Foreign Exchange

Project and Seminar Material for Accountancy / Accounting

Foreign Exchange

Abstract

The research is aimed at evaluating the impact of exchange rate on the economy. Economic induces such as exchange rate and inflation rate were considered in determining change in Gross Domestic Product (GDP) in Nigeria. Secondary data collected from Annual Reports of Central Bank of Nigeria (CBN), Nigerian Stock Exchange (NSE), and Nigeria Securities and Exchange Commission (SEC) were analysed through simple percentage and Taro yamen principle. The result shows that the two factors – exchange rate and inflation rate- impact significantly on the Gross Domestic Product and economic growth of Nigeria. Exchange rate has a negative impact on the GDP because as it increases, the economic growth is negatively affected, while inflation rate exerts a positive impact on GDP, indicating that firms are more willing to produce when inflation rate is high and vice versa. In order to enthrone a favourable exchange rate that would boost the nations GDP, the government is therefore advised to make Nigerian economic climate investment friendly by restoring security of lives and property, infrastructural development and improvement of local production in order to reduce the pressure on the dollar.

Chapter One

Introduction

1.1 Background of the Study

Foreign exchange is the means of payment for international transaction. It is made up of convertible currencies that are generally accepted for the settlement of international trade and other external obligation. Just like every other commodity, a market is established which works more like any other market having a supply curve, a demand curve and an equilibrium price and quantity. There are also conditions which are held constant (creteris paribus). When these conditions change, the curve shift and there is a change in the equilibrium price quantity. This market for currencies is known as the foreign exchange market.

The foreign exchange market according to the central bank of Nigeria is the medium of interaction between the sellers and buyers of foreign exchange a bid to negotiate a mutually acceptable price for the settlement of international transactions. The sellers of foreign exchange constitutes the supply while the buyers of foreign exchange constitutes its demand. The supply of foreign exchange is derived from oil exports, non-oil export, expenditure of foreign tourist in Nigeria, capital repatriation by Nigerians resident abroad etc.

The demand for foreign exchange on the other hand consist of payments for imports, financial commitments to international organizations, external debt service obligations etc.

Before 1958, when the central bank was established and the enactment of the exchange control act of 1962, foreign exchange was earned by the private sectors and held in balances abroad by commercial banks which acted as agents for local exporters. Another feature of this period was that agriculture exports contributed the bulk of foreign exchange receipts. The fact that the British pound sterling was at par with the Nigerian pound sterling with easy convertibility delayed the establishment of an active foreign exchange market.

However by 1958, when the central bank was established and subsequent centralization of foreign exchange authority. In banks, the need for a local foreign exchange market because paramount. Other factors that led to the evolution of the foreign exchange market in Nigeria include:

The changing pattern of international trade institutional changes in the economy. structural shift in production, etc.

By the early 1970’s, the official exchange receipt was enhanced following the sharp rise in prices and demand for crude oil exports which had by now displaced agricultural exports. The foreign exchange market experienced a boom during this period and there became a need for the management of foreign exchange resources. However, it was not until 1982 that comprehensive exchange controls were applied.

The exchange control system failed to evolve an appropriate mechanism for foreign exchange allocation. This led to the development of a dual exchange rate system, comprising of the first and second tier foreign exchange market which was adopted in September 1986. The first tier was managed while the second tier was subjected to market forces. Not only has there been a metamorphosis of the institutional frame work from second tier foreign exchange market (SFEM) to foreign exchange market (FEM) to inter bank foreign exchange market (IFEM) to Autonomous Foreign Exchange market (AFEM) etc, there have been frequent changes in operational guidelines and procedures. Various pricing methods, marginal and weighted average exchange rates determinations and the Dutch Auction System (DAS) among other have also been adopted .

All those aimed at ensuring more efficient allocation and utilization of scarce foreign exchange resources, to enhance the flow of capital into the country, stimulates domestic industrial production, promote export, increase revenue to the government, help reschedule our foreign debt at more profitable terms etc.

When there are fluctuations in foreign exchange rates, various economic activities are usually affected such as the purchasing power, balance of payment, prices of goods and services, import structure, export earning, government revenue, external reserves among others.

