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The Impact
Of Exchange Rate Instability On Investment In Nigeria
ABSTRACT
This
research work is centered on the effects of exchange rate instability on
investment in Nigeria. With special emphasis on the purchasing power of average
Nigerian and the level of international trade transaction. Without exchange
rate, the exchange of goods and services among trading partners will be focused
with a lot of problems, which may virtually narrow it down to trade by barter.
This exchange also is used to determine the level of output growth and
investment of the country. Hence, the rate at which exchange rate fluctuate
calls for a lot of attention. However, with the already existing exchange rate
policies, a constant exchange rate has not been attained. The rate by which
exchange rate fluctuates brings about uncertainty in the trade transaction, and
also in the rate of naira has been unstable and continued to depreciate. This
has resulted to declines in the standard of living of the population; increase
in cost of production (this is because most of the raw materials needed by
industries are usually imported), which resulted in cost push inflation. Many
test, such as unit root test, which we made use of the battery test and also
t-statistics table was used when we found out that real interest rate has a
negative effect on the output growth.
CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
Foreign exchange is the means of payment
for international transaction. It is made up of convertible currencies that are
generally accepted for the settlement of international trade and other external
obligation. Like every other commodity, a market is established which works
like any other market, having a supply curve, a demand curve, and an
equilibrium price and quantity. There are also conditions which are held
constant. When these conditions changes, the curve shifts and there is a change
in the equilibrium price and quantity. This market for currencies is known as
the foreign Exchange market.
The foreign exchange market according to
the central bank of Nigeria is a 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 transactions. The seller of foreign
exchange constitutes the supply while the buyers of foreign exchange
constitutes its demand. T he supply of foreign exchange is derived from oil
exporter, non oil exporter, expenditure of foreign tourist in Nigeria, capital
repatriation by Nigerians resident abroad etc.
The 1980s witnessed increased flows of
investment around the world. Despite the increased flow of investment to
developing countries, Nigeria lagged behind in attracting foreign investment.
The uneven dispersion of Foreign Direct Investment is a cause of concern since
FDI is an important source of growth for developing countries. This is because
not only can FDI add to investment resources and capital formation; it can also
serve as an engine of technological development with much of its benefits arising
from positive spillover effects. Such positive spillovers include transfers of
production technology, skills, innovative capacity and organizational and
managerial practices.
Given the significant role of FDI in
developing economies, there have been several studies that tried to determine
the factors that influence FDI inflows into the Nigerian economy. One of such
factor is exchange rate and its volatility. The existing literature has been
split on this issue with some studies finding a positive effect of exchange
rate volatility on FDI, and others finding a negative effect. A positive effect
can be justified with the view that FDI is export substituting. Increases in
exchange rate volatility between the head quarters and the host country induce a
multinational to serve the host country via a local production rather than
export, thereby insulating against currency risk. The negative effect of
exchange rate volatility on foreign investment can be found in the
irreversibility literature by Dixit and Pindyck (1994). They stated that “A direct investment in a
country with a high degree of exchange rate volatility will have a more risky
stream of profits”. As long as this investment is partially irreversible, there
is some positive value of holding off on this investment. Given that there are
finite numbers of potential direct investments countries with a high degree of
currency risk will lose out on FDI to countries with more stable currencies.
Nigeria is one of the countries that fall into the category with high degree of
currency risk. With a population of about 130 million people vast mineral
resources and favorable climatic and vegetation features, Nigeria has the
largest domestic market in sub-Saharan Africa.
