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Okafor Christian
AN APPRAISAL OF THE DEMAND FOR FOREIGN EXCHANGE
IN NIGERIA
Business administration
Banking and Finance
Okeke,chioma m
Digitally Signed by: University of Nigeria,
Nsukka
DN : CN = okeke,chioma m
O= University of Nigeria, Nsukka
OU = Innovation Centre
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TITLE PAGE
AN APPRAISAL OF THE DEMAND FOR FOREIGN EXCHANGE
IN NIGERIA
CERTIFICATION
This is to certify that the study, "The appraisal of the demand for foreign
exchange in Nigeria" was undertaken by Okafor Christian with registration number
PG/MBA/08/53160 in the department of Banking and Finance, University of
Nigeria.
……………………………. ……………. Okafor Christian DATE …………………………… …………….. Dr. J.U.J Onwumere DATE (Supervisor) …………………………… ………………. Dr. J.U.J Onwumere DATE (H.O.D)
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DEDICATION The research work is committed to God, the fountain of knowledge and
wisdom through whom we are able to accomplish set goals.
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ACKNOWLEGEMENTS I am indebted to a number of persons who in one way or the order helped to
make the research work a reality. I am grateful to God who granted me wisdom and
insight, knowledge, perseverance and good health throughout the period of work.
I thank Peter Anienwelu who facilitated the approval of the topic. I also thank
Christian Chukwu and Ezekiel Ezenduka who gave useful advices at the beginning of
the work and how I could go about it. I thank Elochukwu Oguebue who assisted in
the gathering of secondary data that was used to study.
Finally, I thank my supervisor, Dr. Onwumere who read through the work
and made the necessary corrections. With him I am better able to appreciate the
procedures involved in a thesis as this,
Okafor Christian
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ABSTRACT The paper evaluates the demand for foreign exchange in Nigeria for a twenty
four year period (1986 – 2009). The argument is that increases in exchange rate
positively affect the demand for foreign exchange in Nigeria. This is based on
observation from historical data on foreign exchange demand and official exchange
rates. The objective of the study is to establish the direction of association between
the demand for foreign exchange and exchange rates. To achieve this historical data
were obtained from the Central bank of Nigeria. The model had exchange rates,
inflation rates and aggregate imports as independent variables while foreign
exchange demand was the dependent variable. The results of the analysis show that
coefficients of the variables carried both positive and negative signs. The study
revealed that imports drive the demand for foreign exchange and not exchange
rates. Some recommendations for policy were made based on the findings. One is
the need to ensure the stability of foreign exchange by ensuring adequate supply in
the short run and reducing the over dependence on imports in the long run to
mitigate the pressure on demand for foreign exchanges.
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TABLE OF CONTENTS Title page……………………………………………………………………………………………………………………….i Certification …………………………………………………………………………………………………………………..ii Dedication …………………………………………………………………………………………………………………… iii Acknowledgement …….…………………………………………………………………………………………………..iv Abstract …………………………..…………………………………………………………………………………………….v CHAPTER ONE: INTRODUCTION 1.1 BACKGROUND OF THE STUDY ………………………………………………………………………………. 1 1.2 STATEMENT OF THE PROBLEM ……………………………………………………………………. 4 1.3 OBJECTIVES OF THE STUDY ………………………………………………………………………………. 5 1.4 RESEARCH QUESTIONS ………………………………………………………………………………. 5 1.5 HYPOTHESES OF THE STUDY ……………………………………………………………………. 6 1.6 SIGNIFICANCE OF THE STUDY ………………………………………………………………………………. 6 1.7 SCOPE OF THE STUDY ………………………………………………………………………………. 7 1.8 LIMITATIONS OF THE STUDY ………………………………………………………………………………. 7 1.8 OPERATIONAL DEFINITION OF TERMS …………………………………...…………………….. 8 CHAPTER TWO: LITERATURE REVIEW 2.1 FOREIGN EXCHANGE CONCEPT …………………………………..……………………………….. 10 2.2 EXCHANGE RATES ……………..…………………………………………………….. 14