These prevailing instability in exchange rates and its effects on various economic variables, will be the areas of concentration of the research work.

1.2. Statement of the Problem

Since September 1986, when the market determined exchange rate system was introduced via the second tier foreign exchange market, the naira exchange rate has exhibited the features of continuous depreciation and instability.

This instability and continued depreciation of the naira in the foreign exchange market has resulted in declines in the standard of living of the populace, increased cost of production which also leads to cost push inflation. It has also tended to undermine the international competitiveness of non-oil exports and make planning and projections difficult at both micro and macro levels of the economy. A good number of small and medium scale enterprises have been strangled out as a result of low dollar/ naira exchange rate and so many other problems resulting from fluctuations in exchange rates can also be identified.

This movement of the exchange rate along the path of depreciation since 1986 has raised a lot of questions on the impact of exchange rate policies on the Nigerian economy.

It is therefore the goal of this study to identify thses problems and make recommendations which will help reverse this prevailing trend.

1.3 Objectives of the Study

In a highly import dependent economy like Nigeria, the naira exchange rate has become one of the most widely discussed topic in the country today. This is not surprising as this topic has had a lot of macroeconomic impact on the Nigeria economy.

It is therefore the objectives of this study to:

Evaluate the effect of exchange rate fluctuation and management on various sectors of the Nigerian economy.
Identify those economic variable mostly affected by exchange rate fluctuations.
Identify the strengths and weakness of various exchange rate policies.

In the light of its findings, make certain recommendations which will be helpful in management, restructuring ensuring stability and appreciation in the naira exchange rate

1.4 Formulation of Hypothesis

For meaningful findings, conclusions and recommendations, a set of testable hypothesis based on available data will be necessary. In the course of this research work, the following hypothesis would be tested.

Hypothesis 1

Ho: The continued fluctuation in the exchange rate of the naira has not reduced the purchasing power of the average Nigerian.
Hi: Exchange rate fluctuations have no effect on Nigeria economy.
Hi: It has fluctuations in exchange rate has significant effect on the purchasing power of the average Nigerian.

Hypothesis 2

Ho: The fall in the naira exchange rate has not affected the importation of goods
Hi: The fall in the exchange rate has significant effect on importation.

Hypothesis 3

Ho: Exchange rate fluctuations have no effect on importation of goods in Nigeria economy.
Hi: It has exchange rate fluctuation have no effect on importation of goods in Nigeria economy.

1.5 Significance of the Study

The study would identify the strengths and weakness of exchange rate policy and management, identify those economic variables that are mostly affected by instability in exchange rate and provide the general public with the awareness on the foreign exchange transaction and its impact on the economy.

The various findings of this would enable the government and financial authorizes to device, modify and adopt a better foreign exchange transaction for the economy.

1.6 Definition of Terms

1. Foreign Exchange

Foreign exchange is a means of payment for international transactions. It is made up of currencies of other countries that are freely acceptable in settling international transactions.

2. Foreign Exchange Market

This is a medium of interaction among buyers and sellers of foreign- exchange with a view of negotiating acceptable prices for settling international transaction.

3. Exchange Rate

This is the price of one currency in terms of another

4. SEMI

Second tier foreign exchange market. Under this system the exchange rate is largely determined by market forces.

5. AFEM

Autonomous foreign exchange market. This exchange rate under this system are being determined essentially through market forces.

6. IFEM

Inter bank foreign exchange market.

7. Dutch Auction System (DAS)

This is a method of exchange rate determination through action where the bidders pay last bid rate that clears the market.

8. Dual Exchange Rate Regime

This situation exist when two exchange rates are in existence in an economy.

9. Marginal Pricing Method

This is the method in which bid rates are arranged in a descending order of magnitude . the last bid rate at which available foreign exchange is exhausted (marginal rate) is the applicable exchange rate.

10. Exchange Control

This is a foreign exchange arrangement in which the government purchase all incoming foreign exchange and is the only source from which foreign exchange can be purchased legally.

