EFFECTS OF INFLATION ON INVESTMENT IN NIGERIA, 1987-2011- Banking and Finance Project Materials

ABSTRACT

 

Economists tend to emphasize that inflation causes economic damage by distorting investments and consumption decisions. These distortions could result from households and businesses’ uncertainty about the effect of increases in prices of goods and services. When inflation is stable, people are likely to have the same anticipation of its future level, however, when inflation is volatile, future expectations will be uncertain thereby hindering the ability to forecast with certainty. Investment is an indispensable aspect of any economy as it drives the productive sectors of the economy, however, the confidence to invest is eroded in at an atmosphere of uncertainty in future prices of goods and services as a result of inflation, it poses economic problem to that economy. The problem posed by inflation on investment affects both the private and public sectors of the economy. It triggers prices of goods and services if not properly managed as well as reduce the zeal for investment; it increases the cost of doing business such as increases in transaction cost, information cost and these inhibit economic growth and development. It is against this background that this study examined; the impact of inflation on core credit to the private sector of the Nigerian economy, the impact of inflation on foreign exchange availability for private sector investment in the Nigerian economy, the impact of inflation on non-infrastructural investment of the public sector of the Nigerian economy and the impact of inflation on infrastructural investment of the public sector of the Nigerian economy. Time series data for 25years, 1987-2011 were collated from Central Bank of Nigeria published annual reports and statistical bulletin for the country aggregate data.  Four hypotheses were formulated and the least square (LS) regression was used to estimate the effects of Inflation on Investment in Nigeria. The annual rate of inflation was adopted as the independent variable for the four hypotheses while dependent variables were Core Credit to the Private Sector, Foreign Exchange for Import, Non-infrastructural Investment and Infrastructural Investment for the four hypotheses. The findings from the study revealed inflation has negative and non-significant impact on the core credit to private sector in Nigeria (coefficient of inf = -1.216, t-value = -0.948). Inflation has positive and non-significant impact on the foreign exchange availability in Nigeria (coefficient of inf = 0.013, t-value = 0.291). Inflation has negative and non-significant impact on the non-infrastructural investment in Nigeria (coefficient of inf = -0.33, t-value = -1.107). Inflation had negative and significant impact on infrastructural investment (coefficient of inf = -0.386, t-value = -3.637). The study thus recommends among others that monetary policy authorities should ensure that policies that will assist in maintaining a stable general price level are pursued. This will guarantee a steady growth in Nigeria.       .

 CHAPTER ONE

INTRODUCTION

1.1       BACKGROUND OF THE STUDY

Some recent studies have found cross-country evidence supporting the view that long -term growth is adversely affected by inflation (Kormendi and Meguire 1985; Fischer 1983, 1991, 1993; De Gregorio 1993; Gylfason 1991; Roubini and Sala-i-Martin 1992; Grier and Tullock 1989; Levine and Zervos 1992). Countries (especially in Latin America) that have experienced high inflation rates, have also witnessed lower long-term growth (Cardoso and Fishlow 1989; De Gregorio 1992a, 1992b). This literature is part of the endogenous growth literature, which tries to determine the causes of differences in growth rates in different countries. There is now considerable evidence that investment is one of the most important determinants of long-term growth (Barro 1991; Levine and Renelt 1992). It has often been suggested that a stable macroeconomic environment promotes growth by providing a more conducive environment for private investment. This issue has been directly addressed in the growth literature in the work by Fischer 1991, 1993; Easterly and Rebelo 1993; Frenkel and Khan 1990; and Bleaney 1996. Among the reasons why high inflation is likely to be adverse for growth are: economies that are not fully adjusted to a given rate of inflation usually suffer from relative price distortions caused by inflation. Nominal interest rates are often controlled, and hence real interest rates become negative and volatile, discouraging savings. Depreciation of exchange rates lag behind inflation, resulting in variability in real appreciations and exchange rates; real tax collections do not keep up with inflation, because collections are based on nominal incomes of an earlier year (the Tanzi effect) and public utility prices are not raised in line with inflation. For both reasons, the fiscal problem is intensified by inflation, and public savings may be reduced. This may adversely affect public investment and high inflation is unstable. There is uncertainty about future rates of inflation, which reduces the efficiency of investment and discourages potential investors.

