Oil Price And Exchange Rate Volatility In Nigeria

Project and Seminar Material for Economics

Oil Price And Exchange Rate Volatility In Nigeria

Abstract

Nigeria is a mono-product economy, where the main export commodity is crude oil, changes in oil prices has implications for the Nigerian economy and, in particular, exchange rate movements. The latter is mostly important due to the double dilemma of being an oil exporting and oil-importing country, a situation that emerged in the last decade. The study examined the effects of oil price, external reserves and interest rate on exchange rate volatility in Nigeria using yearly data from the year 1970 to 2011. The theoretical framework of this study is based on Generalized Autoregressive Conditional Heteroskedasity modeled by Tim Bolerslev (1986) and Exponential General Autoregressive Conditional heteroskedastic modeled by Daniel Nelson (1991). The models are used to estimate the relationship between oil price changes and exchange rate. Relevant descriptive and econometric analyses were employed. The econometric tests used include the unit root tests, Johansen co-integration technique and the Vector Error Correction Model (VECM) when the unit root tests were carried out; all the variables were stationary at first difference. The long run relationship among the variables was determined using the Johansen Co-integration technique while the vector correction mechanism was used to examine the speed of adjustment of the variables from the short run dynamics to the long run. It was observed that a proportionate change in oil price leads to a more than proportionate change in exchange rate volatility in Nigeria by 2.8%. I therefore recommend that the Nigeria government should diversify from the Oil sector to other sectors of the economy so that Crude oil will no longer be the mainstay of the economy and frequent changes in crude oil price will not influence exchange rate volatility significantly in Nigeria.

Chapter One

Introduction

1.1 Background of Study

“There are various evidences, particularly over the post-Breton woods era, pointing to the vital role of oil price fluctuations in the determination of the path of the exchange rate” (Adeniyi et al, 2004). According to Krugman (1983), exchange rate appreciates in response to rising oil prices and depreciates with response to falling oil prices in oil exporting countries, while the opposite is expected to be the case in oil importing countries.

Volatility is the fluctuation in the value of a variable, especially price (Routledge, 2002). According to Englama et al (2010), a volatile exchange rate makes international trade and investments more difficult because it increases exchange rate risk. Exchange rate volatility tends to increase the risk and the uncertainty of external transactions and predisposes a country to exchange rate related risks (Jin, 2008).

According to Adedipe (2004), when Nigeria gained politically independence in October 1960, agricultural production was the main stay of the economy, contributing about 70% of the Gross domestic product (GDP), also employing about seventy percent of the working population and responsible for about ninety percent of foreign government revenue. The initial period of post-independence till mid – 1970s witness a fast advancement of industrialized capacity and output, as the contributions made by the manufacturing sector to GDP rose from 4.8% to 8.2%. This pattern changed when crude oil became very important to the world economy.

According to Englama et al (2010), crude oil became an export commodity in Nigeria in 1958, following the discovery of the first producible well in 1956. The contribution of oil to the federal government revenue in 1970 rose to 82.1% in 1974 from 26.3% and in 2008 constituted 83% of the federal government revenue, largely on account of increase in oil prices in the international market. The gigantic rise in oil revenue was caused by the Middle East war of 1973. It created extraordinary, surprising and unforeseen wealth for Nigeria and the naira appreciated as foreign exchange influxes offset outflows and Nigeria foreign reserves assets increased (Adedipe, 2004). The economy of Nigeria gradually became dependent on crude oil as productivity declined in other sectors (Englama et al, 2010).
Nigeria is a mono – product economy, according to OPEC statistical bulletin (2010/2011) the value of Nigeria’s total export revenue in 2010 was US$70,579 million and the revenue of petroleum exports from the total export revenue was US$61,804 million which is 87.6% of total export revenue this means that Nigeria’s economy will be vulnerable to the movements of oil prices.

During periods of favorable oil price shocks triggered by conflict in oil – producing areas of the world, the rise in the demand for the commodity by the consuming nations, seasonality factors, trading positions etc. Nigeria experiences favorable terms of trade evidenced by a large current account surplus and exchange rate appreciation. On the converse, when crude oil prices are low, occasioned by factors such as low demand, seasonality factors, excess supply, the Nigeria experiences unfavorable terms of trade evidenced by budget deficit and slow economic growth (Englama, 2010). An example was a drop in the revenue from oil exports during the global financial crisis in 2009. According to, OPEC statistical bulletin (2010/2011), oil export revenue dropped from US$74,033 million in 2008 to US$43,623 million in 2009 and the naira depreciated to N148.902 in 2009 from N118.546 in 2008.

