Impact Of Exchange Rate Instability On Foreign Direct Investment In Nigeria (1981-2014)

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Impact Of Exchange Rate Instability On Foreign Direct Investment In Nigeria (1981-2014)


Abstract


The study seeks to empirically analyze the impact of exchange rate instability on foreign direct investment in Nigeria from 1981 -2014. The data for the research study was extracted from CBN statistically bulletin volume 25, 2014 edition. The methodology is ordinary least square were foreign direct investment was regressed on Exchange Rate, Real Gross Domestic Product and Openness of the economy. Some econometrics test were conducted such as the unit Root, Contegration and Vector Autoregressive Model.

The unit root result shows that none of the variables were stationary at level, but at first differencing they all became stationary. The contegration result shows that there is no long run relationship among the variables. The vector autoregressive model shows that exchange rate had an impact on economic growth. It is on this note that the researcher recommends amongst others that: policy makers should continue on the part of floating exchange rate policy to enable our domestic currency assume its proper level among the committee of world currencies, for purpose of establishing stability in the exchange rate of the naira, to ensure effective economic planning and sustainable growth and development.


Chapter One


Introduction

1.1 Background of the Study

The power of the exchange rate policy under the structural Adjustment programme are to discourage imports and promote agricultural production, encourage local sourcing of raw materials something they had considered impossible before the introduction of structural adjustment programme. One cannot fail to notice that importation has decreased, exports other than crude oil has increase over the months.

Problems crisis in international transactions is because of the inefficiency in our financial system, which introduce “lag” between the time the importer and the time of the fund are actually remitted to the exporter. The remittance lag as we call it, introduces exchange rates risk into the transaction. For example the rate prevailing at the time of payment by imports may differ from the rate of which the commercial banks will use in remitting the funds.
The 1980s witnessed increased flows of investment around the world. Total world outflows of capital in that decade grew at an average rate of almost 30%, more than three times the rate of world exports at the time, with further growth experienced in the 1990s (Kosteletou and Liargovas, 2000). Despite the increased flow of investment, especially, to developing countries, Sub-Saharan Africa(SSA) countries still lag behind other regions in attracting foreign direct investment. The uneven dispersion of FDI is a cause of concern since FDI is an important source of growth for developing countries. Not only can FDI add to investment resources and capital formation, it can also serve as an engine of technological development with much of the benefits arising from positive spillover effects. Such positive spillovers include transfers of production technology, skills, innovative capacity, and organizational and managerial practices.

Given these significant roles of FDI in developing economies there have been several studies that tried to determine the factors that influence FDI inflows into these economies. One of such factors that recently have been a source of debate is exchange rate and its volatility. The existing literature has been split on this issue, with some studies finding a positive effect of exchange rate volatility on FDI, and others finding a negative effect. A positive effect can be justified with the view that FDI is export substituting. Increases in exchange rate volatility between the headquarters and the host country induce a multinational to serve the host country via a local production facility rather than exports, thereby insulating against currency risk (Foad 2005).

In economic analysis, Foreign Direct Investment (FDI) is a direct investment by a corporation in a commercial venture in another country. Mallampally and Sauvant (2009) define FDI as an investment by multinational corporations in foreign countries in order to control assets and manage production activities in those countries. It plays an extraordinary and growing role in global business by providing a firm with new markets and marketing channels for their products. For a host country or the foreign firm which receives the investment, it provides a source of new technologies, capital, process, products, organizational technologies and modern management practices.

Foreign direct investment (FDI) not only provides developing countries (including Nigeria) with the much needed capital for investment, it also enhances job creation, managerial skills as well as transfer of technology. All of these contribute to economic growth and development. To this end, Nigerian authorities have been trying to attract FDI via various reforms. The reforms included the deregulation of the economy, the new industrial policy of 1989, the establishment of the Nigeria Investment Promotion Commission (NIPC) in early 1990s, and the signing of Bilateral Investment Treaties (BITs) in the late 1990s. Others were the establishment of the Economic and Financial Crime Commission (EFCC) and the Independent Corrupt Practices Commission (ICPC). However, FDI inflows to Nigeria have remained low compared to other developing countries (CBN, 2010).

