Financial Instability Hypothesis as it Relates to the African Economy: The Nigerian Case

- By Chinedu Okoye 

Abstract:

In this paper I explore how Minsky's Financial Instability Hypothesis (FIH) which originated in the context of the American capitalist system, can be adapted to understand economic instability in Nigeria —a structurally different, underdeveloped and resource-dependent economy.

The paper doesn't just mechanically apply Minsky but, interrogates where it fits, where it breaks and structural realities that alter its conclusions. Assessed here, is the mismatch of assumptions, the nature of instability, Ponzi like characteristics of economic entities including the government, policy constraints, and the need for structural reforms 

Minsky's FIH assumes deep innovative financial markets and efficient and/or stabilizing government spending. However unlike the American economy in the 1960s, Nigeria lacks these attributes, with shallow financial markets and government spending constrained by debt, making for a poor transmission of demand management tools.

Introduction:

Drawing from Minsky's work on the subject matter, we attempt to apply it to a model underdeveloped, and highly indebted county —Nigeria, to be used as a proxy for Sub Saharan African Countries.

This is to explain the merits of the theory, in the African economy, marred by challenges unique to them. We find differences in the structure of the financial system in the American economy which Minsky modeled and thag of the Nigerian economy.

These differences lead to contrasting behaviors and responses to economic factors, that induce or encourage investment, and the extent to which it does so. This then builds up from financial instability concerns into an economic instability Hypothesis for Nigeria on the part of businesses (real sector) as well as banks.

Because the financial structure and indeed the entire economic structure of both countries differ, all aspects of Minsky's theory may not hold. But the essential relationship holds, barring any structural challenges.

However, the structural differences have implications for the efficiency of monetary policy in its conventional form, placing financial policy and a monetary restructuring of it at the forefront of the theory of the Nigerian business cycle.

Minsky's Financial Instability Hypothesis: The Nigerian case.

Here we analyse the Nigerian economic instability through Minsky's lense. Hyman Minsky's ideology was built on two important features of the American economy;

(i) Efficient Markets: that markets are efficient and innovative enough, to ensure seamless dissemination of capital, from an established link between financial markets (Banks, mutual funds, hedge funds etc) and industry.

(ii). That government deficit spending is done in such a way that stabilises demand (revenue and debt going to financing or subsidizing essential items like welfare and business support programs), and offsets the crowding-out effect of big government in the process.

For as more capital flock to "risk free" yielding assets, the yield on treasuries reduces making higher yielding riskier assets attractive (corporate debts, stocks and commercial papers).

However, in reality, the conditions of (i) and (ii) above are different in form, in Nigeria and resource rich sub Saharan Africa, this makes it difficult for orthodox demand management policies to provide long-term stability and significant or desired growth levels.

The Instability Problems and Policy Risks:

Unlike Minsky's case, Nigeria faces a different type of Instability problem. A financial sector with narrow choices in the way of lending to the real sector.

Most debt financed small businesses, by default start of as or detoriate quickly from hedge financing to speculative financing units, and a ton of those turn near Ponzi (where current and future expected returns are outweighed by debt obligations).

In boom periods (described here as times of high oil receipts and subsidized rates that stimulate local investments by making imports prices stable), banks have the tendency to oblige business expansion projects and this affects asset prices (pushes it upwards)to a point that these hedge financing units turn to speculative financing units.

In times of revenue shortfalls, household government and business units turn quickly from hedge to speculative and from speculative to Ponzi. As the federal government increasingly rolls over short-term debts to cover deficits, especially during revenue shortfalls (e.g., oil price collapses), competition for funds in the capital markets increase.

This leads to decreasing liquidity and fragmented financial markets where sectors and industries are prioritized over others for their lower risk feature, and high immunity to structural imbalances and not necessarily their growth potential.

Whereas, companies with higher growth potential but exposed to these structural imbalances experience a tighter financial market. 

Ineffectual or Limiting Demand Management Policies:

The Nigeria budget is clogged with deb servicing obligations, as there's a high yield risk premium on Nigerian government securities. So, any increased spend would require an incresed debt issuance which would only add to the cost of debts for both the government and private sector, excercebating the crowding-out effect.

This results in a high liquidity preference and structural challenges that would prevent capital from flowing to business debt instruments, if structural challenges aren't eliminated. The government stability effect as a demander of goods and servces is neutralized, as it can only spend a minimal amount of its cash resources (revenue + debt), on capital expenditure — infrastructure, business support programs, etc.

Monetary Policies taken to quell inflation, in Nigeria in the past year, though well prescribed in our view have led to; higher rates, sustained inflationary pressures, dampened effective demand (from a reduction in real wages). The economy is only now seeing steady disinflationary signals, but aggregate demand stays weak. 

These conditions are barely recipes for long-term capital investments and the heightened risk and uncertainty only goes to increase the cost of debt (interest rates), for businesses looking to finance capital assets purchases.

The bleak short-term expectations continues to guide investment decisions, and long-term expectations precluding intensification of real capital investments.

This calls form regulatory changes and innovative policy thinking to restructure the financial markets such that Financial Institutions are linked and incentivised to lend to industry. An increase in credit allocation to businesses could gradually reduce the liquidity preference of the economy,.if said issuances are subsidized.

