2

2009

ECONOMIC ENVIRONMENT OF BUSINESS

TERM PAPER
BY

2008MBA046
Notwithstanding the public policy response to the global economic recession, business performance will continue to deteriorate. Agree or Disagree?

LAGOS BUSINESS SCHOOL 3/19/2009

NOTWITHSTANDING THE PUBLIC POLICY RESPONSE TO THE GLOBAL ECONOMIC RECESSION, BUSINESS PERFORMANCE WILL CONTINUE TO FAIL.DO YOU AGREE?

EXECUTIVE SUMMARY
The global economic recession which started off as a financial crisis was caused by a wave of defaults in U.S sub-prime mortgages by home owners in 2007. The impact, which rapidly impacted upon credit-backed securities led to situations in which banks had to write off large illiquid assets from mid 2007 to 2008 causing the collapse of the international market for mortgage backed securities. Access to credit has reduced as U.S banks tightened their credit standards in the light of the capital erosion. And because the U.S is a credit driven economy, the effect of the financial crisis led to a drastic slowdown in economic activities, weakening consumer demand thus leading companies to embark on massive job cuts. Inter-related markets and countries worldwide have suffered, with some countries coming up with several responses such: creating some form of fiscal stimulus package to bring their economy out of recession i.e. stimulating aggregate demand by injection of fresh capital into companies, and also governments providing lending guarantees to restore liquidity, various central banks have embarked on cutting interest rates and liquidity injections. And it is on this ground that I want to talk about Nigerias policy response to the global recession, we are not going through it but we are feeling its effects. The whole world is NOT in an economic recession, but the major economies of the world are experiencing recessions in their respective domestic economies, 2009 sample projections has shown that U.S.A has a GDP of -1.2%, Japan -1.4%, and Britain -1.7%. Now this is going to have a ripple effect on the economies of

the world. For instance the United States is the biggest buyer of Nigerias crude oil, and right now this country is in a recession. There has been a fall in aggregate demand. This deterioration in the world economy has led to a significant reduction in global oil consumption. The sudden and massive erosion in demand has helped push crude oil inventories up sharply in some key areas close to maximum capacity. This has now led to fall in oil prices. Nigeria has experienced on the average a GDP growth rate of 6.6% in the last 5 years. Aggregate output growth measured by the gross domestic product (GDP) was estimated at 8.2 per cent during the fourth quarter of 2008, compared with 6.0 per cent in the preceding quarter. Also the annual GDP growth rate increased from 6.2% in 2007 to estimated 6.8% in 2008(NBS). The growth was driven by the non-oil sector. However the Federal Government is trying to pursue an expansionary fiscal policy, going by the 7 point policy agenda of the Government the 2009 budget is N-3.1018billion, it is going to have a fiscal deficit of N-836.6 billion. The government intends to finance part of the deficit by way of issuing a $500million naira denominated international bond. This accounts for 8.7% of the total deficit. This means that the government would end up borrowing from the same domestic credit market with firms to fund part of its deficit. This would crowd out credit to the private sector and consequently stifle economic growth. The CBN has also put in place monetary policies such as reducing liquidity ratio from 40% to 30%, reduced the CRR from 2% to 4%. The security and exchange commission has also taken some steps; The SEC, NSE, and all Capital market operators reduced fees by 50%. The NSE reviewed trading rules and regulations: 1% maximum downward limit on daily price.

