THE INFLUENCE OF CROWDING-OUT EFFECT ON SECTORAL PERFORMANCE IN NIGERIA

THE INFLUENCE OF CROWDING-OUT EFFECT ON SECTORAL PERFORMANCE IN NIGERIA

This research aims to ascertain the influence of the Crowding-out effect on sectoral performance in Nigeria.

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CHAPTER ONE

INTRODUCTION

• Background to the Study

Although the relationship between government expenditures and private investment has been investigated substantially in the literature, the impact of government expenditure on private investment and economic growth is a controversial issue. There are three schools of thought concerning this issue namely Neo-classical, Keynesian and Ricardian. The Neo-classical economists believe that the market is full employment, advocating free markets and minimal intervention of government in the economy argued that increased government expenditure is met by borrowing from the capital market which causes a rise in interest rate (Basar, Polat and Oltulular, 2011) as a consequence of competition for available funds. The increased interest rates will raise the cost of capital for the private sector and reduce private investment. That the increased government expenditures financed by borrowing reduce the loanable funds at the disposal of private investments as the demand becomes higher than the supply, hence higher interest which results in a high cost of capital for private investment is called “crowding-out” hypothesis. The Neo-classical also asserts that increased government involvement in the economy (mainly through expenditure activities) might distort the economic and political environment of business and discourage or crowd-out private sector investment. From the point of Crowding-Out hypothesis, government borrowing and government expenditure are seen as the same because government borrowing is used to finance government expenditure.

On the other hand, the Keynesian view argues that an increase in government spending stimulates economic activity and thus crowd-in private investment rather than crowd-out. According to the Keynesian view, it is rare for an economy to always be at full employment level. In general, economies are at an underemployment level. In such a case, the sensitivity of private investment to interest rates would be low. This economic school of thought believes that government protective and productive investments in physical, legal, and human capital infrastructure might crowd-in private sector investments (Atukeren, 2010). Government capital expenditure in infrastructures crowds-in private investment as the cost of operation is reduced leading to greater aggregate demand hence output. This is referred to as the Infrastructural hypothesis.

The final argument on the crowding-out effect belongs to the Ricardian view which is based on the Ricardian equivalence theorem. It suggests that private investment results in neither crowding-in nor crowding-out effect, and as such, private investment and government spending are considered to behave independently from each other. The premise for this view is that an increase in government spending is anticipated to be accompanied by a rise in taxes in the future, if not today (Philip Arestis 2011). So government spending financed by the issue of public bonds is expected to be repaid by revenue generated through taxes levied in the future. Interest rates and private investment, therefore remain unchanged as economic agents realize that their income would be taxed in the future, and hence they do not alter their current savings and consumption level.

It is thus vital to establish whether efforts being made by the governments of African nations, about their investment contributions, are adverse or fostering the private sector’s incentive to invest. Ascertaining such a relationship between these two key elements is imperative for economic growth-oriented public policy in the region.

Private investment is essential for ensuring economic growth, sustainable development, and poverty reduction. It increases the productive capacity of an economy, drives job creation, brings innovation and new technologies, and boosts growth. Private investment plays an important role in developing nations for the same reason that it does in industrialized countries. Various pieces of literature and theories recognize that private investments are better drivers of the economy than public investments. Private investment determines the rate of accumulations of physical capital and is thus an important factor in the growth of productive capacity (Agenor and Montiel, 1996). However, the amount of physical capital in general and private investment, in particular, falls short of development needs in these countries especially African nations. According to Ajayi (2000), developing countries usually take debts because they are in the phase of development, and need extra supports. Several studies, such as Mlambo & Oshikoya (2001), Anyanwu (2006), Bayraktar & Fofack (2007), Douglas and Quentin (2007) and Bakare (2011) show that the contributions to the growth of physical capital and total factor productivity in Sub-Saharan Africa (SSA) have been low and have declined over time.