This study attempts to discover the extent to which oil price influences exchange rate volatility in Nigeria. Oil price changes directly affects the inflow of foreign exchange into the country, therefore there is a need to investigate its impact on the naira exchange rate volatility (Englama et al, 2010).

1.2 Statement of Problem

Crude Oil is a key source of energy in Nigeria and the in the world. Oil being an important part of the economy of Nigeria plays a strong role in influencing the economic and political fate of the country. Crude oil has generated great wealth for Nigeria, but its effect on the growth of the Nigerian economy as regards returns and productivity is still questionable (Odularu 2007). From the period of the oil boom of the 1970s till now, Nigeria has neglected her strong agriculture and light manufacturing bases in favor of unhealthy dependence on crude oil. New oil wealth has led to a concurrent decline of other sectors in the economy and has fueled massive migration to cities and led to increasingly wide spread poverty especially in rural areas. Nigeria’s job market has witnessed very high degree of unemployment, small wage and pitiable working environments (Adedipe, 2004 and Odularu 2007). Between 1970 to 2000, Nigeria’s poverty rate increased from 36 percent to just fewer than 70 percent and it is believed that oil revenue did not seem to add to the standard of living at this time but actually caused it to decline (Martin and Subramanian, 2003).

Oil price fluctuations have received important considerations for their presumed role on macroeconomic variables. Higher oil prices may reduce economic growth, generate stock exchange panics and produce inflation which eventually leads to monetary and financial instability. It will also lead to high interest rates and even a plunge into recession (Mckillop, 2004). Sharp increases in the international oil prices and the violet fluctuations of the exchange rate are generally regarded as the factors of discouraging economic growth (Jin, 2008).

A very good example is the period of the global financial crisis, the price of oil fell by about two thirds from its crest of $147.0 per barrel in July 2008 to $41.4 at end of December 2008. Before the crises, oil price was high, exchange rate was stable but with the dawn of the global financial crisis (GFC) oil price crashed and the exchange rate caved-in, depreciating by more than 20 per cent. Since oil price volatility directly affects the inflow of foreign exchange into the country, there is a need to investigate if it has direct impact on the Naira exchange rate volatility (Englama et al, 2010) the oil market has been and will continue to be an ever changing arena. This is because oil is so vital to the world economy, it is present in everyone’s daily lives and its market is truly global (El – badri, 2011).

Thus, it is on this note that this research seeks to find out the effect of oil price on exchange rate volatility and its effects on the Nigerian economy, as well as suggest methods of minimizing the adverse effects it can produce on the economy as a whole.

1.3 Scope of Study

The purpose of the study is to determine the relationship between oil price and exchange rate in the Nigerian economy. 1t covers the period between 1970 and 2011.

1.4 Research Questions

The study attempts to give answers to the following questions

  1. Do oil price have a significant relationship with exchange rate volatility in Nigeria?
  2. What is the long run impact of oil price on exchange rate volatility in Nigeria?

1.5 Objectives of the Study

The major objective for this research is to determine if a long run relationship exists between oil price and exchange rate in Nigeria.

The specific objectives include:

  1. To examine if there exists a significant relationship between oil price and exchange rate volatility in Nigeria.
  2. To assess the long run impact of oil price on exchange rate volatility in Nigeria.

1.6 Research Hypothesis

In effort to realize the objectives of the study, the following hypothesis will be tested: H0: Oil price has no statistical significant effect on exchange rate volatility in Nigeria

H1: Oil price has a statistical significant effect on exchange rate volatility in Nigeria

H0: There is no long run relationship between oil price and exchange rate volatility in
Nigeria

H1: There is a long run relationship between oil price and exchange rate volatility in Nigeria

1.7 Definition of Terms

Volatility:

Fluctuations in the value of a variable, especially price.

Oil – Price:

The price in dollars at which a barrel of crude oil is sold for in the international market.

Exchange Rate:

The price of one currency in terms of another. It can be expressed in one of two ways, as units of domestic currency per unit of foreign currency or units of foreign currency per unit of domestic currency

Economic Growth:

This is the growth of the real output of an economy overtime.

Exchange Rate Volatility:

It refers to the swings of fluctuations in the exchange rates over a period of time or the deviations from a benchmark or equilibrium exchange rate.

