Instruments of monetary policy

142. In implementing monetary policy, the CBN uses a mix of instruments to achieve its monetary objectives. These include reserve requirements, liquid asset ratios, open market operations and the discount window. Starting in the early 1990s, the CBN has gradually moved away from interest rate and credit controls, although at times it still attempts to influence these variables through moral suasion or directed lending. Among the current instruments of liquidity management, the CBN actively uses open market operations and the discount window.

143. Through its regulatory powers, the CBN exerts direct control over bank liquidity by imposing a statutory cash reserve requirement (CRR) on banks’ total liabilities and a liquidity asset ratio (LR). While not used at high frequency, both have been effective for monetary control purposes. For instance, in the face of persistent excess liquidity in the financial system, the CBN raised both sharply in 2001: the CRR was raised in two steps from 10 percent to 12½ percent and the LR in one step from 35 percent to 40 percent (Figure V-4).

Nigeria: Developments in Key Short-Term Interest Rates, January 1999–September 2002

(In percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Sources: Central Bank of Nigeria; and Fund staff estimates.1/ The interbank interest rate is a weighted average of the 7-day call rate (49 percent weight) and the 30-, 60-, and 90-day rates (20 percent weight each).2/ Adjusted for annual average consumer price index inflation.

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Nigeria: Developments in Key Short-Term Interest Rates, January 1999–September 2002

(In percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Sources: Central Bank of Nigeria; and Fund staff estimates.1/ The interbank interest rate is a weighted average of the 7-day call rate (49 percent weight) and the 30-, 60-, and 90-day rates (20 percent weight each).2/ Adjusted for annual average consumer price index inflation.

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Nigeria: Developments in Key Short-Term Interest Rates, January 1999–September 2002

(In percent, unless otherwise indicated)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Sources: Central Bank of Nigeria; and Fund staff estimates.1/ The interbank interest rate is a weighted average of the 7-day call rate (49 percent weight) and the 30-, 60-, and 90-day rates (20 percent weight each).2/ Adjusted for annual average consumer price index inflation.

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144. The CRR forms part of banks’ reserves with the CBN. The cash reserves that are deposited with the CBN are partially remunerated at market interest rates at levels in excess of 8 percent (i.e., between 8 percent and 12.5 percent). ⁵⁰ The CRR, however, is not applied uniformly to all deposits, as foreign exchange deposits are not subject to the requirement. Excluding certain deposits can create incentives for banks to shift deposits from one category to another. Furthermore, unlike in many countries using reserve requirements, the calculation of the cash reserve requirement is not based on averaging during the maintenance period—the average of daily positions—but on total liabilities (demand, savings, and time deposits) at a point in time (mid-month and end-month). This tends to lower banks’ ability to flexibly manage their daily liquidity needs, and they may end up holding more reserves than required. The average method, on the other hand, permits banks to use part of their reserves over the maintenance period to smooth out short-term fluctuations in liquidity conditions. ⁵¹

145. CRRs serve several functions. For liquidity management purposes, the CBN uses them to absorb excess liquidity in the banking system generated through an expansion of government deposits from oil proceeds. The monetary effect is realized through their impact on banks’ marginal demand for bank reserves. The higher the ratio, the smaller the amount banks have freely available for credit expansion. They are also used to signal a change in the stance of monetary policy. Since not fully remunerated, they are also a source of revenue for the CBN (seignorage). Like in many developing countries with underdeveloped financial markets, reserve requirements can be appealing: they are administratively easy to implement and monitor; they are reliable and, hence, enhance the predictability of demand for bank reserves.

146. Reserve requirements, however, introduce distortions and are not viewed as ideal for short-term liquidity management. If not fully remunerated or remunerated below-market rates, they tax financial intermediation as banks shift the burden onto their customers by raising lending rates and lowering deposit rates. In addition to the high level of nonperforming loans, they are one of the contributing factors to the high interest rate spread found in Nigerian banks (at end-September 2002, about 24 percentage points). Frequent changes for short-term monetary control purposes are costly as they require banks to shift portfolio compositions, and they can be disruptive, especially in a thin market and where liquidity is unevenly distributed among banks. Frequent changes also undermine the CBN’s ability to target broad money.