The government borrows to fund its deficit. In Nigeria, there has been a quantum leap in government borrowing to finance capital expenditures not met by dwindling revenue. Nigeria’s debt started in 1958 when $28.0million was borrowed from World Bank to finance her Railway constructions. By 1960, the debt profile rose to $69.7 million, and $246 million in 1970. By 1980, it rose to $9billion and $716,815.6 billion in 1995 though dropped to $489,269.6 billion in 2004. As released by Nigeria’s Debt Management Office (DMO), Nigeria’s domestic debt stood at about $43.185billion equivalent of N7.25 trillion as at March 2015 (DMO,2015) while as at 30 June 2016, it rose to N10.606 trillion making Nigeria one of the largest debtor nations in sub-Saharan Africa, Ayadi, and Ayadi (2008). We often come across something like crowding out of private investment, Crowding-out refers to a situation where the private sector gets edged out of the debt market due to higher demand for government funds.  When the government increases its borrowing it consequently increases the demand for money which in turn increases interest rates. The problem is that the government can always pay the market interest rate, but there comes a point when corporations and individuals can no longer afford to borrow at higher rates. Also, Banks then prefer investing in Gilts rather than lending to other non-government entities as high-interest rates increase the risk of default. Thus Private borrowers which include Industry (Term Loan, Working Capital Loan, Machinery Loan, etc.) and Individuals (Personal Loan, Home Loan, etc.) find it difficult to get a loan more importantly at a cheap rate. This fall in investment by Individuals and Corporates affects long term growth thereby impacting several macroeconomic indicators like the Index of Industrial Production (IIP), Unemployment, Inflation, etc.

Many studies have found it difficult to evaluate the influence of the crowding-out effect due to their inability to capture it sufficiently, but a review of the literature (Sonigara, 2010; Bhole, 2004; 2009) reveals that ratio of Governments’ borrowing to an incremental deposit of banks is a good indicator to measure the crowding-out effect.

• Statement of the Problem

A strong controversy in economic theory and policy is whether public and private investments are substitutes or complements. The free markets advocates argue that public sector activity competes with the private sector for scarce resources and drives their prices up. Particularly, if government capital expenditures are financed by borrowing, this leads to a rise in market interest rates and thereby raising the cost of capital for the private sector. As a result, public sector investments crowd out private investment. Contrary to this argument is that public investment may be of benefit to the development of the private sector. Government capital expenditure, particularly in infrastructure crowd in private sector spending by reducing costs, and raising productivity, this, in turn, increases private returns ( Aschauer, Munnell, 1992 and Buiter, 1977). This is termed the Infrastructural hypothesis.

Various methodologies, nevertheless, exist in the literature for investigating the crowding-in and crowding-out effects of public investment on private sector investment and literature on the crowding in or crowding out an implication of government capital expenditure for developing economies is also inconclusive. Studies by Khan and Reinhart (1990) and Khan and Kumar (1997) have shown that private sector investment has more effect on economic growth in the developing economies compared to public investment. Nigeria, as a developing economy, in recent years has been making assiduous efforts to develop her private sector to achieve her growth objective. Thus this empirical investigation for Nigeria is motivated by the far-reaching policy implications of this important and controversial nature of the relationship between public and private investment on the growth of the economy. A better understanding of this relationship will help in shaping the direction of public policy on government capital expenditures. Also, the composition of public investment is expected to have differential effects on the private sector spending on investment.

To the best of our knowledge, the empirical literature on the influence of the crowding-out effect on economic growth in Nigeria is scanty. Recently, Udah (2010) reveals that the government size variable does not complement private investment despite the huge government expenditure on capital projects related infrastructure in the past two decades. While the attention of most of the studies is on the aggregate government capital expenditure, this study, therefore, will differ by evaluating the influence of crowding out effect in light of the ratio of government borrowing to deposit prowess of Deposit Money Banks and see its influence on sectoral economic growth in Nigeria.

• Aim and Objectives of the study

This research aims to ascertain the influence of the Crowding-out effect on sectoral performance in Nigeria. While the specific objectives are to:

1. Examine the influence of the Crowding-out ratio on Agricultural sector output in Nigeria.
2. Evaluate the influence of the Crowding-out ratio on Industry sector output in Nigeria.
3. Estimate the influence of the Crowding-out ratio on Construction sector output in Nigeria.
4. Appraise the influence of the Crowding-out ratio on Trade sector output in Nigeria.
5. Evaluate the influence of the Crowding out ratio on Service sector output in Nigeria.