Nigeria has over the years been a beneficiary of Foreign Direct Investment (FDI) inflow. For instance, FDI inflows increased from N786.40 million in 1980 to N2193.40 million in 1982, but soon dropped to N1,423.50 million in 1985. The value of FDI rose from N6,236.70 million in 1988 to N10,450.0 million and N55, 999.30 million in 1990 and 1995, respectively. However, the value of FDI fell drastically to N5,672.90 million in 1996 and further to N4,035.50million in 1999. The inflows of FDI has continued to rise since the year 2001, moving fromN4937.0 million to N13531.2 million in 2003 and N20,064.40 million in 2004. The FDI inflows stood at N41734.0 million in 2006 (CBN, 2006). In terms of growth rate, FDI inflows increased by 182.68 percent in 1986, the value soon fell by -24.76 percent in 1989 and further to -89.87 percent in 1996. Since the year 2000 the growth of FDI has remained positive except in 2001 when the value was -70.00 percent but since recently, 2010, 2011, 2012, 2013, and 2014 the values have been 1.09552, 2.236095, 0.668744, 7.953192 and 2.261765 respectively and they are all positive. The recent surge in FDI inflows to the country is attributable to the reduction in the nation’s debt profile (through debt arrangements with London club and Paris club) and the renewed confidence of foreign investors in the Nigerian economy (CBN, 2006).


1.2 Statement of the Problem

Justification for a negative impact of exchange rate on FDI can be found in the irreversibility literature pioneered by Dixit and Pindyck (1994). A direct investment in a country with a high degree of exchange rate will have a more risky stream of profits. As long as this investment is partially irreversible, there is some positive value to holding off on this investment to acquire more information. Given that there are a finite number of potential direct investments, countries with a high degree of currency risk will lose out on FDI to countries with more stable currencies (Foad 2005).

One of the countries that fall into this category (countries with a high degree of currency risk) is Nigeria. With a population of about 130 million people, vast mineral resources, and favourable climatic and vegetation features, Nigeria has the largest domestic market in Sub-Saharan Africa. The domestic market is large and potentially attractive to domestic and foreign investment, as attested to by portfolio investment inflow of over N1.0 trillion into Nigeria through the Nigerian Stock Exchange (NSE) in 2003 (Central Bank of Nigeria, 2004). Investment income, however, has not been encouraging, which was a reflection of the sub-optimal operating environment largely resulting from inappropriate policy initiatives.

Except for some years prior to the introduction of the Structural Adjustment Programme (SAP) in 1986, gross capital formation as a proportion of the GDP was dismally low on annual basis.

It was observed that aggregate investment expenditure as a share of GDP grew from 16.9% in 1970 to a peak of 29.7% in 1976 before declining to an all-time low of 7.7% in 1985. Thereafter, the highest was 11.8% of GDP in 1990, before declining to 9.3% in 1994. Beginning from 1995, investment/GDP ratio declined significantly to 5.8% and increased marginally to 7.0% in 1997 and remained there about till 2004 when 7.1% was recorded. On the average, about four-fifth of Nigeria’s national output was consumed annually.

The sub-optimal investment ratio in Nigeria could be traced to many factors including exchange rate instability, persistent inflationary pressure, low level of domestic savings, inadequate physical and social infrastructure, fiscal and monetary policyslippages, and low level of indigenous technology as well as political instability. A major factor was exchange rate instability, especially after the discontinuation of the exchange rate control policy. The high lending rate, low and unstable exchange rate of the domestic currency and the high rate of inflation including government expenditure made returns on investment tobe negative in some cases and discouraged investment, especially when financed with loans.

The Naira (Nigerian currency, N) exchange rate witnessed a continuous slide in all the segments of the foreign exchange market (that is, official, bureau de change and parallel markets). In the official market, the exchange rate depreciated progressively from N8.04 per US dollar in 1990 to N81.02 per dollar in 1995 and further to N129.22 in 2003 and N133.00 in 2004. Similarly, it depreciated from N9.62 and N9.61 per dollar in 1990 to N141.36 and N141.07 per dollar in 2003 in the bureau de change and parallel market, respectively. Consequently, the premium between the official and parallel market remained wide throughout the period.