147. The LR functions similarly to the CRR in that it limits banks’ ability to create credit as banks are required to hold a minimum share of their liabilities in eligible liquid assets (such as vault cash, excess reserves, treasury bills, and CBN certificates). As such, they influence the demand for financial instruments and, hence, the interest rate structure. Their very high level—beyond the precautionary level of reserves banks desire to hold voluntarily for liquidity and prudential purposes—may have contributed to misreporting. The LR also provides a source of captive demand for government securities. The high ratio effectively lowers the cost of borrowing to the government, and it can lead to fiscal indiscipline and in the process, undermine the effectiveness of monetary control. The high LR has also stifled secondary market trading, as banks are discouraged from actively managing liquidity. Countries that have been pushing for secondary market reforms have been lowering their LRs (or removing them entirely) and replacing them with other prudential regulations and a risk-focused, forward-looking supervisory framework. While the LRs serve a limited prudential role, especially if the securities and interbank markets are thin, they generally are viewed as an ineffective monetary policy instrument.

148. In line with international trends, the CBN has, since the early 1990s, been moving to a greater reliance on market-based operations to manage its day-to-day liquidity operations. There are two main types of indirect instruments that are being used: open market operations and the discount window.

Open market operations

149. The primary objective of the CBN’s open market operations is to minimize fluctuations in bank liquidity with the aim of aligning bank reserves with bank reserve targets and broader monetary aggregate objectives. A secondary objective is to help market development. The CBN transacts predominantly in short-term government paper—91-day treasury bills—and since 2001 also in its own paper.

150. The CBN conducts open market operations through the primary and secondary markets as well as through its own discount window. Primary and secondary market operations take place once a week. ⁵² The secondary market operation follows the primary as it is largely used to reverse unwarranted liquidity injections that have been made during the week through the discount window, a smaller amount of subscriptions by banks in the primary auction, and/or the CBN’s actions in the foreign exchange market. While the CBN has actively used secondary open market operations to sterilize excess liquidity, it has been unable to do so effectively. In part, this is because of the thin secondary market, but also because the CBN has been reluctant to take a loss on the treasury bills it has picked up in the primary market at below-market interest rates (see discussion below).

151. Faced with excess liquidity in the financial system, the CBN in early 2001 began issuing its own security with 180 day and 360 day maturities. Because of an attractive interest rate (a substantial differential between the issue rate of the CBN certificates and the primary treasury bill rate) the initial issues were oversubscribed, and, by August 2001, their outstanding amount reached N 85 billion (17 percent of average base money in 2001). As the differential with the treasury Bill rate gradually narrowed, the market lost interest in CBN certificates, hi April 2002, the CBN discontinued the practice of rolling over the maturing certificates. However, in late October, the CBN began considering the launching of its own open market operation paper (OMO bill) to mop up liquidity in the secondary market.

152. There are clear advantages for the CBN—but also some disadvantages—to issue its own paper. The CBN paper is a flexible way to manage short-term liquidity since the terms of issuance are at the discretion of the monetary authorities. This can enhance the CBN’s control over its monetary operations in the face of undue pressure from the government to keep borrowing costs low. The CBN paper is also useful in signaling a change in the stance of monetary policy—a separate objective from that of public debt management. The CBN paper provides for flexibility, especially when securities are scarce and the secondary market is thin. Further, the instrument allows for a fine tuning of market intervention. The use of the paper, however, comes at a cost. It lowers central bank profits, particularly if the central bank has to issue large amounts to sterilize excess liquidity in the financial system. Hence, while useful for managing short-term liquidity, the CBN paper may not be effective in addressing the excess liquidity problem stemming from expansionary fiscal policies.

Discount window

153. As an alternative to open market operations in the primary auction and secondary market, the CBN operates a discount window. Most importantly, the discount window allows for unlimited outright sales of securities or repurchase agreements (Figure V-5). Treasury-bills serve as the underlying asset for the bulk of these transactions.⁵³ Although most of the transactions are outright sales or purchases, repurchase agreements have also been used, but remain ineffective since a short-term withdrawal of liquidity does not address the underlying problem of excess liquidity. The CBN’s policy rate—the minimum rediscount rate (MRR)—is applied to all these transactions. In this role, the discount window allows banks to manage their liquidity needs rather than use the money market. The MRR is used to signal a change in the monetary policy stance. In 2001, in an effort to tighten the stance, the CBN raised the MRR from 14 percent to 20.5 percent, with five separate increases, Finally, the discount window serves as a lender of last resort function: banks can borrow reserves at a markup to the MRR.

