THE CBN: Keys to the Nigerian Petroleum Economy

By Ifeanyi Aloh

The Central Bank of Nigeria (CBN) is solely entrusted with the duty of formulating monetary policy for the Nigerian economy. It is also popularly regarded and known as the lender of last resort; banker to the government and other commercial banks. The origin of CBN could be traced to the G.D. Paton Report, which was an enquiry of the banking practices within the period 1892 – 1952 instituted by the colonial government. This report gave rise to the Banking Ordinance of 1952, which sough to set the guidelines for orderly commercial banking and to ensure that only viable banks are set up. This Ordinance paved the way for the enactment of the CBN Act, 1958; which became fully operational when the bank started operation in July 1^st, 1959. [1] 

The CBN Act, 1958 and the Banking Decree 1969 (as amended by subsequent decrees and Act of 1991, 1993, 1997, 1998, 2007; and Banking and Other Financial Institutions (BOFI) Decrees 24 & 25 of 1991, 1998, and 1999 respectively) set out the operational and regulatory functions of the CBN over the banking sector- In each instance, reducing or increasing the powers, autonomy and supervisory functions of CBN.

The CBN Act, 2007 and the BOFI (Amendment) Decree No. 40 of 1999 clearly spelt out the functions and powers of the CBN to include: ensuring continuity in policies and economic stability; issuance of currency; safeguarding the value of the naira in the international exchange market; promoting and maintaining monetary stability and sound financial system; and offering economic advice to the Federal Executive Council (FEC) and acting as banker to the Federal Government. BOFI also empowers CBN to enforce sanctions over erring banks and their officers.[2]  

 

Flowing from the foregoing, we can deduce that the statutory framework creating the CBN did not outline the guideline that will act as a compass to the bank in making these all-important monetary policies. This loophole created a huge gap in Nigerian economic monitoring system, thereby leading to absence of economic growth, unemployment, inflation and high interest rate.

The development above occurred within the 1989- 1994 period, shortly after the implementation of SAP. In response, the federal Military Government set up the Okigbo Panel, which in its 1994 report, recommended amongst other things- the constitution of a high powered panel. This panel would comprise the following people:

• The Governor of the CBN
• The Minister of Finance
• The Minister of National Planning
• The Minister of Petroleum Resources
• The Economic Adviser to the President
• The Vice President of the Federation (Chairman)[3]   

The report suggested that this committee will not only formulate policies for the regulation of monetary transmission, but will also monitor it at different stages of the implementation.

Further to the above, section 12 of the CBN Act (2007) provides thus:

    

“In order to facilitate the attainment of the objective of price stability and to support 

      the economic policy of the Federal Government, there shall be a committee of the  

      Bank known as the Monetary policy Committee (on this Act referred to as “MPC”),”[4]

The Act recognized MPC as the highest policy making body of the bank and provide sfor its constitution as follows:

1. The Governor of the CBN
2. The four Deputy Governors of the CBN
3. Two members of the Board of Directors of CBN
4. Three members appointed by the President
5. Two members appointed by the Governor[5]

Having traced the origin of the CBN and how the MPC evolved along with its power to formulate, monitor and implement monetary policies, let us examine how their activities affect the energy sector, especially during the 2008/2009 economic crisis.

MONETARY TRANSMISSION MECHANISM

Having set up the MPC, the CBN Act 2007 went ahead to assign certain functions to them; which includes the following:

• Review economic and financial conditions in the country;
• Determine appropriate stance of policy in the short and medium term;
• Review regularly, the CBN monetary policy framework and adopt changes when necessary;
• Also communicate monetary/financial policy decisions effectively to the public and ensure the credibility of the model of transmission mechanism of monetary policy.[6]

Following the constitution and empowering of the MPC under the CBN Act 2007 to formulate and monitor monetary policy, it was further empowered to formulate plans or policy regimes that will enable it to realize the above mandates. Before we look at the methods used by the MPC in carrying out its mandate, what is monetary transmission mechanism?

Begg, D., et al (2008) defines monetary transmission mechanism as the ways through which the monetary policy influences output and employment.[7]  Lipsey & Chrystal (2007) define monetary transmission mechanism as the relation of the changes in monetary policy to the change in investment and aggregate demand.[8] Thus, monetary policy involves the making of economic decisions over certain variables and how these choices affect the general economy is what could be termed monetary transmission mechanism. In essence, it involves how the decision of MPC to reduce the quantity of the money in circulation or the interest rate payable to secure money for investment affects the general output, income and expenditure in the economy.