This high exchange rate volatility in Nigeria, among others, led to a precarious operating environment which can be attributed to the reason why Nigeria was not only unable to attract foreign investment to its fullest potentials but also had a limited domestic investment. As such, despite the vast investment opportunities in agriculture, industry, oil and gas, commerce and infrastructure, very little foreign investment capital was attracted relative to other developing countries and regions competing for global investment capital.


1.3 Research Questions

In this research, the following research questions will be addressed:

  1. What is the effect of exchange rate fluctuation on Foreign Direct Investment ?.
  2. What is the effect of interest rate on Foreign Direct investment ?
  3. What is the effect of inflation on Foreign Direct investment ?
  4. What is the impact of Gross fixed capital formation on Foreign Direct Investment ?
  5. What is the impact of economic growth on Foreign Direct Investment ?

1.4 Objectives of the Study

The broad objective of this study is to ascertain the determinants of foreign direct investment in Nigeria. In line with this, the following specific objectives will be actualized:

  1. To examine the effect of exchange rate fluctuation on Foreign Direct Investment.
  2. To examine the effect of interest rate on Foreign Direct investment
  3. To examine the effect of inflation on Foreign Direct investment.
  4. To examine the impact of Gross fixed capital formation on Foreign Direct Investment.
  5. To examine the impact of economic growth on Foreign Direct Investment.

1.5 Hypotheses of the Study

In carrying out this study, the following hypotheses will be tested:

Hypothesis One
  • HO: Exchange rate fluctuation has no significant impact on foreign direct investment in Nigeria.
  • H1: Exchange rate fluctuation has significant impact on foreign direct investment in Nigeria.
Hypothesis Two
  • HO: Interest rate has no significant impact on foreign direct investment in Nigeria.
  • H1: Interest rate has significant impact on foreign direct investment in Nigeria
Hypothesis Three
  • HO: Gross fixed capital formation has no significant impact on foreign direct investment in Nigeria.
  • H1: Gross fixed capital formation has significant impact on foreign direct investment in Nigeria.
Hypothesis Four
  • HO: Inflation has no significant impact on foreign direct investment in Nigeria.
  • H1: Inflation has significant impact on foreign direct investment in Nigeria.
Hypothesis Five
  • HO: Economic growth has no significant impact on foreign direct investment in Nigeria.
  • H1: Economic growth has significant impact on foreign direct investment in Nigeria.

1.6 Significance of the Study

A 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 grounds that it will reveal the significant determinants of foreign direct investment in Nigeria for the years under review; and thus provides a framework for policy prescriptions and interventions. In furtherance to the above, this research will find its relevance as made evidence in the following:

Government:

The federal government will find this study highly relevant as it will provide a picture of the relative determinant and impact of selected macroeconomic variables on foreign direct investment 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 foreign direct investment and relative determinants in Nigeria.

Scholars:

Students will find this piece highly relevant as it will undeniably increase their knowledge and horizon on the concept of foreign direct investment and corresponding determinants.

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.

Researchers:

This study would enable the researchers to investigate and understand trendsand relationships of variables involved in this study and probably build on it in their studieson FDI determinants.


1.7 Scope of the Study

The subject scope of this study is anchored on carrying out an empirical analysis of the impact of exchange rate and inflation on foreign direct investment in Nigeria. This will encompass the period 1981-2014.


1.8 Definition of Terms

Exchange Rate:

In the context of this study, this is defined as the price of a local/domestic currency at the international foreign exchange market. In this research, the exchange is the relative price of naira to U.S Dollars.

Inflation:

This is the measure of price level in the economy. By definition, it is the rate at which general level of prices of goods and services is rising and consequently, the purchasing power of currency is falling.

Foreign Direct Investment:

This is the investment made by a foreigner in a given country for the sole purpose of maximizing profit. Most Multinational Companies (MNCs) in a given country are foreign direct investments.