The Nigerian
domestic market is large and potentially attractive to domestic and foreign
investment as attested to by port folio investment inflow of over N1.0 trillion
into Nigeria through the Nigerian stock exchange (NSE) in 2003 (Central Bank Of
Nigeria, 2004). Investment income, however has not been encouraging which was a
reflection of the sub-optimal operating environment largely resulting from
inappropriate policy initiatives. Except for some years prior to the
introduction of Structural Adjustment Programme (SAP) in 1986, gross capital formation
as a proportion of the GDP was dismally low on annual basis. It was observed that aggregate investment
expenditure as a share of GDP grew from 16.9% in 1970 to a peak of 29.7% in
1976 before declining to an all-time low of 7.7% in 1985. There after the
highest was 11.8% of GDP in 1990 before declining to 9.3% in 1994. Beginning
from 1995, Investment declined significantly to 5.8% and increased marginally
to 7.0% in 1997 and remained there about till 2004 when 7.1% was recorded.
For a developing country like Nigeria
that is highly dependent on trade, the exchange rate which is the price of
foreign exchange plays a significant role in the ability of the economy to
attain its optimal productivity. In addition, the exchange rate level has implications
for balance of payments viability and the level of external dept. For example,
if the exchange rate is overvalued, then this will result in unsustainable
balance of payments deficits and escalating external debt shock. These will in
turn lead to a declining level of investment. Thus it is imperative to let the
exchange rate find its equilibrium level. It is only when the equilibrium
exchange rate prevails that there is viability of the balance of payment
position. In general, a stable foreign exchange rate regime will lead to
macroeconomic stability and encourage investment and growth. An overvalued
exchange rate tends to encourage capital flight. Stability of the exchange rate
regime will therefore reduce capital flight and encourage capital inflow in the
form of foreign private investment.
However, exchange rate volatility is
being increasingly recognized as a disincentive to the choice of Nigeria as
Foreign Direct Investment destination because it adds to the list of risks
inherent in the country. Exchange rate volatility is driven largely by
inflation, nominal and foreign reserves shocks in the country. Exchange rate
and FDI policy coordination, with a view to minimizing the harmful effect of
exchange rate volatility and FDI on each other is therefore, a challenge to
fiscal and monetary authorities must face. Exchange rate volatility generates
air of uncertainty as the variance of expected profits rises and its net
present value falls. This could cause investors to hesitate about committing significant
resources to FDI, thus serving as a serious disincentive for investment and
compounding the existing political and economic risks.
In 1989, the Bureaux de change was
established to accord small users’ greater access to foreign exchange. In order
to further reduce instability in the foreign exchange market, the Inter- bank
procedure was modified in December 1990 when the Dutch Auction System was
introduced. Since instability in the foreign exchange market could not be
stemmed, the model weighted average method of exchange rate determination was
introduced in August 1991. Under this system, the rates tending towards the
models were used to determine the market exchange rate. Although this system
succeeded in reducing the fluctuation in the official exchange rate,
instability soon set in and the parallel market commenced process of sustained
depreciation, leading to a widening gap between the parallel and the official
market. For example the parallel market premium reached 99.2% in February 1992,
compared with 35.5% in 1991 and the internationally accepted standard of 5.0%.
The CBN completely floated the Naira on March 5, 1992 in a bid to arrest the
drift with this, the parallel market premium was narrowed to a level below 10%
but as a result of renewed demand pressure and speculative activities, the
premium started to widen again.
In 1993, the federal government pegged
the official exchange rate at #21.9960 =$1.00. The re-regulation of the economy
in 1994, instead of appreciating the value of the naira and stabilizing the
foreign exchange market, further reduced the value of the naira and resulted in
a self sustaining phenomenon of exchange rate depreciation in the parallel
market. The foreign exchange market was deregulated in 1995 under a policy
guided by deregulation in order to build-up external reserves to improve the
credit worthiness of the Nigerian economy and its competitive, strengthen the
naira and gradually move the currency towards convertibility. The policy
measures were retained in 1996. The dual exchange rate system was returned in
1998. By 2002, the IFEM was deregulated and the IFEM was reformed to allow
Bureaux de change to source their foreign exchange requirements. In July 2002
the CBN replaced the 33 months old IFEM with the Dutch Auction System (DAS) and
the following achievements have been recorded: Improvements in the external
reserves position of about US $ 20 billion as at December 2004 which has
increased to US $ 3 billion at January 2006.
