IMPACT OF FOREIGN EXCHANGE RATE FLUCTUATIONS ON MAJOR MACROECONOMIC VARIABLES IN NIGERIA (1987-2011)

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IMPACT OF FOREIGN EXCHANGE RATE FLUCTUATIONS ON MAJOR MACROECONOMIC VARIABLES IN NIGERIA (1987-2011)

ABSTRACT

Foreign exchange volatility affects the performance of macroeconomic indicators positively and negatively. Most import-dependent economies like Nigeria face the problem of foreign exchange rate volatility. Nigeria’s over dependence in the oil and gas sector of the economy has affected the major macro economic variables, and adverse foreign exchange rate regimes have affected the Nigerian economy over the years. Nigeria’s major foreign earning is from oil; hence, volatility of crude oil prices in the world market has made the economy highly susceptible to the ever changing exchange rates. Nigeria’s failure to diversify its economy which would have helped cushion the effect of the constant changes in oil prices has made the country susceptible to fluctuations in exchange rate. This has had a heavy toll on our foreign reserves and invariably on our balance of trade and balance of payment. A proper foreign exchange rate management in many ways strives to balance the level of imports with that of exports of goods that the country has comparative advantage. Such balance is necessary for an economy to develop to levels beyond subsistence. However, lack of government support for the real sector of the Nigerian economy as a result of its focus on foreign exchange earned from oil has also contributed immensely to the abysmal performance of the all other sectors especially the manufacturing sector. Manufacturers, who account for substantial contributions to Nigeria’s gross domestic product before now have been unable to produce, hence fewer jobs, are created. The Nigerian economy is in dire need of effective foreign exchange rate management that will aid its diversification, break the dominance of the oil sector, and give more opportunities to other sectors of the economy such as the manufacturing, agriculture, solid mineral mining etc and ultimately improve its balance of payment. It is against this background that this study sought to examine the impact exchange rate fluctuations on economic growth, balance of payment position, consumer price stability, and foreign private investment in Nigeria. The study adopted the ex-post facto research design. Annual time series data for 25-years were collated from Central Bank of Nigeria – Statistical bulletin, for the period, 1987-2011. Four major hypotheses were formulated and tested using the 2Stage Least Square (2SLS) estimation. Gross domestic product (GDP), balance of payment (BOP) consumer price index (CPI) and foreign private investment (FPI) were used as the independent variables while exchange rate (EXR) was the dependent variable for the four hypotheses respectively. Export rate (EXPR) and Import rate (IMPR) were introduced as control variables. The results reveal that exchange rate fluctuations had a positive and non-significant impact on Nigeria’s gross domestic product growth rate (coefficient of EXR = 0.033, t-value = 1.327); Exchange rate fluctuations had positive and non-significant impact on Nigeria’s balance of payment (coefficient of EXR = 0.005, t-value = 1.449); Exchange rate fluctuations had negative and significant impact on Nigeria’s consumer price index (coefficient of EXR = -0.411, t-value = -3.554); and Exchange rate fluctuations had positive and significant impact on Nigeria’s foreign private investment (coefficient of EXR = 0.007, t-value = 5.906). This study contributes to literature by modifying Serven and Soilmano (1992) model, by including in-flow channel of foreign exchange (export rate) and outflow of foreign exchange (import rate) into the model. Thus, the study therefore, recommends amongst others, that an aggressive expansion of the Nigerian economy especially investment in the real sectors of the Nigerian economy will obviously lead to less dependence on oil revenue which is determined by fluctuations in exchange rate prices.