What are the Monetary Transmission approaches of the CBN?

Contrary to situations in other economy, there is little or no research work concerning the reaction of CBN monetary authorities to changes in economic realities or variables.[9] The CBN monetary policy approach could be categorized into pre and post 1986 approaches. Whereas, the first approach employed direct monetary control mechanism, the second approach uses indirect or market mechanism. The second approach (the current) involves a gamut of policy decisions targeted at achieving monetary and price stability. It includes policies such as Open Market Operations (OMO), used to manage the amount of money in circulation; discount window, which allows CBN to act as a lender of last resort; sale of securities in the open market to influence contraction or dry-up of liquidity; employment of deposit and lending facility to enhance foreign exchange sales and inter-bank transactions.

Furthermore, in 2006, the CBN adopted a new monetary rate (MPR) policy guideline, with the objective of ensuring stability in the value of the naira through stable short term interest rates around an Operating Target. It fixes the MPR as the operative rate in all money market transactions whether inter-bank transactions or other financial institutions. MPR also replaced the Minimum Rediscount Rate (MRR) and was set at 10 percent with 600 points spread around the rate. In other words, 300 basic points above and 300 basic points below.[10]

 

The new policy framework includes the liberalization of the exchange market by adopting the Whole Sale Dutch Auction System (WDAS) in place of the Dutch Auction System (DAS). This replacement led to the admission of Bureau De Change using the WDAS window in the second quarter of 2006. This policy decision gave rise to the union of the exchange rate between the official and the parallel market.  

The monetary transmission mechanism is usually manifested through the following economic channels, namely; exchange rate, credit, interest rates (also called liquidity channel), and other assets prices. These channels have multiplier effects on each other; hence a lag effect on the economy.[11] Let us look at them briefly.

1. Exchange Rate Channel:

It is positively related to interest rate, as such, once there is increase in the domestic interest rate, following the inflow of short term capital investment to take advantage of the situation, it puts a pressure on exchange rate, forcing it to appreciate; all things being equal. The MPC in their statutory monthly meeting in 2006, raised the rates from 13% to 15% with the hope of instigating contraction of money supply. Whereas, it achieved its purpose of reducing the GDP growth rate from 6.51% in 2005 to 5.63% in 2006; it also led to an increase in the external reserve from US$28.3billion to US$41.9billion, showing an increase by US$13.6billion as a result of capital inflow into the economy.

2. Credit:

The CBN can influence the amount of money available for lending by either increasing the CRR (Cash Reserve Requirement), discount window rate or adopting a contractionary monetary policy, it leads to a fall in bank reserve and the bank deposit, hence, forcing the bank to reduce the amount available for credit or loans. It also affects GDP growth rate as the firms would not be able to secure loans for investment or capital intensive projects.

In September, 2007, the MPC raised the MPR by a 100 basis points (from 8.0% to 9.0%) with the intention of encouraging inter-bank trading and encouraging banks to make resources available so as to enlarge the credit market.[12]

3. Interest Rates:

This is a major tool normally employed by the MPC in managing the economy or the amount of money in circulation. A fall in interest rate leads to a rise in investment and household spending, thereby affecting the growth of the GDP and also the net export through a multiplier process. It also affects the exchange rate negatively, as it leads to the outflow of short term financial investment in line with arbitrage. On the other hand, an increase in the interest rate discourages borrowing as it would increase the cost of production; and the households are actually encouraged to save their money rather than spend. At the same time, it leads to an inflow of short term investment, which forces the exchange rate to go up.

4. Other Assets Prices:

This channel raises a major objection against the Keynesian monetary transmission theory, which dwells only on one relative asset price (interest rate). The other assets prices could be explained using two main approaches: Tobin’s q theory of investment and the wealth effect on consumption.