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2.3 THE NIGERIAN FOREIGN EXCHANGE SYSTEM .…………………………………………………… 24 2.4 EXCHANGE RATE VOLATILITY AND TRADE ………………………………………………………… 37 2.5 THE DEMAND FOR FOREIGN EXCHANGE ………………………………………………………… 38 2.6 IMPORTATION IN NIGERIA ...………………………………………………………………………. 42 2.7 THE SUPPLY OF FOREIGN EXCHANGE ……………………………………………...……………………. 47 2.8 FOREIGN RESERVES ………………………………………………………………………………………… 48 CHAPTER THREE: RESAERCH METHODOLOGY 3.1 INTRODUCTION ……..……………………………………………………………………….. 54 3.2 RESEARCH DESIGN ……..……………………………………………………………………….. 54 3.3 POPULATION OF THE STUDY ……..……………………………………………………………………….. 54 3.4 SAMPLE AND SAMPLING TECHNIQUE ………………..………………………………………………….. 55 3.5 SOURCES OF DATA ……………………………………………………………………………… 55 3.6 MODEL SPECIFICATION ……………………………………………………………………………… 56 3.7 METHOD OF DATA ANALYSIS ……………………………………………………………………………… 56 CHAPTER FOUR: PRESENTATION AND ANALYSIS OF DATA 4.1 PRESENTATION OF DATA …………………………………………………………………………. 58 4.2 TEST OF HYPOTHESES …………………………………………………………………………. 62 CHAPTER FIVE: SUMARRY OF FINDING AND RECOMMENDATION 5.1 SUMMARY OF RESEARCH FINDINGS ………………………………………………………………. 68 5.2 CONCLUSION …………………………………………………………………………. 70
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5.3 RECOMMENDATIONS …………………………………………………………………………..70 BIBLIOGRAPHY APPENDICE
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CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
The demand for foreign exchange in Nigeria is peculiar. In disparity to the
law of demand, it is positively related to the foreign exchange rates; it rises with the
rate of exchange. For instance, the demand for foreign exchange rose from
137.37(US$ million) in January of 1997 to 1,401.43 (US$ million) in December of
2006 at a time the average monthly exchange rate of the Nigerian naira in relation
to the United States dollars rose from 79.6(=N=) in January of 1997 to 127.78(=N=)
in December of 2006 (CBN: 2008). Analyzing the demand for foreign exchange
showed an upward trend since 1986. Of a fact, the Structural Adjustment
Programme (SAP) of 1986 brought about a massive shake up in Nigeria’s domestic
and external economy. Prior to the adjustment programme, the demand for foreign
exchange was regulated with no undue pressure on the reserves; exchange rates
were stable and the Nigerian naira had value when compared to other foreign
currencies. In 1976 for instance, 0.6265 unit of the naira exchanged for a unit of the
United States’ dollar and 1.1317 units of the naira exchanged for a unit of the British
pound sterling (CBN: 2008).
The exchange rate regime was pegged at the time because the policy thrust
was to equilibrate the balance of payments; preserve the value of external reserves
and maintain a stable exchange rate. However, the economic objectives played a
major role in determining the exchange rates for the nominal exchange rate was
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appreciated every year. This was perhaps to source imports cheaply to implement
development projects and service import-substituting industries. The policy
encouraged heavy reliance on imports which ultimately led to balance of payments
problems and depletion of external reserves.
A policy of gradual devaluation began from 1981 due to collapse of oil prices
in the world market and as a part of the austerity measures. However, it was the
devaluation of 1986 that began the continuous diminution of the naira value. The
introduction of the managed float regime and liberalization of the foreign exchange
market saw the free fall of the naira and an instigated rise in the demand for foreign
exchange. Since then, the issue of exchange rates, demand for foreign exchange and
the value of the Nigerian naira in relation to other world currencies has remained a
topical issue. This is because; it is the goal of every economy to have a stable rate of
exchange with its trading partners (Opaluwa et el 2010). The naira exchange rate
has exhibited the features of continuous instability, for most of the period, reflecting
unidirectional depreciation in the official, bureau de change and parallel markets for
foreign exchange (Obadan M: 2006). Frequent and often large devaluation or
depreciation of the naira became an issue of serious concern at times. This made
exchange rate management policy by the Central bank hilarious.