Nigeria: Central Bank of Nigeria's Liquidity Operations, 2001

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

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Nigeria: Central Bank of Nigeria's Liquidity Operations, 2001

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

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Nigeria: Central Bank of Nigeria's Liquidity Operations, 2001

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

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154. There are downsides to the current modalities governing the discount window, as banks, unlike in open market operations, initiate access and have unlimited access to rediscounting. There is also no incentive for them to go to the interbank market since the MRR tends to be below average interbank rates. On occasions, the MRR has also fallen below the treasury bill rate creating an almost risk-free arbitrage opportunity. If not properly coordinated on a daily basis, and across instruments, this situation can lead to substantial, unwarranted base money creation and undermine money targeting. In addition to undermining money market growth, the activities at the discount window do not foster transparency and market efficiency.

Banking agent of the government

157. The CBN acts as banking agent of the government. The government sells all its foreign exchange earnings to the CBN, The federal government holds the capital account of its line ministries with the CBN, while all other accounts (e.g., to pay for salaries of public sector employees or overhead costs) are held with the commercial banks. The two lower tiers of government, the state and local governments, hold their deposits with commercial banks.

158. A number of issues arising from this arrangement complicate the conduct of monetary policy. First, any drawdown, if not predicted, can give rise to unwanted liquidity expansion. The larger the proportion of government deposits held with the CBN, the more destabilizing will movements in the monetary base be, especially if the drawdown is not coordinated in advance with the monetary authorities (Figure V-6). A key problem has been the lack of coordination and information exchange between the treasury and the CBN. Improvements in this area could minimize the impact of fiscal surprises and unwarranted liquidity expansions.

Nigeria: CBN’s Exposure to the Federal Government, December 1997–August 2002

(In billions of naira)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Source: Central Bank of Nigeria (CBN)1/ Changes in the CBN’s treasury bill holdings can be due to the CBN’s take-up in the primary market, secondary market operations, outright sales/purchases, and repayment of treasury bills via the discount window. The CBN’s holdings can also change through the practice of automatically converting the government’s overdraft into treasury bills in the last month of the calendar year.

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Nigeria: CBN’s Exposure to the Federal Government, December 1997–August 2002

(In billions of naira)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Source: Central Bank of Nigeria (CBN)1/ Changes in the CBN’s treasury bill holdings can be due to the CBN’s take-up in the primary market, secondary market operations, outright sales/purchases, and repayment of treasury bills via the discount window. The CBN’s holdings can also change through the practice of automatically converting the government’s overdraft into treasury bills in the last month of the calendar year.

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Nigeria: CBN’s Exposure to the Federal Government, December 1997–August 2002

(In billions of naira)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Source: Central Bank of Nigeria (CBN)1/ Changes in the CBN’s treasury bill holdings can be due to the CBN’s take-up in the primary market, secondary market operations, outright sales/purchases, and repayment of treasury bills via the discount window. The CBN’s holdings can also change through the practice of automatically converting the government’s overdraft into treasury bills in the last month of the calendar year.

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159. Second, owing to their sheer size, the disbursement of public sector deposits can lead to significant and volatile changes in bank liquidity, thereby impairing the CBN’s ability to sterilize the impact that given the shallow money market, the lack of intervention instruments, and the ensuing impact intervention could have on interest rates and the real economy. This points to the need to develop broader and more liquid markets. The lack of such markets explains in part the continued use of the CRR and LR to sterilize excess bank liquidity.

160. Finally, the CBN faces the problems of irregular payments with respect to timing and size on cash calls due to the joint-venture companies of the government in the oil industry and the frequent ad-hoc changes to the revenue sharing rules among the tiers of government. These factors can be sizable and undermine the CBN’s ability to forecast and control bank liquidity and, hence, credit to the economy.

