ABSTRACT
Fluctuation in exchange rate has been a recognized catalyst that brings about change in other macroeconomic indicators. This phenomenon was underscored by series of mechanisms through which economic activities of a given country reflect on its exchange rate to other international currencies. In order to assess the empirical influence of rising fluctuation in exchange rate, this study focused on the impact of exchange rate volatility (EXV) on selected macroeconomic variables in Nigeria which included gross domestic product (GDP), foreign direct investment inflow (FDI), index of trade openness (TOP) and inflation rate (INF). The Autoregressive Distributed Lag model (ARDL) and Vector Error Correction Model (VECM) were used in the study. Annual time series data from 1981 to 2015 were obtained from the Central Bank of Nigeria Statistics Bulletin 2015. Having carried out necessary pre- and post diagnostic tests, the results show that increase in exchange ratevolatility significantly decreased gross domestic product by about 0.003 per cent on average per annum. There is further evidence of short run and long run significant positive effect of exchange rate volatility on trade openness. Although EXV has both negative and positive relationship with FDI in the long run and short run respectively, its effect was considered insignificant. Similarly, EXV has insignificant positive effect on inflation rate. Lastly, while there is evidence of short run unidirectional causality from EXV to GDP and TOP respectively, the study found cases of independence between EXV and FDI on one hand and EXV and INF on the other hand. Above key findings led to the study’s conclusion, among other things, that exchange rate volatility is one of the major determinants of gross domestic product growth in Nigeria. As such, it was recommended that adequate effort should be made to minimize fluctuation in exchange rate through necessary fiscal and monetary policy as well as close monitoring of key players in the foreign exchange market.
CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Exchange rate is the price of one country’s currency in relation to another country`s currency. It is the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a particulartime.Exchange rate is a key macroeconomic measure in the context of general economic reform programmes and its management has been a contemporary issue among academics and policy makers in recent time. For instance, the relationship between exchange rate and economic growth is of a crucial issue from both descriptive and policy perspectives. It is therefore not surprising that exchange rate is among the most watched, analyzed and government manipulated macroeconomic variable.
The extent to which exchange rate is managed can affect the growth and development of such country. As succinctly stated by Edwards (1994),it is not an understatement to postulate that the behaviour of exchange rate occupies an important position in government policy evaluation and design. Aron, Elbadawi and Kahn (2002)expressed that exchange rate has direct influence on employment, trade flow, balance of payments and the arrangement of production and consumption. On the other hand, exchange rate is an important determinant of the growth of cross-border trading of a country and it serves as a measure of its international competitiveness.
One of the most important aspects of currency exchange rates is the fluctuation in the value of a currency with respect to another. The value of a given currency rises and falls with supply and demand of that currency, which in turn, determines the exchange rate.Exchange rate movements have been a big concern for the public sector, foreign investors and private individuals since the collapse of the Bretton Woods system. In Nigeria, this system was replaced by a flexible exchange rates systemwith the introduction of the Structural Adjustment Progra-mme (SAP) of
1986in which the price of currencies was determined by the supply and demand of money. Thus, this led to the devaluation of naira and a free fall of naira against the United State dollar. Given
the frequent changes of supply and demand influenced by numerous external factors, this new system increased the currency fluctuations (Grier & Mark, 2010).
According to Jhigan (2005), the variables that influence the exchange rate includes country’s exports, imports and structural influences. If country’s exports exceed imports, the demand for its currency rises and consequently, it has a positive impact on the exchange rate. On the other hand, if imports exceed exports, the desire for foreign currency rises and hence, exchange rate for such country move-up. Undoubtedly, any measure that tends to increase the volume of exports more than the rate of import, will definitely raise the value of the domestic currency against other foreign currencies. Moreover, economies are getting more open with international tradingconstantly increasing and as a result, nations become more exposed to exchange rate fluctuations. Exchange rate volatility is the sensitivity of changes in the real domestic currency value of assets, liabilities or operating incomes to unanticipated changes in exchange rate (Dufour, 2010).
