IMPACT OF EXCHANGE RATE VOLATILITY ON ECONOMIC GROWTH IN NIGERIA
ABSTRACT
The degree of volatility of exchange
rate movements has led policy makers and researchers to investigate the
nature and extent of the impact of such movements on growth. This study
examines the impact of exchange rate volatility on the economic growth
in Nigeria. The thesis offers empirical evidence on the impact of
exchange rate volatility on Nigeria’s economic growth. A review of
literature shows that exchange rate volatility can have either positive
or negative effects on economic growth depending on the parameter used.
The study used annualized time series data for the period 1987-2014 to
examine the impact of exchange rate volatility on economic growth in
Nigeria using real gross domestic product growth rate as proxy for
economic growth. The data sources were mainly from Central Bank Nigeria
Statistical Bulletin (various years).The study builds on absolute
percentage change measure for exchange rate volatility measurement. The
unit root tests employed are based on the work of Dickey-Fuller.
Application of Johansen multivariate procedure was to obtain the trace
and maximum eigenvalue likelihood ratio test statistics. The impact of
exchange rate volatility on exports and imports were also examined so as
to determine the extent to which this volatility can influence these
variables via growth. For a more robust model, inflation, a determinant
of economic growth was also included to examine its effect. The
empirical analyses began with the testing of the four formulated
hypotheses for the thesis. From the findings, exchange rate volatility
had a negative and significant impact on the economic growth in Nigeria
within the period studied. The study also found a negative and
significant casual relationship between inflation and economic
growth.Exchange rate volatility exerted positive and significant impact
on exports, and negative and significant impact on imports. This
indicates that higher exchange rat risk encourages exports and
discourages imports, and also discourages economic growth. Although
economic theories suggest that export oriented economies tend to grow
faster than import dependent ones, yet the Nigeria case was different
during the period studied. Thus, the study recommends that Nigeria
should increase her economy diversification by encouraging production
and exportation of primary commodities and discouraging importation of
goods that can be locally produced.
CHAPTER ONE
1.0 INTRODUCTION1:1 BACKGROUND TO THE STUDY
Exchange rate lies at the heart of the
global financial system and set the terms on which countries trade each
other’s goods and services. Exchange rate is a key macroeconomic
variable in the context of general economic policy making and of
economic reform programmes. Its management determines the pace at which a
country’s economic activities will grow. Thus the analysis of exchange
rate management and the variability associated with exchange rate has
been a recurring topic in international monetary economics. According to
Chou (2000), the debate on exchange rate management transcended the
collapse of the gold standard in the 1930s to the emergence of Bretton
Wood System of adjustable peg from the 1940s through other various
exchange rates.
This debate on exchange rate volatility
and uncertainty has long divided economists. At one end, the argument
supports the fixed exchange rate while the other, the floating system.
The Nigerian economy has been visibly distressed in the different phases
of exchange rate management (ERM); each coming with its own, possible
problem.
According to Idika (1998) frequent
changes in foreign exchange policies caused by unstable political
environment have prevented these policies from coming full circle.
Exchange rate stability, which is essential for growth is influenced
greatly by the appropriate policy mix by governments in their quest to
attain macroeconomic targets.
The term stability does not connote
static condition but a situation that permits variability in response to
changes in the market fundamentals. Examples are changes in relative
prices, international terms of trade and other factors that impinge on
the price competitiveness of the domestic market agents’ products. In
fact, the exchange rate arrangement that emerged after the collapse of
Bretton-Wood has always been criticized on the grounds that it does not
have a mechanism to reduce or regulate excessive rate volatility among
the major currencies(dollar, yen and deutsche mark), which is the G-3
currency ( Gerardo and Felipe, 2001)
With the move from fixed to flexible
exchange rates in Europe in 1973, there was increasing concern about
effects of exchange rate variability on trade. Flexible exchange rate
that followed the collapse of the Bretton Wood System is of concern to
economists and policy makers about the effect of exchange rate
volatility on economic growth (see Williamson 2001). In a flexible
exchange regime, the exchange rate is determined directly by market
forces, and is liable to fluctuate as dictated by changing market
condition (Isard, 1998). For instance, Oyovwi (2012) evaluated in his
studies that the flexible exchange rate produced a significant
volatility and uncertainty effect in the exchange rate of Naira.
