Relationship between interest rate and exchange rate in Nigeria: does the banking sector debt level matter?

Abstract

This study examines how the exchange rate responds to interest rate changes in the presence of a high debt level in the banking sector in Nigeria. Using the Pesaran, Shin and Smith’s Bounds testing approach to analyse their level relationships, we estimated an Autoregressive Distributed Lag (ARDL) model with annual data for the period of 1981 to 2019. We constructed an interaction variable between the level of debt dummy and the interest rate to examine the marginal effect of interest rate under the condition of high debt. The results show that high interest rates, in the presence of a low debt level of the banking system, tends to induce exchange rate appreciation, possibly as capital inflows increase. However, in the presence of a high debt level in the banking system, the reverse effect is found to be the case: higher interest rates tend to induce exchange rate depreciation. This, we argue, could be because investors may be scared away by the fear of bankruptcy in the system. This finding, we argue, underscores the potentially important role of corporate debt level in determining the efficacy of monetary policy for exchange rate stabilisation. It is, therefore, recommended that monetary authorities should keep a close watch on the debt profile of the banking system, making sure it doesn’t reach an alarming level.