Fluctuations in exchange rates may have an adverse effect on macroeconomic variables such as inflation rate, unemployment, trade openness,economic growth rate, foreign direct investment (FDI) etc.Exchange rate uncertainty affects FDI through the channel that depreciation of the currency of host country against the home currency raises the relative wealth of foreigners thereby increasing the attractiveness of the host country for FDI as firms are able to acquire assets in the host country relatively cheaply. Thus a depreciation of the host currency should increase FDI in the host country, and conversely an appreciation of the host country’s currency should decrease FDI (Ullah, Haider & Azim, 2012).
Moreover, Exchange rate movements can influence domestic prices via their effects on aggregate supply and demand. On the supply side, exchange rates could affect prices paid by the domestic buyers of imported goods directly. In an open small economy (an international price taker), when the currency depreciates it will result in higher import prices and vice versa. Exchange rate fluctuations could have an indirect supply effect on domestic prices. The potentially higher cost of imported inputs associated with an exchange rate depreciation increases marginal cost and leads to higher prices of domestically produced goods (Hyder& Shah, 2004). Furthermore, import-competing firms might increase prices in response to an increase in foreign competitor
price in order to improve profit margins. The extent of such price adjustment depends on a variety of factors such as market structure, nature of government exchange rate policy, or product substitutability. Exchange rate variations can also affect aggregate demand. To a certain extent, exchange rate depreciate or appreciate foreign demand for domestic goods and services, causing increase or decrease in net exports and hence aggregate demand which may increase real output (Hyder & Shah, 2004). Furthermore, the expansion in domestic demand and gross national product may increase input prices and accelerate wage demands by workers seeking higher wages to maintain real wages. The nominal wage rise may result in further price increases.
There had been series of exchange rate policy reform by successive Nigerian government to promote macroeconomic stability and export growth. However, the effectiveness of these policies in achieving macroeconomic stability is questionable. The Nigeria exchange rate control Act was enacted in 1962. Though, the exchange rate system was in operation even before the establishment of the Central Bank of Nigeria in 1958. Before the enactment of exchange rate control Act of 1962 the foreign exchange earned by private sector were held in commercial banks abroad. These commercial banks acted as agents for local exporters. However, due to the shortage in supply of foreign exchange between 1970 and 1980`s prompted the monetary authorities to initiate adequate measure in controlling the excessive demand of foreign exchange. Furthermore, a fixed exchange rate and a comprehensive exchange rate control were adopted in
1982. But the fixed exchange rate system was abandoned in September 26, 1986. This was because of the inability of the monetary authority to effectively control the increasing demand for foreign exchange to achieve internal balance.
The flexible and managed float regime was instigated in 1986 under the Structural Adjustment Programme (SAP). This policy allowed exchange rate to float freely and to be determined by market forces. The monetary authorities were intervening intermittently in the Foreign Exchange (FOREX) market to ensure stability of the rate. Also foreign exchange market (FEM) was adopted in 1987 to ensure favorable external balance and to preserve the value of domestic currency. This led to the establishment of Bureau de change in 1989 with the aim of enlarging the scope of FEM. The above policies could not resolve the high pressure on the foreign exchange market. This led to another policy reversal in 1994 which encompassed the formal
pegging of the Naira exchange rate, the centralization of foreign exchange in Central bank of Nigeria (CBN) and the restriction of Bureau de change to buy foreign exchange as an agent of CBN.
In addition, the monetary authorities went further to introduce a guided deregulation policy in
1995 that led to establishment of Autonomous Foreign Exchange Market (AFEM). AFEM was later transformed into Inter Bank Foreign Exchange Market (IFEM) in 1999. The guided deregulation policy also failed and this led to the introduction of Dutch Auction System in 2002. The Dutch auction system was introduced to solve the problem of persistent increase in demand for foreign exchange and relentless depletion of the country`s external reverses (Obadan, 2006). Also in May 2016 the monetary authorities reintroduced a flexible exchange rate where exchange rate is allowed to be determined by demand and supply of foreign currency. This development was as a result of the failure of fixed exchange to address foreign exchange rate problem. Even the recent adopted flexible exchange policy have worsen the Nigeria economy as foreign exchange rate continues to fluctuates on daily bases and prices of goods continues to inflate on a high rate.
