CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

Financial liberalization refers to a package of operational reforms and policy actions through which state controls over the financial system are dismantled and its structure is reshaped, so that a market-driven arrangement emerges under an appropriate regulatory framework (Loizos, 2018). Although scholars describe the concept in different ways, most descriptions converge on a common set of official measures: loosening credit controls, freeing interest rates from administrative ceilings, opening the domestic market to foreign financial institutions, privatizing state-owned financial institutions, and easing restrictions on cross-border financial transactions (Lajili & Gilles, 2018). Financial liberalization therefore has both a domestic and an external dimension. At its core, it seeks to introduce or reinforce the price mechanism in financial markets and to create conditions that favour competition. Its opposite, financial repression, is recognised by ceilings on interest rates and on the expansion of credit, selective credit allocation, high reserve requirements, and barriers to entry into the banking industry (Loizos, 2018).

Interest in the part played by financial liberalization in economic growth has revived in recent years, and two developments account for this. The first is the global financial crisis, which badly damaged economies around the world, particularly in the West, and which exposed the apparent inability of mainstream classical and neo-classical models to explain or remedy it. The second is the extensive intervention by governments in the financial systems of many countries that followed. These interventions have prompted fresh questions about the McKinnon-Shaw proposition that liberalized finance acts as a catalyst for growth, and about the Schumpeterian notion of "creative destruction" in freely functioning economies. Reviews of the repression-liberalization debate have noted that these events reopened long-standing disagreements over both the theory and the policy implications of liberalization (Loizos, 2018).

The crisis, the large-scale rescue of financial and non-financial institutions, and the hesitant and uncertain reactions to such unprecedented public involvement in market activity have, taken together, produced four conceptual consequences. First, the empirical record is forcing a rethinking of what a capitalist market economy is. Second, it has shown the limits of the creative-destruction argument, which assumes that weak firms and projects are simply cleared away by market forces. Third, it has raised doubts about whether prevailing economic models and analytical tools are adequate. Fourth, it is pointing towards the emergence of what some commentators describe as a "new market economy". The severity of the downturn invited comparison with the Great Depression of the 1930s, yet the present episode differed in important ways: its effects spread quickly and across the whole world, and the sums committed to rescue operations were enormous. Because conditions were so different, the experience of the 1930s offered little reliable guidance. As each government struggled to deal with its own problems, public authorities became involved in market activity, particularly in the financial system, to a degree that had previously been regarded as outside the limits of a functioning market economy.

From a theoretical standpoint, it is widely accepted that liberalizing the financial system can contribute significantly to economic development. Since the pioneering analysis that supplied the rationale for financial sector liberalization as a development strategy, a large volume of theoretical and empirical research has examined the idea across many countries, contexts and time periods (Iwasaki & Ono, 2024; Lajili & Gilles, 2018). A number of scholars have questioned the wisdom of financial repression, contending that it harms the real economy (Loizos, 2018). One strand of the argument holds that repression lowers the efficiency of capital. Another stresses two further channels: repression weakens the efficiency with which savings are channelled into investment, and, because it depresses the return on savings, it also lowers the equilibrium levels of saving and investment. On this view, investment suffers in quality as well as quantity, since lenders ration scarce funds according to their own discretion rather than the marginal productivity of competing projects. Under such conditions the financial sector is likely to stagnate. Low returns on bank deposits push savers towards unproductive stores of value such as land instead of potentially productive deposits. High reserve requirements squeeze the supply of loanable funds even further, while directed credit programmes distort allocation because political priorities rarely coincide with the marginal productivity of different forms of capital.

The policy prescription that follows from this analysis is straightforward: abolish interest rate ceilings, lower reserve requirements, and end directed credit programmes. In other words, financial markets should be freed and the allocation of credit left to market forces. Critics have pointed out that this reasoning assumes a competitive market with few frictions, and so overlooks oligopolistic banking structures and the credit rationing that arises from imperfect information (Loizos, 2018). In the idealized account, the real interest rate adjusts to the level at which saving and investment balance, low-yielding projects are eliminated (the "creative destruction" effect), and the overall efficiency of investment rises. As the real interest rate rises, saving and the real supply of credit expand, which in turn supports a larger volume of investment. Growth is then stimulated not only by greater investment but also by a higher average productivity of capital. Lower reserve requirements reinforce the effect of higher saving on the supply of bank loans, and the abolition of directed credit is expected to improve the allocation of credit still further, adding to the productivity of capital.