The effect of macroeconomic instability on growth comes largely from the effect of uncertainty on private investment. Multi-country panel data studies on investment report that measures of macroeconomic instability, like the variability in the real exchange rate or the rate of inflation, have an adverse impact on investment (Serven and Solimano 1992). In a study of 17 countries, Cordon (1990) finds that although there are outliers, evidence generally supports the view that high growth is associated with low inflation. This is suggested both by cross-country evidence and comparison over time for countries where the rate of growth has fallen in relation to an increased as the rate of inflation.

Fischer (1993) examines the role of macroeconomic factors in growth. He found evidence that growth is negatively associated with inflation and positively associated with good fiscal performance and undistorted foreign exchange markets. Growth may be linked to uncertainty and macroeconomic instability where temporary uncertainty about the macro-economy causes potential investors to wait for its resolution, thereby reducing the investment rate (Pindyck and Solimano 1993). Uncertainty and macroeconomic stability are, however, difficult to quantify. Fischer suggests that, since there are no good arguments for very high rates of inflation, a government that is producing high inflation is a government that has lost control. The inflation rate thus serves as an indicator of macroeconomic stability and the overall ability of the government to manage the economy.

Fischer found support for the view that a stable macroeconomic environment, meaning a reasonably low rate of inflation, a small budget deficit and an undistorted foreign exchange market, is conducive to sustained economic growth. He presents a growth accounting framework in which he identifies the main channels through which inflation reduces growth. He suggests that the variability of inflation might serve as a more direct indicator of the uncertainty of the macroeconomic environment. However, he finds it difficult to separate the level of inflation from the uncertainty about inflation, in terms of their effect on growth. This is because the inflation rate and its variance are highly correlated in cross-country data. Evidence is in favour of the view that macroeconomic stability, as measured by the inverse of the inflation rate and the indicators of macroeconomic trends, is associated with higher growth.

A good number of factors have been identified as the causes of inflation in Nigeria, which according to Nwankwo (1981) they includes excess demands, rising cost of production, limiting outputs and increasing money supply. People’s immediate concern is with how their income holds up with changes in their expenses. Businesses care about how the prices of their product do in relation to their cost. Also government battle with polices to keep inflation rate at the barest minimum and ensure effective and efficient administration.

In terms of geography, there are very few studies on the impact of inflation on investment in this part of the world, hence this study fill this gap in terms of geography. Given government recent wooing of international investor into the country, the need to examine the impact of inflation on investment becomes imperative. The Central Bank of Nigeria main policy objective is to maintain stable price of goods and services. This study thus examines the impact of inflation on investment.

 

1.2       STATEMENT OF PROBLEM

Inflation affects both the private and government sectors as well as individuals and this can occur directly and indirectly. Inflation increases transactions and information cost which inhibits economic growth and development. For example, when inflation makes nominal values uncertain, investment planning becomes difficult. Individuals may be reluctant to enter into contracts when inflations cannot be predicted, making relative prices uncertain. This reluctance to enter into contract over time will inhibit investment which will affect economic growth and result in financial recession (Hellerstein, 1997). The problem should not be over emphasized as it is a monster in the growth of any economy and investment environment. Due to the fact that this challenge affect return on investment, discourages savings and inhibit growth of the Nigerian economy.

One way inflation might affect investment hence economic growth through the banking sector is by reducing the overall amount of credit that is available to businesses. The story goes something like this. Higher inflation can decrease the real rate of return on assets. Lower real rates of return discourage saving but encourage borrowing. At this point, new borrowers entering the market are likely to be of lesser quality and are more likely to default on their loans. Banks may react to the combined effects of lower real returns on their loans and the influx of riskier borrowers by rationing credit. That is, if banks find it difficult to differentiate between good and bad borrowers, they may refuse to make loans, or they may t least restrict the quantity of loans made. Simply charging a higher nominal interest rate on loans merely makes the problem worse because it causes low risk borrowers to exit the market. And in those countries with government imposed usury laws or interest rate ceilings, increasing the nominal interest rate may not be possible.

Whatever the cause, the persistent rise in price (inflation) affects financial institutions intermediation function hence the result is lower investment in the economy, thus with lower investment, the present and future productivity of the economy tends to suffer. This, in turn, lowers real economic activity. It is therefore against this background that this study sought to investigate the effect of inflation on Investment in Nigeria.

