THE IMPACT OF EXCHANGE RATE FLUCTUATIONS ON NIGERIAN BALANCE PAYMENTS


THE IMPACT OF EXCHANGE RATE FLUCTUATIONS ON NIGERIAN BALANCE PAYMENTS   

ABSTRACT

Exchange rate refers to the price of one currency (the domestic currency) in terms of another (the foreign currency). Exchange rate plays a key role in international economic transactions because no nation can remain in autarky due to varying factor endowment. Movements in the exchange rate have ripple effects on other economic variables such as interest rate, inflation rate, unemployment, money supply, etc. Through its effects on the volume of imports and exports, exchange rate exerts a powerful influence on a country’s balance of payments position.The problem of the study arises in two forms. Based on the historical perspectives we noticed that Nigerian BOP has been cascading and it was attributed to exchange rate fluctuations and over dependence on oil export.This research is aimed at evaluating how exchange rate fluctuations affect the level of balance of payments in Nigeria for the period under study. Time series data was collated from central bank of Nigeria statistical bulletin for the periods under study and was analyzed using the Linear Regression with the application of Ordinary Least Squares (OLS) technique and the ARCH and GARCH model as a technique to evaluate variable fluctuations. The results showed that there is the presence of fluctuation in exchange rate series in Nigeria. The OLS result showed that exchange rate fluctuation had a negative and significant impact on balance of payments in Nigeria.There was negative and insignificant difference in the effect of exchange rate fluctuations in the fixed era and there was positive and insignificant difference in effect of exchange rate during flexible era on balance of payments in Nigeria. The result reveals that Inflation had a positive and insignificant impact on balance of payments and Interest rates had negative and insignificant impact on balance of payments in Nigeria. It is therefore the recommendation of this paper that the monetary authorities should employ every monetary tool to minimize the level of exchange rate fluctuations in the economy and the policy of exchange rate flexibility should be maintained but with government intervention guide.

TABLE OF CONTENTS

Title Page - - - - - - - - - - i

Certification - - - - - - - - - - ii

Approval Page- - - - - - - - - - iii

Dedication - - - - - - - - - - iv

Acknowledgements - - - - - - - - - v

Abstract - - - - - - - - - - vi

Table of contents - - - - - - - - - vii

List of Figure - - - - - - - - - - x

List of Tables - - - - - - - - - - x

CHAPTER ONE: INTRODUCTION

Background of the Study-------1

Statement of the Problem-------3

Objectives of the Study-------4

Research Questions--------4

Hypothesis of the Study-------4

Significance of the Study-------5

Scope of the Study---------6

Operational Definition of Terms------6

References - - - - - - - - - 8

CHAPTER TWO: REVIEW OF RELATED LITERATURE

------9

- - - - - - 9

- - - - - - 10

- -- - - - - 11

- - - - -- - 11

- - - - - - 12

Conceptual Framework -

The Concept of Balance of Payment

The Concept of Interest Rate-

The Concept of Exchange Rate -

The Concept of Inflation--

Theoretical Review--

Optimal Currency Area (OCA) Theory-----12

Purchasing Power Parity Theory------13

Theory of Exchange rate, Exchange rate Fluctuations and Balance of Payments13

Types of Exchange Rate Regimes------14

Exchange Rate Management before the SAP (Fixed regime)--15

Exchange Rate Management since the SAP (Flexible regime)--16

Foreign Exchange Market (FEM)------18

Completely Deregulated Exchange Rate System----18

Reintroduction of the Fixed Exchange Rate System ----19

Balance of payment--------27

The Elasticity Approach-------33

The Absorption Approach-------34

The Monetary Approach-------34

Empirical Review--------36

Balance of Trade/payment flow and Exchange Rate Volatility inNigeria; a Trend Analysis

- - - - - - - - - - 36

Exchange Rate Fluctuations and the Balance of Payment:

Channels of Interaction in Developing and Developed Countries - - 38

Intertemporal Balance, Sustainability and Efficiency of the Exchange Rate Mechanism---------41

