Economic Analysis Of The Determinants Of Exchange Rate In Nigeria
The study examines the determinants of real exchange rate in the recent years in Nigeria over the period of 1980 to 2010 using the Nigerian time series data. Following literature, we identified the potential determinants of real exchange rate as lag of real exchange rate, real interest rate, inflation rate, trade openness and real gross domestic product. After examined the time series characteristics of the data with Augmented Dickey-Fuller (ADF) unit roots test of stationarity and Engle-Granger procedure for co-integration test, we applied Auto-regressive Distributed Lag Model (ARDL-ECM). The result suggests that one year past value of real exchange rate and immediate past value of trade openness are the major determinants of real exchange rate in Nigeria. The result further indicates that there is evidence of long run relationship between real exchange rate and two explanatory variables (gross domestic product growth rate and trade openness).
1.1 Background to the Study
The role of exchange rate and its effects on macroeconomic performance has continued to generate interest among economists. Many economists argue that exchange rate stability facilitates production activities and economic growth. They are also of the view that misalignment in real exchange rate could distort production activities and consequently hinders exports growth and generate macroeconomic instability (Mamta Chowdhury, 1999)Exchange rate policy guides investors on the, best way they can strike a balance between their trading partners, and investing at home or abroad (Balogun, 2007). Mordi (2006) argued that the exchange rate movements have effects on inflation, prices incentives, fiscal viability, and competitiveness of exports, efficiency in resource allocation, international confidence and balance of payments equilibrium.
Exchange rate is one of the key ‘barometers’ of economics performance, indicating growth (output), demand conditions, the levels and trends in monetary and fiscal policy stance (Afolabi, 1991). Exchange rate policy emerged as one of the controversial policy instruments in developing countries in the 1980s, with intense opposition for fear of its inflationary impact, among other effects. Nigeria faced such a situation and there has been interest, therefore, in economic performance and the role of the exchange rate in the process (Afolabi1991).
The exchange rate, when applied in conjunction with other macroeconomic policies is expected to lead to the achievement of the goals of price stability, improved and sustained economic growth, reduced unemployment and balance of payment stability. An optimal and stable exchange rate has to be right and stable since it is an important relative price that influences other prices. When the exchange rate is not optimal, however, the achievement of these objectives becomes different and often impossible according to Afolabi 1991. For example, if the exchange rate is not in equilibrium, it allows rent-seekers and speculators to exploit the subsidy element involved. The situation is worse when a parallel market develops as a result of restriction in the official market and inability of the market to satisfy the demand for foreign exchange.
Thus, the opportunity cost of transacting business in the official market is the value of the subsidy or the premiums that would otherwise be lost by the official sector but gained by third party arbitrators and speculators. The disability nature of foreign exchange subsidy (premium) is the fundamental reason why unification of exchange rate is canvassed as a short to medium term objectives of exchange rate management. The smaller the parallel market relative to the official market, and the higher the demand and supply elasticity of foreign exchange in the official market relative the closer the unified equilibrium rate is likely to be the official rate.
However, if there is a large unsatisfied demand in the official market which cannot be diverted to the parallel market because of administrative restrictions, the equilibrium rate in a unified market would tend to be closer to the parallel market rate or could even be beyond it (John, IMF, 1985). The retention of a dual exchange rate system for a long time would be counter productive in the long run by undermining the objective of exchange rate stability and structural reform of an economy. The continued existence of dual or multiple rates would be encouraging wasteful allocation of resource, thereby stunting economic recovery and groups. Foreign exchange liberalization, accompanies by appropriate demand management policies targeted at ensuring macro economic stability is necessary for exchange rate convergence, if the costs(subsidy) are to be reduced. This is because the burden of adjustment is often borne by the official exchange rate.
One of the broad objectives of the Structural Adjustment Programme (SAP) introduced in Nigeria 1986 was to achieve macroeconomic stability by reducing the level of inflation through the achievement of a stale and realistic exchange rate. Towards this and government deduced to deregulate exchange rate determination and the foreign exchange allocation system by relying largely on market focus. In this regard, various allocation mechanism, beginning from the second-tier foreign exchange market (SFEM),the interbalance foreign exchange market (IFEM), the Dutch, Auction system (DAS) to the pro-rate system and, lately, fixing of the official exchange rate and application of a free market exchange rate for purely commercial transactions, were adopted in order to achieve the goals of policy.
