1. Interest rate is the price that lenders/savers charge for giving loans to borrowers. The rate at which a central government (in the case of Nigeria, the FGN) borrows her own currency is a very important benchmark in every economy. This is because a central government can levy taxes in her currency and even print money to repay her loans. This is why the rate at which a central government borrows her currency is referred to as a risk-free rate.
2. Let us assume a scenario where in a particular year, the Federal Government of Nigeria (FGN) wants to spend NGN 2 trillion more than she would earn, does not have savings to cover this deficit and therefore needs to borrow. The FGN working with the Debt Management Office (DMO) and the Central Bank of Nigeria (CBN) then informs lenders that she wants to borrow NGN 2 trillion from them for a duration of say one year and that lenders should come and bid for these treasury bills. These lenders (Pension Funds Administrators, Closed Pension Fund Administrators, Insurance companies, Asset managers and retail savers) bid, through their banks, for these treasury bills. Now, let’s assume CBN/DMO receives bids totaling NGN 3 trillion and start accepting these bids from the lowest interest rate offered (because everyone wants to borrow as cheaply as possible). When they get all the NGN 2 trillion they need, they then reject the remaining bids. Assuming the last bid they accepted was at 13.0% interest per annum, this then represents the marginal interest rate.
3. In arriving at the rate to quote, the lenders would have taken into account, amongst other things, the rate of inflation, particularly expected inflation over the next one year. The 13.0% that emerges in this example becomes the one-year risk-free rate from the primary market. Financial institutions will of course trade these instruments in the secondary market and this will make the risk-free rate change based on the demand for and supply of these instruments.
4. The risk-free rate for a particular duration has a significant impact on what savers can earn for that duration. It represents minimum return savers should earn for that duration. Banks and companies in the real sector who want to borrow from these savers must do so at the risk-free rate plus a credit risk premium. Credit rating agencies help to measure the level of credit risk attributable to a borrower using their nine point scale from AAA (the safest) to C (the riskiest). The market then prices these risks on the principle that the higher the risk, the higher the credit risk premium. For example, assume XYZ Company is rated AA, the market might demand a premium of say 1.0% on top of the risk-free rate for a one year loan. This means that XYZ Company would borrow one year money at 14.0%.
5. Because the returns that savers get are priced off the risk free rate using the principle of RISK-FREE RATE + CREDIT RISK PREMIUM, it is crucial that the risk-free rate gives a “fair” return to savers. How much is a “fair” return to savers? The chart below compares the average yield on FGN’s one year treasury bills with 10-Year average inflation.
Sources: FMDQ & NBS
6. In the chart below, we have also compared the average yield on one year treasury bills with average inflation for that particular year. Both charts show us that 2022 will be the third consecutive year when the return on FGN’s one year securities will be significantly lower than the annual rate of inflation. This means that savers will lose purchasing power at about 10% per annum for the third consecutive year!
Sources: FMDQ & NBS
7. Setting the risk-free rate at a level significantly below the rate of inflation reduces confidence in the Nigerian Naira because savers are unable to earn a positive return in real terms. It also fuels speculative demand for foreign exchange as savers seek solace in currencies that can store value better. A significant portion of pension assets are held in fixed income securities in Nigerian Naira and the current situation is resulting in a significant erosion in the purchasing power of these assets. If this situation continues, the defined contribution system of pensions will be at grave risk.
8. The current interest rate management policy of Nigeria makes savers lose purchasing power while it gives loans at subsidized rates (rates below the rate of inflation) to borrowers. Who are the people funding the subsidy being given to borrowers? They are Nigerian workers saving to build pensions assets, shareholders of banks and insurance companies and small savers. Who are the key people benefitting from this subsidy? The largest borrower in Nigeria is the FGN with aggregate Naira debts of about NGN 40 trillion as at the end of 2021 compared to total loans to customers of about NGN 20 trillion by the banking industry as at the same date.
9. Savers are now scrambling to protect the value of their savings. Institutional savers and individuals are exploring the possibility of holding their savings in hard currencies fueling demand for USD.
10. It is important for policy makers to review Nigeria’s interest rate policy to ensure that those who save in Nigerian Naira do not lose purchasing power. This will reverse the erosion of the value of pension assets and reduce speculative demand for hard currencies. If interest rates are uncompetitive, demand for government securities wanes and savers will seek solace in hard currencies putting pressure on exchange rates.
11. It may be good government policy to give subsidized loans to industries that the government wants to grow however, these subsidies should be borne by the government and not by savers and the shareholders of lending institutions. This can be done through grants or tax incentives to these industries.
Bode Agusto
August 2022
Please note that the views expressed in this article are those of the author and not of any of the businesses he may be affiliated to.