The bank adopted various exchange rate regimes aimed at determining an
appropriate naira exchange rate and ensuring its stability. Prior to the 1986
devaluation, the foreign exchange market operated under the exchange control
regime (act). It changed with the September 1986 implementation of SAP which was
to promote price stability as a sound basis for sustainable economic growth. The
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naira was first managed against a basket of currencies of its major trading partners
and competitors. The bank then operated the Autonomous Foreign Exchange
Market (AFEM), and the Inter Bank Foreign Exchange Market. (IFEM), as a managed
float market relying on the inter bank exchange market as the core. It later operated
the Dutch Auction System (DAS) and presently the Wholesale Dutch Auction System
(WDAS) which brought about relative exchange rate stability and convergence.
Exchange rate is a key macro economic indicator. It is a vital price in an
economy which influences most other prices and, indeed the general price level.
Consequently, exchange rate levels and movements have far reaching implications
for inflation, price incentives, fiscal viability, and competitiveness of exports,
efficiency in resource allocation, international confidence and balance of payments
(Mordi: 2006). A prolonged misalignment of the exchange rate in the foreign
exchange market will, in the medium term, tend to impact adversely on economic
performance (Sanusi: 2004). Hence the need for adequate exchange rate policies to
ensure stability, equilibrium of the rates and reduction of excessive demand for
foreign exchange which Odusola (2006) listed as a non traditional objective of the
exchange rate policy.
What then is responsible for the unusual relationship between the rate of
exchange and the demand for foreign exchange? Could this be as a result of
movements along the foreign exchange demand curve or as a result of shift in the
demand curve to a position not affected by the rates or as a result of both factors?
What sustains the increasing demand for foreign exchange irrespective of the rate of
exchange? Could other factors be responsible for this? Of a truth, other factors affect
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demand besides price. Foreign exchange demand is affected by a myriad of factors
which include the exchange rates, inflation rates, the demand for imports, national
income, standard of living, population size and structure and the index of industrial
production.
Amongst these factors is the demand for imports. Nigeria is an import
dependent economy. It relies on foreign nations for virtually all her needs. Nigeria
imports all kinds of products from food, furniture, drugs, and insecticides to cement,
raw materials, spare parts, machinery and refined oil. Central bank figures show a
steady rise in the demand for imports in Nigeria. It rose from 431.8 (N’ Million) in
1960 to 756.4 (N’ Million) and 9095.6 (N’ Million) in 1970 and 1980 respectively. It
also rose from 755,127.7 (N’ Million) in 1995 to 985,022.4 (N’ Million) and
5,921,449.7 (N’ Million) in year 2000 and 2008 respectively.
Could imports then be the main reason for sustained foreign exchange
demand or in combination with other factors? Is the rate of foreign exchange of
significant contact with the demand for foreign exchange in Nigeria? The study will
appraise these.
1.2 STATEMENT OF THE PROBLEM
The challenge of the study is to evaluate the association between the rate of
exchange and the demand for foreign exchange in Nigeria. It is also to know the
impact the demand for foreign exchange has played on the level of external reserves.
It is observable that rising exchange rates have not stalled excessive demand for
foreign exchange. Figures show that foreign exchange demand rises when rates are
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rising. What could be responsible for this unusual trend? Is foreign exchange a
status symbol or its value is perceived to be related to its price to warrant a
positively sloped demand curve? Could exchange rates be solely responsible for the
upsurge in foreign exchange demand; in combination with other factor(s) or
entirely excluded? These are the basic curiosity for the research and what it seeks to
explore.
1.3 OBJECTIVES OF THE STUDY
The research is projected towards:
Establishing the direction and significance of the foreign exchange rates on
the demand for foreign exchange in Nigeria.
Other objectives include:
To validate the association between the demand for imports and the demand
for foreign exchange in Nigeria.
To determine the impact of the demand for foreign exchange on the level of
foreign reserves.
1.4 RESEARCH QUESTIONS
The research questions for the study are derived from the objectives of the
study. The research will basically seek to answer the following questions:
Is there a significant positive association between the exchange rate and
quantity demanded of foreign exchange in Nigeria?
What is the level of association between the demand for imports and the
demand for foreign exchange in Nigeria?
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Of what significance is the demand for foreign exchange on the level of
foreign reserves in Nigeria?
1.5 HYPOTHESES OF THE STUDY
The Null hypotheses for this study are outlined in this sub section, they
include:
1. H₀: There is no positive association between the exchange rates and the
demand for foreign exchange in Nigeria.