Nigeria is currently the second largest oil exporting country in the Organization of Petroleum Exporting Countries (OPEC) and is heavily reliant on its crude oil exports which accounts for 95% of its exports and foreign exchange earnings and about 80% of government revenue annual budgets (EIA, 2010). Oil has been the dominant factor in Nigeria’s economy since its discovery in 1956 (Budina et al, 2006). Oil exporting nations may experience exchange rate appreciation when oil price rise, conversely exchange rate of oil exporting nations may depreciate when oil price falls.
From 1980 to 1985 following the oil price increase, it has be observed that an upward trend with the real exchange rate appreciating significantly leading to loss of competitiveness for the Nigeria economy. In 1986, Nigeria experiences a sharp decline in its real exchange rate following declining oil prices and the Structural Adjustment Programme (SAP) which led to the devaluation of the Nigerian currency – the naira. Between 1993and 2000, there were substantial movements in the real exchange rate. Since then, the real exchange rate index fluctuated around a constant trend with evidence of mild appreciation of the real exchange rate. In recent years, owing to rising global oil prices and increased oil exports, Nigeria experienced large foreign exchange inflows. The real exchange appreciate could be described to be a response to the large foreign exchange inflow that characterized the Nigerian economy or it could as well be a response to productivity gains.
Approaches employed to analyze the problems of exchange rate determination ranged from the traditional balance of payment approach to the modem approaches of exchange rate determination, consisting of the monetary and port-folio balance approaches (that is after deregulation) argues that the exchange rate, being a relative of the two natural monies, is determine primarily by the relative supplies and demands for the monies. The approach is also referred to as asset market approaches to the determination of exchange rate, since the demand for the various national monies depends on expectations, income and rates of return and other factors relevant for port-folio choice.
1.2 Statement of Problem
There has been several exchange rate systems in use in historical times out of which is the Gold Standard System which has been the first historical system in modern times, the free exchange rate system was determined by the supply and demand for foreign currencies or the demand and supply of domestic currencies, none of the two systems stated above have given a stabilizing foreign exchange market (Akinmoladun, 1990).
The exchange rate under the Gold Standard System brought about a subordination of the demand for domestic equilibrium to the vicissitudes of the external sector.
The case against the free exchange rate is similar though allowed for external and internal equilibrium, but had disadvantages since the fluctuating deter exporters
and importers where as stable rates give them more confidence. In Nigeria, during the regime of exchange controls, the black markets rates were much higher than the official rates for foreign exchange and this underscored the high over-valuation of the naira and the consequent deficit disequilibrium which the black market supply was geared to full.
Nigeria’s high external indebtedness as a result of continuing disequilibrium in the balance of payment has really posed the problem of how to fund a correct exchange rate in the face of dynamic changes in underlying conditions behind autonomous transactions. A rate that is set too high under values domestic currency and a rate that is set too low over values the domestic currency.
There has been an ongoing debate on the appropriate exchange rate policy in developing countries. The debate focuses on the degree of fluctuations in the exchange shocks. Exchange rate fluctuations are likely, in turn, to determine economic performance. In judging the desirability of exchange rate fluctuations, it becomes. Therefore, necessary to evaluate the macroeconomic factors that influence the fluctuations. This is the main focus of this study.
1.3 Research Questions
The following questions would be considered in the course of the study:
- What are the macroeconomic factors that influence exchange rate in Nigeria?
- To what extent do inflation and money supply affect exchange rate in Nigeria?
- What are the major issues in exchange rate policy and management in Nigeria?
- Over the years, is exchange rate stable?
- How could the exchange rate be influence to stimulate economic growth in Nigeria?
- How does the Structural Adjustment Programme contribute to a realistic exchange rate?
1.4 Aim and Objectives of the Study
The objectives as regard this study shall be considered on the followings:
- To identify the macroeconomic factors that influence exchange rate in Nigeria;
- To investigate the effect of inflation, and money supply on exchange rate, after deregulation;
- To know whether exchange rate is stable over the years before and after Structural Adjustment Programme (SAP)
- To examine the impact of economic performance and volume of imports on exchange rate;
- To raise and discuss issues in exchange rate policy and management.
1.5 Justification of the Study
The need for foreign exchange management lies only within the framework of countries engaged in international trade in contract to a closed economy. This need is underscored by the economic theory of comparative advantage, theory of comparative cost as well as international resources endowment differentials.
The study is expected to reveal the macroeconomic factors that influence the exchange rate so that the monetary authorities could manipulate them effectively to stimulate growth in the economy, ‘ thereby, enhancing policy formulation and implementation.