Exchange rate instability, the volatility
of international capital movements and bubbles in asset prices are all
closely interlinked. Wilson and Ren (2007) argued that in 1997 Asia
crisis, for example, the rush to invest in “Asian miracle” led to the
influx of capital which led to a boom in share and property prices, and
also upward movement on exchange rates. A change in sentiment led to
reduction of capital movements, a collapse in asset prices and a sharp
fall in exchange rates. According to Wilson et .al (2007), following the
aftermath of the Asian financial crisis, the issue of the choice of
exchange rate regime for the East Asian Countries re-emerged.
Aside economic crisis, exchange rate
fluctuations as put by Smith (2002) can have a positive effect on
industrial output which also promotes employment from industry’s point
of view: the two objectives are that rates should be competitive and
stable. The most striking issue to the economists is the fluctuation of
rates at the times of financial crisis, but equally serious are the
effects of continuing fluctuations and misalignments of rates on
industry and employment and in the longer run on both developed and
underdeveloped economies.
Moreover, changes in exchange rates also
have powerful-effects on imports and exports of the countries in
question through effects on relative prices of goods. Mordi (2006)
posits that the Nigerian economy is highly dependent on import for both
consumption and production. Usually all the major industrial raw
materials are sourced from abroad while the country depends on foreign
supply for intermediate and capital goods. The major non-oil exports
products are basically primary produce whose prices have been on the
downward trend and are exogenously determined making exports to be
highly inelastic. These exports are slow in responding to exchange rate
adjustments.
According to World Bank (2003), research
has shown that many oil producing nations are exposed to variations in
exchange rate due their large oil wealth. This variation will then act
as tax on investment in traded goods production notably agriculture and
manufacturing which have an adverse impact on growth. For instance,
since the oil discoveries in the early 1970s made Nigeria one of the
world’s top ten exporters, the country’s over-dependency on oil as the
chief source of revenue resulted in negligence of non-oil exports for
foreign exchange earnings. Oil accounts for about 90 per cent of total
exports and about four-fifths of total government revenue while non-oil
per capita GDP has been falling dramatically since the early 1970. The
displacement of agricultural exports by crude oil exports in the early
1970s as the major foreign exchange earner owing to the sharp rise in
petroleum prices; enhanced official foreign exchange receipts. Jin
(2008) showed that the implications of over-dependence on export of oil
is that economy is highly prone to external shocks in that any crash in
oil price will lead to decline in foreign exchange earnings and
destabilizing effects on exchange rate. This shift in relative prices
would lead to a corresponding shift in the allocation of domestic
resources and move economic structure away from the production of export
goods (agriculture), and into services sectors.
To explain high exchange rate volatility
in oil rich countries (ORCS), it has been argued that countries with
many interest groups competing for the resources’ rents are likely to
overspend in good years, and under-adjust in bad years. Each interest
group tries to over exploit windfall gains in an attempt to at least
partially offload efforts (see the “voracity effect”, Lane and Tornell
1995). Federal states like Nigeria are thought to be especially
vulnerable to what amounts to an equivalent of overgrazing the commons.
An expenditure behaviour that leads to
overspending in good days and under adjustment in bad days may end up
with an economy with even higher volatility than is to be expected on
the basis of the volatility in its revenue streams alone as suggested by
Hamilton (1983). There is possibly high exchange rate volatility in oil
rich countries (ORCs): an explanation that starts from the surprising
fact that many oil rich countries (ORCs) have indeed landed themselves
in debt problems, their oil wealth notwithstanding.
