The Impact Of Monetary Policy On Balance Of Payment In Nigeria

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The Impact Of Monetary Policy On Balance Of Payment In Nigeria


This research work is centered on the impact of Monetary Policy on Balance of Payment in Nigeria with the scope being from 1970 to 2006.

The Central Bank of Nigeria (CBN) monetary policy instruments were discussed and the IS-LM framework of an open economy was also discussed including the CBN monetary policy guideline from 1970 to date which is the major channel through which the Central Bank’s activities are based on.

The ordinary least square estimator (OLS) was the analysis adopted and from analysis and result obtained it indicates a negative impact of monetary policy on balance of payment. However, recommendations were made with respect to the CBN’s to adopt the Charles Soludo new exchange rate proposal 2007 and to shift emphasis to non-oil sectors of the economy in order to have a viable balance of payment.

Chapter One


1.1 Background of the Study

The monetary approach to balance of payments explains the elimination of payments disequilibrium in terms of factors bringing the demand and supply of money into equality. It treats the supply of money as endogenous by assuming a feedback from the balance of payments through changes in international reserve to changes in the monetary liabilities of the central bank and government.

One important question of monetary policy is the extent to which the monetary authority of an open economy can affect the price level or the other arguments of the demand for money, such as the level of real output and the interest rate. If it were the case that these could not be changed, then any increase in monetary liabilities of the authority would be met by an equal and offsetting outflow of international reserve (or an equi-proportionate rise in the price of home goods and foreign exchange), and one would have to argue that monetary policy had no influence on the real response of the system.

A second purpose of this research work is to clarify the effects of external shocks on the balance of payments. The simple monetarist model may provide an incorrect answer to the question. “What is the impact effect of an increase in particular world prices on the balance of payments of a small country?” The simple model (monetarist model) tells us that the balance of payments will temporarily improve as the higher prices produce an increase in the demand for stock of money. But we shall see that the answer is far more complex – indeed the effects on balance of payments depends on whether it is import or export prices that have risen and on a more traditional consideration of elasticity of demand (George and James, 1978).

The monetary approach focuses on the supply and demand of money and the money supply process. The monetary approach hypothesizes that the balance of payment and exchange rate movement result from changes in money supply and demand. Consider what happens if the Central Bank domestic currency money supply exceeds money demand. There is pressure for the domestic currency to depreciate. The Central Bank must sell foreign exchange reserve until money is equal to money demand. There has been no net impact on the monetary base and money supply as the change in foreign exchange reserve offset the change in domestic currency. However, a balance of payment deficit as foreign exchange reserve is less than zero. Flexible exchange rate regime, the foreign exchange reserve component of monetary base does will adjust to eliminate my monetary disequilibrium.

If money supply exceeds money demand, now the domestic currency must depreciate to balance money supply and money demand. The monetary approach postulates that changes in a nation’s balance of payment or exchange rate are a monetary phenomenon (Nankai University Fan Xiaoyun, 2004).

We now want to gain a fuller understanding of the wide variety of international transactions which create a demand for and generate a supply of a given currency. The spectrum of international trade (balance of payment) and financial transaction is reflected in the “United States” international balance of payments. A nation’s balance of payment statement attempts to record all the transactions which take place between its residents (including individuals businesses and governmental units) and the residents of all foreign nations. These transactions include merchandise exports and imports, tourist expenditures, purchases and sales of shipping and insurance services, interest and dividends received or paid abroad, and so forth. Stated differently, the Nigeria’s balance of payment, shows the balance between all payments Nigeria receives from foreign countries and all the payments which we make to them (Mcconnel, 1987).

According to (Afolabi, 1990), the need for balance of payment includes living on account of the import of a country, and this will act as a signal for domestic policies. Telling us a country’s export composition and the extent to which the country depend on certain commodities for its foreign exchange earning, showing whether a country is having a deficit or a surplus in its trade transactions with the rest of the world, provision of a basis for comparison of trade relation among countries and financial integrity whether it is at a deficit or surplus position in the balance of payments which can be used to know if a country is aid-worthy or credit worthy, provision of historical data on import and export overtime which could be used for planning and also providing statistics for the net foreign investment component of the national income.

Campbell McConnel (1987) in his work said whether a country’s balance of payment is at a deficit or surpluses; if it is good or bad is dependent in firstly, the event causing them and secondly, their persistence through time. For example, the large payments deficits imposed upon the United States and other oil-importing nations by OPEC’s dramatic run-up of oil prices in 1973 – 1974 and 1979 – 1980 were very disruptive in that they forced the United States to invoke a variety of policies to curtail oil imports. Similarly, any nation’s official reserve are limited. Therefore, persistence or long-term payments deficits which must be finance by drawing dawn those reserves, would ultimately cause reserve to be depleted. In the case the nation would have to undertake specific policies to correct its balance of payments. These policies might entail painful macroeconomic adjustment, the use of trade barriers and similar restrictions, or changing the international value of its currency.