This would have the effect of both a fiscal and expansion. But there's a need for both institutional and regulatory modifications.

The Imperative need for Institutional and Regulatory Modifications:

The foundational problem here lies in the inadequacies of financial intermediaries. The financial markets aren't deep enough, and there also exist structural challenges that exacerbate this crowding-out effect (more money going to government securities than businesses), or a concentration of a select few industry players.

This leaves institutional investors, directly or indirectly at the mercy of cyclical downturns, and increases their liquidity preference, as a natural response to the above.

Though much is changing, and more economic units (households, businesses) are gaining access to credit, it comes at a huge interest rate cost, and at higher price levels—from monetary tightening in the past year. And in competition with government securities as oil output stays stagnant and with declining prices.

This has implication for industry's bottomline, and for the financial system —should the trend in private sector lending increase exponentially. Higher interest costs and a low money multiplier would constrain investments, or leave businesses (and the government) dependent on debt in an inflationary environment.

This calls for changes to monetary policy;

 1. The Cash Reserve Ratio would need to be revised downwards, since banks are much stronger now, they could withstand a lot more risks.

 2. Government backed Funds for key industries, partnering with banks who put up these funds initially and are reimbursed for any losses incurred.

 3. Exclusion of select real sector segments from the loan-to-deposit ratio calculation.

The Switch to Ponzi and the Regulatory response:

Per Minsky, the higher amount of speculative financing units relative to hedge, the more fragile the economy becomes, and the higher prices increase. 

Households and SMEs rely on informal borrowing or loan apps with extremely high interest rates—typical of Ponzi-like financing cycles. Many state governments rely on federal allocations, borrowing unsustainably when oil revenue falls.

This explains the high Cash Reserve Ratio and other regulatory moves. Both the Central Bank and Commercial Banks (amd other FIs), are motivated to avoid a debt-deflationary environment—both have a high liquidity preference.

This however stalls growth, as not enough (endogenous) money is created to match the demands from investors/producers—the reason why the growth in loans to the private sector and overall private sector (earnings) growth has been sluggish and concentrated.

Risk Aversion and Regulations stifling Growth and leading to Instability from Concentration and Inflation Risks:

This risk aversion and tight regulation, inadvertently leads to economic instability and vulnerabilities that could spark it. The financial instabilty concerns leads to economic Instability concerns, as lenders are concentrated and affected by similar factors.

This makes for a limited amount of available credit for investors looking at real capital. And cycles dependent on Oil and Gas. In a downturn of the sector, all business and the government become speculative and/or Ponzi financing units depending on their status prior to the cyclical downturns —an unstable economic environment.

Monetary tightening becomes recipes for output contraction and higher inflation, and indiscriminate expansion could lead to unsustainable debts by the private sector, weakening the capital market structure as (financial) asset prices decline—debts, share capital, bonds, commercial papers and other forms of credit money.

The Nigerian economic instability originates from this tentative knife edge situation of extreme financial conditions and posturing that leaves the economy open to cyclical downturns from either a decline in concentrated industries, or the quality of debt and other financial instruments through which business activity are funded. With inflationary pressures maintained.

The Nigerian Instability Hypothesis:

The Nigerian case is unique in that both government and private sector economic units are dependent (directly or indirectly), on similar factors and posses similar financing postures. Periods of commodity-driven stability create political and financial confidence that fuels misallocation of concentrated distribution of capital, rising public and private debt dependence, and weakening of institutional buffers.

Wen the going in good (ie, when oil prices and revenue are relatively higher than long-term trends), governments, businesses, households/individuals are relatively hedged. As financing is secure somewhat.

A hit to the Oil and Gas sector, from which revenues are expected, would have inflationary effects that trickle down to the private sector. This concentration speeds up the transition from hedge financing to speculative and from speculative to Ponzi financing.

These dynamics, are excercebated by shallow financial markets, with institutions absent the will or incentive to innovate or evolve to suit market needs and a large informal economy, which are almost perpetually in a state of speculative to Ponzi financing posture.

These factors produce instability not primarily through endogenous credit cycles, but through vulnerability to fiscal, external, and policy shocks. These hasten the transition from hedged to speculative behavior within a structurally fragile economic state.

Inadequacies in tangible and intangible infrastructure makes for an economy prone to sustained levels of instability and stunted growth in output and employment.

Conclusions:

Economic entities in Nigeria save for a few money, money between hedge, speculative and Ponzi but not necessarily due to endogenous exuberance or optimism as in Minsky's FIH.

Orthodox demand management instruments fail because of the structural crowding out, sustained inflationary pressures and high liquidity preference (or risk aversion) of financial institutions.

Where Minksy's hypothesis describes a capitalist systems endogenous drift towards fragility —from financial markets developments— Nigeria's "drift" is both endogenous and exogenous, and heavily amplified by structural inefficiencies, policy inconsistencies or outright design flaws.

Understanding the structural differences between both economies is key to formulating, crafting and implementing effective and appropriate policies that are logically and theoretically sound.

Adapting Minksy's FIH for the Nigerian economy requires analytical flexibility and an understanding that cycles here is less about euphoria and more ensuring structural fragility, and resolving structural inefficiencies. These inefficiencies are addressable only through sustained and consistent institutional and policy reforms.