TABLE OF CONTENTS

Title page . . . . . . . i

Declaration . . . . . . . ii

Approval page . . . . . . . iii

Dedication . . . . . . . iv

Acknowledgments . . . . . . . v

Abstract . . . . . . . vi

Table of Contents . . . . . . . vii

List of Tables . . . . . . . x

List of Figures . . . . . . . ix

CHAPTER ONE INTRODUCTION. . . . . . 1

1.1 Background of the Study. . . . . . 1

1.2 Statement of the Problem. . . . . . 5

1.3 Objectives of the Study. . . . . . . 7

1.4 Research Questions. . . . . . . . 7

1.5 Research Hypotheses. . . . . . 7

1.6 Scope of the Study. . . . . . . . 8

1.7 Significance of the Study. . . . . . . 8

References. . . . . . . . . . 10

CHAPTER TWO REVIEW OF RELATED LITERATURE. . 12

2.1 Theoretical Framework. . . . . . 12

2.1.1 Definition of Exchange Rate. . . . . . . 12

2.1.2 Overview of Exchange Rate Policies. . . . 13

2.1.3 Foreign Exchange Management in Nigeria. . . . 16

2.1.4 Types of Exchange Rate Policies. . . . . 18

2.1.5 Flexible Exchange Rate Policy. . . . . . 18

2.1.6 Fixed Exchange Rate Policy. . . . . . . 21

2.1.7 The Concept of Exchange Rate Fluctuations. . . 22

2.1.8 Determinants of Exchange Rate Regimes. . . . 24

2.1.9 Central Bank Intervention and Exchange Rate Fluctuations. 30

2.1.10 Monetary Policy and Macro-Economic Stabilization. . 36

2.1.11 Foreign Exchange Rate Management and Transmission Mechanism. . 37

2.1.12 Exchange Rate Regimes and Fluctuations. . . 39

2.1.13 Real Exchange Rate and Measurement. . . 42

2.1.14 The Parallel Market and Economic Performance. . 43

2.2 Empirical Review. . . . . . . 49

2.2.1 Exchange Rate and Economic Growth. . . 49

2.2.2 Exchange Rate and Balance of Payment. . . 52

2.2.3 Exchange Rate and Inflation. . . . . . 57

2.2.4 Exchange Rate and Foreign Direct Investment. . 62

2.2.5 Exchange Rate and Investment. . . . 68

2.2.6 Exchange Rate Fluctuations and International Trade. 69

2.2.7 Exchange Rate and Export. . . . . 74

2.2.8 Exchange Rate and Import. . . . . . 76

2.2.9 Exchange Rate and Macroeconomic Fundamentals. . . 77

2.2.10 Exchange Rate and Macroeconomic Performance. . . 82

2.2.11 Foreign Exchange Market and Globalization. . 83

2.2.12 Exchange Rate Systems and Economic Fluctuations. . 85

2.2.13 Exchange Rate and Investment. . . . . 87

2.2.14 Foreign Exchange Rate and Interest Rate. . . . 88

2.3 Review Summary. . . . . . . 91

References. . . . . . . . . . 92

CHAPTER THREE RESEARCH METHODOLOGY. . . . . 115

3.1 Research Design. . . . . . . 115

3.2 Nature and Sources of Data. . . . . 115

3.3 Model Specification. . . . . . . 116

3.3.1 Model. . . . . . . . . 116

3.3.2 Assumptions. . . . . . . . . 117

3.4 Description of Variables. . . . . . 118

3.4.1 Dependent Variables. . . . . . . 118

3.4.2 Independent Variable. . . . . . 119

3.4.3 Control Variables. . . . . . . 120

3.5 Techniques of Analysis. . . . . . . 122

References. . . . . . . . . . 123

CHAPTER FOUR PRESENTATION AND ANALYSIS OF DATA. 125

4.1 Presentation of Data. . . . . . . 125

4.1.1 Prelude. . . . . . . . . 125

4.2 Test of Hypotheses. . . . . . . . 139

4.2.1 Test of Hypothesis One . . . . . 139

4.2.2 Test of Hypothesis Two. . . . . . 140

4.2.3 Test of Hypothesis Three. . . . . . 141

4.2.4 Test of Hypothesis Four. . . . . . 142

4.3 Implication of Results. . . . . . 143

References. . . . . . . . . . 148

CHAPTER FIVE SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS. . . . 150

5.1 Summary of Findings. . . . . . 150

5.2 Conclusion. . . . . . . . 150

5.3 Recommendations. . . . . . . 152

5.4 Contribution to Knowledge. .. . . . . 153

5.5 Recommendations for Further Studies. . . 153

Bibliography. . . . . . . . . . 154

LIST OF TABLES

Table 4.1 Exchange Rate and Economic Growth Indicator (1987-2011). 125

Table 4.2 Exchange Rate and Balance of Payment Indicator (1987-2011). 128

Table 4.3 Exchange Rate and Price Stability (1987-2011). . . 133

Table 4.4 Exchange Rate and Foreign Private Investment from 1987-2011. 136

Table 4.5 Control Variables (Import and Export) 1987-2011. 136

Table 4.6 Regression Result for Hypothesis One. . . 140

Table 4.7 Regression Results of Hypothesis Two. . . . 140