The whole sale Dutch Auction System was
introduced on February 2006 replacing the retail DAS, the liberalized foreign
exchange market witnessed unprecedented stability most of which include the
following:
―Unification of exchange rates between the official and inter-bank
markets and resolution of the multiple currency problems.
―
Facilitation of greater market determination of exchange rates for the Naira
vis-Ã -vis other currencies.
The table below shows the historical value
of one US Dollar in Nigerian Naira since 1989 to 2009. Pm = parallel market
Date Naira per US $
dollar
1989 N7.39 (10.70)
1990 N7.39 (10.70)
1991 N8.04 (9.30)
1992 N9.91
1993 N17.30 (21.90)
1994 N22.33 (56.80)
1995 N21.89 (71.70)
1996 N21.89 (84.58)
1997 N21.89 (84.58)
1998 N21.89 (84.70)
1999 N21.89 (88-90)
2000 N85.98 (105.00)
2001 N99 - N106 (104-122)
2002 N109- N113 (122-140)
2003 N114- N127
(135-137)
2004 N127- N130 (137-144)
2005 N132- N136 (140-146)
2006 N128.50-
N131.80 (141-146)
2007 N120- N125 (141-146)
008 N115.50- N120 (145-151)
2009 N145- N171 (151-153)
` The sub-optimal investment ratio in
Nigeria is traced to many factors which include exchange rate instability,
persistent inflationary pressure, and low level of domestic savings, inadequate
physical and social infrastructure etc. A major factor is exchange rate
instability, especially after the discontinuation of the exchange rate control
policy. The high lending rate, low and unstable exchange rate of the domestic
currency and the high rate of inflation made returns on investment to be
negative in some cases and discouraged investment, especially when financed
with loans.
The Naira (Nigerian currency N)
exchange rate witnessed a continuous slide in all the segments of the foreign
exchange market (that is official, Bureau de change and parallel markets). In
the official market, the exchange rate depreciated progressively from N8.04 per
US dollar in 1990to N81.02 per dollar in 1995 and further to N129.22 in 2003
and N133.00 in 2004. In Bureau the change and parallel market it depreciated
from #9.62 and #9.61 per dollar in 1990 to N141.36 and N141.07 per dollar in
2003.
Consequently, the premium between the
official and parallel market remained wide throughout the period. This high
exchange rate volatility in Nigeria among others, led to a precarious operating
environment which can be attributed to the reason why Nigeria was not only
unable to attract foreign investment to its fullest potentials but also had a
limited domestic investment. As such, despite the vast investment opportunities
in agriculture, industry, oil and gas, commerce and infrastructure, very little
foreign investment capital was attracted relative to other developing countries
and regions competing for global investment capital.
Since the democratic dispensation of
Obasanjo administration, Nigeria renewed interest in flexible exchange rate
that is exchange rate determined by the forces of demand and supply drawing
from the advantages of high oil prices and huge accumulation of foreign
reserve. Many analysts have argued that incessant changes associated with
flexible exchange rate regime and the ability of Central Bank to control such
changes will hurt manufacturing export. Olebune (2008). This controversy led to
the abandonment of the new naira policy proposed by CBN governor in August
2007. Exchange rate has really been a big problem to the Nigerian economy,
especially since the introduction of SAP in 1986, which allowed the exchange
rate to be determined through price mechanism that is, the interaction of
demand and supply.
1.2 STATEMENT OF THE PROBLEM:
This
research work is meant to emphasize on the issue of exchange rate instability
and its impact on investment in Nigeria.
Some of the problems which cause
instability on exchange rate on investment in Nigeria can be seen below:
― The wide
premium between the official and parallel market in the foreign exchange
market. The high exchange rate volatility in Nigeria led to a precarious
operating environment which is attributed to the reason why Nigeria was not
only unable to attract foreign investment to its fullest potentials but also
had a limited domestic investment.