2. H₀: There is no direct correlation between the demand for imports and the
demand for foreign exchange in Nigeria.
3. H₀: There is no association between the demand for foreign exchange and the
level of foreign reserves.
1.6 SIGNIFICANCE OF THE STUDY
The study would benefit the managers of the Nigerian economy. Having
knowledge of the reason and effect of foreign exchange volatility and rising foreign
exchange demands would make the authorities better able to address the
fundamental imbalance in the economic structure. They would be able to address
exchange rate volatility, falling value of the naira, and sustained demand for foreign
exchange and imports. The study would also contribute to the body of knowledge
and serve as a point of reference to future researchers who would be undertaking a
study in this field or a similar one.
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1.7 SCOPE OF THE STUDY
The study would analyse annual average and aggregate macro economic
variable for the years 1986 to 2009. Data would be collected on average annual
exchange rates; annual foreign exchange disbursement; inflation rates and annual
imports. Data would also be obtained for the monthly aggregate of foreign exchange
demand and the monthly foreign reserves position for the years 1996 to 2008.
Also, foreign exchange would be limited to the United States dollar (USD) for
the purpose of this study. The USD is Nigeria’s reserve currency and also the
currency of reference. The dollar is thus a better measurement of the demand for
foreign exchange in Nigeria.
1.8 LIMITATIONS OF THE STUDY
Data for the study are presented at different intervals: monthly, quarterly
and yearly. A monthly analysis would have been more revealing but inability to
conform some data to monthly intervals has made these impossible.
Also, the Nigerian foreign exchange market is characterised by multiple
exchange rates which include the official exchange rates, the inter bank foreign
exchange rates and the parallel foreign exchange rates. A lot of foreign exchange
transactions are consummated in the parallel market with no official records of
data available. Against this background is the difficulty of ascertaining accurately,
the aggregate demand for foreign exchange and the choice of exchange rates use
that would be accurate.
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1.9 OPERATIONAL DEFINITION OF TERMS
The terms below are the working definition for vital terms that would be
used in the study. They include:
Foreign Exchange: The exchange of currency from one country for currency from
another country.
Nominal exchange rates: The nominal exchange rate is defined as the number of
units of the domestic currency that can purchase a unit of a given foreign currency
or vice versa. For purpose of this study, the nominal exchange rate will be defined as
the exchange rate.
Real exchange rates: The real exchange rate is defined as the ratio of domestic
price level and the price level abroad, where the latter is converted into domestic
currency units via the current nominal exchange rate.
Foreign exchange demand: The quantity of foreign exchange that consumers are
actually buying at the current exchange rates as opposed to notional demand.
Fixed foreign exchange rate: It is a type of exchange rate regime wherein a
currency’s value is matched to the value of another single currency or to a basket of
other currencies, or to another measure of value, such as gold.
Flexible Floating exchange rates: This is a type of exchange rate regime wherein a
currency’s value is allowed to fluctuate according to the forces of demand and
supply in the foreign exchange market.
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REFERENCES
Central Bank of Nigeria (2008), "Section D: External sector statistics," CBN Statistical Bulletin, Volume 17. Mordi C (2006), "Challenges of exchange rate volatility in economic management in Nigeria," CBN Bullion Volume 30 No 3. Obadan M (2006), "Overview of exchange rate management in Nigeria from 1986 to date", CBN Bullion Volume 30 No 3. Odusola A (2006), "Economics of exchange rate management," CBN Bullion Volume 30 No 3, July- September. Opaluwa D, Umeh J C and Ameh A A (2010), "The effect of exchange rate fluctuations on the Nigerian manufacturing sector," Africa Journal of Business Management Vol. 4 (14), pp. 2994-2998. Sanusi J O (2004), "Exchange rate mechanism: The current Nigerian experience," A speech delivered at the luncheon of the Nigerian-British chamber of commerce on February 24th.