The Balance of Payment Constrained Growth Model---42

Foreign Trade Constraint and Cyclical Development ---44

Effect of Exchange Rate Reforms on the Trade Balance of Nigeria --44

Brief Overview of Exchange Rate Policy in Nigeria ----49

Some Prior Studies--------50

Review Summary--------67

References - - - - - - - - - 69

CHAPTER THREE:METHODOLOGY

3.1 Research Design - - - - - - - - 82

3.2 Sources of Data - - - - - - - - 82

3.3 Model Specification - - - - - - - - 82

3.4 Description of Variables - - - - - - - 85

3.5 Technique of Analysis - - - - - - - 86

References - - - - - - - - - 89

CHAPTER FOUR

Presentation and Analysis of Data------90

Descriptive Analysis of The Variables 1970 – 2012 ----90

Graphical Analysis of Variables------91

Test of Hypotheses--------92

Test of Hypothesis One-------92

Test of Hypothesis Two-------94

Test of Hypothesis Three-------96

Implications of the Results-------99

CHAPTER FIVE: SUMMARY, CONCLUSION AND RECOMMENDATIONS

5.1 Summary of Findings- - - - - - - - 100

5.2 Conclusion - - - - - - - - - 100

Recommendations--------101

Area for further study --------101

Contribution to knowledge.-------101

Appendices - - - - - - - - - 103

Bibliography - - - - - - - - - 110

List of Tables

Fig 4.1.2 Graphical Analysis of the data 1970 – 2012 - - - - 103

List of Figure

Exchange rate unit root test - - - - - - - - 104

Balance of payments unit root test - - - - - - - 105

Inflation unit root test - - - - - - - - - 106

Interest rate unit root test - - - - - - - - 107

Cointegration test of the variables using the engel-granger approach. - - 108

Data used in the analysis - - - - - - - - 109

CHAPTER ONE

INTRODUCTION

BACKGROUND OF THE STUDY

In an ordinary parlance, Exchange rate refers to the price of one currency (the domestic currency) in terms of another (the foreign currency). Exchange rate plays a key role in international economic transactions because no nation can remain in autarky due to varying factor endowment. Movements in the exchange rate have ripple effects on other economic variables such as interest rate, inflation rate, unemployment, money supply, etc. These facts underscore the importance of exchange rate to the economic well-being of every country that opens its doors to international trade in goods and services. The importance of exchange rate derives from the fact that it connects the price systems of two different countries making it possible for international trade to make direct comparison of traded goods. In other words, it links domestic prices with international prices. Through its effects on the volume of imports and exports, exchange rate exerts a powerful influence on a country’s balance of payments position.

Consequently, nations in the pursuit of the macroeconomic goals of healthy external balances as reflected in their balance of payments (BOP) position, find it imperative to enunciate an exchange rate policy.

Nigeria has practiced both fixed and flexible exchange rate polices. From the period of 1967 through to 1970, Nigeria experienced a civil war. This adversely affected the fixed exchange rate regime which was in place at the time. The fixed exchange rate regime was accompanied by strict controls and regulations which ultimately resulted in the overvaluation of the exchange rate. This had negative implications for the economy as it encouraged the importation of finished goods which created more competition for the domestic producers.

Besides, the balance of payments position and the country’s external reserves level were both compromised by the overvalued exchange rate (Sanusi, 2004, Sanni, 2006). In 1980 Nigeria was an oil-exporting country faced with high capital inflows which resulted in the appreciation of the naira. The oil boom came to an end by 1983 and the prevailing currency appreciation distorted the growth of the economy. In 1986, Nigeria implemented the IMF-World Bank imposed Structural Adjustment Program (SAP) which emphasised a market oriented approach to exchange rate determination (Mordi, 2006). However, the exchange rate depreciated throughout the 1980s. This decision was informed by the compromised balance of payments position as well as the country’s declining external reserves level. Both the nominal and the real exchange rate were depreciated so as to align them to their equilibrium levels (Obadan, 1994; Mordi, 2006).

The institutional agenda in place in 1986 was the Second-Tier Foreign Exchange Market (SFEM). The objective of the SFEM was to attain a realistic exchange rate through a series of exchange rate devaluations. SFEM implemented a dual exchange rate system and in 1987, the two rates merged at the rate of 3.74 Naira-US$ for one US dollar. A Dutch Auction System (DAS) was introduced in 1987 in order to improve the level of efficiency in the bidding system. The SFEM and DAS were then replaced by the Foreign Exchange Market (FEM) before in 1987 in an attempt to reduce the replications in the Nigerian exchange rate system, as well as ensure the depreciation of the Nigerian Naira. In 1989, the Bureau de change and the Inter-bank Foreign Exchange Market (IFEM) were initiated in order to cater for the needs of small end- users (Obadan, 1994). In 1990, the IFEM was re-organized to accommodate the re-enunciation

of the DAS. The reduction in arbitrage opportunities in the oil marketing sectors combined with stronger controls in foreign exchange practices led to a noticeable moderation in foreign exchange net demand (Obadan, 2006). The volatility in the official rates, however, was limited with the coefficient of variation being 1.28 per cent for the year as a whole compared to 0.32 per cent in 2010. From 1992 to 1993 the exchange rate system in Nigeria was deregulated and this was further enhanced by realigning the official exchange rate with the exchange rate in the parallel market (Ogiogio, 1996). In 1994 the Autonomous Foreign Exchange Market (AFEM) replaced the IFEM to ensure that foreign exchange rate was sold at a market determined price, by authorized dealers. Although the exchange rate became relatively stable in the mid-1990s, the exchange rate was further depreciated and at the close of 1995, the Naira-US$ exchange rate became eighty-two Naira in the autonomous part of the market. This however widened the gap between the parallel and official exchange rate (Odusola, 2006). The further devaluation of the Naira fostered a (Mordi, 2006, Obadna, 2006, Odusola, 2006).