The study also would contribute to knowledge by examining the macroeconomic factors that influence exchange rate in contrast to existing paper that have examined the impact of exchange rate on macroeconomic variables, thereby enriching the lacuna in literature.
1.6 Scope of the Study
The foreign exchange market shall be studied and the role it plays on the macroeconomic objectives. It is important to note that various exchange rate policy ranging from exchange control, free exchange rate, and Dutch auction method are important policies to be considered.
However, the empirical investigation of the factors that determines the exchange rate in Nigeria shall be restricted to the period 1980 to 2010.
The limitation of the study is confined to the era when deregulation started in Nigeria, an attempt will be make to consider the period between 1970-1985 before Structural Adjustment Programme (SAP) and the period between 1986-2001 which takes care of the period during and after SAP;
1.7 Definition of Terms
It refers to the rate at which one currency exchange for another (Jhingan, 2003). Exchange rate is said to depreciate if the amount of domestic currency require buying a foreign currency increases, while the exchange rate appreciate if the amount of domestic currency requires buying a foreign currency reduces. Exchange rate volatility refers to the swings or fluctuations in the exchange rate over a period of time or the deviation from a benchmark or equilibrium exchange rate (Mordi, 2006).
Gross Domestic Product (GDP):
Is the summation of all the values of goods and services produced in a country by the nationals and non-nationals. It does not include incomes and property earnings of the nationals abroad neither does it excludes the income and property earnings of the non-nationals in the country.
Inflation exists when there is a sustainable increase in the price level or a persistent tendency for prices and money wages to increase. That is rise in the price of goods and services as a result of large volume of money in circulation used in the exchange for the few available goods and services.
The amount of money in an economy. This may be the country’s own money supplied by its banking system, or foreign money used in preference to domestic money.
Balance of Payments
Balance of Payments is an overall statement of a country’s economic transactions with the rest of the world over some period. A table of the balance of payments shows amounts received from the rest of the world and amounts spent abroad.
Foreign Exchange Market
Foreign Exchange Market is the medium of-interaction between the sellers. and buyers of foreign exchange in a bid to negotiate a mutually acceptable price for the settlement of international transaction.
Deregulation is the removal or dismantling of restriction and control measures, and this may be in ranging degrees.
Structural Adjustment Programme (SAP):
SAP was introduced in June 1986 to achieve structural balances in Nigeria economy. The programme basic strategy was to deregulate the economy and enhance the role of a realistic exchange rate and the co-ordination of the country’s economic activities.
Summary, Conclusion and Policy Recommendation
This study examined the determinants of real exchange rate in the recent years in Nigeria over the period of 1970 to 2006 using the Nigerian time series data. Following literature, we identified the potential determinants of real exchange rate as lag of real exchange rate, real interest rate, inflation rate, trade openness and real gross domestic product. We started the modeling by examined the time series characteristics of the data. Specifically, we conducted the stationarity test using Augmented Dickey-Fuller (ADF) unit roots test and co-integration test using Engle-Granger procedure. The variables were stationarized at different integration level.
The accompanying co-integration test revealed there is an evidence of cointegration between two explanatory variables (gross domestic product growth rate, trade openness and the dependent variable real exchange rate. Arising from this scenario; we employed the Auto-regressive Distributed Lag Model (ARDLECM) specified in equation number (6). Initially, using the Akaike information criteria (AIC), we adopted 4-period lag lengths. However, applying Granger marginalization procedure we are able to drop 3-period lag lengths as we perceived they are redundant in the model. Hence the parsimonious model was achieved using one period lag length. The overall outcome of the estimations is adjured satisfactory by the fact that the outcome of the results meet
The empirical result shows on the first hypothesis that the lag value of real exchange rate has a negative and significant relationship with real exchange rate. The result suggests that one year past value real exchange rate is a major determinant of real exchange rate in Nigeria. The current and past value of real interest has a positive relationship with real exchange rate, but it is however not statistically significant to determine real exchange rate in Nigeria. Similarly, gross domestic product growth rate is not a major determinant of real exchange rate in Nigeria. Inflation rate investment displays a negative relationship with real exchange rate both in the current and past one year. Notwithstanding, inflation rate is not a significant factor determine country real exchange rate. Lastly, while trade openness both at the current and past one year value has a positive relationship with real exchange rate, the current year value is insignificant to determine real exchange rate, while the past one year value appeared to be one of the major determinant of real exchange in Nigeria.