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CHAPTER TWO
REVIEW OF RELATED LITERATURE
2.1 FOREIGN EXCHANGE CONCEPT
Foreign exchange can be defined as foreign currency or any other financial
instrument acceptable as a means of payment or exchange for international
transactions (Odusola 2006). It is made up of convertible currencies that are
accepted for the settlement of international transactions- trade and other external
obligations. Foreign exchange is the conversion of one country’s currency into that
of another. It is the purchase or sale of one currency in exchange for another
currency, usually conducted in a market setting. It makes international transactions
such as imports and exports and the movement of capital between countries
possible. In a free economy, a country’s currency is valued according to factors of
demand and supply. In other words, a currency’s value can be pegged to another
nation’s currency such as the United States dollar, or even to a basket of currencies.
However, the government can fix a country’s currency value.
2.1.1 HISTORY OF FOREIGN EXCHANGE
There was little need for foreign exchange when trade among nations was
insignificant, and when there was a need, it was served by gold. As trade expanded,
there was a need to exchange currency rather than gold because it is heavy and
difficult to transport. The challenge then was how a nation could equalize her
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currency in terms of other currencies. This was accomplished by equalizing all
currencies in terms of the amount of gold that it represented.
Foreign exchange history can be traced to 1875 with the development of the
gold standard monetary system. Prior to this, countries had primarily used gold and
silver to make international payments (Holly: 2010). The gold exchange standard
prevailed from 1879 to 1934. The value of the major currencies was fixed in terms
of how much gold for which they could be exchanged, and consequently were fixed
in terms of every other currency.
One of the requirements that the countries adhering to the gold standard
needed to follow was to maintain their money supply to a fixed quantity of gold, so
the government could only issue more money if it had obtained more gold. This
requirement, of course, was to prevent countries from just printing money to pay
foreigners, which had to be prevented if foreign trade was to continue.
A corollary of this requirement was that gold had to flow freely between
different countries; otherwise no country could export more than they import, and
vice versa, and still maintain its supply of currency to the gold it held in stock. If
there was a net transfer of currency from one country to another, gold would have
to follow (Spalding 2005).
The reality of the gold standard was the possibility of an economy loosing
more gold if she was not competitive in the world marketplace, as more goods
would be imported and less exported. With less gold in stock, the country would
have to contract the money supply, which would hurt the country's economy. Less
money in circulation reduces employment, income, and output; and more money
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implies higher income and output. This is the basis of modern monetary policy,
which is implemented by Central banks to stimulate a sluggish economy by
increasing the money supply or to reign in an overheating one by contracting the
supply of money.
Countries started abandoning the gold standard during the great depression
of 1930’s by reducing the amount of gold backing their currency so that they could
increase the money supply to stimulate their economies. This deliberate reduction
of value is called a devaluation of currency. When some of the countries abandoned
the gold standard, it just collapsed. It was a system that could not work unless all of
the trading countries agreed to it.
The leaders of the allied nations met at Breton Woods, New Hampshire in
1944, to set up a better system of fixed exchange rates. An ounce of gold was fixed
at thirty-five United States dollars. This official fixed rate of exchange was known as
the par value of currency. The new system required that each country value its
currency in terms of gold or the United States dollar and maintain an account at the
International Monetary Fund (IMF) that was proportional to the country's
population, volume of trade, and national income. It also provided for an adjustable
peg that allowed the exchange rate to be altered under specific circumstances.
Each country had to maintain the exchange rate within narrow limits, except
when the balance of payments deficit became too large. To maintain the limits, a
country could use her official reserves; borrow from the IMF or sell gold to a
country for its currency. When the imbalances became too large, it could adjust its
rate to no more than ten percent of the current value. Any larger adjustment
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required the approval of the IMF board. This prevented countries from devaluing
their currency for their own benefit.
The Breton Woods system began to weaken in the 1960s, when foreigners
accumulated large amounts of dollars. There were concerns as to whether the
United States had enough gold to redeem all the dollars. With reserves of gold falling
steadily, the situation could not be sustained and the United States decided to
abandon this system. In 1971, President Nixon announced that the dollar would no
longer be convertible into gold. This action led to the system of managed floating
exchange rates that exist today.
2.1.2 THE FOREIGN EXCHANGE MARKET
The foreign exchange market is the market for buying and selling different
currencies. It is the medium through which the interaction of demand and supply
results in the determination of the rate of exchange of a local currency against other
foreign currencies (Mordi: 2006). The foreign exchange markets are the markets
where currencies of different nations are bought and sold. It is an electronically
linked network of banks, foreign exchange brokers, and dealers whose function is to
bring together buyers and sellers of foreign exchange.