Chapter Five


Discussion of Findings, Conclusion and Recommendations

5.1 Discussion of Findings

Exchange rate fluctuation has a positive relationship with foreign direct investment. This implies that an increase in exchange rate fluctuation will bring about an increase in foreign direct investment. This is not in consonance with the a priori expectations and also the findings of Chukwu (2007) who studied the effect of exchange rate volatility on foreign direct investment. Exchange rate fluctuation has no significant impact on foreign direct investment. This implies that Exchange rate fluctuation has no real impact on foreign direct investment. The findings agree with the findings of Odior (2012) who concluded that Exchange rate fluctuation has no significant impact on foreign direct investment.

Interest rate has a positive relationship with foreign direct investment. This implies that an increase in Interest rate will bring about an increase in foreign direct investment. This is not in consonance with the a priori expectations and also the findings of Rasheed (2010) who investigated the impact of macroeconomic variables and foreign direct investment. Interest rate has no significant impact on foreign direct investment. These findings agree with the findings of Ekpo and Umoh (2012) in their study of the impact of leading interest rate and foreign direct investment.

Inflation has a Positive relationship with foreign direct investment. This implies that an increase in inflation will bring about an increase in foreign direct investment. This is in not in consonance with the a priori expectations and also the findings of Kirandeep,(2014) who empirically investigated the relationship between inflation and FDI. Inflation has significant impact on foreign direct investment. This implies that inflation has real impact on foreign direct investment.

Gross fixed capital formation has a negative relationship with foreign direct investment. This implies that an increase in gross fixed capital formation will bring about a decrease in foreign direct investment. This is in not in consonance with the a priori expectations.

Gross Domestic Product which is used as a proxy for Economic growth has a negative relationship with foreign direct investment. Gross Domestic product has no significant effect on foreign direct investment.


5.2 Conclusion

This works attempts to ascertain the Exchange rate instability and foreign direct investment in Nigeria : an empirical examination. Data were obtained from Central Bank of Nigeria (CBN) statistical bulletin and World Development Indicators ranging from 1981-2014. Multiple regression models were used in which Exchange Rate Fluctuations, Inflation Rate, Interest Rate, Gross Fixed Capital Formation, Gross Domestic Product were used as the independent variable while Foreign Direct Investment was used as the dependent variable.

Ordinary least square method was used to estimate the parameters using E –View computer software. The results showed that Exchange Rate Fluctuation has a positive relationship with foreign direct investment and has no significant impact on Foreign Direct Investment in Nigeria. Variables such as: Gross Fixed Capital Formation and Gross Domestic Product have a negative relative with the inflow of Foreign Direct Investment in Nigeria while Inflation and Interest rate have a positive significant effect on Foreign Direct Investment in Nigeria.


5.3 Recommendations

From the foregoing, we recommend the following;

  1. Break government monopoly that shuts foreign investment out. Nigeria has the potential to attract and retain significant inflows of Foreign Direct Investment into its large network of infrastructural sectors including rail transportation, gas pipeline and electricity transmission as it has successfully done in telecommunication. Nigeria stock of Foreign Direct Investment is currently concentrated into telecommunication, oil and gas. There are only two sectors in which the government has liberalized entry of Foreign Direct investment. Government monopoly in key infrastructure sectors like rail transportation, gas pipelines and power transmission obstructs beneficial Foreign Direct Investment inflows. The Nigerian government needs to take immediate measures to break government monopoly in critical infrastructure sectors to allow the inflow of needed foreign investment.
  2. Government should create stable and peaceful political environment so as to attract foreign investors and encourage domestic employment of resources which could enhance inflow of capital.
  3. There is need for the Nigerian government to formulate investment policies that will be favorable to local investors in order to complement the inflow of investment from abroad.
  4. The government in collaboration with the Central Bank and other policy making bodies in Nigeria should make policies that will help the economy attain a stable exchange rate regime. This will not only attract real inward FDI but will also boost domestic production as it will help the domestic firms compete favorably with the multinationals.

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