ECONOMIC ENVIRONMENT OF BUSINESS 2008MBA046

All these policy responses are commendable but they would not stop the further deterioration of business performance, because business performance has been deteriorating before the recession. These responses are more of reactionary responses. The GDP which constitutes a summary index of business operations within an economy tells a tale of failure (decline in real GDP) notwithstanding these myriad of policies both on the fiscal and monetary sides.(See figure 1.1) The analysis tries to establish the relationship between interest rates and inflation rates and how the changes in these rates impact on investments. The analysis also explored the trend of consumption and also showed the role aggregate consumption played in the profitability of firms. On the whole business performance is, has been, and would continue to deteriorate. The government must make sure that it pursues sustainable and realistic long term policies. INTRODUCTION This period of global economic recession has seen governments (even of countries such as Nigeria that are not in recession) putting policies and hedges in place to try to counter the effects of recession, one of which is deterioration and continual failure of business performance. However, in spite of all these measures, which will be shown in the analysis done below, business performance is deteriorating and will continue to deteriorate. The global economic recession started small, only few ever anticipated that it would assume the frightening proportions that it has now assumed. And this has sparked fears and debates among governments ,policy makers, business leaders and economists. But before I go ahead to discuss the main topic heading I would first of all like to shed more light on what a recession is. A recession occurs when there are two successive quarterly declines in gross domestic product (GDP), a measure of the nation's output. This two-quarter metric is now a commonly held definition of a recession. Or more accurately put a recession is a decline in a country's gross domestic product (GDP), or negative real economic growth, for two or more successive quarters of a year. IMF describes it as periods when global growth is less than 3% of total GDP. The current global recession was triggered by the subprime lending crisis in the United States. This crisis was caused by a dramatic rise in mortgage delinquencies and foreclosures and this had major adverse consequences for banks and financial markets around the globe. The whole world is NOT in an economic recession, however the major economies of the world are experiencing recessions in their respective domestic economies, 2009 sample projections has shown that U.S.A has a GDP of -1.2%, Japan -1.4%, and Britain 1.7%. Now this is going to have a ripple effect on the economies of the world. For instance the United States is the biggest buyer of Nigerias crude oil, and right now this country is in a recession. There has been a fall in aggregate demand. This deterioration in the world economy has led to a significant reduction in global oil consumption. The sudden and massive erosion in demand has helped push crude oil inventories up sharply in some key areas close to maximum capacity. This has now led to fall in oil prices. NIGERIAS STORY The financial crisis in the U.S and other Western countries has sparked a recession in these countries, Nigeria has however been insulated from this recession, Nigeria is technically not in a recession, as a matter of fact, Nigeria has experienced on the average a GDP growth rate of 6.6% in the last 5 years. Aggregate output growth measured by the gross domestic product (GDP) was estimated at 8.2 per cent during the fourth quarter of 2008, compared with 6.0 per cent in the preceding quarter. Also the annual GDP growth rate increased from 6.2% in 2007 to

ECONOMIC ENVIRONMENT OF BUSINESS 2008MBA046

estimated 6.8% in 2008(NBS). The GDP growth rate in ted both real and nominal terms is shown in figure 1.1. The growth was driven by the non-oil sector. non Figure 1.1 reserves.

GDP growth rate

50% 40% 30% 20% 10% 0% Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 05 05 06 06 07 07 08 08 Real Growth rate Nominal Growth rate

Figure 1.2 (Source: OPEC Source: OPEC) The figure above shows the trend of global oil prices and shows recent the plunge in oil prices. prices The impact of the recession has not been enough to drive Nigeria into a recession; however it has had the following undesirable impacts on the Nigerian economy: Commodity prices collapsed especially y of oil price and this has led to the devaluation of the naira against western currencies especially the dollar. Capital inflows have been on the decline, hot money otherwise called portfolio money has left the economy in form of capital flight. PUBLIC POLICY RESPONSE Nigeria has put in place some policies to hedge against the effects of the global financial crisis. The government has put in place fiscal, monetary and regulatory policies to hopefully protect Nigerias economy to some extent, from my the challenges and threats that the global economic recession could portend. One major challenge is to build a consensus in conse terms of policy direction, and another major direction challenge in the process of finding solution to the economic crisis. This requires a shift in . terms of the policies we are pursuing and also a the implementation of these policies The policies. Federal Governments interpretation of the macroeconomic variables is key to the formulation and implementation of policy.

But since economies like Nigerias have trade relationships with these countries, they are not totally free from the ongoing recession no lly thanks to globalization and international trade. So this is how it works, Nigerias revenue is gotten principally from the proceeds of oil exports. So the fall in demand for crude oil coupled with the fall in the price are twin ce problems for Nigeria, first of all demand has dropped, then we are now selling at lower ling prices. As at July 2008 oil prices got as high as $147 per barrel today it stands at around $40 per barrel. And the Federal government has approved a budget of N-3.1018 trillion, against 3.1018 a benchmark of $45 per barrel. The budget deficit is N-836.6 billion or 3.02% of GDP. 836.6 GDP However the benchmark was set against high projections of oil revenues. But the trend as it is now is that oil prices have dropped below the benchmark and this poses a problem because this means a higher budget deficit which must be financed. IMPACTS ON THE NIGERIAN ECONOMY The impact of the global recession would be felt in Nigeria, as I have stated earlier, crude oil accounts for 90% of Nigerias foreign exchange earnings. Nigerias revenue has fallen and the expenditure component of the GDP has also dropped. Also, Nigeria has eaten into its foreign earnings and they risk eroding the foreign