There is an argument by some economists that the above depreciation is attributed to the decline in the nation’s foreign exchange reserves, fragile export and weak production base. In contrast others are of the veiw that the recent decline in naira is attributed to the activities of speculators and banks. These practices have led to the fluctuation and misalignment in the real exchange rate. Thus, there is need to examine the impact of exchange rate volatility on some selected macroeconomic variable.
Statement of the problem
The effect of exchange rate volatility on macroeconomic variables in Nigeria is a major issue. There is a general consensus that exchange rate volatility causes problems for aggregate economic performance.However there is less agreement on the relationship between exchange rate volatility, economic growth and how it affects economic activities at the macroeconomic level. This has generated significant debate both theoretically and empirically. The level of the country’s exchange rate volatility is no longer the only problem, but the fact that exchange rate
volatility has reached a crisis stage. Since the introduction of the Structural Adjustment Programme (SAP) of 1986, exchange rate has become so volatile in Nigeria and the recent rate of exchange rate has been a cause of great concern to many as Figure 1.1 shows.
Figure 1.1: Trend of mean annual naira exchange rate to US dollar (1981-2015)
250
200
150
100
50
0
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Year
However, despite government effort to maintain exchange rate stability to avoid fluctuations, the naira exchange rate to the U.S dollar continues to depreciate as was depicted in Figure 1 above. For example, the naira depreciated from ₦0.61 in 1981 to ₦2.02 in 1986 and further depreciated to an average of ₦4.02, ₦8.04 and ₦9.91 to US$1.00 in 1987, 1990, and 1991 respectively. Though exchange rate was relatively stable in mid 1990s, it depreciated further to ₦120.97,
₦129.36 and ₦133.50 in 2002, 2003 and 2004 respectively. Thereafter, the exchange rate
appreciated to ₦132.15, ₦128.65, ₦125.83 and ₦118.57 in 2005, 2006, 2007 and 2008 respectively (Central Bank of Nigeria, 2008). It further depreciated from ₦132 in 2009 to
₦148.68 in 2010, though appreciated in 2011 to ₦146. It also depreciated to ₦150.20, ₦156.00,
₦199.02, ₦199.05 in 2012, 2013, 2014 and 2015 respectively (Central Bank of Nigeria, 2015). In 2016-2017 it hovers around ₦350 and ₦420 per dollar.
But the question that comes to the mind of macroeconomists, central banks, investors and policymakers is how should volatility of exchange rate be in order to grow the economy rapidly? This is because unfavourable state of volatility is capable of disrupting smooth functioning of an economy by imposing certain costs which inhibit economic growth. Due to its impact on business and the economy at large, the popular view remains that investors and businessmen would prefer a stable exchange rate to a volatile one. Persistent fluctuation of exchange rate, which often results in continuous depreciation of the home currency is considered volatile in the exchange rate parlance. It has been recognized in previous studies that sustaining a relatively stable exchange rate is important in boosting economic growth. Volatility of exchange rate induces uncertainty and risk in investment decisions with subvert impact on the macroeconomic performance (Mahmood& Ali, 2011).
Moreover foreign exchange is said to be an important element in the economic growth and development of a developing nation. Foreign exchange policies influence the economic activities and to a large extent, dictate the direction of the macroeconomic variables in the country. Most of the developing countries, including Nigeria have a high degree of uncertainty in the macroeconomic variables.This high volatility of foreign exchange rate brings uncertainties about predictions. Economists generally believed that allowing exchange rate to be determined in the free market would not lead to large fluctuations in their values. Recent experience has proved them wrong as exchange rate volatility in Nigeria tends to be high during flexible than fixed or float-managed exchange rate regime.
Mordi (2006) noted that operatives in the private sector are concerned about volatility of exchange rate because of its effects on their investment, which may be capital gains or losses. Exchange rate volatility has asymmetric effects on macroeconomic variables. Aliyu (2009) cited that appreciation of exchange rate results in increased imports and reduced export while depreciation would expand export and discourage import. Also, depreciation of exchange rate tends to cause a shift from foreign goods to domestic goods. Hence, it leads to diversion of income from importing countries to those exporting through a shift in terms of trade. This tends to have impact on the exporting and importing countries’ economic growth. Exchange rate depreciation has a negative effect on developing countries (Razazadehkarsalari, Haghir&Behrooznia,2011).
