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Thursday, June 13, 2024

Does inflation hamper domestic credit to private sector in Ghana?

One of the major concerns of policymakers in developing countries is to control inflation rates, which are highly disturbing for all sectors economy.

In an inflationary environment, households and company`s really finds it difficult to make adequate investment decisions due to the presences of inflation which reduces planning period as well as damages confidence.

In developing economies where financial systems are predominantly bank-based, banks operations result in the channeling of funds from surplus units to deficit units for productive purposes in a cost-effective, well-structured manner.  Irony is that, as a business grows, it requires more capital to fund its operational activities.

However, many companies find it difficult to arrange short-term or medium-to-long term capital for such purposes. Not only do corporate clients find it difficult to raise funds of various forms, but also the decision to settle for debt or equity financing presents serious challenges (Boako et al, 2017).

It is also noted by various theoretical and empirical studies that excessive inflation could sabotage the efficiency of financial intermediaries in providing these services, which is likely to be the case in Ghana too. The trade-off theory of capital structure recognizes that firms want to enjoy the benefits of lower costs of borrowing (Myers, 1977).

From this, it is expected that firms enjoying high profits create additional debt-servicing capacity and have more taxable income to shield and therefore operate on higher borrowing levels.

An alternative view to the trade-off theory is the pecking order theory, which argues that most clients prefer to employ internal financing (operational cash flow); and where external financing is required, preference is given to debt over equity

The case of Ghana is interesting to study. The financial sector over the past decade has seen appreciable number of new entrants coupled with an improvement in performance.

However, this improvement does not translate into higher credit. Availability of domestic credit to private sector has remained a serious constraint in Ghana.

For instance, domestic credit provided to the private sector as a share of GDP declined from 15.8% in 2008 to 15.5% in 2009. It further declined from the 15.5% to 14.3% in 2011 down from 14.5% in 2010.

Again, Credit to Private Sector by Banks was reported at 16.043 % in Dec 2017 which saw a decrease from the previous number of 18.564 % for Dec 2016.

The effect of inflation is usually underemphasized by researchers and policy maker’s alike. Despite the volatile inflation in Ghana, the specific connection between inflation and private credit remained blurry due to lack of adequate and conclusive evidence.

We spent some time to examine both the short and long run dynamic relationships between inflation and domestic credit to the private sector in Ghana, by specifically focusing on the following gaps in literature:
(i) Examining the impact of inflation on domestic credit to the private sector in Ghana, and also
(ii) Examining whether gross national savings has effect on domestic credit to the private sector in Ghana.

Indeed, to answer the main objective of the study, we used annual time series data covering the period 1980 to 2018, it adopted empirical models used by Boako et al (2017), Adugna (2019) and also based on theoretical reviews (McKinnon1973, Shaw 1973), the study included some control variables (exchange rate, gross national savings and lending rate) to generate a baseline line model as shown below;

…. (1.1) Where DCPS is the domestic credit to private sector while the regressor’s variables were Gross National Saving (GNS) and Inflation (INF). Additionally, lending rate (LRt), real exchange ratewere included.

Autoregressive Distributed Lagged (ARDL) Model
Our study adopted the ARDL model in assessing the impact inflation has on domestic credit to private sector in Ghana. The ARDL estimating technique was chosen because it is applicable to a set of time series that are integrated of both orders one and zero, thus I(1) and I(0). The ARDL model is specified as; (1.2)

After ascertaining the presence of both I(0) and I(1) integration in the unit root test among the variables, ARDL became the ideal model employed for this study. The Table 1.1 presents the result of the Long Run estimates of the study.

Variable Coefficient Std. Error t-Statistic Prob.
INF -0.014070 0.006032 -2.332565 0.0263
LR -0.003435 0.024526 -0.140070 0.0462
GNS  0.045102 0.053010  0.850822 0.4014
EXR -0.316944 0.416518 -0.760937 0.4524
C 0.554110 0.358058 1.547544 0.1319
 Table 1.1 ARDL long run coefficients

From Table 1.1, the p-value indicates that inflation had a significant impact on domestic credit to the private sector in Ghana in the Long run. The inflationary trend in Ghana could have a formidable effect on domestic credit availability to private sector.

In the Ghanaian context, one important transmission channel could be via reduced savings and weaken mobilization of deposit. It could also reduce the real saving over time thereby undermining mobilization of loanable funds.

With regard to the diminishing purchasing power of individuals, high inflation reduces the disposal income of Ghanaians which decrease their consumption and saving abilities. This confirms theoretical suggestion that an increase in inflation rate brings about macroeconomic unsteadiness and therefore will discourage financial institutions to make credit available to the private sector. 

According to the theory of the ‘paradox of thrift’, depositors begin to realize reductions in their holdings because the interest income does not commensurate earnings they could get from alternative productive capital investments, ceteris paribus.

Subsequently, depositors recall their deposits and this has the effect of reducing the size of loanable funds available to banks to issue as credit to the private sector.