ECONOMIC ENVIRONMENT OF BUSINESS 2008MBA046

Policy must strive to balance exchange rate, inflation, interest rate, etc. They are the key variables/parameters. Within this context, we have identified issues relating to the financial sector as particular issues relating to the regulation. Some of the policy responses are: Monetary Policies Reduction of liquidity ratio from 40% to 30%. By doing this, the CBN is trying to ensure that banks hold more money and can give out more money, which should therefore result in increased consumption. The CBN reduced the Cash Reserve Requirement from 4% to 2%. Devaluation of the Naira, that is allowing the Naira to have a free fall against the dollar. CBN switched from wholesale Dutch Auction System to Retail DAS. Reduction of the MPR from 10.25% to 9.75%. Directive to banks that they have the option to restructure margin loans up to 2009 Expanded lending facilities to banks up to 360 days. Stopped Liquidity Mopping-up since September 2008 Introduced expanded discount window facility. Fiscal Policies Withdrawal of $1.5b from excess crude account. Reduction of excise duties. Reduction in salaries for govt officials. Deficit budget of N836.6b. i.e 3.02% of GDP. Increase in tax collection efficiency. Reduction of pump price from N70 to N65 due to fall in the world crude oil prices to reduce energy and transportation costs. Regulatory Policies The SEC, NSE, and all Capital market operators reduced fees by 50% The NSE reviewed trading rules and regulations: 1% maximum downward limit on daily price movements, and 5% on upward movement, this was reversed in October to a 5% change either way. The NSE released a 15% maximum share buy-back rule for companies. These policies have had virtually no impact on the stock market as it remains depressed with the NSE All Share Index (ASI) at an all time low. BUSINESS PERFORMANCE I want to assess business performance by measuring the level of investment, since the level gross capital formation should be directly impacted upon by the level of profit made by them and also by the interest rates of financing their investments. In my analysis I want to see the behavior of investment before the recession so as to ascertain what the trend could possibly be considering the recession. Please refer figure 1.8 in the appendix for gross fixed capital formation). The graph shows that the real Gross Fixed Capital Formation has been on the rise relative to GDP. And since the GDP has been increasing in real terms over the years in question, it would not be out of place to conclude that the Gross Capital Fixed Formation has been increasing over these years. I want to see the relationships and impacts of changes in both interest rates and inflation rates on investment as measured with gross fixed capital formation (using correlation analysis) and which of these drivers of

ECONOMIC ENVIRONMENT OF BUSINESS 2008MBA046

investment is contributing the higher
Correlations GFCF GFCF Pearson Correlation Sig. (2-tailed) N INFLATION Pearson Correlation Sig. (2-tailed) N MLR Pearson Correlation Sig. (2-tailed) N 5 .134 .866 4 -.904
*

And this explains Nigerias growth without development. Another issue is with the maximum lending rate, it has been on the

INFLATION 1 .134 .866 4 1

MLR -.904
*

increase as illustrated in figure 1.9 I used the ase 1.9, maximum lending rate in my analysis because this is the rate at which banks are allowed to hich lend to businesses, the prime rate is not a real indicator because prime lenders are very few.Business performance is hinged on and can Business also be measured by aggregate consumption and investments/gross capital formation. Over the last 5 years aggregate consumption has st
5

.035 5 .219 .781

4 .219 .781 4

4 1

.035 5

been on a decline. The direction of business performance can be inferred from gross consumption statistics (both private and public) and gross investments, however public policies

*. Correlation is significant at the 0.05 level (2-tailed). tailed).

percentage to investment. Using SPSS, the following result is obtained:

Where: GFCF = Gross Fixed Capital F Formation MLR = Maximum Lending Rate
This means that the observed change in e Investment can be strongly explained by the Maximum Lending Rate moving in the opposite g direction and minimally by movement of the inflation rate in the same direction. Investment=0+ 1Inflation + 2Interest rate Looking at the graph in figure 1.8 gross capital oking 1.8, formation as a % of GDP seems to be on the increase, and GDP has also been climbing, but yet businesses are still deteriorating, and unemployment is still on the rise. This is because the investment in Nigeria is speculative; there is no real new investment. l