Several studies have recently addressed the relationship between financial liberalization and growth. Some concentrate on the quantity effects of liberalization, others on its quality effects, and they draw on both firm-level and cross-country data (Iwasaki & Ono, 2024; Okungbowa, 2021). Firm-level work for developing economies in Asia and Latin America has produced mixed findings: some studies conclude that liberalization eased the financing constraints facing firms, whereas others find far less support for the idea that liberalization relaxed constraints and stimulated investment (Loizos, 2018). Evidence from African firms points the same way. Machokoto, Ibeji and Chipeta (2021), using panel threshold models on listed firms from nine African countries over 2003 to 2012, found that investment-cash flow sensitivity was declining even during the global financial crisis and even among firms most likely to be financially constrained, which casts doubt on its usefulness as a measure of financing constraints. Vengesai and Kwenda (2018), analysing 815 listed non-financial African firms with dynamic panel techniques, found that volatile cash flows were associated with lower average investment, including among firms with high cash flows and those regarded as unconstrained.

Cross-country panel studies are similarly divided. Lajili and Gilles (2018), using data on 108 developing countries from 1984 to 2008, found that financial liberalization raises growth both directly and indirectly, with investment acting as one of the transmission channels. Other cross-country analyses are less encouraging about the quantity effects of liberalization, and some conclude that deregulation has only a marginal effect on capital accumulation and, hence, on investment (Loizos, 2018). The relationship also appears to be non-linear. Fasanya and Olayemi (2020) reported that very high degrees of financial openness tend to erode the growth-promoting role of financial development in Nigeria, while Adeniyi, Oyinlola, Omisakin and Egwaikhide (2015) modelled the finance-growth link in Nigeria with threshold techniques that allow the effect of financial development to change across levels of financial depth. Meta-analytic work on the finance-growth nexus similarly underlines that results differ systematically with the level of economic development and with the empirical design used (Iwasaki & Ono, 2024).

It can be seen from the foregoing that the findings of existing research on how financial liberalization affects investment and growth remain inconclusive. Studies carried out at the micro (firm) level may throw more light on the matter. The inconsistencies in earlier results point to the importance of disaggregation when trying to isolate the effect of liberalization on investment, and to the need for econometric techniques capable of combining time-series and cross-section information. There is also considerable heterogeneity across industries, which can bias the results of any aggregate-level study. Firm-level studies reflect this shift from macro to micro analysis (Okungbowa, 2021; Machokoto et al., 2021). Given these considerations, company-level panel data, with their finer level of disaggregation and greater variability, are likely to be advantageous.

1.2 Statement of Research Problem

For more than two decades after independence, the Nigerian financial system was repressed. This was evident in ceilings on interest rates and credit expansion, selective credit policies, high reserve requirements, and restrictions on entry into banking. These features weakened the functioning of the financial system and, in particular, limited its capacity to mobilize savings and finance productive investment. In order to reverse this situation, and in keeping with the prevailing orthodoxy of the period, Nigeria, like many other developing countries, adopted financial liberalization as one of the main pillars of its Structural Adjustment Programme (SAP) in 1986 (Orji, Eigbiremolen & Ogbuabor, 2014).

Efforts to liberalize the Nigerian financial sector can be grouped under five headings: reform of the financial structure, monetary policy reforms, foreign exchange reforms, liberalization of capital movements, and capital market reforms. Reform of the financial structure comprised measures to increase competition, to strengthen the supervisory role of regulators, and to improve the relationship between the public sector and the financial sector. In this direction, bank efficiency was to be enhanced through greater competition and better management by licensing more banks. The conditions for licensing new banks were relaxed, and, as a result, the number of banks rose sharply from 40 in 1986 to 120 in 1992, with a comparable expansion in non-bank financial institutions. Bank supervision was strengthened and the viability of banks was improved through adequate regulations on minimum capital, on the range of assets and liabilities banks could hold, and on the introduction of uniform accounting standards to promote accuracy, reliability and comparability. Two banking laws took effect in June 1991: the CBN Decree No. 24 of 1991 and the Banks and Other Financial Institutions Decree (BOFID) No. 25 of 1991. Later in the reform path, the Central Bank of Nigeria introduced the 2004/2005 banking sector consolidation, which was designed to recapitalize banks and build a stable financial system able to support the real sector; however, the gains from that exercise came under strain when the global financial crisis emerged in 2009 (Fasanya & Olayemi, 2020).