Thus volatility in exchange rate is
harmful to economic growth, a problem that is common in less developed
countries (LDCs) because of the extreme volatility of their income
streams. Nigeria’s experience so far indicates that managing exchange
rate volatility in a poor institutional environment is difficult. The
poor macroeconomic environment of the past largely contributed to the
problem in the external sector of the economy. For example, Nigeria was
ranked as the third most volatile economy in terms of trade volatility
out of 90 countries in a World Bank (2003) study covering the period
1961-2000. This shows that the impact of high volatility on output and
growth was further worsened by an inflexible real exchange rate policy
in Nigeria. This is to say that if expenditure is highly volatile, a
flexible real exchange can at least prevent or reduce impact on output
volatility and growth. This is because high expenditure volatility
requires exchange rate flexibility to accommodate downturn effects on
growth.
Obadan (1998) further opines that failure
by the Federal Government of Nigeria to adjust the exchange rate to the
decline in expenditure necessitated by declining oil prices and more
difficult access to external finance, resulted in unemployment rising
instead. In the end, the oil price collapse, high interest rates and
public debt problems as of early 1980s, made high nominal exchange rate
unsustainable and massive nominal and real exchange rate depreciation
followed. Thus exporters following official exchange rates effectively
would be faced with a high tax further discouraging non-oil exports. For
instance, in the early 1970s, most economic agents had to patronize the
Central Bank of Nigeria for foreign exchange allocation due to
instability in the rates.
In an effort to highly manage the
exchange rate, the Federal government of Nigeria rationed foreign
exchange and created multiple windows for foreign exchange transaction,
which created a parallel market for foreign exchange. Also as stated by
Central Bank of Nigeria (2006), the existence of the parallel market has
continued to foster speculative activities in the foreign exchange
market. Throughout the 1990s, annual investigation by the regulatory
authorities has revealed significant exchange rate premium between the
official rate and the parallel market rate for arbitrage gains. For
example, the parallel market premium was as high as 79.2 percent in
February 1992, compared with 35.5 percent in 1991 and the
internationally acceptable standard of 5.0 percent. Exporters that had
to surrender foreign exchange at official rates effectively faced a high
tax further discouraging non-oil exports. This was not enough to
resolve the imbalance: an inflationary process further fuelled by
substantial deficit financing through money issue by the public sector
brought about further real exchange rate appreciation. As a result while
the nominal exchange rate remained relatively stable, the black market
premium reached 330 percent when oil prices collapsed.
Aghion (2006) has shown empirically that
high exchange rate volatility slows down productivity and growth by
substantial margin in countries with a relatively underdeveloped
financial sector, like Nigeria. In their sample study, Hausman and
Rigobon (2002) showed that a 50% increase in volatility slows down
productivity growth by 33% on average. And there is substantial evidence
that oil rich countries have more volatile economics than non-oil rich
countries. Thus, there is logic to focus on exchange rate volatility as
an explanatory factor for Nigeria’s poor growth record. It is also
evident that Nigeria’s economy is struggling to leverage the country’s
vast wealth in fossil fuels in order to displace the crushing poverty
that affects about 57 percent of its population. Economists refer to the
co-existence of vast wealth in natural resources and extreme personal
poverty in developing countries like Nigeria as the “resource curse” as
shown in appendix A (see Manzano and Rigobon, 2001, Budina and
Wijnbergen 2006).
Thus, prior to the adoption of the
structural Adjustment Programme in September 1986, Nigeria’s exchange
rate system was administratively managed (adjustable peg). The country’s
currency experienced a continuous appreciation (except for few years),
amidst a noticeable macroeconomic disequilibrium reflected in the
bourgeoning non-oil trade deficit, balance of payments crisis, and
fiscal deficits. Even when a free-floating exchange rate system was
adopted, the monetary authorities were criticized for not allowing the
market fundamentals to determine the operations of the market. The
genuineness of these allegations is reflected in the ever widening
premium between the official and parallel exchange rates. This measure
and other subsequent measures did little or nothing to bring stability
in exchange rate.
Thus, following the quest for corrective
measures of the exchange management strategies in Nigeria and the need
to ward off distortions in the foreign exchange market various
modifications have been made to the institutional framework with a view
to achieving a realistic exchange rate objective. That is from
Second-tier Foreign Exchange Market (FEM), Dutch Action System (DAS),
and currently the Wholesale Dutch Action System (WDAS). All the
aforementioned regimes will be discussed in detail in the next chapter.
