CBN JAS Article: An Assessment of the Effectiveness of Central Bank Sterilization on Capital In?ows in Nigeria

CBN Journal of Applied Statistics Vol. 11 No. 2

201-230

An Assessment of the Effectiveness of Central Bank Sterilization on Capital Inflows in Nigeria

Tijjani M. Jume1

This paper assesses the monetary policy response of the Central Bank of Nigeria (CBN) to increases in capital inflows into Nigeria using monthly time series data from January 2009 to December 2017. It presents an econometric assessment of the degree to which the CBN sterilizes net foreign assets (NFA) in response to the capital flows, using Autoregressive Distributed Lag (ARDL) Bounds testing approach. The long run sterilization coefficient obtained suggests that the CBN successfully offset 95per cent of capital inflows in the period of analysis. Against the background of rising financial instability in Nigeria, the study illustrates how sterilization has not adequately tackled the major risks of capital inflows which resulted in asset price bubbles and bursts, equity capital inflows reversal, banking crisis, and currency depreciation which contributed, partly, to the economic recession in 2016. The paper argues that effective policy response to capital inflows must adequately address the major downside risks of capital inflows in the short and medium terms through some clearly defined capital flows management and macro-prudential measures.

Keywords: Assets price, capital flows, impossible trinity, sterilization

JEL Classification: E52, E58

DOI: 10.33429/Cjas.11220.8/8

1. Introduction

The waves of capital flows to Emerging Market and Developing Economies (EMDEs)2 before and after the Global Financial Crisis (GFC) pose strong concerns for financial system stability as well as good prospects for their growth. For instance, in 2007, total capital flows to EMDEs (excluding official flows) was over 1.5 trillion US$, which was reduced to 0.6 trillion US$ in 2009 during the GFC (Adrian, 2018). In the aftermath of the GFC, capital flows to EMDEs surged again to 1.5 trillion US$ between 2010 and 2012 and reduced to 0.5 trillion US$ in 2013 (Adrian, 2018).

• Department of Economics, Ahmadu Bello University, Zaria. Kaduna State, Nigeria. Email: [e-mail]

2The IMF defined and listed EMDEs as some 142 countries in 6 regions across the world. This includes Nigeria in the sub-Saharan Africa. See International Monetary Fund's World Economic Outlook Report, October 2012 @ http://www.imf.org/external/pubs/ft/weo/2012/02/pdf/text.pdf, 182-183.

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The Nigerian economy, like most EMDEs, is open and had attracted capital inflows since 2005 following financial globalization and the implementation of capital account liberalization reform recommended by the International Monetary Funds (IMF). There is a consensus among economists and policymakers that capital flows could pose serious concerns (This is because countries want to enjoy all the benefits of capital flows while shielding themselves from the likely macroeconomic shocks of these financial flows) from three major risk areas; macroeconomic risks, financial stability risk and sudden reversal of capital flows, particu- larly, equity capital flows (Adrian, 2018; Calvo, Leiderman & Reinhart, 1993; Kawai & Takagi, 2008). Capital inflows could undermine the ability of the Central Bank of Nigeria (CBN) to oversee its primary function of maintaining price stability. Likewise, capital flows could create volatilities in the capital market and trigger sudden reversal of portfolio inflows (equity inflows), banking crises and sharp currency depreciation that could push the economy into a recession.

The fear of the major downside risks of capital surge had necessitated the sterilization policy response from the CBN. Sterilization is the deliberate monetary response by the central bank to tame the potential effects of foreign capital inflows on the domestic money supply mainly through the sale (or purchase) of securities known as open market operations (OMO). The CBN also uses other instruments such as cash reserve requirements (CRR), public sector withdrawal of deposits from Deposit Money Banks (DMBs) as well as some exchange rate flexibility options to sterilize excess liquidity.

This study is motivated by the dearth of studies on monetary policy response to capital flows to Nigeria. Given the openness of the Nigerian economy to capital flows, particularly after the GFC, to the best of our knowledge, there is no study that investigated the CBN's monetary sterilization policy except Okpanachi (2012) which did not evaluate the CBN's sterilization policy along the lines of each of the downside risks of capital flows. Also, the scope of his analysis was restricted to the period 2000 to 2011, using simple Ordinary Least Squares (OLS) regression analysis. This study attempts to fill the gap in the literature by making two key contributions. First, it expands the literature by using the ARDL Bounds test approach to cointegration to analyze the CBN sterilization response to capital inflows in Nigeria. Sec- ondly, it presents an empirical evaluation of sterilization policy in tandem with each of the downside risks of capital flows which previous study failed to do.

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The objective of this study, therefore, is to assess the effectiveness of the CBN's sterilization of capital flows to Nigeria from 2009 - 2017 using monthly data and adopting the Autoregressive Distributed Lag (ARDL) Bounds test approach to cointegration. In addition to estimating the sterilization coefficient, the study empirically evaluates the CBN sterilization response in the context of the major risks of capital flows.

The paper is organized into 5 sections as follows: Section 2 reviews the empirical and theoretical literature. In Section 3, data and methodology of the study are presented. Section 4 presents and discusses the results while Section 5 concludes the paper and presents policy recommendations.

2. Literature Review

The literature review is divided into two parts. The first part reviews the theoretical literature from which the theoretical framework of the study emerged. The second part reviews the available empirical literature for Nigeria and also a number of country-specific and cross- country studies.