In view of this lingering problem, the government has introduced many policies so as to reduce or eliminate the pressure on balance of payments, some of these policies according to Stephen and Osagie (1985) are viz. Exchange control, foreign exchange budgeting, cutting down government expenditure abroad, import restriction through tourists production and deflation policy though the use of a combination of monetary and fiscal policies etc.

According to the CBN briefs (2004), the impact of government policies as it relates to management of external debts are to outline strategies of increasing foreign exchange earnings thereby reducing the need for external borrowing to determine the criteria for borrowing from external sources and the type of project for which external loans may be obtained. The impact of the exchange control policy is the reduction of imports by making import difficult to obtain the necessary foreign currency on invisible items such as remittance by foreigners and limit the outflow of capital account by imposing restriction on foreign investors.

To keep the value of money stable, its quantity and cost has to be controlled and maintenance of relative price stability and a healthy balance of payment position that monetary policy comes in to play an important role.

Monetary policy refers to the attempt to achieve the national economic goals of full employment without inflation, rapid economic growth and balance of payments equilibrium through the control of the economy’s supply of money and credit. Since the rate of interest is the cost of credit, monetary policy includes the control of money supply (through the control of high-powered reserves) and the rate of interest. In a wider sense, monetary policy may also be taken to include attempts to influence the external values of a nations currency, i.e. exchange rate management (in a regime of floating exchange rate) (Iyoha, 2002).

Because of the impact monetary policy has on financing conditions in the economy (not just the costs, but also the availability of credit or banks’ willingness to assume specific risks) but also because of its influence on expectations about economic activity and inflation, monetary policy can affect the prices of goods, asset prices, exchange rates as well as consumption and investment (Oesterreichische National Bank, 2002).

There are some disagreements in the usage of monetary policy. These disagreements include, how effective is the use of monetary policy as a tool of economic management? What is the channel through which monetary policy can actually work? Since monetary policy cannot be used to pursue all goals simultaneously, hence, which goal or goals should be targeted first before other? What technique should be used in the conduct of monetary policy? What is the influence of monetary and fiscal policy can be used to correct the persistence or sharply negative balance of payment? This leads us to why we are carrying out the research work, the impact of monetary policy on balance of payment.

1.2 Statement of Research Problem

Because of the impact monetary policy has on financial condition (Balance of payment) in the economy (not just the cost, but also the availability of credit or bank’s willingness to assume specific risk) but also because of its influence on expectations about economic activity and inflation, monetary policy can affect the prices of goods, assets prices, exchange rate as well as consumption and investment (Oesterreichische National Bank, 2002).

Every monetary policy impulse (e.g. an interest rate change by the Central Bank, change in the monetary base resulting from changes in minimum reserve rate) has a lagged impact on the economy. Moreover, it is uncertain how exactly monetary policy impulses are transited to the price level or how real variable develop in the short and medium term.

The difficulty of the analysis is to adjust the effect of the individuals channels for external factors e.g. supply and demand shocks, technical progress or structural change may be superimposed on the effect of central bank measures, and it is difficult to isolate monetary policy effects on various variables for analytical purposes. Moreover, the time lag in the reaction of the real sector to monetary measures renders the analysis more difficult. Hence monetary policy must be forward looking (Oesterreichische National Bank, 2002).

According to Campbell McConnel (1987), a country operating on a balance of payment disequilibrium can be determined by the event causing them and the persistence through time. Hence, monetary policy then seeks to adjust the problem of disequilibrium in the balance of payment, whether the monetary measures complicates the situation or amends it. Even if the balance of payment is at equilibrium the question is “does the monetary policy measures adopted maintain or destabilizes the payment situation of the economy? What is the efficiency of monetary policy measures adopted on the macroeconomic variables (general price level, exchange rate, net export, growth, money reserve, interest rate unemployment etc) to influence balance of payment position? However, these are major issues this research work seems to clarify.

1.3 Objectives of the Study

Based on the fact that the Nigeria economy is largely underdeveloped, be set by high level of unemployment, price instability, and slow growth rate and balance of payment problems with the Naira depreciation.