OPEC:

Organization of Petroleum Exporting Countries. It consists of twelve members which includes Nigeria.

1.8 Significance of study

Research conducted in this field of study have found out that oil price influence exchange rate to a great extent, especially oil producing countries. Nikbakbt (2009) showed that real oil prices have been a dominant source of real exchange rate movement and there exist a long run and positive linkage between real oil price and real exchange rates for OPEC countries. Oil exportation has contributed positively to Nigeria GDP, local expenditure, government revenue and foreign exchange reserves (Odularu 2007). Also in the words of Adedipe (2004) the oil price influences government policy and exchange rate in Nigeria.

Although a wealth of literature exist relating oil price and exchange rate to economic growth in Nigeria, little focus on the effect of the oil price on exchange rate in Nigeria. This project seeks to fill this gap in literature as it focuses on the effect of oil price on exchange rate volatility in Nigeria and whether or not it has a significant influence on exchange rate volatility in Nigeria. Thus, this study is of great benefit to the government and policy makers. It reemphasizes the need to diversify and promote the growth of other sectors of the economy, in other to increase economic growth and improve the standard of living for Nigerians.

Chapter Five

Summary, Recommendation and Conclusion

5.1 Summary

This research study set to find out if oil price as a significant influence on exchange rate volatility in Nigeria over the periods 1970 -2010 by analyzing time series data. It also looks at other factors that can influence exchange rate in Nigeria like external reserves and interest rate.

To achieve these objectives, a model was formulated based on GARCH model. In the model exchange rate volatility was the dependent variable and the independent variables were oil price, external reserves and interest rate. After the review of relevant literature and the necessary empirical analyses it was observed that a proportionate change in oil price will lead to a more than proportionate change in exchange rate volatility.

5.2 Recommendations

In the words of Jin (2008), Exchange rate volatility increases the risk and uncertainty of external transactions and predisposes a country to exchange rate related risks. For the purpose of this research work, the following strategies are suggested to reduce exchange rate volatility in Nigeria.

  1. Ketil (2004) research on the effect of external reserves on exchange rate volatility after enforcing controls for the endogeneity induced by the exchange rate regime that can affect both reserves and exchange rate showed that a high level of external reserves reduce exchange rate volatility. Therefore Nigeria government should take advantage of increases in the price of oil price by Nigeria external reserves and reduce exchange rate volatility.
  2. Research carried out on exchange rate volatility by Adeoye and Atanda showed that there is presence and persistency of volatility shocks in the nominal and real exchange rates for naira vis-à-vis U.S dollar in Nigeria between 1986 and 2008. This implies that the conservative monetary management policies put in place for stabilizing the exchange rate of a unit U.S dollar to naira over the years has been ineffective. There is a need for FOREX management measures particularly in terms of meeting the high demand for foreign currency which characterized and order the performance and trade balance and overall economic performance in Nigeria. There is also the need for sound monetary policy to attain stability in the exchange rate.
  3. According to the Brahmbhatt et al (2010), resources that a gift by God to a country prices and revenues are a lot unpredictable because of the small diminutive supply elasticity of natural resource yield. Assuming government expenditure is closely aligned to revenue from natural resource, the revenue will become more unpredictable. Expenditure instability, will in turn cause instability in the real exchange rate. A bulky body of empirical work records the terrible effect of the impact of economic volatility on investment and growth. Therefore Nigeria government should look for new ways to diversify the economy from dependence on oil and explore other sectors like manufacturing sector and agricultural sector to reduce volatility in the economy and the overall effect on it.
  4. Lastly, higher revenue gotten from increases in oil prices should be invested different areas of the economy the economy as the exchange rate of a country is affected by state of the economy.

5.3 Limitations to the Study

The limitations of this study were mostly data related. I originally wanted to use FOREX supply as one of the independent variable but the data available was only from the year 1996 to 2011. Another limitation was error in estimation a characteristic of secondary data.

5.4 Suggestions for Further Study

An interesting variant to this study would be an in-depth review of past approaches to controlling or reducing exchange rate volatility in countries that have Dutch disease and lessons that can be learnt to develop strategies and approaches that will reduce exchange rate volatility in Nigeria.

5.5 Conclusion

This research project looked at oil price in Nigeria and its effect on exchange rate volatility in Nigeria. The policy discussed and recommended if carried out will help Nigeria take advantage of increases in oil price and the help reduce exchange rate volatility which in turn will improve economic growth in Nigeria.

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