Monetary policy reforms were designed mainly to stabilize the economy in the short run and to encourage the emergence of a market-oriented financial sector. They included the rationalization of credit controls. Although credit ceilings on banks were not entirely removed, the number of sector-specific credit distribution targets was compressed from 18 in 1985 to two in 1987, namely priority sectors (agriculture and manufacturing) and non-priority sectors (all others). Other credit measures included the elimination of exceptions within the ceiling on bank credit expansion, the equal treatment of commercial and merchant banks with respect to required liquidity ratios and credit ceilings, the modification of cash reserve requirements so that they were based on total deposits (demand, savings and time) rather than on time deposits alone, and the reintroduction of stabilization securities.

Interest rate liberalization was intended to enable banks to charge market-based lending rates and to promote the efficient allocation of scarce resources. In 1989, banks were encouraged to pay interest on current account deposits, with the rate negotiated between banks and their customers. In June 1993 there was a shift from a direct to an indirect system of monetary control with the introduction of open market operations (OMO). Under the scheme, OMO was to be conducted exclusively through licensed discount houses, which were expected to form the open market for government securities. The introduction of OMO was meant to replace direct controls as the means of managing liquidity in the economy. The period of deregulation was nevertheless marked by large swings in interest rates and continuing depreciation of the naira, and this volatility limited the ability of banks to supply credit (Fasanya & Olayemi, 2020).

All these reform measures aimed to remove distortions in the allocation of resources to productive investment, especially in the private sector, on the premise that growth is efficient and sustainable only when it is driven mainly by private-sector activity. Despite these measures, empirical evidence on the effect of financial liberalization on private-sector investment in Nigeria is mixed, and several studies suggest that the effect has been modest or conditional. Orji et al. (2014), working with data from 1970 to 2012, found that liberalization, proxied by the real interest rate, had a significantly positive effect on private investment and that a structural break occurred around the SAP reforms, although Granger causality tests showed dependence without causation running in either direction. By contrast, Fasanya and Olayemi (2020) found that very high levels of financial openness weaken the growth-enhancing role of financial development, and Kalu, Arize, Onwumere and Okechukwu (2023) showed that the response of private investment to credit, interest rates and exchange rates in Nigeria is shaped by their joint dynamics, with the exchange rate showing a negligible elasticity. Bora, Kirikkaleli, Zoaka, Bekun and Ekwueme (2020) similarly reported that broad money supply raises private investment in the long run while the exchange rate is inversely related to it. At the sectoral level, Asaleye, Adama and Ogunjobi (2018) found that credit to the private sector and the prime lending rate were the financial indicators that explained most of the variation in manufacturing performance, and that causality between most financial indicators and manufacturing output ran in one direction only, with stock market capitalization being the exception.

Moreover, many of these macro-level studies did not incorporate firm-level data in their analysis, and they concentrated largely on structural change in investment behaviour under liberalization using money-market indicators. Studies that do use firm-level data are still few. Okungbowa (2021), using data on 80 Nigerian firms between 2006 and 2016, found that investment growth is strongly determined by internal cash flow, indicating pronounced financial constraints across industries, and that capital account liberalization influences investment mainly through the indirect channel of credit availability. Ososuakpor (2021), using firms listed on the Nigerian Stock Exchange between 2005 and 2019, found that exchange rate volatility is strongly detrimental to corporate investment, and that macroeconomic uncertainty discourages firms with irreversible investments more than those with easily reversible projects. Because firms remain the main drivers of the economy, an empirical analysis of investment under financial liberalization that brings together firm-level investment data and macroeconomic data within a Post-Keynesian framework has become imperative. A Post-Keynesian, institutional perspective has itself been identified as a promising basis for a new synthesis in the repression-liberalization debate (Loizos, 2018). In addition, at a time when most countries in the global community are re-examining their economic models and financial architecture in response to the economic downturn, a study of this nature is not only imperative but compelling. Moreover, after more than two decades of operating a liberalized economic and financial model, an empirical work that chronicles the impact of liberalization on investment in Nigeria at the firm level has become necessary for both academic and policy purposes. This work filled that important research gap. It did so using firm-level and macroeconomic data extracted from the balance sheets and income statements of manufacturing companies quoted on the Nigerian Stock Exchange and published in the NSE Yearly Factbook, together with the Central Bank of Nigeria Statistical Bulletin, for the period 1990 to 2009.