Hence, the main monetary authority (CBN) must attempt to keep money supply growing at an appropriate rate to maintain internal and external stability, and therefore solve the problems arising from disequilibrium balance of payment (BOP). It is however necessary to state the objectives of this study at this point and these objectives are as follows:

  1. To examine the trend in Nigeria’s balance of payment (BOP).
  2. The determination of the impact of monetary policy in Nigeria’s balance of payment.
  3. To analyze the effectiveness of monetary policy in Nigeria.
  4. To analyze how these monetary policies has been able to achieve macro-economic objective viz; economic growth, price stability, full employment and balance of payment equilibrium.
  5. Finally the limitations and the advantages or strength of some of the monetary instruments used in achieving macro-economic objective will also be highlighted.

1.4 Hypotheses of the Study

For purpose of this study, I wish to make the hypotheses with respect to each of the parameters:

(a) The null hypothesis (Ho)

To be tested is that the balance of payment is determined by the following parameters viz – inflation exchange rate, net export and M2.

N.B. M2 equals M1 plus savings deposit where M1 equals currency in circulation plus demand deposit. Hence M2 equals near money (Iyoha).

(b) The alternative hypothesis (H1)

Is that balance of payment is not determined by the parameters mentioned above.

The hypothesis will be tested at 5% level of significance that is using the ordinary least square method.

1.5 Scope of Study

The research will cover the Central Bank of Nigeria’s (CBN) assessment of the nation’s balance of payments position for a period of 1970 – 2006.

It will also highlight the impact of Central Bank of Nigeria’s monetary policy guideline on the balance of payments of the country for these periods under review.

These will also include the examination of some of the monetary instruments used in pursuance of the macro-economic objectives such as credit ceiling, sectoral allocation of loans and advances variables, rediscount rate and interest rate will be mentioned.

In the process of finding out how the monetary policy has been able to achieve the macro-economic goals such as domestic production will be looked into. The role of monetary policy in this aspect will be highly scrutinized.

1.6 Methodology of the Study

The approaches to be adopted in assessing the impact of monetary policy on Nigeria’s balance of payments are econometric analysis of the ordinary least square estimation. The OLS shall be adopted in order to establish a relationship between the dependent variable and the independent variables, i.e. the explanatory variables.

Also in achieving the objectives of this study the description of various monetary policies during the period under the study and impacts of the policies on the balance of payments is to be adopted.

Another approach also to be adopted is the description of the changes in the balance of payment position during the year under review.

1.7 Significance and Importance of the Study

The quality of research work lies on the relevance to the society being studied. The importance is the ability to draw a relationship between monetary policy and economic activities in Nigerian economy, whether monetary policy has any impact on Nigeria’’ balance of payments.

Again, this research will be of immense value to the different sectors of the economy (both public and private) most especially the policy makers.

In conclusion, the study would be of immense help to individuals, economists, students, planners, financial analysts, stock brokers and others who might be interested in researching into the field in the future, by shedding more light into the widely held view about the relationship between monetary policy and balance of payments activities in the economy.

1.8 Sources of Data

Effort will be made to provide comprehensive data using mostly secondary data gathered from text books, Central Bank of Nigeria bullion and financial journals, economic journals, business times; articles, related textbooks on monetary policy and data from Federal Office of Statistics (FOS) Abstracts.

1.9 Data Constraints and Limitation of the Study

Like any other study, this research work is constrained by the following factors:

  1. The poor data collection system in Nigeria which makes it difficult for researchers to produce a thorough and proper researched work.
  2. The difficulty in obtaining research materials.
  3. Other factors like time, distance and finance could also be regarded as limitation to this study.
  4. Lastly, the problem associated with securing information which are regarded as “classified” or “select” in developing countries is well known. It becomes more acute in financial institution where “trade secrets” are closely guarded. There was therefore problem of extracting vital information/data from the banking system.

1.10 Structure of the Study

This research work is divided into five chapters.

Chapter one shall deal directly with the general introduction of the study. Issues like the statement of the problem, objectives of the study, the significant and importance of the study, methodology, scope of the study and limitation of the study.

Chapter two of the study shall review some literature relevant to the field of study. In this chapter previous work and findings relevant to the field of study shall be thoroughly examined.

Chapter three of this study shall deal with the theoretical framework, sources of data, model specification and method of analysis.

Chapter four deals with the presentation and interpretation of the regression result as well as the policy implementation of the study.

Finally, chapter five shall summarize the study, make some recommendation and conclude the study.

Chapter Five

Summary, Recommendation and Conclusion

5.1 Summary of Findings

The purpose of the study has been to examine the effectiveness of the monetary policies on the country’s balance of payments, and the trend of the balance of payments position for the years under study (1970 – 2006).

From the empirical investigation we obtained the following findings:

Paradoxically, there exists insignificant positive relationship between exchange rate (EXR) and balance of payment 9BOP).