The foreign exchange market or currency market is a worldwide-
decentralized financial market for the trading of currencies. There is no central
marketplace for the exchange of currency, but the trading is conducted over the
counter. The purpose of the foreign exchange market is to assist international trade
and investment. It permits a Nigerian business for instance to import British goods
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and pay pounds even though the business’s income is in Nigerian naira. The foreign
exchange market is the largest and most liquid financial market in the world.
Traders include large banks, Central banks, currency speculators, corporations,
governments, and other financial institutions. The market is always expanding. Daily
turnover was reported to be over US $3.2 trillion in April 2007 by the bank for
International settlements.
2.2 EXCHANGE RATES
Odusola (2006) describes exchange rates as the prices which currencies
trade for each other: spot and forward rates. It is the value of a foreign currency
expressed in terms of domestic or other currencies. Mordi (2006) describes
exchange rates as a vital price in an economy which influences most other prices
and indeed, the general price level. The rate of exchange is the official value of a
nation's monetary unit at a given date or over a given period of time, as expressed in
units of local currency per USD and as determined by international market forces or
official fiat. It is the price of one nation’s currency in terms of another nation’s
currency often termed the reference currency. For instance, the naira/dollar
exchange rate is the number of naira that one dollar will buy. If a dollar will buy a
hundred and fifty naira, the exchange rate would be expressed as N150/1$ and the
dollar would be the reference currency.
Exchange rates can be expressed either in nominal or real terms. The
nominal exchange rate is a monetary concept which measures the relative price of
two moneys or currencies_ the naira in relation to the dollar for instance. The real
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exchange rate is a real concept that measures the relative price of two goods-
tradable goods (exports and imports) in relation to non tradable goods (goods and
services produced and consumed locally). The study is focused on the nominal
exchange rate. Most exchange rates are determined by the foreign exchange market.
For this reason, exchange rates vary daily, depending on what traders think the
currency is worth. This depends on a lot of factors, including Central banks’ interest
rates, the country's debt levels, and the strength of its economy.
2.2.1 EXCHANGE RATES REGIMES
There are basically two regimes of exchange rates. They are the fixed or
pegged exchanged rate regime and the flexible or floating exchange rate regime.
Authorities also seek to have some stabilizing influence on the exchange rate but do
not try to fix it at some publicly announced par value while others adjust their fixed
exchange rate from time to time to reflect the present economic reality. These are
known as managed float and adjustable peg exchange rate regimes respectively.
FLEXIBLE FLOATING EXCHANGE RATES
This is an exchange rate that is set in a freely competitive market with
no intervention by the authorities. Like any competitive price, this rate
fluctuates according to the conditions of demand and supply. Exchange rates
vary every day. This is because currencies are traded on an open market and
the demand for them varies based on what is happening in a particular
nation. As the demand and supply schedules for a currency change over time,
the equilibrium exchange rate will also change. The forces of demand and
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supply lead to an equilibrium at which quantity demanded equals quantity
supplied. Some of the factors that influence currency supply and demand are
inflation rates; interest rates, economic growth, political and economic risks
and speculations about expectations of future exchange rates movements.
FIXED EXCHANGE RATES
This is a situation of official intervention in the foreign exchange
market to maintain a particular exchange rate range. This would stop some
movements in the exchange rate that would otherwise have happened. In
this way it may prevent the exchange rate from adjusting sufficiently to
guarantee that the current account balance and the (private sector) capital
account balance are equal and opposite. In this situation the authorities must
satisfy any private sector excess demand or supply of foreign exchange. In
the process of intervention, the authorities will be building up or melting
down their foreign exchange reserves.
In a fixed exchange rate regime with an overvalued currency, the
monetary authorities will be suffering a loss of reserves and the balance of
payment becomes a problem. It is not necessarily a current account deficit
that is the problem but the overall excess supply of the domestic currency
(excess demand for foreign exchange) in the foreign exchange market, which
could arise from any component of the balance of payments.
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2.2.2 CHANGES IN EXCHANGE RATES
The demand and supply of foreign exchange in the market is responsible for
the movement in flexible exchange rates along the demand and supply curves.