1.2 STATEMENT OF THE RESEARCH PROBLEM`
A lot has been said about the management
of exchange rate in Nigeria following the various regimes of exchange
rate policy, accomplishments have been less than satisfactory. Since the
generalized fixed exchange rate regime and adoption of a generalized
floating system by the industrialized countries in 1973, most countries
including Nigeria, have experimented with various types of exchange rate
arrangement ranging from the peg system to weighted currency basket to
managed floating and more recently to the monetary zone arrangement (see
Mordi 2006). Inconsistent management of the various exchange rate
policy/regimes adopted so far by the country to help check volatility in
exchange rates has jeopardized the overall macroeconomic policy
objectives.
According to Mordi (2006), once an
exchange rate is not fixed, it is subject to variations, thus floating
exchange rates tend to be more volatile. The degree of volatility and
the extent of stability maintained are affected by economic
fundamentals.
Thus strong economic fundamentals are
meant to produce favourable economic environment. Friedman (1953)
supported this argument in his thesis noted that “…instability of
exchange rate is a symptom of instability in the underlying economic
structure …”
The naira exchange rate has been
fluctuating since the introduction of the Structural Adjustment
Programme (SAP) in 1986. The Nigerian situation since SAP has mostly
been characterized by increasing demand which outstripped supply,
contributing generally to the continuous depreciation of the naira. The
SAP was designed to deal with the underlying imbalances in the Nigerian
economy following the collapse of international oil market. This
phenomenon of excess demand for foreign exchange in relation to supply
has contributed to the dwindling fortunes of the naira in all the
foreign exchange markets. Also weak production base and undiversified
nature of the economy are the factors that led to the depreciation of
Naira.
The country’s over dependency on oil as
the main source of revenue resulted in negligence of non oil exports for
foreign exchange earnings in the early1970’s. The enormous foreign
exchange earnings from crude oil exports encouraged the massive
importation of finished goods and services. The implication of this over
dependency on export of oil is that the Nigeria economy is highly prone
to external shocks in that any crash in the oil price will lead to
decline in foreign exchange earnings, and destabilizing effects on
macroeconomic variables such as exchange rate, gross domestic product,
interest rate, and inflation rate. According to Obadan (1998), adverse
foreign exchange rate regimes adopted so far have affected the Nigerian
economy over the years. The combined effects of dwindling in price of
oil and the volatility in exchange rate due to inconsistent exchange
rate regimes has led to constant depreciation of naira.
Again, most import dependent economies
like Nigeria face the problem of exchange rate volatility because the
economy’s technological base is weak, industrial activities tended to be
organized to depend largely on imported inputs. Nigeria relies so much
on revenue from oil exports, but massively imports refined petroleum and
other related products. The prevailing import-dependent industrial
structure became unsustainable as the mounting import bills could not be
matched by current export earnings (Ojo 1998).
The various monetary policy reforms and
exchange rate adjustments failed to restore stability in exchange rate
and maintain a low and stable inflation rate.
Despite the various measures adopted and
strategies for implementation, instability in exchange rate has
persisted. Gerardo and Felipe (2001) have argued that G-3 currency
instability have been at root of some of the currency and financial
crisis that have affected several developing countries. Caballero and
Corbo (1989), for example, show that higher volatility of the real
exchange rate hurt exports in a large group of developing countries,
thus affecting economic growth. Economic theory is ambiguous on the
impacts of increased exchange rate variations, some models predict
negative or positive impacts depending on the key parameters used. Many
other authors have also attempted to investigate whether exchange
volatility depresses trade flows in different periods and for different
countries. This literature has been surveyed by Mckenzie (1999), who
concludes that empirical results on this matter have so far been
inconclusive. In other words, theoretical and empirical work on the
subject has produced mixed results. This study attempts to explore the
impact of exchange rate volatility on the economic growth of this
country Nigeria.
1.3 OBJECTIVES OF THE STUDY
The main objective of this study is to
examine the impact of exchange rate volatility on economic growth in
Nigeria. To achieve this, the study strives to fulfill the following
objectives:
- To ascertain the magnitude of the impact of exchange rate volatility on economic growth in Nigeria.