Table 4.8 Regression Results for Hypothesis Three. . . 142

Table 4.9 Regression Results of Hypothesis Four. . . 145

LIST OF FIGURES

Figure 4.1 Exchange Rate and Gross Domestic Product Growth Rate (1987-2011). . 127

Figure 4.2 Nigeria’s Gross Domestic Product Trend from 1987-2011. . 127

Figure 4.3 Exchange Rates and Balance of Payment per GDP. 130

Figure 4.4 Nigeria’s Balance of Payment Position from 1987 to 2011. 131

Figure 4.5 Trend of Exchange rate and Consumer Price Indices from 1987-2011. . 133

Figure 4.6 Trend of Exchange Rate and Ratio of Foreign Private Investment to GDP 1987- 2011. . . . . . 133

Figure 4.7 Quantum of Foreign Private Investment in Nigeria 1987-2011. 135

Figure 4.8 Export and Import in Nigeria from 1987-2011. . 136

Figure 4.9 Export Rate and Import Rate in Nigeria from 1987-2011. 138

CHAPTER ONE

INTRODUCTION

BACKGROUND OF THE STUDY

There is scarcely any country that lives in absolute isolation in this globalised world. The economies of all the countries of the world are linked directly or indirectly through asset or/and goods markets, made possible through trade and foreign exchange. The price of foreign currencies in terms of a local currency is therefore important to understanding of the growth pattern of economies of the world.

The history of exchange rate systems in Nigeria is traceable to the early 1960s. According to Bakare (2011:3), …before the establishment of the Central Bank of Nigeria in 1958 and the enactment of the Exchange Control Act of 1962, foreign exchange was earned by the private sector and held in balances abroad by commercial banks that acted as agents for local exporters… The oil boom experienced in the 1970s made it necessary to manage foreign exchange rate in order to avoid shortage. However, shortages in the late 1970s and the early 1980s compelled the government to introduce some ad hoc measures to control excessive demand for foreign exchange. However, it was not until 1982 that a comprehensive exchange controls were applied. Then a fixed exchange rate system was in practice. The increasing demand for foreign exchange and the inability of the exchange control system to evolve an appropriate mechanism for foreign exchange allocation in consonance with the goal of internal balance made it to be discarded in September 26, 1986 while a new mechanism was evolved under the Structural Adjustment Programmes (SAP). The main objectives of exchange rate policy under the Structural Adjustment Programmes were to preserve the value of the domestic currency, maintain a favourable external balance and the overall goal of macroeconomic stability and to determine a realistic exchange rate for the Naira.

In macroeconomic management, exchange rate policy is an important tool. This is derived from the fact that changes in the rate of exchange have significant implications for a country’s balance of payments position and even its income distribution and growth. It aids international exchange of goods and services as well as achieving and maintaining international competitiveness and hence ensures viable balance of payment position.lt serves as an anchor for domestic prices and contributes to internal balance in price stability (CBN, 2011). It is not surprising therefore, that monetary authorities attach much importance to proper management of a country’s foreign exchange since its behaviour is said to determine the behaviour of several other macroeconomic variables (Oyejide, 1989). It is even more so for Nigeria which had embarked on a course of rapid economic growth with its attendant high import dependency. An exchange rate, as a price of one country’s money in terms of another’s, is among the most important prices in an open economy. It influences the flow of goods, services, and capital in a country, and exerts strong pressure on the balance of payments, inflation and other macroeconomic variables. In this way, the choice and management of an exchange rate regime is a critical aspect of economic management to safeguard competitiveness, macroeconomic stability, and growth (Cooper, 1999).