― The
instability and continuous depreciation of the naira in the foreign exchange
market. This problem has been in existence since September 1986, when the
market determined exchange rate system was introduced via the second tie
foreign exchange market. This instability and continued depreciation has
resulted in decline in the standard of living of the populace.
― Jhingan
(1997) emphasized that exchange rate fluctuation cause uncertainty and impede
international trade. This uncertainty and impediment on international trade
transaction pose a lot of problem such as inflation, which determine the
internal balance of a country. In view of this, a stable exchange rate system
will speed up domestic production, reduce inflationary speed and guarantee the
attainment of internal balance. Obasikene (2006).
It has also
tended to undermine the international competitiveness of non oil exports and
make planning and projections difficult at both micro and macro levels of the
economy, some small and medium scale enterprise have been strangled out as a
result of low dollar naira exchange rate.
Considering these general situation, we
shall now be faced with such questions as:
― having adopted some policies, have they been
able to maintain a constant exchange rate?
― to what extent has Nigeria gone in
maintaining a constant exchange rate?
― how does
exchange rate instability cause inflationary bias and to what extent has inflation
impeded on international trade?
1.3 OBJECTIVE OF THE STUDY
In a highly
dependent economy like Nigeria, the naira exchange rate has become one of the
most widely discussed topics in the country today. This is not surprising as
this topic has had a lot of macroeconomic impact on investment in Nigeria. It
is therefore the objective of this study to:
― Evaluate
the effect of exchange rate instability on investment in Nigeria.
― To trace
the transmission of structural shock among exchange rate instability and its
determinant.
― To examine
if the continuous fluctuation of exchange rate of naira have an impact on the
purchasing power of an average Nigerian.
― To examine
the extent by which money supply and interest rate affects the economy.
― To make
policy recommendation based on the findings.
1.4 STATEMENT OF HYPOTHSIS
Only the null hypothesis is tested which are
in line with the objective stated above:
―H0:
exchange rate instability affects investment in Nigeria negatively.
―H1: The continued
fluctuation in the exchange rate of the naira has reduced the purchasing power
of the average Nigerian.
1.5 SIGNIFICANT OF THE STUDY
The study will identify the strength and
weakness of exchange rate policy and management, identify those economic
variable that are mostly affected by instability in exchange rate and provide
the general public with the awareness on the foreign exchange transaction and
its impact on investment.
The various find of this study would enable
the government and financial authorities to device, modify and adopt a better
foreign exchange transaction for the economy.
In general the study benefits the following:
1 Banks
especially the universal banks.
2 Policy makers of central bank of Nigeria.
3 Importers who make payment in foreign
currencies.
1.6 SCOPE AND LIMITATIONS OF THE WORK
Although there are many economic variables
that operate within the Nigeria economy, this research work is limited to the
study of the impact of instability in exchange rate.
The scope of this research work is also
limited to the period between 1989-2009
1.7 DEFINITION OF TERMS
FOREIGN
EXCHANGE: Foreign exchange is a means of payment for international
transactions. It is made up of currencies of other countries that are freely
acceptable in setting international transactions.
FOREIGN
EXCHANGE MARKET: This is a medium of exchange among buyers and sellers of
foreign exchange with a view of negotiating acceptable prices for setting
international transaction
EXCHANGE
RATIO: This is the price of one currency in terms of another.
AFEM:
Autonomous Foreign market is where the exchange rates under this system are
being determined essentially through market forces.
DUTCH
AUCTION SYSTEM (DAS): This is a method of exchange rate determination through
actions where the bidders pay according to their bid rats. The ruling rate is
arrived at the last bid rate that clears the market.
EXCHANGE
CONTROL: This is a foreign exchange arrangement in which the government
purchase all incoming foreign exchange and is the only source from which
foreign exchange can be purchased legally.
DUAL
EXCHANGE RATE REGIME: These situations exist when two exchange rate are in
existence in an economy.
MARGINAL
PRICING METHOD: This is a method in which bid rates are arranged in a
descending order of magnitude.
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