One of the major challenges related to the management of the foreign exchange market in Nigeria comes back to oil revenues over time; the largest supplier of foreign exchange in Nigeria is oil sales by state. Experience has shown that the decline, indeed, in oil revenues makes problem in the economy.
Despite above discussed chains of challenges associated with exchange rate volatility, it is important to note that only very few studies were interested to know how it affects some macroeconomic variables. Specifically, there is known links between exchange rate and macroeconomic variables like inflation rate, gross domestic product, trade openness and foreign direct investment. It is expected that high volatility of exchange rate could improve or deteriorate situation of these indicators, and thus have some noticeable impact on standard of living. This unknown implication of exchange rate volatility on above macroeconomic variables is what this study considered important to investige using time series data from the Central Bank of Nigeria.
1.3 Research Questions
In view of above stated problems, the following research questions will guide the study;
1) What is the impact of exchange rate volatility on GDP growth, FDI inflow, trade openness and inflationary pressure in Nigeria?
2) What is the causal relationship between exchange rate volatility and and selected macroeconomic variables (GDP growth rate, FDI inflow, trade openness and inflationary pressure) in Nigeria?
1.4 Research Objectives
The broad objective of this study is to analyse the impact of exchange rate volatility on selected macroeconomic variables in Nigeria. The specific objectives of the research include the followings.
1) To estimate the impact of exchange rate volatility on GDP growth rate, FDI inflow, trade openness and inflationary pressurein Nigeria .
2) To analysethe causal relationship between exchange rate volatility and and selected macroeconomic variables (GDP growth rate, FDI inflow, trade openness and inflationary pressure) in Nigeria?
1.5 Research Hypotheses
In line with the above stated objectives, the following research hypotheses shall be tested:
H01: Exchange rate volatility has no significant impact on GDP growth rate, FDI inflow, trade openness and inflationary pressurein Nigeria .
H02: There is no causal relationship between exchange rate volatility and and selected macroeconomic variables (GDP growth rate, FDI inflow, trade openness and inflationary pressure) in Nigeria?
1.6 Policy Relevance of the Study
The fact that Nigeria engages in international trade made it inevitable to avert the influence of exchange rate fluctuations on macroeconomic variables. As such this study which estimated the impact of exchange rate volatility on selected macroeconomic variables will benefit mostly the Nigerian government through the monetary authorities. The study will give insight on impact of exchange rate volatility on gross domestic product growth rate, foreign direct investment inflow, trade openness and inflationary pressure within the economy. These variables are macro indicators which if the influence of exchange rate volatility on them were ascertained, policy makers will be in a better position to advice the government on how to minize such impact and their negative effect on the entire economy.
This study will also be of great benefit to students and scholars, as it will provide the additional knowledge on real relationship between exchange rate volatility and the above mention macroeconomic variables in Nigeria. It will equally provide information on the causal relationship among the variable. This will pave the way for effective policy formulation that is needed to stimulate the economy especially in this period of recession. Finally, this work will
assist policymakers and government to know where more of their policy actions will be channeled, so as to increase international competiveness.
1.7 Scope of the Study
The study is basically geared toward estimation of the impacts of exchange rate volatility on gross domestic product growth rate, foreign direct investment inflow, trade openness and inflationary pressure and investigate the causal relationship of same variables in Nigeria. Time Series data from 1981 to 2015 were employed for this study. The choice of this period is based on data availability.
This material content is developed to serve as a GUIDE for students to conduct academic research
THE IMPACT OF EXCHANGE RATE VOLATILITY ON SELECTED MACROECONOMIC VARIABLES IN NIGERIA
PROJECTOPICS.com Support Team Are Always (24/7) Online To Help You With Your Project
Chat Us on WhatsApp » 07035244445
DO YOU NEED CLARIFICATION? CALL OUR HELP DESK:
07035244445 (Country Code: +234)YOU CAN REACH OUR SUPPORT TEAM VIA MAIL: [email protected]