produced and available for sale are less than the money in circulation, the government can instead work towards an increment in the quantity of goods produced in the economy. This is so that the goods produced can be equivalent to or even greater than the money circulating in the economy. Through this, the prices of commodities can be reduced, and inflation will therefore be reduced. The need for more hands will translate into increased employment opportunities.

Therefore, as more goods are produced, the price tends to decrease to encourage purchase. This increases the purchasing power of the currency, as people can now get more goods for less money, resulting to the value of the currency rising. This is one of the causes of the increase in the value of the US dollar as the state experiences an increase in oil production alongside a decrease in global oil prices. More oil will be purchased at a lower currency quantity, thus causing an increase in the value of the dollar.

Based on this, the increase in the production of goods for both local and foreign purchases in Nigeria would translate into an increase in the value of the Nigerian currency as well. Then, Nigeria would not have to worry about the exchange rate between the Dollar and the Naira as both currencies would be increasing in value and, thus, the exchange rate would reduce. This signifies the possibility of inflation reduction and exchange rate balances without the need for increases in lending or federal reserve interest rates.