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Monetary Policy

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Policy Measures

The CBN has since 2002 adopted a medium term monetary policy framework to free monetary policy implementation from the problem of time inconsistency and minimize over-reaction due to temporary shocks. However, periodic amendments are made to the Policy Guidelines in the light of developments in the financial markets and performance of the economy during the period under review. Thus, in 2005 some new reforms were introduced as “amendments and addendum” to the 2004/2005 monetary policy circular No. 37. These include:

Exchange Rate Band (of +/-3.0%)
Under the West African Monetary Zone Exchange Rate Mechanism (ERM) arrangement, member countries are required to maintain a band of +/-10.0 %. However, given the appreciable level of external reserves and the relative stability of the naira exchange rate which were achieved in 2004; the CBN shall seek to maintain a narrower band of +/- 3.0% during the course of 2005. The band is intended to anchor expectations and to enable investors and end-users of forex to plan and to minimize transaction costs. It is also hoped that the band shall discourage the destabilizing practices of speculation, hoarding and carrying of large inventories by businessmen.

Interest Rate Policy
Over the years, the spread between banks’ deposit and lending rates has remained unacceptably wide with adverse implications for savings mobilization and investment promotion. With the declining trend in the rate of inflation, there is no justification why the MRR should be currently fixed at 15.0%, when the year-on-year inflation rate for December 2004 was about 9.5%. The CBN is moving to a regime of more active monetary policy, with decisions on interest rate regime reviewed every quarter. The CBN shall henceforth, anchor its Minimum Rediscount Rate (MRR), on the year-on-year inflation rate adjusted for seasonality, which reflects the current fundamental policy changes in the economy; as opposed to the traditional practice of anchoring the MRR on the 12 month moving average rate of inflation, which reflects both current and past policy errors. The adoption of this new strategy in 2005 shall render the MRR more proactive and allow it to become a true anchor on which other rates in the money market would be predicted. Accordingly, the MRR has been reduced to 13% in the first quarter of 2005.

Wholesale Dutch Auction Forex Market (DAS)
In order to deepen the foreign exchange market and ensure sustained exchange rate stability, the CBN will establish a framework and guidelines for the introduction of a wholesale Dutch Auction System after the successful completion of the recapitalization and consolidation of the banking industry by end-December, 2005. Also the CBN will ensure the installation of requisite infrastructure to monitor banks’ open position for the effective implementation of the DAS. It is envisaged that the introduction of a Wholesale Dutch Auction System will not only deepen the forex market, but will also assist in the convergence of the DAS and the interbank exchange rates and eliminate rent-seeking behaviour by the authorized dealers.

National Savings Certificate
To enhance liquidity management and ensure monetary stability, the National Savings Certificate (NSC), will be launched in 2005. It is expected that the issuance of the NSC would encourage the growth of domestic savings, as well as address the problem of excess liquidity in the economy on a more sustainable basis.

Cash Reserve Requirement (CRR) -
Two Week’s Maintenance Period
The CRR will complement OMO in ensuring that excess liquidity in the banking system is minimized. The maintenance period of the CRR averaged 8 weeks in 2004. Consequently, it did not effectively serve the purpose for which it was intended. The existing ratio of 9.5% shall remain in force in 2005. However, the maintenance period shall be two weeks. The computation of the CRR will be based on each bank’s total deposit liabilities (i.e. demand, savings and time deposits of both private and public entities), certificates of deposit, and promissory notes held by non-bank public and other deposit items.

Public Sector Deposits
Consistent with its traditional function as the banker to the government, the withdrawal of public sector funds from deposit money banks to the CBN was initiated in 2004 to address the problem of excess liquidity in the banking system, and to encourage the banks to mobilize savings from traditional sources other than the public sector. Its brief implementation proved very effective in liquidity management. However, this measure was suspended because of the apparent mixed signals which it conveyed to the public at the beginning of the banking system recapitalization exercise. Depending on the liquidity condition in the banking system, the CBN may resort to this instrument for liquidity management in 2005. Accordingly, banks are strongly advised not to rely heavily on public sector funds for their portfolio management. The CBN shall give a two weeks notice to the banks and the relevant public agencies whose funds are to be withdrawn. However, the withdrawn funds will be returned to the banks when and, if the liquidity condition improves.

Settlement/Clearing Banks
Seven (7) banks that meet the requirement for maintaining settlement account with the CBN were appointed and designated as “Settlement Banks” to perform clearing and settlement functions for other banks with effect from 1st April, 2004. Cognizant of the need to provide collateral commensurate with the volume and value of cleared items and the need to further enhance the settlement and clearing systems of the banking industry, the guidelines were reviewed in 2005.

Monetary Policy Targets

Monetary Policy Programme

Appraisal of Monetary Policy
Over the years, the objectives of monetary policy have remained the attainment of internal and external balance of payments . However, emphasis on techniques/instruments to achieve those objectives have changed over the years. There have been two major phases in the pursuit of monetary policy, namely, before and after 1986. The first phase placed emphasis on direct monetary controls, while the second relies on market mechanisms.