Macroeconomic performances under different exchange rate regimes have been a subject of continuing research and controversy. Ghosh, et. al., (1996) using a three-way classification analyzed the link between exchange rate regimes, inflation and growth. The result indicates that pegged exchange rates are associated with lower inflation and less variability. They therefore argued that this was due to a discipline effect the political costs of failure of defending the peg induce disciplined monetary and fiscal policy and a confidence effect to the extent that the peg is credible, there is a stronger readiness to hold domestic currency, which reduces the inflationary consequences of a given expansion in money supply. The study also found that pegged rates are associated with higher investment but correlated with slower productivity growth. On net, output growth is slightly lower under pegged exchange rates compared to floating and intermediate regimes (Ghosh, et. al., 1996)

A study by IMF that extends the period of analysis to mid-1990s reports similar findings (IMF 1997). However, in an analysis of experience with increasing capital market integration and the replacement of fixed exchange rates in the 1990s, Caramaza and Aziz (1998) found that the differences in inflation and output growth between fixed and flexible regimes are no longer significant.

Also, using data from 159 countries for the 1974-99 periods, Levy-Yeyati and Sturzenegger (2000) reclassified the exchange rates into three groups (float, intermediate, fixed) and estimated the correlation between the actual (de facto) exchange rate regimes and macroeconomic performance. The main findings include: (a) fixed exchange rate regimes seem to have no significant impact on the inflation level when compared with pure floats, while intermediate regimes are the clear under-performers; (b) pegs are significantly and negatively correlated with per capita output growth in non-industrial countries; (c) output volatility declines monotonically with the degree of regime flexibility; and (d) real interest rates appear to be lower under fixed rates than under floating rates because of lower uncertainty associated with fixed rates.

More recent studies both in Nigeria and abroad abound with different perspectives on the impact of exchange rate on macro-economic fundamental of a country. Yougbare (2006),investigating the effect of exchange rate regimes on growth volatility found that fixity in nominal exchange rates increases the volatility of real GDP growth. Moreover, it amplifies the adverse impact of terms of trade instability on growth volatility whereas the negative impact of exchange rate fixity on growth stability is attenuated by a higher financial development. These results also suggest that as countries develop, they would gain more in terms of reduced growth volatility by adopting more flexible exchange rate arrangements.

Bacchetta and Wincoop (2009) posit that it is well known from anecdotal, survey and econometric evidence that the relationship between the exchange rate and macro fundamentals is highly unstable. This could be explained when structural parameters are known and very volatile, neither of which seems plausible hence they argue that large and frequent variations in the relationship between the exchange rate and macro fundamentals naturally develop when structural parameters in the economy are unknown and change very slowly.

Junye-Li andWeiwei-Yin (2008),investigated the relationship between short-run exchange rate dynamics and macroeconomic fundamentals by adopting a no-arbitrage international macro-finance approach, under which the macroeconomic fundamentals enter into the exchange rate dynamics in a nonlinear form and having been amplified by the time-varying market prices of risks, the macroeconomic innovations help capture large volatility of exchange rate changes. The foreign exchange risk premium can largely alleviate the forward premium anomaly.

Mahmood, Ehsanullah, and Ahmed (2011) posit that therole of exchange rate in affecting the macroeconomic performance of any country is of leading nature. Hence, their study was conducted to investigate whether uncertainty or fluctuations in exchange rate affect the macroeconomic variables in Pakistan. If so, what is the direction of this effect will be? Although, there are large numbers of macroeconomic variables, but out of these only four variables i.e, GDP, FDI, growth rate and trade openness was included in this study. Finding of this study confirmed the impact of exchange rate volatility on macro economic variables in Pakistan. It was also concluded that exchange rate volatility positively affects GDP, Growth rate and trade openness and negatively affects the FDI.

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