Surprisingly, Broad Money Supply (M2) has an insignificantly positive impact on balance of payment. However, Broad money lagged one period (M2t-1) is negatively significant with balance of payment which conforms to the case of a small country (Nigeria).

Inflation rate (INF) has an insignificantly positive relationship with balance of payment which is quite unexpected. Nevertheless, inflation rate lagged one period shows an insignificant negative relationship with balance of payment which is in conformity with the apriori expectation.

Both Net-Export (NXP) and Net-Export lagged one period (NEXt-1) shows a significantly negative relationship with balance of payment. However, this shows an unfavourble balance of trade (Balance of payment) in the country.
Interestingly, Gross Domestic Product (GDP) and GDP lagged one period (GDP6-1) both has a significantly positive payment.

The conduct of monetary policy has passed through two phases in the period of our study. Between 1970-1985 (before 1986), it was direct monetary control, which characterised the conduct of monetary policy in Nigeria. This is usually what obtains in an underdeveloped financial system. However, the country has adopted indirect or market-based monetary management since 1986 (After 1986 Monetary policy) to date. Instructively, a more conclusive approach for policy purpose would have been the examination of monetary policy effectiveness on domestic production under the two policy scenario, but for limited degree of freedom and lag in monetary policy we could not. This no doubt impacted on the outcome of our result (e.g. wrong signs of the variables).

Consequently, the Central Bank of Nigeria’s monetary policy guidelines for these years was accessed. From the study carried out the following findings were made.

There was fluctuation in the nation’s balance of payments position during the year under review, and the fluctuations show that monetary policy guidelines formulated during these years have been responsible to great extent for the change in the overall balance of payment and components (current account, capital account).

It was further established from the analysis made that these change or fluctuations in the balance of payments were mostly from the variation in the current accounts than in the other components. This is so, for a country like Nigeria where the external sector a largely dominated by trends in the current accounts.

From the trend in the current account, it was established that there were obvious dependence of our economy on external activities which makes us depend on the decision, action and developments in another country or group of countries.

5.2 Recommendations

Notwithstanding the limitations encountered in this study, we make bold to proffer the following limited recommendations so as to resole the imbalance of the balance of payments position.

In order to solve the problems from the imbalance, attention must be directed towards changing the size and pattern of spending by government.

The dependence of the country’s economy on external activities should be reduced to a small degree and consequently there is need to pursue vigorously the diversification of the country’s economy which will help the economy with the flexibility required to withstand external shocks.

The continuous unfavourable balance of payments positions where deficit were recorded throughout the years under review could be solved by government taking or seeking balance of payments support loan from the international institutions.

A situation, were over-invoicing of projects exist should be discouraged with appropriate policy so as to reduce the inflationary trend and where the propensity to import is high as in the case of Nigeria, the increased money income would lead to a fall in our balance of payments position.

The monetary authority should make policies that would give viable balance of payments equilibrium such as increasing the country’s international competitiveness (i.e. investing on project that are productive base and not resource based project to increase productivity).

The monetary authority should also formulate an active exchange rate policy so as to strengthen the balance of payments position.

Government should shift emphasis to the non-oil sectors of the economy with less dependence on the international price determinant.

The proposed new Naira Exchange rate policy by Prof. Chukwuma Soludo on 8th August 2007 is one major long term policy that will increase productivity, attract investors to invest thereby solving the imbalance in the balance of payment. Though, this policy have been criticised by a cross section of Nigeria who neglect the country and lodge huge sums of had currency in foreign banks but still remains the solution to the current problem at hand The aim of the much talked about policy is to make the Naira (i.e. one Naira) equal to 1.27 dollars.

5.3 Conclusion

To conclude this, it would not be out of place to say that Nigeria’s balance of payment may continue to be on the deficit side. This is based on the relevant facts and data stated earlier in the study, and because of the fact that to a large extent, monetary policies and government can come up with policies that will re-orientates Nigerians both in the public and private sectors for them to drop the thirst for imported goods.

Nigeria has a vast natural resources plus human resources which can be harvested and should not ordinarily be running a deficit in its balance of payments if these resources are properly and optimally tapped.

As earlier recommended, government should emphasise or shift emphasis to the non-oil sector of the economy and the adoption of the central bank new exchange rate policy proposal. Experience has shown that countries like Nigeria, are usually at the mercies of the internationally rich and developed nations in deciding prices of their exports and import respectively, consequently such countries should explore and concentrate on available natural resources rather than the continuous dependence on imports and flamboyant on elephant projects.

Well-intended monetary policies are most times neglected at the implementation stages due to corruption and unnecessary adjustments and changes of those policies.

For well-intended monetary policies to hold, discipline should be the watchword and should be strictly enforced at the point of implementation.

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