Anything that shifts the demand curve for the Nigerian currency to the right or the
supply curve of the naira to the left leads to an appreciation of the naira. Anything
that shifts the demand curve for naira to the left or the supply curve of the naira to
the right leads to a depreciation of the naira.
There are many reasons for the shifts in demand and supply of foreign
exchange that lead to changes in the exchange rates. Some are transitory and some
are persistent. Lipsey and Chrystal (2007) identified them to include:
A rise in the domestic price of exports: If the price of exports increases and
export goods do not reduce commensurately (inelastic), then foreign buyers would
pay more for local products bringing about an increased demand and appreciation
of the naira which will shift the demand curve to the right. If the demand is elastic,
lesser naira would be demanded because close substitutes abound elsewhere. This
would make the demand curve for naira shift to the left
A rise in the foreign price of imports: If the demand for imported products like
phones for instance is elastic, any increase in price would bring about lesser
patronage of such products for close substitutes. Hence the supply of naira would be
reduced and the demand for foreign exchange reduced. The supply curve of the
naira shifts to the left and the naira appreciates. If the demand were inelastic, the
supply of the naira would shift to the right leading to a depreciation of the naira.
26
Capital movements: A significant movement of investment into a country has the
effect of appreciating the currency of the capital-importing country and depreciating
the currency of the capital-exporting country.
Changes in Price level: If the general price level of one country is rising relative to
that of another country, the equilibrium value of its currency will be falling relative
to that of the other country. If Inflation is higher in Nigeria when compared to the
United States for instance, Nigerian exports would become expensive in the
American markets while American exports to Nigeria would be less expensive. This
would shift the demand curve for naira to the left and the supply curve to the right
leading to the depreciation of the naira.
Indeed the price level and the exchange rate are both measures of a
currency’s value. The price level is the value of a currency measured against a
typical basket of goods while the exchange rate values a currency against other
currencies.
Structural Changes: An economy can undergo structural changes that alter the
equilibrium exchange rate. Such changes could include a change in technology, the
invention of new products, consumer trends and anything else that affects the
pattern of comparative advantage. For instance, the production of oil and gas from
the North Sea in the United Kingdom (UK) reduced her demand for imported oil,
leading to a reduced supply of pounds in the foreign exchange market for oil
purchase and an appreciation of the British pounds.
27
2.2.3 CALCULATING EXCHANGE RATE CHANGES
The amount of naira appreciation or depreciation is computed as the
fractional increase or decrease in the dollar value of the naira and it depends on the
current value of the naira relative to the dollar. For example, if the naira/dollar
exchange rate goes from N150=$1 to N147.98 to $1, the naira is said to have
appreciated by the change in its dollar value, which is 1.35% and derived from (150-
147.98)/150. The general formula by which we can calculate the naira’s
appreciation or depreciation against the dollar is as follows:
Amount of naira appreciation (depreciation) = 𝑁1−𝑁0
𝑁0
Where N₁ = New naira value of dollar
And N₀ = Old naira value of dollar
2.2.4 OVERSHOOTING EXCHANGE RATES
Differences in interest rates between countries arising from differences in
monetary and fiscal policies among other factors can trigger large capital flows as
investors seek to place their funds where returns are highest. These capital flows
will in turn result in swings in the exchange rate between the two countries. Some
economists explain this as the fundamental reason for the wide fluctuations in
exchange rates observed. An expansion of domestic money supply would result in
increase in relative price levels. This would lead to a temporal depression of
domestic interest rates in bonds as individuals and firms would use the excess cash
within their disposal to invest. A relative reduction in domestic interest rates will
cause a capital outflow to foreign investments where interests are higher and a
28
depreciation of the domestic currency. In order for the new, lower domestic interest
rates to be in equilibrium with foreign interest rates, investors must expect the
domestic currency to appreciate to compensate for lower interest payments with
capital gains. Future expected domestic currency appreciation in turn requires that
the exchange rate temporarily overshoot its eventual equilibrium level. After
initially exceeding its required depreciation, the exchange rate will gradually
appreciate back to its new long-run equilibrium. Equilibrium occurs when the
reduction in the value of the naira in the foreign exchange market is large enough
that investors will expect a future appreciation, which just offsets the interest
premium from investing funds in foreign currency denominated assets. The key is
that the expected return includes not only the interest earnings, but also the
expected gains or losses that might arise because of changes in the exchange rate
during the period of investment. A policy that lowers domestic interest rates above
world levels will cause the external value of the domestic currency to depreciate
enough to create an expected future appreciation that will be sufficient to offset the
interest differential in the long run (Lipsey and Chrystal: 2007).