On the second hypothesis, the result obtained indicates that there is evidence of long run relationship between real exchange rate and two explanatory variables (gross domestic product growth rate and trade openness).
5.2 Policy Recommendation
The findings above have some implication for dynamic monetary policy formulations in Nigeria mostly in determine the real exchange rate in Nigeria. Arising from this, we propose the following recommendations for the economy.
The lag of real exchange rate have a crucially effect on expectations of future exchange rate changes, this will aid the forecasts of future economic conditions. Therefore, sound policies and management should consolidate on this lag impact so as to better the economy.
The study shows that real exchange rate responds positively to real interest rates.
Monetary policy is crucial here. There is need for the monetary authority to pursue interest rate stability as swings in interest rate will post a serious treat to maintaining stability in real exchange rate.
The pursuance of a stable exchange rate regime that results in a balance of payments position that is viable and sustainable is one of the ultimate goals of monetary policy. The pursuits of this objective and the extent to which they are met have important implications for investment decisions, and, indeed, international capital flows into Nigeria, especially in increasingly globalised financial markets. Hence, we suggest that the exchange rate has to be competitive, in order to attract foreign investors in Nigeria. That is, the exchange rate should, and indeed, must reflect market realities to promote efficiency in resource allocation and productivity growth. Therefore, the goal of CBN should be to pursue monetary policy that is consistent with the maintenance of a realistic and stable exchange rate regime, vis-à-vis those of our trading partners.
Findings from this study shows that trade openness is one of the major determinant of real exchange rate in Nigeria. Depreciation in exchange rate will make Nigeria’s export cheaper relative to imports, this will increase the country’s export receipts and in turn improve the position of the foreign reserve. The exchange rate should not be allowed to appreciate too much, since it may reduce the foreign reserve of the country as well as to be able to import at lower cost.
Equally worthy to note is the fact that there has been a remarkable improvement in the annual average depreciation rate which implies a stronger currency for the country. Government should try to encourage monetary policies so as to maintain the strength of the naira.
Government should pursue strategies that are designed to neutralize the effects of such practices as round tripping, over-invoicing and under-invoicing which have characterized the activities of the banking sectors in the recent years.
Lastly, foreign exchange control policies should be adopted in order to help in determination of appropriate exchange rate value. This will go a long way of strength the naira.
A major gain from Nigeria’s adoption of structural adjustment programme was the liberalization of the foreign exchange market, in which the determination of the exchange rate of the national currency (Naira) has largely been dictated by market forces. This has helped to enhance efficiency in the allocation and utilization of foreign exchange resources. Over the years, various types of market mechanisms have been adopted, with Dutch Auction System (DAS) being the latest. The introduction of DAS has been a giant step in promoting increased flexibility in the management of the naira exchange rate. Under the DAS, satisfactory progress has been made to make naira exchange rate to be truly market-determined.
However, there are some considerations for adopting a particular exchange rate regime. If the market behaves in an efficient and rational manner, then free floating is the proper policy to follow. If the market occasionally produces irrational and inefficient outcomes (market failure), then managed floating will be an appropriate policy. The actual exchange rate regime chosen by the authority will have consequences in the economy. Most countries will not follow a prescribed exchange rate regime due to different circumstances facing the economy for every external shock. For instance, developing economies like Nigeria are subject to external shock of investor sentiment and market participants’ perception of risk.
Also, business cycle, monetary policy, and fiscal policy of developed countries have impact on the economies of developing countries and their exchange rates. The choice between floating and hard peg depends on the inflationary history of the economy and its own characteristics. Finding the exchange rate that serves many economic objectives is not an easy task. The appropriate regime at any given time for a given economy should be based on the structural characteristics and the flexibility of that economy.
The Complete Material Will Be Sent to You in Just 2 Steps
Quick & Simple…
Make Payment (Through Transfer) of ₦3,000 to Any of the Account Below
|Acc No: 0811003731|
|Acc No: 1225513212|
|Acc No: 8143831497|
Or CLICK HERE To Pay With Debit Card
|FOR STUDENTS OUTSIDE NIGERIA|
|CLICK HERE To Purchase Material ($15)|
|FOR GHANIAN STUDENTS|
|Make Payment of 80 GHS to 0553978005 | Douglas Osabutey | MTN MoMo|
Send the Following Details on WhatsApp ( 08143831497) After Payment
- Payment Details
- TOPIC: Economic Analysis Of The Determinants Of Exchange Rate In Nigeria
The Complete Material Will Be Sent To You On WhatsApp After Receiving Your Details
T & C Apply