Monetary Policy Before 1986
Analysis of the institutional growth and structure indicates that the financial system grew rapidly in the mid 1980s to 1990s. The number of commercial banks rose from 29 in 1986 to 64 in 1995 and declined to 51 in 1998, while the number of merchant banks rose from only 12 in 1986 to 54 in 1991 and subsequently declined to 38 in 1998. In terms of branch network, the combined commercial and merchant bank branches rose from 1,323 in 1985 to 2,549 in 1996. There was also substantial growth in the number of non-bank financial institutions, especially insurance companies. The economic environment that guided monetary policy before 1986 was characterized by the dominance of the oil sector, the expanding role of the public sector in the economy and over-dependence on the external sector. In order to maintain price stability and a healthy balance of payments position, monetary management depended on the use of direct monetary instruments such as credit ceilings, selective credit controls, administered interest and exchange rates, as well as the prescription of cash reserve requirements and special deposits. The use of market-based instruments was not feasible at that point because of the underdeveloped nature of the financial markets and the deliberate restraint on interest rates.

The most popular instrument of monetary policy was the issuance of credit rationing guidelines, which primarily set the rates of change for the components and aggregate commercial bank loans and advances to the private sector. The sectoral allocation of bank credit in CBN guidelines was to stimulate the productive sectors and thereby stem inflationary pressures. The fixing of interest rates at relatively low levels was done mainly to promote investment and growth. Occasionally, special deposits were imposed to reduce the amount of free reserves and credit-creating capacity of the banks. Minimum cash ratios were stipulated for the banks in the mid-1970s on the basis of their total deposit liabilities, but since such cash ratios were usually lower than those voluntarily maintained by the banks, they proved less effective as a restraint on their credit operations.

From the mid-1970s, it became increasingly difficult to achieve the aims of monetary policy. Generally, monetary aggregates, government fiscal deficit, GDP growth rate, inflation rate and the balance of payments position moved in undesirable directions. Compliance by banks with credit guidelines was less than satisfactory. The major source of problem in monetary management were the nature of the monetary control framework, the interest rate regime and the non-harmonization of fiscal and monetary policies. The monetary control framework, which relied heavily on credit ceilings and selective credit controls, increasingly failed to achieve the set monetary targets as their implementation became less effective with time. The rigidly controlled interest rate regime, especially the low levels of the various rates, encouraged monetary expansion without promoting the rapid growth of the money and capital markets. The low interest rates on government debt instruments did not sufficiently attract private sector savers and since the CBN was required by law to absorb the unsubscribed portion of government debt instruments, large amounts of high-powered money were usually injected into the economy. In the oil boom era, the rapid monetization of foreign exchange earnings resulted in large increases in government expenditure which substantially contributed to monetary instability. In the early 1980s, oil receipts were not adequate to meet increasing levels of demands and since expenditures were not rationalised, government resorted to borrowing from the Central Bank to finance huge deficits. This had adverse implications for monetary management.

Monetary Policy since 1986
The Structural Adjustment Programme (SAP) was adopted in July, 1986 against the crash in the international oil market and the resultant deteriorating economic conditions in the country. It was designed to achieve fiscal balance and balance of payments viability by altering and restructuring the production and consumption patterns of the economy, eliminating price distortions, reducing the heavy dependence on crude oil exports and consumer goods imports, enhancing the non-oil export base and achieving sustainable growth. Other aims were to rationalise the role of the public sector and accelerate the growth potentials of the private sector. The main strategies of the programme were the deregulation of external trade and payments arrangements, the adoption of a market-determined exchange rate for the Naira, substantial reduction in complex price and administrative controls and more reliance on market forces as a major determinant of economic activity.

The objectives of monetary policy since 1986 have remained the same as in the earlier period - the stimulation of output and employment, and the promotion of domestic and external stability. In line with the general philosophy of economic management under SAP, monetary policy was aimed at inducing the emergence of a market-oriented financial system for effective mobilization of financial savings and efficient resource allocation. The main instrument of the market-based framework is the open market operations. This is complemented by reserve requirements and discount window operations. The adoption of a market-based framework such as OMO in an economy that had been under direct control for long, required substantial improvement in the macroeconomic, legal and regulatory environment.

In order to improve macroeconomic stability, efforts were directed at the management of excess liquidity; thus a number of measures were introduced to reduce liquidity in the system. These included the reduction in the maximum ceiling on credit growth allowed for banks; the recall of the special deposits requirements against outstanding external payment arrears to CBN from banks, abolition of the use of foreign guarantees/currency deposits as collaterals for Naira loans and the withdrawal of public sector deposits from banks to the CBN. Also effective August, 1990, the use of stabilization securities for purposes of reducing the bulging size of excess liquidity in banks was re-introduced. Commercial banks' cash reserve requirements were increased in 1989, 1990, 1992, 1996 and 1999.

