ECONOMIC ANALYSIS OF THE DETERMINANTS OF EXCHANGE RATE IN NIGERIA

CHAPTER ONE

1.0    INTRODUCTION

The role of exchange rate and its effects on macroeconomic performance has continued to generate interest among economists. Many economists argue that exchange rate stability facilitates production activities and economic growth. They are also of the view that misalignment in real exchange rate could distort production activities and consequently hinders exports growth and generate macroeconomic instability (Mamta Chowdhury, 1999)Exchange rate policy guides investors on the, best way they can strike a balance between their trading partners, and investing at home or abroad (Balogun, 2007). Mordi (2006) argued that the exchange rate movements have effects on inflation, prices incentives, fiscal viability, and competitiveness of exports, efficiency in resource allocation, international confidence and balance of payments equilibrium.

Exchange rate is one of the key 'barometers' of economics performance, indicating growth (output), demand conditions, the levels and trends in monetary and fiscal policy stance (Afolabi, 1991).  Exchange rate policy emerged as one of the controversial policy instruments in developing countries in the 1980s, with intense opposition for fear of its inflationary impact, among other effects. Nigeria faced such a situation and there has been interest, therefore, in economic performance and the role of the exchange rate in the process (Afolabi1991).

The exchange rate, when applied in conjunction with other macroeconomic policies is expected to lead to the achievement of the goals of price stability, improved and sustained economic growth, reduced unemployment and balance of payment stability. An optimal and stable exchange rate has to be right and stable since it is an important relative price that influences other prices. When the exchange rate is not optimal, however, the achievement of these objectives becomes different and often impossible according to Afolabi 1991. For example, if the exchange rate is not in equilibrium, it allows rent-seekers and speculators to exploit the subsidy element involved. The situation is worse when a parallel market develops as a result of restriction in the official market and inability of the market to satisfy the demand for foreign exchange. Thus, the opportunity cost of transacting business in the official market is the value of the subsidy or the premiums that would otherwise be lost by the official sector but gained by third party arbitrators and speculators. The disability nature of foreign exchange subsidy (premium) is the fundamental reason why unification of exchange rate is canvassed as a short to medium term objectives of exchange rate management. The smaller the parallel market relative to the official market, and the higher the demand and supply elasticity of foreign exchange in the official market relative the closer the unified equilibrium rate is likely to be the official rate. However, if there is a large unsatisfied demand in the official market which cannot be diverted to the parallel market because of administrative restrictions, the equilibrium rate in a unified market would tend to be closer to the parallel market rate or could even be beyond it (John, IMF, 1985). The retention of a dual exchange rate system for a long time would be counter productive in the long run by undermining the objective of exchange rate stability and structural reform of an economy. The continued existence of dual or multiple rates would be encouraging wasteful allocation of resource, thereby stunting economic recovery and groups. Foreign exchange liberalization, accompanies by appropriate demand management policies targeted at ensuring macro economic stability is necessary for exchange rate convergence, if the costs(subsidy) are to be reduced.  This is because the burden of adjustment is often borne by the official exchange rate.

One of the broad objectives of the Structural Adjustment Programme (SAP)

introduced in Nigeria 1986 was to achieve macroeconomic stability by reducing the level of inflation through the achievement of a stale and realistic exchange rate. Towards this and government deduced to deregulate exchange rate determination and the foreign exchange allocation system by relying largely on market focus. In this regard, various allocation mechanism, beginning from the second-tier foreign exchange market (SFEM),the interbalance foreign exchange market (IFEM), the Dutch, Auction system (DAS) to the pro-rate system and, lately, fixing of the official exchange rate and application of a free market exchange rate for purely commercial transactions, were adopted in order to achieve the goals of policy.

Nigeria is currently the second largest oil exporting country in the Organization of Petroleum Exporting Countries (OPEC) and is heavily reliant on its crude oil exports which accounts for 95% of its exports and foreign exchange earnings and about 80% of government revenue annual budgets (EIA, 2010). Oil has been the dominant factor in Nigeria's economy since its discovery in 1956 (Budina et al, 2006). Oil exporting nations may experience exchange rate appreciation when oil price rise, conversely exchange rate of oil exporting nations may depreciate when oil price falls.

From 1980 to 1985 following the oil price increase, it has be observed that an upward trend with the real exchange rate appreciating significantly leading to loss of competitiveness for the Nigeria economy. In 1986, Nigeria experiences a sharp decline in its real exchange rate following declining oil prices and the Structural Adjustment Programme (SAP) which led to the devaluation of the Nigerian currency - the naira. Between 1993and 2000, there were substantial movements in the real exchange rate. Since then, the real exchange rate index fluctuated around a constant trend with evidence of mild appreciation of the real exchange rate. In recent years, owing to rising global oil prices and increased oil exports, Nigeria experienced large foreign exchange inflows. The real exchange appreciate could be described to be a response to the large foreign exchange inflow that characterized the Nigerian economy or it could as well be a response to productivity gains.

Approaches employed to analyze the problems of exchange rate determination ranged from the traditional balance of payment approach to the modem approaches of exchange rate determination, consisting of the monetary and port-folio balance approaches (that is after deregulation) argues that the exchange rate, being a relative of the two natural monies, is determine primarily by the relative supplies and demands for the monies. The approach is also referred to as asset market approaches to the determination of exchange rate, since the demand for the various national monies depends on expectations, income and rates of return and other factors relevant for port-folio choice.