2.1 Theoretical Literature

The basis of any theoretical discussion on monetary sterilization policy in an open macroeconomic framework must begin with the analysis of capital account deregulation policy which allows free flows of capital between nations. Capital flows are divided into; debt, portfolio equity, foreign direct investment (FDI) and cross-border real estate investments that are recorded in the capital account of the balance of payments. Capital outflows include; purchases of foreign assets and repayment of foreign loans by residents (Eichengreen, et al. 1999).

According to Haberer and Lux (2012), as well as Rajan and Subramanian (2005), the potential problems to free capital mobility are clustered around 4 issues. First is the fear of currency appreciation in terms of currency exports competitiveness, causing decline in ex- ports. Where the currency is defended by the Central Bank to prevent appreciation, excess money supply can cause inflationary pressure. Second is the issue of 'hot money'; a sudden injection of capital in form of portfolio inflows into small open markets like EMDEs, can cause initial dislocation. There is also the fear of sudden withdrawal, which depreciates the currency and destabilizes markets. Third is the fear that large volumes of capital inflows in

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search for higher yields can cause the dislocation of the financial system. It can also fuel assets price bubbles, encouraging excessive risk taking by commercial banks. The last is the fear of loss of monetary policy sovereignty, without which exchange rate stability, monetary policy autonomy and capital account deregulation would not be possible.

Mundell (1963) and Fleming (1962), hereafter M-F, postulated an important static general equilibrium approach that portrays the short-run relationship between nominal exchange rate, interest rate, and output in a small open economy. The model using the IS-LM-BOP framework predicts that macroeconomic policy choices in open economies are constrained by the trilemma; that an economy cannot simultaneously maintain three desirable but contradictory macroeconomic objectives. The simultaneous pursuit of these three objectives could lead to financial and banking crises. Specifically, the principle of the impossible trinity suggests that only 2 of the following policies can be pursued at any given time:

1. Fixed (Stable) Exchange Rate: Facilitates engagement and future planning of exports and imports and hence is important in boosting domestic and international trades.
2. Independent (Sovereign) Monetary Policy: This is an economy stabilizer and can be used to address recession and inflation. Central banks can vary money supply and interest rates according to the economic cycle to achieve growth and stability.
3. Capital Account Deregulation: Makes the country's economy open to international capi- tal flows which encourage foreign investors to bring resources and expertise into the country for investment and growth. Under capital account deregulation, the domestic interest rate equals the world interest rate and so there is no possibility for independent monetary policy.

Calvo, Leiderman and Reinhart (1993), and Reinsen (1993a, 1993b) built on the M-F framework to contest the sustainability of monetary policy response to capital flows. Briefly put, the major argument posted by Calvo et al. (1993) suggests that under free capital mobility regime, it is not sustainable for a central bank to sterilize capital inflows because the policy tends to perpetuate a high domestic-foreign interest rate differential which gives rise to repeated rounds of capital inflows. These rounds of capital inflows imply increased fiscal cost to sterilize them which becomes unsustainable over time. On the other hand however, Reinsen (1993a, 1993b) posited that sterilization is possible and easier under a condition of limited perfect mobility of capital, which in practice, some EMDEs managed by using the

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trilemma framework and successfully sterilized capital inflows in their countries. Frankel (1994) reviewed these arguments and concluded that a successful application of sterilization intervention can be achieved under the standing assumptions of the two different models.

2.2 Empirical Literature

There is a large number of empirical studies on sterilization policy across the EMDEs particularly in Asia, Europe, North America and some parts of Africa. In sub-Saharan Africa however, there is a dearth of empirical studies that investigated the monetary sterilization pol- icy. For instance, in Nigeria, to the best of our knowledge, apart from the work of Okpanachi (2012), there are no other studies that investigated the CBN sterilization index. Because of this literature gap, our review of empirical literature on Nigeria is built entirely on Okpanachi (2012) and complemented with some similar studies drawn across other EMDEs to fill the literature gap. The review of the empirical literature is based on the methodology/findings by the authors.

The first group of empirical studies that investigated the sterilization response to capital in- flows includes, inter alia, Okpanachi (2012), Khushk, Gilal and Taherani (2015), and Car- darelli et al. (2010). These studies used econometric techniques such as simple Ordinary Least Squares (OLS) method, 2 Stage Least Squares, instrumental variables and pooled OLS to estimate the sterilization coefficient. For instance, Okpanachi (2012) used the simple OLS to investigate the response of CBN to capital flows in Nigeria using monthly data for the period 2000 - 2011. The study estimated the sterilization coefficient to be -0.69 for the equation with NDA as dependent variable and when broad money (M2) was used, the coefficient remained -0.69. The study found no attempt by the CBN to smooth sterilization over time but Sterilization coefficients for all the rolling regressions were statistically significant, suggesting that the CBN sterilized NFA throughout the sample period with varied intensity. Khushk et al. (2015) used instrumental variables method to estimate the sterilization coefficient for Pakistan over the period 1982 - 2013. The results suggest that the central bank sterilized 35 per cent of capital inflows during the period, indicating that the changes in net domestic assets were fully offset by equal and opposite direction changes in net foreign assets. In addition, estimates of the real exchange rate were positive showing that an increase in real exchange rate resulted in an increase in net domestic assets. Cardarelli et al. (2010) used pooled OLS regression technique to examine the macroeconomic implications and policy re-

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