The rising level of fiscal deficits was identified as a major source of macroeconomic instability. Consequently, government agreed not only to reduce the size of its deficits but also to synchronize fiscal and monetary policies. By was of inducing efficiency and encouraging a good measure of flexibility in banks' credit operations, the regulatory environment was improved. Consequently, the sector-specific credit allocation targets were compressed into four sectors in 1986, and to only two in 1987. From October, 1996, all mandatory credit allocation mechanisms were abolished. The commercial and merchant banks were subjected to equal treatment since their operations were found to produce similar effects on the monetary process. Areas of perceived disadvantages to merchant banks were harmonized in line with the need to create a conducive environment for their operations. The liquidity effect of large deficits financed mainly by the Bank led to an acceleration of monetary and credit aggregate in 1998, relative to stipulated targets and the performance in the preceding year. Outflow of funds through the CBN weekly foreign exchange transaction at the Autonomous Foreign Exchange Market (AFEM) and, to a lesser extent, at Open Market Operation (OMO) exerted some moderating effect. The reintroduction of the Dutch Auction system (DAS) of foreign exchange management in July, 2002 engendered relative stability, and stemmed further depletion of reserves during the second half of 2002. However, the financial system was typically marked by rapid expansion in monetary aggregates, particularly during the second half of 2000, influenced by the monetization of enhanced oil receipts. Consequently, monetary growth accelerated significantly, exceeding policy targets by substantial margins. Savings rate and the inter-bank call rates fell generally due to the liquidity surfeit in the banking system through the spread between deposit and lending rates remained wide. Specifically, 2003 policy measure were design to promote a stable macroeconomic environment to achieve a non-inflationary output growth rate of 5 per cent. In pursuit of its development effort, the Bank, in collaboration with the Bankers’ Committee, established the Small and Medium Industries Equity Investment Scheme (SMIES). In 2003, credit delivery to real sector was encouraged through the SMIEIS and an incentive of lower Cash Reserve Requirement (CRR) regime was prescribed for those banks that increased their credit allocation to the real sector by 20 per cent or more. Moreover, the Bank provided guarantees for agricultural loans under the Agricultural Credit Guarantee Scheme (ACGS)

In recognition of the fact that well-capitalized banks would strengthen the banking system for effective monetary management, the monetary authority increased the minimum paid-up capital of commercial and merchant banks in February 1990 to N50 and N40 million from N20 and N12 million, respectively. Distressed banks whose capital fell below existing requirement were expected to comply by 31st March, 1997 or face liquidation. Twenty six of such banks comprising 13 each of commercial and merchant banks were liquidated in January, 1998. Minimum paid up capital of merchant and commercial banks was raised to a uniform level of N500 million with effect from 1st January, 1997, and by December 1998, all existing banks were to recapitalize. The CBN brought into force the risk-weighted measure of capital adequacy recommended by the Basle Committee of the Bank for International Settlements in 1990. Before then, capital adequacy was measured by the ratio of adjusted capital to total loans and advances outstanding.

The CBN in 1990 introduced a set of prudential guidelines for licensed banks which were complementary to both the capital adequacy requirement and Statement of Standard Accounting Practices. The prudential guidelines, among others, spelt out the criteria to be employed by banks for classifying non-performing loans. The CBN has continued to examine and monitor banks in order to promote stable banking system. Also the Bank handles the problem of distressed and illiquid banks. The CBN imposes holding actions and revokes licenses of affected banks as well as encourages mergers and acquisitions. In an effort to improve the operations of the money market, an auction-based market for treasury securities was introduced in 1989; and these treasury instruments were made bearer bills to enhance transferability and promote secondary trading. The developments in the money and capital markets were mixed in 1998. While the activities in the money market were influenced largely by developments in the Autonomous Foreign Exchange Market (AFEM), the capital market witnessed increased transactions in terms of volume despite the observed decline in market capitalization. The sanitization and restructuring of the financial sector by the CBN continued in 1999 and 2000, resulting in the decline in the number of distressed banks. Moreover, the CBN in the context of its surveillance role carried out routine and target examinations of the financial institutions to ensure compliance with guidelines and ensure efficiency in their operations. The non-bank financial institutions, whose operations did not meet the prescribed standard, were either closed or had their operating licenses withdrawn. In order to improve the efficiency of the payment systems, some measures were put in place including the introduction of N200 currency note in 2000. The operational environment for banks was further liberalized in 2001 with the introduction of universal banking, while the supervisory framework of the financial system was enhanced with the establishment of a new department in the Bank to supervise other financial institutions. In 2002, monetary policy implementation was faced with some challenges as the problem of excess liquidity persisted, and the demand pressure in the foreign exchange market intensified. In order to encourage banks to reduce interest rate on lending, the Minimum Rediscount Rate (MRR) was reviewed downward accompanied with moral suasion. These developments led to a fall in bank deposit and lending rate, particularly during the second half of 2002. In pursuit of its commitment to improve the payments system, the CBN ensured the full installation of Magnetic Ink Character Recognition (MICR) in all the clearing zones, and was involved in the live-run of the Nigerian Automated Clearing System (NACS) in the Lagos clearing zone in 2002.

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