Based on the above historical profile analysis, one can see that the level of exchange rate in Nigeria has been experiencing significant interventions as a result of its nature of volatility and fluctuations, thus this research will be focused on analyzing the impact of exchange rate fluctuations on balance of payments in Nigeria covering the period 1970-2012.

Statement of the Problem

The position of international trade reflected in its balance of payments is considered and has been attributed as one of the major determinants of a country’s level of economic growth and development. This entails that based on a simple transmission mechanism; a favourable balance of payment has the prospect of increasing the national productivity of an economy and an unfavourable balance is expected to produce the opposite.

The Nigeria balance of payments/trade has been cascading which could be attributed to its dependence on oil exports and exchange rate fluctuations (CBN, 2009). The dependence of Nigeria on crude oil exports had important implications for the Nigerian economy since the oil market is a highly volatile one. For example, being dependent on the export of crude oil, the

Nigerian economy became subject to the vicissitudes and vagaries of the international oil market such that international oil price shocks were immediately felt in the domestic economy. Coupled with this, Nigeria implemented a fixed exchange rate system that engendered overvaluation of the domestic currency, serving as a disincentive for increased exports through non- competitiveness of the country’s non-oil exports. On the other hand, the overvalued exchange rate enhanced imports thereby exacerbating the already precarious balance of payment position.

The level of exchange rate remained volatile and exposed the economy to further deterioration during the 1970’s and 1980’s until 1986 when a comprehensive economic adjustment programme was put in place to restructure the economy. Exchange rate reform was a major component of this economic reform agenda that was further intensified under the Nigerian Economic Empowerment and Development Strategy (NEEDS). The goal of exchange rate reform is to systematically attain an appropriate value for the Nigerian currency that would serve as a major incentive for exports but disincentive for increased imports hence boosting the position of the balance of payments to favorable heights.

Habib Ahemed and et al, (2011) in this study analyses the impact of exchange rate on macroeconomic aggregates in Nigeria. Based on the annual time series data for the period 1970 - 2009. This study however fills gaps discovered in the above existing empirical literatures. Firstly, a critical review of the above literature reveals that they focused mostly on exchange rate as a given variable without taking into cognizance the fluctuating status of exchange rate which is an inherent factor in exchange rate. This research thus creates a point of departure via estimating the impact of exchange rate fluctuations on balance of payments in Nigeria 1970 - 2012.

Objectives of the Study

On a broad perspective, this research is aimed at evaluating how exchange rate fluctuations affect the level of balance of payments in Nigeria for the period under study. In line with this, the specific objectives were to:

1. analyze the impact of exchange rate fluctuations on balance of payments in Nigeria.

2. analyze the effect of exchange rate fluctuations during the fixed and flexible eras on balance of payments in Nigeria.

3. determine the effect of exchange rate accompanying variables [Inflation and Interest Rates] on balance of payments in Nigeria.

Research Questions

In response to the objectives of this study, the following research questions which will be addressed pilots the study

1. To what extent has exchange rate fluctuations affected the balance of payments in Nigeria?

2. Is there any significant difference between the impact of exchange rate fluctuations during the fixed and flexible regime on balance of payments in Nigeria?

3. To what extent has inflation and interest rates as exchange rate accompanying variables affected the level of balance of payments in Nigeria?

Hypothesis of the Study

In the course of this research, the following hypotheses will be tested

Ho: Exchange Rate fluctuations had no positive and significant impact on balance of payments in Nigeria during the period 1970 - 2012

Ho: There is no positive and significant difference in the effect of exchange rate fluctuations in the fixed and flexible era on balance of payments in Nigeria.

Ho: Inflation and Interest rates had no positive and significant impact on balance of payments in Nigeria.

Significance of the Study

Generally, the research draws its relevance from the present and prospective beneficiaries and its contribution(s) to academia at large. The pertinence of this research is justified on the ground that it will show the impact of exchange rate fluctuations on the balance of payments in Nigeria

for the years under review; and thus provides a framework for policy prescriptions and interventions.

In furtherance to the above, the research will be of significance to the following:

The Banking Sector: as exchange rate is a pure financial variable, the banking sector will find this research relevant given that it will provide a clear information on the extent to which exchange rate has affected the balance of payments in Nigeria.