Financing of the fiscal deficit

161. The CBN’s financing of the fiscal deficit is another source of monetary expansion. As stipulated under the Central Bank of Nigeria Act, the CBN may grant temporary advances to the federal government to fill shortfalls in government revenues. The federal government can borrow on average up to 12.5 percent of the previous year’s revenue (equivalent to N 80 billion in 2002, or 1.5 percent of GDP). This outstanding advance must be repaid by the end of the fiscal year (equivalent to the calendar year) in which it was extended. Failure to do so denies the federal government access to the CBN facility the following fiscal year.

162. However, the practice has been to automatically securitize the CBN outstanding advances into treasury-bills at the end of each year. Because interest rates are, at times, kept below market-clearing rate (see below), the CBN is forced to pick up the new amount of debt issued, although by law it is not required to do so. At end-2001, an additional N 119 billion in new debt was added to the previous stock. While not in violation of the CBN act, the practice of granting quasi-automatic extensions for the overdrafts and the high access limit to the overdraft facility allows for a significant monetization of the fiscal deficit. These factors also infringe on the CBN’s ability to control money and suggest that the CBN may lack full independence. Consideration could be given to lowering the limit on the overdraft balance and to removing the CBN from its role as net buyer of government securities in the primary market. ⁵⁵

Fiscal agent of the government

163. Until recently, the CBN was responsible for managing the debt of the federal government. The responsibility has been transferred to a newly constituted Debt Management Office (DMO). ⁵⁶ About 60 percent of the federal government’s outstanding stock of domestic debt (N 1.01 trillion at end-2001) is structured in the form of 91-day treasury bills. ⁵⁷ Most of the public debt is (or has been) held by the CBN. At end-2001, the CBN held about 60 percent of the government’s outstanding stock of debt. The government’s current domestic debt strategy has been to rollover the amount maturing on its 91-day treasury bills. The short-term nature of the debt implies that every three months, an amount equivalent to about one fifth of GDP comes due for repayment, and that the government borrows the same amount to pay off the maturing debt and interest payments.

164. The CBN has played the role of underwriter of government securities in the primary market, taking up the undersubscribed amount in the weekly primary auctions (Figure V-7). In order to keep borrowing costs low on the government’s sizable stock of short-term debt (about 14 percent of GDP), the CBN has administratively set the stop rate—the rate at which it accepts bids. At this rate, the market has not always cleared, and then the CBN finds itself not only rolling over the maturing stock of treasury-bills that it holds but adding new treasury-bills that the financial institutions do not want to roll over at below-market-clearing rates to its outstanding stock of treasury-bills. This has increased net credit to the government and has expanded base money beyond desired levels. The CBN typically finds itself unable to unwind these transactions in the ensuing secondary open market operations in part because of thin trading, the narrow investor base, and the lack of interest (since the open market operation rates are tied to the below-market clearing rates set in the primary auction). The below-market rates in the primary market, aside from distorting the cost of capital, undermine monetary control.

Nigeria: Central Bank of Nigeria's Take-up of Treasury Bills

(In billions of naira)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

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Nigeria: Central Bank of Nigeria's Take-up of Treasury Bills

(In billions of naira)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

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Nigeria: Central Bank of Nigeria's Take-up of Treasury Bills

(In billions of naira)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

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165. The passage of the DMO act and the repeal of Article 34 of the CBN act—which deals with the role of the CBN in debt management—would be a step toward ending the CBN’s past practice of automatically subscribing treasury-bills not taken up by the public. Other important reforms are being considered. These include: (i) restructuring of current maturities on 91-day treasury-bills to avoid the problem of bunching; (ii) establishing market-pricing mechanisms to remove distortions and attract new nonbank investors; ⁵⁸ (iii) lengthening the maturities by restructuring the existing debts; and (iv) introducing alternative instruments, such as indexed bonds, to compensate for exchange rate or inflation risk. These reforms would not only help strengthen the government securities market, provide a basis for conducting open market operations, but also help improve the government’s cash management. However, a well-functioning capital market can only develop in an environment supported by stable macroeconomic policies and a healthy banking system.