1.3 Objectives of the Study

The study examined empirically the impact of financial liberalization on investment in Nigeria using firm-level and macroeconomic data. To achieve this broad objective, the study sought to:

a. Investigate how financial liberalization has evolved over time in Nigeria and the bank development indicators that influenced that evolution.

b. Identify the various financial liberalization indicators and determine how these indicators affected the investment of manufacturing firms in Nigeria.

c. Examine the impact of financial liberalization on aggregate assets as a determinant of the investment decisions of manufacturing firms in Nigeria.

d. Ascertain the impact of financial liberalization on macroeconomic measures of uncertainty as a determinant of the investment decisions of manufacturing firms in Nigeria.

1.4 Research Questions

The study sought to answer the following questions:

a. How did financial liberalization evolve over time in Nigeria, and what bank development indicators influenced that evolution?

b. What are the indicators of financial liberalization, and how do these indicators affect the investment of manufacturing firms in Nigeria?

c. What is the impact of financial liberalization on the aggregate assets of firms as a determinant of the investment decisions of those firms in Nigeria?

d. Does financial liberalization have any impact on macroeconomic measures of uncertainty as determinants of the investment decisions of manufacturing firms in Nigeria?

1.5 Research Hypotheses

To achieve the above objectives, the following hypotheses, stated in null form, were investigated in the study:

a. Financial liberalization is not positively and significantly related to bank development indicators in Nigeria.

b. Financial liberalization is not positively and significantly related to firm-level investment in Nigeria.

c. Financial liberalization is not positively and significantly associated with the aggregate assets of firms as a determinant of firm-level investment in Nigeria.

d. Financial liberalization is not positively related to macroeconomic measures of uncertainty as determinants of firm-level investment in Nigeria.

1.6 Scope of the Study

The study focused on the impact of financial liberalization on investment in Nigeria using firm-level and macroeconomic data. Specifically, only manufacturing firms quoted on the Nigerian Stock Exchange were covered. In line with previous firm-level studies of similar orientation, and given the dynamic nature of investment models, only firms that remained in continuous existence for at least five years after the initial year (1990) were included (Machokoto et al., 2021; Vengesai & Kwenda, 2018). Only manufacturing firms were included in the data set because physical capital accumulation (investment) was the focus of the study. Financial and insurance firms are highly leveraged entities whose investment horizon differs from that of firms in the real sector, a distinction that recent firm-level studies of Nigeria and Africa also observe by restricting their samples to non-financial firms (Okungbowa, 2021; Vengesai & Kwenda, 2018). The exclusion of diverse sectors such as commerce and agriculture helped to keep firm heterogeneity in the sample under control.

Furthermore, only manufacturing firms with less than 50% government ownership were included in the sample. State-owned enterprises (SOEs) are subject to managerial procedures different from those of privately owned firms. Since such enterprises are best understood as part of a country's long-term development plans, their financing and investment decisions cannot be expected to follow the models that apply to their private competitors.

1.7 Significance of the Study

Financial liberalization and the role of government in economic growth and development have once again moved to the centre of national and international discourse, because of the global financial and economic meltdown and the apparent inability of prevailing theoretical models to reverse it (Loizos, 2018). Nigeria is not immune from this global shock. Like many other countries, it is re-examining its economic models in search of the best combination for achieving its economic aspirations. The country has also operated a liberalized economy for more than two decades, yet firm-level empirical work remains scarce (Okungbowa, 2021). A study of this nature, at this time, is therefore of considerable benefit for both policy and academic purposes. Specifically, the following stakeholders may find the results of this work useful:

a. Manufacturing Firms

Existing empirical evidence indicates that financial liberalization has had a modest or conditional effect on investment in Nigeria (Fasanya & Olayemi, 2020; Orji et al., 2014). A central theoretical premise of financial liberalization is that it relaxes financial restrictions and allows market forces to determine real interest rates, which in turn encourage saving and greater investment, and greater investment is expected to promote growth and development. If this expectation has not been fully realised in Nigeria, it stands to reason that institutional and structural factors may be responsible; for example, firms in Nigeria continue to rely heavily on internal cash flow to finance investment, which signals persistent financing constraints (Okungbowa, 2021), and exchange rate volatility has been found to weigh heavily on corporate investment decisions (Ososuakpor, 2021). Empirical evidence along these lines is of strategic importance to manufacturing firms seeking to improve their performance.

b. Policy Makers

This work will also be important to policy makers, such as the Federal Government and its agencies, by providing a platform for designing economic and financial models that enable government to deliver on its mandate of providing an appropriate policy framework in which private enterprise can thrive in Nigeria. At a time when traditional economic models and financial architecture seem unable to offer solutions to economic downturns, the results of this work may supply a missing link. The evidence that credit conditions, interest rates and exchange rates jointly shape private investment (Bora et al., 2020; Kalu et al., 2023) underlines why firm-level findings are valuable for coordinating monetary and financial policy.

c. Financial System Regulators

For a long time, the prevailing orthodoxy of the 1970s and early 1980s held that liberalizing financial markets would improve savings mobilization and the efficiency with which capital is allocated. Belief in the efficiency of financial markets led many to assert that deregulation would bring higher levels of investment and growth, and liberalization was expected to remove inefficiencies in financial intermediation and deepen the financial system (Loizos, 2018). This line of thought motivated the Nigerian Government to liberalize the financial sector as one of the main pillars of the Structural Adjustment Programme (SAP) in 1986. After more than two decades, it is imperative that the impact of liberalization be evaluated empirically at the firm level, since an understanding of how firms make investment decisions is a major step in designing macroeconomic policies that stimulate investment. The results of this work may therefore be useful to regulatory authorities such as the Federal Ministry of Finance, the Central Bank of Nigeria, the Nigeria Deposit Insurance Corporation and the Securities and Exchange Commission.

d. Academia and the General Public

The literature on financial liberalization has a long pedigree. It began with the seminal McKinnon-Shaw analysis of "financial repression" and the argument that developing economies should allow real interest rates and other financial prices to be set by market forces. Since then, hundreds of empirical studies have tested the hypothesis in many different contexts (Iwasaki & Ono, 2024). Initially, the debate focused on the effects of low or negative real interest rates on saving and investment in developing countries. More recently, researchers have broadened the debate to cover the effects of repression on economic growth, financial crises, poverty and related outcomes, and a growing body of work now examines the potentially destabilizing consequences of liberalization itself (Lajili & Gilles, 2018; Loizos, 2018). Studies on the relationship between liberalization, savings and investment in Nigeria continue to appear (Ahmad & Premaratna, 2019), but firm-level work is still at an early stage. The results of this work may act as a springboard for other researchers to undertake more firm-level studies of the impact of financial liberalization on investment, and may add to the body of knowledge on financial liberalization, investment and economic growth. The general public may also find the results informative and may use them to extend the frontiers of knowledge on the financial liberalization-investment nexus.

1.8 Limitations of the Study

Like every research work, the study had its constraints. First, money and time were major constraints. Collecting the required data from a relatively large number of manufacturing firms demanded a great deal of work and expense. Obtaining annual reports and statements of accounts from the sample firms was difficult because of the poor culture of record keeping in the country.

Second, the weak alignment of Nigerian accounting practice with international standards during much of the study period complicated the construction of the data set. Most manufacturing firms in developing countries did not follow international accounting standards in their financial statements, especially with regard to inflation accounting, and this is likely to introduce some measurement error into the variables. Although Nigeria has since converged on International Financial Reporting Standards (IFRS), evidence on the resulting improvement in reporting quality among Nigerian firms is still evolving (Abdullahi & Abubakar, 2020), and the figures used for the earlier years of this study pre-date that convergence. Inflation-adjusted accounting was not widely practised in Nigeria even though the country has long been a high-inflation environment. For instance, if land is not revalued every year, measurement error may enter the calculation of capital stock. In addition, because some balance sheet categories that represent stock items are more sensitive to price-level changes than others, comparing these items may distort the analysis. Accounting reports usually apply revaluation methods only to tangible fixed assets, and these revaluation rates may not closely track the relevant inflation rates. These problems are common, however, in research that uses firm-level accounting data from developing countries (Machokoto et al., 2021; Vengesai & Kwenda, 2018).