1.1    STATEMENT OF PROBLEM

There has been several exchange rate systems in use in historical times out of which is the Gold Standard System which has been the first historical system in modern times, the free exchange rate system was determined by the supply and demand for foreign currencies or the demand and supply of domestic currencies, none of the two systems stated above have given a stabilizing foreign exchange market (Akinmoladun, 1990).

The exchange rate under the Gold Standard System brought about a subordination of the demand for domestic equilibrium to the vicissitudes of the external sector.

The case against the free exchange rate is similar though allowed for external and internal equilibrium, but had disadvantages since the fluctuating deter exporters

and importers where as stable rates give them more confidence. In Nigeria, during the regime of exchange controls, the black markets rates were much higher than the official rates for foreign exchange and this underscored the high over-valuation of the naira and the consequent deficit disequilibrium which the black market supply was geared to full.

Nigeria's high external indebtedness as a result of continuing disequilibrium in the balance of payment has really posed the problem of how to fund a correct exchange rate in the face of dynamic changes in underlying conditions behind autonomous transactions. A rate that is set too high under values domestic currency and a rate that is set too low over values the domestic currency.

There has been an ongoing debate on the appropriate exchange rate policy in developing countries. The debate focuses on the degree of fluctuations in the exchange shocks. Exchange rate fluctuations are likely, in turn, to determine economic performance. In judging the desirability of exchange rate fluctuations, it becomes. Therefore, necessary to evaluate the macroeconomic factors that influence the fluctuations. This is the main focus of this study.

1.2    RESEARCH QUESTIONS

The following questions would be considered in the course of the study:

1.       What are the macroeconomic factors that influence exchange rate in Nigeria?

2.       To what extent do inflation and money supply affect exchange rate in Nigeria?

3.       What are the major issues in exchange rate policy and management in Nigeria?

4.       Over the years, is exchange rate stable?

5.       How could the exchange rate be influence to stimulate economic growth in Nigeria?

6.       How does the Structural Adjustment Programme contribute to a realistic exchange rate?

1.3    AIM AND OBJECTIVES OF THE STUDY

The objectives as regard this study shall be considered on the followings:

1.       To identify the macroeconomic factors that influence exchange rate in     Nigeria;

2.       To investigate the effect of inflation, and money supply on exchange rate, after deregulation;

3.       To know whether exchange rate is stable over the years before and after Structural Adjustment Programme (SAP)

4.       To examine the impact of economic performance and volume of imports on exchange rate;

5.       To raise and discuss issues in exchange rate policy and management.

1.4    JUSTIFICATION OF THE STUDY

The need for foreign exchange management lies only within the framework of

countries engaged in international trade in contract to a closed economy. This need is underscored by the economic theory of comparative advantage, theory of comparative cost as well as international resources endowment differentials.

The study is expected to reveal the macroeconomic factors that influence the exchange rate so that the monetary authorities could manipulate them effectively to

stimulate growth in the economy, ' thereby, enhancing policy formulation and implementation.

The study also would contribute to knowledge by examining the macroeconomic factors that influence exchange rate in contrast to existing paper that have examined the impact of exchange rate on macroeconomic variables, thereby enriching the lacuna in literature.

1.5    SCOPE OF THE STUDY

The foreign exchange market shall be studied and the role it plays on the macroeconomic objectives. It is important to note that various exchange rate policy ranging from exchange control, free exchange rate, and the Dutch auction method are important policies to be considered.

However, the empirical investigation of the factors that determine the exchange rate in Nigeria shall be restricted to the period 1980 to 2010.

The limitation of the study is confined to the era when deregulation started in Nigeria, an attempt will be make to consider the period between 1970-1985 before Structural Adjustment Programme (SAP) and the period between 1986-2001 which

takes care of the period during and after SAP;

1.6    DEFINITION OF TERMS

Exchange Rate: it refers to the rate at which one currency exchange for another (Jhingan, 2003). Exchange rate is said to depreciate if the amount of domestic currency require buying a foreign currency increases, while the exchange rate appreciates if the amount of domestic currency requires buying a foreign currency reduces. Exchange rate volatility refers to the swings or fluctuations in the exchange rate over a period of time or the deviation from a benchmark or equilibrium exchange rate (Mordi, 2006).

Gross Domestic Product (GDP): Is the summation of all the values of goods and services produced in a country by the nationals and non-nationals. It does not include incomes and property earnings of the nationals abroad neither does it excludes the income and property earnings of the non-nationals in the country.

Inflation exists when there is a sustainable increase in the price level or a persistent tendency for prices and money wages to increase. That is rise in the price of goods and services as a result of large volume of money in circulation used in the exchange for the few available goods and services.

Money Supply: The amount of money in an economy. This may be the country's own money supplied by its banking system, or foreign money used in preference to domestic money.

Balance of Payments is an overall statement of a country's economic transactions with the rest of the world over some period. A table of the balance of payments shows amounts received from the rest of the world and amounts spent abroad.

Foreign Exchange Market is the medium of-interaction between the sellers. and buyers of foreign exchange in a bid to negotiate a mutually acceptable price for the settlement of international transaction.

Deregulation is the removal or dismantling of restriction and control measures, and this may be in ranging degrees. .

Structural Adjustment Programme (SAP): SAP was introduced in June 1986 to achieve structural balances in Nigeria economy. The programme basic strategy was to deregulate the economy and enhance the role of a realistic exchange rate and the co-ordination of the country's economic activities.