Tobin’s q theory of investment postulates that a decrease in quantity of money in circulation will invariably lead to a decline in public spending. The reduction in the public spending will also affect the stock market, thereby leading to a fall in the demand for equity. In a multiplier situation, fall in demand for equity will lead to a fall in the price of equities, hence affecting the firm’s capital replacement cost, thus giving rise to a decline in its investment spending[13] and consequently a fall in consumption and output.[14]   

Whereas wealth effect on the other hand, looks at the effects of the decline of certain resources, otherwise called lifetime resources such as real capital, human capital and financial wealth on consumption. It illustrated this position with stocks which form part of one’s financial resources. Thus, if there is a decline in the price of stocks, it will lead to a decrease in the value of financial wealth

FINANCIAL ACCELERATOR

Chairman Bernanke of the US Reserve Bank described the effect of the financial accelerator using two main approaches: Banking System Channel and the Credit channel.[15]

The Banking system channel reasons that the banks are in the business of making funds available to both the firms and households for investment and spending purposes in the domestic economy. However, in the event of increase in the interest rate or a policy decision by the monetary authorities that has contractionary effect on the money supply, the banks will be forced to restrict lending to borrowers hence reducing consumer spending and inhibiting capital investment, thereby aggravating the contraction.

Credit channel on the other hand, manifests when the bank lends money to the firms on the basis of some securities or collateral; this collateral suffers a reduction in its original value as a result of decrease in interest rates precipitated by decline in money supply, the populace will not have money to invest in company’s equities, hence, leading to the fall in share prices with this development having affected the value of the collateral for the loan and the credit worthiness of the company; consequently, the bank is reluctant to lend, and even when it does, it usually lends at a high interest rate.  

NUTSHELL:

This is an intellectually stimulating and quite keenly chronological depiction of the role of the Central Bank of Nigeria in holding the keys to the Nigerian Petroleum Economy. More of the analysis of the relations to the Nigerian Petroleum Economy will come in Ifeanyi's next article however this analysis captures the essence of the discourse. The Keys to the Petroleum Economy are the various channels which have been so described above. Ifeanyi has succeeded in shedding more light on the ability of the Central Bank to be such an influential force. 

The most revealing portion of this article to me though is the portion that indicates that The Minister of Petroleum Resources was recommended by the Okigbo  1994 report to be involved in the process of regulation and monitoring of the Monetary Transmission. What's this like in your part of the world? What are the implications of this? Let's discuss. For more information on this article and to view Ifeanyi's professional profile, click here.-->

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[1]  http://www.cenbank.org/AboutCBN/history.asp   (last visited on 2nd January, 2010).

[2] www.cenbank.org (last visited on 2^nd January, 2010)

[3] Okigbo Panel Report, Panel On the Reorganisation Of The Central Bank of Nigeria, 1994, www.dawodu.com/okigbopanel1a.pdf  (last visited on 2^nd January, 2010)

[4] CBN Act (2007) www.cenbank.org (last visited on 3^rd January, 2010)

[5] Supra.

[6] A Brief On The Central Bank of Nigeria (CBN) Act, 2007,  Legal Services Division, CBN, www.cenbank.org/OUT/PUBLICATIONS/PRESSRELEASE/GOV/2007/PR3-7-07.PDF (last visited on 4th January, 2010)

[7] Begg, D., Dornbusch, R., Fischer S., Economics, 9^th Edition, (London, United Kingdom: McGraw-Hill Higher Education, 2008).

[8] Lipsey & Chrystal, Economics, 11^th Edition, (Oxford: Oxford University Press, 2007).

[10] www.cenbank.org/MoneyPolicy/Conduct.asp (last visited on 4th  January, 2010)

[11] Mishkin, F., Symposium on Monetary Transmission Mechanism, (1995), Journal of Economic  

   Perspective 9(4): 3-10 (NBER Working Paper series 5464)

[12] www.cenbank.org/MoneyPolicy/decisions/2007.asp (last visited on 5th January, 2010)

[13] Tobin (1969)

[14] Modiglani, F., (1971), “Monetary policy and consumption” In Consumer Spending and Monetary Policy: the Linkages, Boston: Federal Reserve Bank of Boston

[15] Chairman Ben S. Bernanke, The Financial Accelerator and the Credit Channel, (2007): Federal Reserve Bank, Atlanta, Atlanta, Georgia (www.federalreserve.gov/newsevents/speech/Bernanke20070615a.htm) last visited on 10^th January, 2010.