It must also be mentioned that local literature on the impact of financial liberalization, particularly at the firm level in Nigeria, remains limited. As a result, foreign theoretical and empirical perspectives made up a large part of the material used in the literature review. The implication is that any local pattern observed in the analysis of the impact of financial liberalization lacked a strictly local theoretical foundation. These limitations did not, however, invalidate the results of the study.

1.9 Operational Definition of Terms

Some terms have been defined in context so as to make them more responsive to the needs of the study. These include the following:

Investment

Investment is the change in capital stock during a given period, usually measured at the end of an accounting year, net of depreciation. Unlike capital, therefore, investment is a flow variable and not a stock variable. The investment flow in period t (It) can be calculated in real terms as the difference between the capital stock at the end of the period and the capital stock at the beginning of the period, excluding replacement capital or the physical depreciation of capital.

Capital Stock

Capital stock refers to the tangible fixed assets on the balance sheets of manufacturing companies, including accumulated depreciation. Specifically, it is the sum of machinery, plant, equipment, buildings, land, property, other tangible assets and construction in progress. Inventories are excluded from the calculation. Under the Nigerian accounting standards applicable during the study period, tangible assets were recorded at historical cost and revalued at the end of every fiscal year according to the revaluation rates provided by the Nigerian Accounting Standards Board. Land was an exception to this revaluation rule because it is usually not revalued. Consequently, it was not possible to exclude land from the calculation of capital stock.

Macroeconomic Uncertainty (U)

Uncertainty is the possibility that an expected outcome will not be realised because of movements in the variables that give rise to uncertainty. In the context of this study, macroeconomic measures of uncertainty include changes in the exchange rate, inflation and the interest rate. Movements in these macroeconomic indicators can affect whether an investment outcome is realised (Ososuakpor, 2021). Uncertainty is therefore the possibility that the future rewards from an investment may be only partly realised or not realised at all. Within the realm of investment, uncertainty cannot be fully forecast or accurately determined beforehand. The Keynesian tradition draws a sharp line between measurable risk, where outcomes can be assigned probabilities, as in games of chance, and genuine uncertainty, where there is no scientific basis for calculating probabilities. Examples of the latter include the price of a commodity or the level of interest rates many years ahead, or the speed at which a new invention becomes obsolete, about which decision makers simply do not know (Loizos, 2018). Real options approaches to corporate investment reach a related conclusion, namely that uncertainty is particularly costly where investment is irreversible, because firms then have reason to delay commitments (Ososuakpor, 2021).

Financial Liberalization Variables (FIN)

These are the measures (proxies) of financial liberalization. They represent essentially the depth of financial deepening and market development, and are defined as follows:

a. M2-to-GDP ratio: This is a broad money aggregate that measures the depth of financial sector development and its inducement to saving and investment. It is calculated as the natural log of the ratio of M2 (comprising deposits, currency outside deposit money banks, and the quasi-money liabilities of these institutions) to real GDP.

b. Private Sector Credit-GDP ratio: Private credit equals the value of credit extended by financial intermediaries to the private sector divided by GDP. The measure isolates credit issued to the private sector and therefore excludes credit issued to governments, government agencies and public enterprises. It also excludes credit issued by the central bank. It is obtained as the natural log of the ratio of private sector credit to real GDP.

c. Stock Market Capitalization-GDP ratio: This is a measure of stock market capital mobilization, liquidity and risk diversification. It equals the total market value of listed shares divided by GDP. The assumption behind this measure is that overall market size is positively correlated with the ability to mobilize capital and diversify risk on an economy-wide basis. It is obtained as the natural log of the ratio of the value of listed shares to real GDP.

d. Public Sector Credit-GDP ratio: This is a measure of total domestic credit accruing to government and indicates whether a crowding-out effect has occurred. It is obtained as the natural log of the ratio of public sector credit to real GDP.

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