Additionally, the p-value of the lending rate indicates that lending rate had a negative significant impact on domestic credit to the private sector in Ghana is in inconsistent with Sharma and Gounder (2012) and Amidu (2014). Specifically, a 1% increase in the lending rate will lead to a 0.003% decrease in the domestic credit to the private sector in the long run.

When the monetary policy rate rises, financial institutions respond to it and also increase its lending rate, banks release huge volumes of loanable funds in anticipation of higher earnings through interest on loans.

Businesses will quickly yield to the call by the financial house, sometimes without considering the cost the loan just because businesses are always in search of funds to fuel their projects.

Due to the high lending rates it becomes difficult for businesses to honor the debt obligations and in order to reduce the volumes of non-performing loans, banks decrease their supply of credit to businesses, hence the negative effect of lending rate on credit to the private sector in Ghana in the long run.

In fact, this theory was developed by Ghosh in 1999  and the theory  indicate that lenders usually consider prevailing interest rates and availability of collateral or substitutes for collaterals to decide on the amount of credit they give out as loans to borrowers. Thus, decision making by lenders to either lend or not to lend is conditional on the kind of surety the borrowers present to them.

To avoid riskier investment and the chances of the borrowers not fulfilling their credit obligations, lenders give out loans at low interest rates. The provision of loans based on other alternatives to collateral provides borrowers with an avenue of defaulting from repaying their loans since their relationship with the lender is not as strong when collateral is involved.

The credit rationing theory suggests that interest rate is very significant in determining the amount a financial institution will be willing to lend and determine the ability of the borrower to repay the loan.  Ghosh (1999) stressed further that, if banks grants loan to customers by considering only collateral and not the cash flows of borrowers then banks are likely to record high non-performing loans especially when the value of such collaterals are impaired and amount to be realized from the sale of the assets are insufficient to pay off the loan in the invent of default by borrowers. This development usually contributes to high non-performing loans in banks.

Furthermore, gross national saving had a positive long run influence on domestic credit to private sector at 5% level of significance. The outcome shows that, a 1% increase in gross national savings will lead to 0.045% increase in domestic credit to the private sector in Ghana. Saving is believed to directly raise the level of deposit and improve the availability of credit in an economy.

Gross national savings had no significant impact on domestic credit to the private sector because over 7 million Ghanaians are still without a bank account or mobile money account (World Bank report, “Gains in Financial Inclusion”).

The unbanked population may not significantly contribute to the economy since financial inclusion is an important factor in economic development in Ghana. Gross national saving exerts insignificant impact on domestic credit to the private sector maybe due a greater portion of the available savings have been channeled towards government projects in Ghana, which might have dwindled domestic credit to private sectors. 

ARDL Short Run Estimates
Our study further tests for the short-run estimates for the variables and the result is presented in Table1.2

Variable Coefficient Std. Error t-Statistic Prob.
D(INF) -0.016618 0.005477 -3.034207 0.0048
D(DLR) -0.004058 0.028929 -0.140265 0.0029
D(DGNS)  0.053273 0.059248  0.899144 0.3755
D(DEXR) -0.374360 0.486733 -0.769128 0.4476
CointEq(-1) -0.811356 0.121154 -6.696891 0.0000
                      Table 1.2 ARDL short run coefficients 

The results of both Table 1.1 and Table 1.2 show some commonalities in the short-run and long-run. For example, from the short run dynamic results, lending rate and inflation rate had a negative significant impact on domestic credit to the private sector in Ghana. The outcome renders the positive effect of gross national saving on domestic credit to the private sector ineffective in Ghana.

Given that gross national saving exerts insignificant injurious impact on domestic credit to the private sector, greater portions of the available savings have been channeled towards government projects in Ghana, which might have dwindled domestic credit to private sectors. The result of the Error Correction Model (ECM) indicates an adjustment to the equilibrium state after a shock. It implies that the short run deviations converge fairly quickly to long run equilibrium at the rate of 81.1% per year in Ghana. 

Policy suggestions and recommendations

Our study recommends that a reasonable reduction in government’s domestic borrowing, lower cost of borrowing, and lower central bank reserve requirements for commercial banks in Ghana are needed to stimulate higher credit demand. Thus, to ensure adequate and sustainable growth of domestic credit to the private sector in Ghana, measures such as controlling the level and volatility of inflation, and promoting financial services like saving are highly recommendable.

Secondly, comprehensive policy direction towards improving financial access to the large unbanked informal sector as in the case of mobile money. This would make the floating funds (currency outside banks) available to the private sector to facilitate long term capital investment and also enhance their business operations. As implied by the literature, a stable macroeconomic environment is a fundamental prerequisite for a strong financial sector.

Disclaimer: The views expressed are personal views and doesn’t represent that of the media house or institution the writer work for.

About the researchers

Carl Odame-Gyenti is a final year PhD (Financial Management) candidate, a Finance and Telecom enthusiast, managing local and global Investors, Intermediaries, Banks and Non-Bank Financial Institution relationships with an International Bank in Ghana. Contact: 

Edmund Obeng Amaning is a researcher and holds a Master’s degree in Economics. Currently a student at Chartered Institute of Bankers. His research interest includes Monetary Economics, Public Finance and Energy.

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