(both on the fiscal and monetary sides) also exert an overwhelming influence on business performance within a domestic economy.The economy. figures below show the trend of consumption co over the last 5 years. Figure 1.3

Consumption as % of GDP
87 76.2 Series1 75.6 74.3 69.7

2003

2004

2005

2006

2007

ECONOMIC ENVIRONMENT OF BUSINESS 2008MBA046

Figure 1.4 government consumption, however private consumption provides a better reflection of business performances within an economy. (Please see figure 1.7 in the appendix for contribution to private expenditure). The steady fall in aggregate consumption could be accounted for either by an increase in the propensity to save by Nigerians or an increase in the unemployment ratios over this same period. The global economic meltdown suggests the latter. (Please refer to figure 1.6 in the appendix) Inflation erodes the value of capital over time. Levels of high inflation can only be buffered by higher interest rates and this provides a mechanism by which monetary policies can be used to reduce the effects of high inflationary pressures that characterize periods of slow economic growth and recession. Nigeria is currently witnessing a resurgence of high inflation figures (see figure 1.5 in the appendix) without any indications of monetary policies being put in place to buffer this effect. CONCLUSION From the analysis business performance would continue to fail, given the fact that the performance of business has already been declining prior to the recession, and past policies of the Federal Government has failed to address the issues, public policy has more or less gone to sleep for a while. The global recession cannot be wholly blamed for deterioration of business performance; issues with regards to policy formulation, policy implementation strategy must be addressed. The government must also look at the state of public infrastructure. As at now the government is more or less taking a rather reactive stance and approach to policy responses in response to the effects of the global recession.

Private Consumption: % of GDP

100 80 60 40 20 0 81.3 69.5 68.9 67.2 62.3 Series1

2003 2004 2005 2006 2007

And business performance can be explained and measured by aggregate consumption. Consumption is basically people buying goods and services from firms. So if aggregate consumption has reduced, it means that the profitability of firms and businesses has been on the decline. Private consumption which is a truer reflector of consumption in relation to business performance has also fallen. Private consumption is net of government consumption, and this component of consumption is important because not all of governments consumption is serviced by businesses. Recurrent expenditure has been high for a while, but capital expenditure has been low. This means that the government not financing capital projects, it is just running recurrent expenses such as servicing its debt and paying salaries and other things. This is just one point that buttresses the fact that business performance has been deteriorating prior to the global recession which started manifesting itself in 2007. Having established this, it is clear that business performance has already been deteriorating. Two aggregate macroeconomic variables that directly reflect the performance of businesses are consumption and investments. Aggregate consumption is a function of private and

ECONOMIC ENVIRONMENT OF BUSINESS 2008MBA046

ECONOMIC ENVIRONMENT OF BUSINESS 2008MBA046

APPENDIX Sources of Information and data OPEC bulletin Wikipedia The Economist magazine CBN 4th quarterly report of 2008 National bureau of statistics IMF website Guardian newspapers The year 2009 budget report Figure 1.5
30.0 20.0 10.0 0.0 -10.0 May May May Jan-05 May Jan-09 6-Jan 7-Jan 8-Jan Sep Sep Sep Sep

Figure 1.7

120 100 80 60 40 20 0

% of Expenditure

Nigeria: Contribution of Private Demand to Expenditure

1999 2000 2001 2002 2003 2004 2005 2006 2007 - Priv Consumption as % of GDP

Figure 1.8

Inflation rate (Year-on %) Inflation rate (12 Month average) Core Inflation rate (Year-on %) Core Inflation rate (12 month average) 25.00 20.00 15.00 10.00 5.00 0.00

Real Gross Fixed Capital Formation as a % of GDP

23.23 19.58 16.47 13.37 9.47

11.37 12.21 10.99

GFCF

2.16 1.79 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Figure 1.6
10 8 6 4 2 1981 1985 1989 1993 1997 2001 2005 0 -2 -4 - Real Marginal Propensity to Consume(1 990 Basic Price)

Figure 1.9
0.25 0.2 0.15 0.1 0.05 0 Prime Lending rate Maximum Lending rate

Source: CBN

ECONOMIC ENVIRONMENT OF BUSINESS 2008MBA046