 

• OBJECTIVES OF THE STUDY

The major objective of this study is to investigate the impact of inflation on investment in Nigeria, however, the specific objectives are:

1. To examine the impact of inflation on core credit to the private sector of the Nigerian economy.

2. To examine the impact of inflation on foreign exchange availability for private sector investment in the Nigerian economy.

3. To examine the impact of inflation on non-infrastructural investment of the public sector of the Nigerian economy and

4. To examine the impact of inflation on infrastructural investment of the public sector of the Nigerian economy.

• RESEARCH QUESTIONS

The following research questions were developed for analytical purpose and convenience.

1. To what extent does inflation has positive and significant impact on core credit granted to the private sector of the Nigerian economy for investment?

2. To what extent does inflation has positive and significant impact on foreign exchange availability to the private sector for investment in the Nigerian economy?

3. To what extent does inflation has positive and significant impact on non-infrastructural investment of the public sector of the Nigerian economy? and

4. To what extent does inflation has positive and significant impact on infrastructural investment in the Nigerian economy

• RESEARCH HYPOTHESES

The following hypotheses were formulated in an attempt to providing solution to the above research questions.

1. Inflation does not have positive and significant impact on core credit granted to the private sector of the Nigerian economy for investment

2. Inflation does not have positive and significant impact on foreign exchange availability to the private sector for investment in the Nigerian economy

3. Inflation does not have positive and significant impact on non-infrastructural investment of the public sector of the Nigerian economy? and

4. Inflation does not have positive and significant impact on infrastructural investment in the Nigerian economy

   • SIGNIFICANCES OF THE STUDY

This study will be beneficial to the following group:

INVESTORS:  The study will enable investors to develop their knowledge and built on investment portfolios that would withstand the rate of inflation.

FIRMS:  Businesses would use this study to makes critical investment decisions that would impact positively on profitability of their organizations.

GOVERNMENTS: It will provide the government will information that would enable them to diversify their investment portfolio in sectors that would reduces government expenditures in the future.

MONETARY AUTHORITIES: This study will provide basic information to regulatory monetary authorities in the formulation of inflation combat policies, so as to promote economic growth and development in the economy.

RESEARCHERS: This study will contributes to the existing body of knowledge on inflation and investments and serves as reference materials.

GENERAL PUBLICS: The study will impact on the knowledge of the general public’s, and so provide  information on making decisions as it relates to saving, investment and  consumption as well as inflation.

1.7       SCOPE OF THE STUDY

This study covers the period 1987-2011. The study is centered on the analysis of the impact of inflation on investment in Nigeria from the era of trade liberalization which was occasioned by the introduction of structural adjustment programme in 1986. The period after the introduction of SAP lead to partial or full liberalization, leading to determination of prices through the forces of demand and supply. Therefore, this study examined the impact of inflation on investment from 1987-2011.

1.8       OPERATIONAL DEFINITION OF TERMS

Inflation: – This is a continuous and persistent rise in general level of prices of goods and services in an economy over a period of time.

Investment: – This is the art of committing money to real or financial assets with a view to earning a return on the investment. Or is the commitment of money or capital to the purchase of financial instruments or other assets so as to gain profitable returns in the form of interest dividends, or appreciation of the value of the instrument (capital gain).

GDP: –            Gross Domestic Product is the total goods and services produced in a country within a year.

Deflation: – Is a continuous and persistent fall in price of goods and services. A general decline in prices is often caused by a reduction in supply of money or credit.

Inflationary Expectations: – This is the belief of stakeholders of the economy that inflation will occur in the future.

Inflation Premium: – This is the profit or gain obtained as a result of inflation.

GDP Price Index: – A price for all the goods and services that make up the GDP. It is used to adjust nominal GDP to real GDP.

Nominal GDP: – this is the value of GDP when inflation has not been considered.

Real GDP: – this is the value of GDP after considering inflation.

Financial Assets: – this is the intangible assets that gives an investor a claim on the profit from the real assets e.g. shares, bonds, preference, stock, etc

Real Assets: – these are tangible assets which include land, buildings, machinery, plant, etc.

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