Government: The federal government will find this study highly relevant as it will provide a picture of the relative impact of exchange rate fluctuations on balance of payments and thus motivate relevant policy reforms or sustenance. This research will also find its relevance in the coffers of financial variable analysts given that the subject under study is purely a monetary phenomenon.

Subsequent Analysts: This investigation will also serve as a stepping stone for researchers who develop interest in carrying an empirical analysis on the concept of exchange and balance of payments.

Scholars: Students will find this piece highly relevant as it will undeniably increase their knowledge and horizon on the concept of exchange rate and its relationship with balance of payments.

The Academia: The education sector is also considered as one of the significant beneficiaries because it is believed that this research will be an addition to the existing stock of knowledge.

Scope of the Study

The scope of this research is primarily focused on analyzing the impact of exchange rate fluctuations on balance of payments in Nigeria ranging from 1970-2012. This scope is chosen because it is believed to have covered the periods of fixed and flexible exchange rate periods and is large enough for statistical analysis. The scope is justified with following economic activities. The 1962 – 1968 First National Development plan, the oil boom era of 1971 -1977. These

economic activities covered the fixed exchange rate regime. Therefore, structural adjustment programme of 1986 justifies the flexible exchange rate regime.

The variable-Scope for this research is limited to the inclusion of Exchange rate figures, interest rates, inflation rates and time series data representing the level of balance of payments for the years stated above.

Operational Definition of Terms

In the course of this work the researcher used certain terms, which are purely related to the topic under-study. These terms are explained below to make the work comprehensive.

1. OCA: Optimal currency area is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency.

2. SFEM: Second – tier foreign exchange market is a market determined exchange rate policy. That means forces in market determine the trading of currencies.

3. IFEM: Inter – bank foreign exchange market, it was a daily bidding system under which the central bank injected official fund into the market as and when funds were available.

4. DAS: Dutch auction system, it entails the payment by an authorized dealer of the exchange rate that bids for foreign currency unlike where all dealers paid a central determined rate by the central bank of Nigeria.

5. Depreciation: This is a situation whereby a given unit of a currency buys a less quantity of other currency than it originally does.

6. Appreciation: This is the opposite of depreciation it is a situation whereby a given unit of a currency buys more quantity of a given unit of another currency

7. Evaluation Control: Is a country’s external reserve and financial assets available to the monetary authority to meet temporary imbalance in the external payment position

8. Bureau De Changes: A place for exchanging currency. An office or part of a bank where foreign currency is exchanged

9. Black Market: These are unorganized foreign exchange market, where exchange activities are carried out without the control or regulation of monetary authority

10. Under-Valuation: Is a situation where a country’s currency is valued below the real value when compared with other currencies. That is, it is exchange at a ratio below its actual value.

11. Over-Valuation: Is a situation where a country’s currency is valued higher than its real value when it is measured with other curr3encies.

REFERENCES

Mordi, N. O. (2006). Challenges of Exchange Rate Volatility in Economic Management in Nigeria. In The Dynamics of Exchange Rate in Nigeria: CBN Bullion, Vol. 30, No. 3, pp. 17-25.

Obadan, M I & I. Ihimodu (1980). Balance of Payments Policies under the Military in Nigeria: Nigerian Economic Society Annual Conference

Obadan, M. I. (1994). Real Exchange Rates in Nigeria: National Center for Economic Management and Administration, Ibadan

Obadan, M. I. (2006). Overview of Exchange Rate Management in Nigeria from 1986 to Date, In The Dynamics of Exchange Rate in Nigeria: Central Bank of Nigeria Bullion, Vol. 30, No. 3, pp. 1-9.

Ogiogio, T. M. (1996). Impact of External Sector Policies on Nigeria’s Economic Development:

Central Bank of Nigeria Economic and Financial Review, Vol 34, No 4, December.

Olayide S.O. (1969). Import Demand Model: An Econometrics Analysis of Nigeria’s Import Trade: The Nigerian Journal of Economics and Social Studies, 10: 13-26.

Olisadebe, E.U. (1991).An appraisal of recent exchange rate policy measure in Nigeria: CBN Economic and Financial Review, Vol. 29, No 2.

Sanni, H. T. (2006). The Challenges of Sustainability of the Current Exchange Rate Regime in Nigeria. In The Dynamics of Exchange Rate in Nigeria: Central Bank of Nigeria Bullion, Vol. 30, No. 3, pp. 26-37.

Sodestine, B.O. (1998). International Finance, London: Macmillian Educ. Ltd. 2nd ed.

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THE IMPACT OF EXCHANGE RATE FLUCTUATIONS ON NIGERIAN BALANCE PAYMENTS



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