Banking sector soundness

166. The weak financial condition of the banking sector and the poor governance practice, are undermining the interbank market and financial intermediation, as well as the effectiveness of monetary policy. The large share of banks in financial distress has contributed to a segmentation of the interbank market, as healthy banks are unwilling to lend to the weak ones. ⁵⁹ As a result, liquidity is unevenly distributed. Larger established banks typically hold excess liquidity and smaller, more distressed banks tend to experience liquidity problems. Poor governance practices, such as misreporting and systemic underprovisioning, have exacerbated this problem.

167. These factors and others, such as inefficiencies in operating the court system (delays and backlogs) and difficulties in foreclosing and collecting nonperforming loans, are among the factors contributing to the wide spreads and have led to financial disintermediation (as reflected in, for example, a low M2/GDP ratio and a large share of cash-driven transactions; see Figure V-8). This has hampered the ability of monetary policy to influence credit demand conditions and the real economy.

Nigeria and Selected Comparators: Broad Money, 1985–2001

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Sources: IMF International Finance Statistics, and Fund staff estimates.

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Nigeria and Selected Comparators: Broad Money, 1985–2001

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Sources: IMF International Finance Statistics, and Fund staff estimates.

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Nigeria and Selected Comparators: Broad Money, 1985–2001

(In percent of GDP)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Sources: IMF International Finance Statistics, and Fund staff estimates.

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Forecasting liquidity and money multiplier

168. The transmission of monetary policy is a complex process operating through various channels, with long and variable lags. Understanding this channel is crucial to the task of appropriately designing and implementing monetary policy.

169. There are a few shortcomings in the area of forecasting. First, the CBN’s liquidity projections are undermined by the government’s inability to prepare accurate cash-flow and expenditure projections. Shortfalls in revenue can result in wide swings in the overdraft advances of the government with the CBN. Furthermore, the cash-flow, expenditure, revenue, and funding instruments of the government are neither regularly updated nor shared with the central bank on a timely basis. These are all essential elements of liquidity projections, since variations in the net government position account for most of the “autonomous” changes in money creation and expansion in bank liquidity.

170. The CBN’s liquidity operations are also scattered across several instruments and markets (primary auctions, secondary open market operations, discount window and foreign exchange market). The use of multiple instruments and the ease with which banks can access the discount window place a huge burden on good coordination and centralization of liquidity information within the CBN. More restrictive access—by raising the cost of borrowing from the CBN above interbank rates and above treasury bill rates—could strengthen the CBN’s control over the discount facility. The CBN also does not yet rely on formal models to estimate the demand for bank reserves, currency, and credit. Developing liquidity-forecasting abilities could improve the CBN’s decisions on the amount of liquidity to inject or withdraw. Having good liquidity projections will allow for a centralization of information on all liquidity operations and the impact that these will have on bank liquidity.

171. The authorities also need to be wary of structural changes that could affect the transmission mechanism. For instance, a greater reliance on indirect instruments, or an increase in the flexibility of the exchange rate, may alter the transmission mechanism. Also, the frequent changes to the LR and the CRR could alter the demand for reserves and affect the money multiplier, making it more difficult to target M2 (Figure V-9).

Nigiera; Developments in Money Multiplier, December 1998–August 2002

(Seasonally adjusted; in percent)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Source: Fund staff estimates1/ C is currency outside banks; D is total deposits in the banking system (includes foreign exchange, time and savings deposits); and R is bank reserves held with the CBN.

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Nigiera; Developments in Money Multiplier, December 1998–August 2002

(Seasonally adjusted; in percent)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Source: Fund staff estimates1/ C is currency outside banks; D is total deposits in the banking system (includes foreign exchange, time and savings deposits); and R is bank reserves held with the CBN.

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Nigiera; Developments in Money Multiplier, December 1998–August 2002

(Seasonally adjusted; in percent)

Citation: IMF Staff Country Reports 2003, 060; 10.5089/9781451828931.002.A005

Source: Fund staff estimates1/ C is currency outside banks; D is total deposits in the banking system (includes foreign exchange, time and savings deposits); and R is bank reserves held with the CBN.

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172. To help strengthen its current liquidity management framework, the CBN is developing a small-scale macroeconomic model with key behavioral relationships. This can help policymakers understand the transmission channels, serve as a basis for policy discussions, and assist in supporting monetary and inflation forecasts. However, coordination and on-time information sharing between the CBN and the government would have to improve to enhance the CBN’s ability to predict and meet its monetary base target.