• Research Questions

The study in line with the above objectives was based on the following research questions:

1. What is the extent of the relationship between the Crowding-out ratio and Agricultural sector output in Nigeria?
2. To what extent does Crowding-out ratio affect the Industrial sector output in Nigeria?
3. What extent is the impact of the Crowding-out ratio on the Construction sector output in Nigeria?
4. To what extent is the impact of the Crowding-out ratio on Trade sector output in Nigeria?
5. What is the extent of the relationship between the Crowding-out ratio and Service sector output in Nigeria?

• Research Hypotheses

To analyze the data, the following null stated hypotheses were tested:

H₀₁: There is no significant relationship between the Crowding-out ratio and Agricultural sector output in Nigeria.

H₀₂: There is no significant relationship between the Crowding-out ratio and Industrial sector output in Nigeria.

H₀₃: There is no significant relationship between the Crowding-out ratio and the Construction sector output in Nigeria.

H₀₄: There is no significant relationship between the Crowding-out ratio and Trade sector output in Nigeria.

H₀₅: There is no significant relationship between the Crowding-out ratio and Service sector output in Nigeria.

• Significance of the Study

The findings of the study will be immensely important to the following sectors:

To practitioners: This study will be significant to various sectors: To public officials, this study will enlighten them as to the level to which financial institutions have influenced output in the nations. To financial institutions, it would elucidate the areas that need aggressive correction and those that might have failed towards meeting their intermediation goals and objectives as planned while cautiously avoiding the crowding out a trap. And would aid the Apex institution to give proper directives to financial institutions like the commercial banks and another relevant bank towards attaining even disbursement of funds to all sectors of the economy. To the general public, this study will enlighten them as to the distribution ratio and influence of Credit Allocated in Nigeria.

To Scholars: This would enlighten scholars as to the measurement of the Crowding-out effect on the real economy and add to the existing literature as to the real effect of the subject matter.

• Scope of the Study

Content Scope: This study will evaluate the sectoral influence of the crowding-out effect and will span the period of 1981 to 2017. It would encompass the five classified sectors of the economy according to the Central bank of Nigeria. This study scope covers the Financial crowding out effect which refers to a decrease in private investment caused by an increase in interest rate necessitated by increased government demand for loanable funds in the economy.

Geographical Scope: This study will be limited to the Nigerian economy and entails all sectoral crowding out effects as within the geographical boundary of Nigeria.

Unit of Analysis: This study is predicated on the institutional and national levels (The bank’s activities and their respective government/economic influence).

• Limitation of Study

The limitation of this study stems from the role of credit disbursed to the aforementioned study which would be too wide for this study to adequately capture coupled with various subsectors that might be passively ignored due to the current Central bank of Nigeria classifications.

• Definition of Terms

Various key terms are defined below:

Crowding-out effect: A situation when increased interest rates caused by higher demand for than supply of loanable funds leads to high-interest rates/cost of capital. This high rate of interest/cost of capital ceteris paribus leads to a reduction in private investment spending such that it dampens the initial increase of total investment spending.

Government borrowing: This represents the amount taken as loan by the Federal, state or local government from the coffers of the various banks in a country at a period.

Incremental deposit of Banks: This is the annual aggregate value of Deposits in the universal banking system at a given point in time.

Crowding-in effect: An economic principle in which private investment increases as debt-financed government spending increases especially caused by government capital expenditure on infrastructures. This is caused by government spending boosting the demand for goods, which in turn increases private demand for new output sources, such as factories. This is in contrast to crowding out.

Output growth: This is an increase in the level of production in a defined environment or area.

Sectoral: An area or portion distinct from others or about an exclusive proportion.

• Organization of the study

This research exercise was organized into the following chapters. Chapter one introduces the background of the study, statement of the problem, the purpose of the study, research hypotheses, research questions, scope, significance of the study and the organization of the study. Chapter two reviews the related literature of the study. Chapter three examines the method of study, it comprises the sources of data collection, model specification and the method of data analysis of the study. Chapter four deals with data presentation, a test of hypothesis and analysis of the regression results. Chapter five ends the study with a discussion of findings, recommendations, and conclusion.