- To assess the impact of exchange rate volatility on inflation rate in Nigeria.
- To establish whether there is a significant relationship between exchange rate volatility and exports in Nigeria.
- To determine what the effect of exchange rate volatility on imports in Nigeria.
1.4 RESEARCH QUESTIONS
To achieve the objectives of the study, these are used to provide answers to following questions:
- To what extent does exchange rate volatility impact on economic growth in
- Nigeria?
- To what extent does exchange rate volatility affect inflation in Nigeria?
- How far has exchange rate volatility had a significant relationship on exports in Nigeria?
- How far does exchange rate volatility have a positive and significant effect on imports in Nigeria?
1.5 RESEARCH HYPOTHESIS
In line with objectives, the following a-priori assumptions were made:
H01: Exchange rates volatility does not have a positive and significant impact on economic growth in Nigeria.
H02: Exchange rate volatility does not have a positive and significant impact on inflation in Nigeria.
H03: Exchange rate volatility does not have a positive and significant relationship on exports in Nigeria.
H04: Exchange rate volatility does not have a positive and significant impact on imports in Nigeria.
1.6 SCOPE OF THE STUDY
The scope of this research work was
limited the impact of exchange rate volatility on economic growth in
Nigeria only and it covers the period of 1987 to 2014.
1.7 SIGNIFICANCE OF THE STUDY
An analytical investigation of the impact
of exchange rate volatility on economic in Nigeria is of great
significance to the Nigerian Government, the Central Bank of Nigeria
(CBN) and the market dealers in Nigeria. This study will also be of
benefit to the following other groups. These groups include:
- Policymakers and Monetary Authorities.
First, this study will be of use to the
Central Bank of Nigeria (CBN) and policy makers in order to maintain
relative stability in the foreign exchange market. For example, to
understand the impact of monetary policies on the major macroeconomic
indicators such as exchange rate and inflation, it is necessary to
analyze variation in exchange rate movements within a time frame. An
appropriate policy mix is important to attain some given macroeconomic
policy objectives of exchange rate stability, economic growth,
employment and external variability. It is evident that the management
of the exchange rate is vested in the Central Bank of Nigeria, and thus
Central Bank of Nigeria (CBN) is expected to help policy makers realize
that exchange rate management without the necessary co-ordination of
macroeconomic policies is not enough to solve the problems of
macroeconomic imbalances in Nigeria.
- Private and Public Sector Operators.
Secondly, exchange rate volatility is
important not only from the perceptive of the CBN but also from the view
point of private sector operators. These private sector operators are
also concerned about exchange rate fluctuations because of its impact on
their portfolios, which may result in capital gains or losses. This
study will be of help to them because the importance of maintaining a
stable real exchange rate at a realistic level is that it gives investor
confidence to plan on creating wealth by exporting or by producing
import-substitutes that can really compete with imports. Exchange rate
is intricately related to economic growth, exchange rate is the price of
money and influences export and import in various ways. Higher exchange
rate means lower imports and higher exports. Lower imports imply
conservation of the foreign reserve, while more exports imply increase
in foreign exchange earnings and thus, more fund for investment.
Exchange rate stability is therefore imperative for driving growth since
it enable investors make reliable future investment plans. Instability
can lead to unnecessary fluctuations in imports, exports, and cost of
production, and makes it difficult to attract foreign investors. Beside
factors such as market opportunity, political risks and the legal
environment, business entities take exchange rate into consideration in
making investment decisions. The focus has always been on the volatility
of exchange rates in the foreign exchange market and its impact on
their business outcomes.
- Academia
Thirdly, those in the field of academics
will find this work to be of great importance for further researches and
references. The different empirical results of the previous works on
exchange rate volatility from different countries were mainly concerned
with exports. It then becomes important for a detailed study of exchange
rate volatility on economic growth. The empirical findings of this
study will guide researchers working on the area that this study did not
cover to draw their conclusions. The findings will also be added to
already existing literature on volatility of exchange rates
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