Chapter Five

Summary Conclusion and Recommendation

5.1 Introduction

It is important to ascertain that the objective of this study was to find out the impact of foreign exchange on economic growth.

In the preceding chapter, the relevant data collected for this study were presented, critically analyzed and appropriate interpretation given. In this chapter, certain recommendations made which in the opinion of the researcher will be of benefits in addressing the challenges of foreign exchange and economic growth.

5.2 Summary

From the foregoing, it was found out that both Exchange rate and inflation rate individually and jointly have significance impact on the economic growth of Nigeria as represented by GDP. The inflation rate has positive correlation with GDP while the exchange rate of naira to dollar has negative correlation with the GDP Though the Nigeria GDP keeps increasing every year, the negative effect of exchange rate has not allowed the GDP to grow maximally as expected. In fact, the naira exchange to $1.00 is N473.00 at the parallel market instead of the official rate of N375.00. This is as a result of the naira being cheaper compared to the dollar. The demand for dollar has remained so high, hence the increase in exchange rate and ultimately resulting to high cost of imported goods and high cost of living as most of the product consume is imported.

5.3 Conclusion

From the above result presented, it is obvious that exchange rate itself does not significantly determine economic growth, but it shows a positive relationship. However, the variables, which an effective foreign exchange rate management policy is deemed to affect; export, foreign direct investment is found to affect economic growth. This therefore points to the fact that foreign exchange management really does significantly affect economic growth through its control variables (Export and foreign direct investment). Evident from the result also is the fact that foreign direct investment (FDI) positively affects economic growth, which is an expected relationship, based on economic theory. Managing the economy’s foreign exchange rate does affect quite a number of economic variables, which in turn affects growth in the economy. Relating these findings to the submission of Unugbro (2007), Akpan (2008) and Abounoori and Zoebeiri(2010), it is obvious that foreign exchange management does affect economic growth owing to the fact that the key control variables; export and foreign direct investment are found to statistically affect the Nigerian economic growth. Also worthy of note in this study is the fact that the response of GDP to policy initiatives on foreign exchange management does not take long before it takes noticeable effect as the adjustment of the variables to yield same long run result is relatively fast, with the 68% recorded as the Error Correction Coefficient. This result is in consonance with the findings of Harris (2002). In line with the scope and focus of the study, inflation, import, foreign direct investment and export are seen as proxies for foreign exchange management, with the expectation that their alteration is bound to either cause a shrink or stimulate economic growth. This fact therefore was confirmed from this study, as it is revealed that all control variables has the potential to stimulate the Nigerian economic growth in the right direction if well managed especially through the foreign exchange management policyAgainst the backdrop of the above findings, it is recommended that effort be made to increase the consumption of made in Nigeria goods, which includes the usage of raw material that can be sourced locally by Nigerian industries in order to increase foreign exchange earnings. The implication of this is that local industries should be encouraged to look inward for their raw materials. Having uncovered from the study that the nexus between economic growth and foreign exchange management, being a short run relationship, it is necessary that the foreign exchange management policy initiatives be made to satisfy the short-run behavioral expectations of the variables used in uncovering this fact.

5.4 Recommendation

Based on the findings therefore, the following recommendations were made.

Nigeria government should be more serious about its economic reforms like the national Economic Empowerment and development Strategy (NEEDS), Small and Medium Enterprises Equity investment Scheme (SMEEIS) and others in order to boost the GDP internally so as to reduce pressure on imported goods which will automatically reduce the demand for dollar. This would lead to favorable exchange rate for the country.
The government should try to make the economy investment friendly by putting in place political stability, security of lives and good economic climate to draw home foreign investors to boost the nation’s productivity. This will also reduce capital flight plaguing the country.
Infrastructural development should be provided in order to reduce costs of production of some goods and services.
The government, as a matter of urgency, through the relevant agencies should reduce the interest rate prevailing in the economy. The current situation where investors have to borrow at 25% interest rate from the Nigerian Banks seems unpalatable for the economy. Therefore, if the above itemized points, and solutions are considered and implemented, it will surely lead to buoyancy on the Gross Domestic Product (GDP) through the impact of favorable foreign exchange rate and sustainable inflation rate.

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