2.2.5 THEORIES OF EXCHANGE RATE DETERMINATION
The degree of exchange rate variability experienced since the advent of
floating exchange rates has led to different debates and controversy among
researchers and policy commentators. Each school has explained the reason for the
volatility from different points of view. This subsection presents a summary of a few
theories of exchange rates determination.
29
PURCHASING POWER PARITY (PPP)
This theory holds that that the average value of the exchange rate
between two currencies depends on their relative purchasing power in the
long run. A currency would tend to have the same purchasing power when
spent in its home country as it would have if it were converted to foreign
exchange and spent in a foreign country. This precisely means that the ratio
of the price level of a fixed amount of goods and services of the two countries
and the exchange rate between those two countries must be equivalent. PPP
is based on the law of one price.
The PPP exchange rate is determined by relative price levels in the
two countries. If at existing values of relative price levels and the existing
exchange rate, a currency has a higher purchasing power in its own country,
it is said to be undervalued. There is then an incentive to sell foreign
exchange and buy the domestic currency in order to take advantage of the
higher purchasing power (cheaper goods). This will put upward pressure on
the domestic currency. The reverse is the case if a currency has lower
purchasing power.
If the inflation rate within a country’s economy increases then the
value of the currency needs to depreciate to revive the PPP. In the absence of
transportation and other similar expenses, the competitive market will
equalize the price of an identical object in two countries when the prices are
expressed by the same currency.
30
BALANCE OF PAYMENTS (BOP) THEORY
Every country needs to maintain a balance in their inflow or outflow
of money. Conventionally all financial influx is treated as a credit to the
Balance of Payments (BOP).
A BOP is the term used to denote the cash balance of a country. The
BOP is always maintained in tune with the rest of the world. The BOP must
equilibrate except for abnormal circumstances like the bankruptcy of a
country. Precisely the BOP must be ‘zero’ denoting that equal amount of
inflow and outflow has taken place. According to this theory, the demand and
supply of a currency depends on the flow of money related to the Balance Of
Payments. Balance of payments can be achieved through trades in goods and
services, direct investment and portfolio investments. Equilibrium Exchange
Rates are determined by the equilibrium in the BOP. In the event of an
imbalance in payments the exchange rates will shift to restore the Balance of
Payments. Therefore the overall Balance of Payment acts to be a good
indicator of the pressure that goes into the valuation that is appreciation or
depreciation of the currency.
THE ASSET APPROACH
This is an asset pricing view of the exchange rate. The idea is that
agents have a portfolio choice decision between domestic and foreign assets.
Those instruments (either money or bonds) have an expected return that
could be arbitraged. This arbitrage opportunity is what determines the
process of the exchange rate. Modern exchange rate models emphasize
31
financial-asset markets. Rather than the traditional view of exchange rates
adjusting to equilibrate international trade in goods, the exchange rate is
viewed as adjusting to equilibrate international trade in financial assets.
Goods prices adjust slowly relative to financial asset prices and financial
assets are traded continuously each business day; the shift in emphasis from
goods markets to asset markets has important implications. Exchange rates
will change every day or even every minute as supplies of and demands for
financial assets of different nations change. An implication of the asset
approach is that exchange rates should be much more variable than goods
prices.
2.2.6 EXCHANGE RATES AND THE TRADE BALANCE
Trade flows have implications for financial-asset flows. If balance of trade
deficits are financed by depleting domestic stocks of foreign currency, and trade
surpluses are associated with increases in domestic holdings of foreign money, we
can see the role for the trade account. If the exchange rate adjusts so that the stocks
of domestic and foreign money are willingly held, then the country with a trade
surplus will be accumulating foreign currency. As holdings of foreign money
increase relative to domestic money, the relative value of foreign money will fall, or
the foreign currency will depreciate. Although realized trade flows and the
consequent changes in currency holdings will determine the current spot exchange
rate, the expected future change in the spot rate will be affected by expectations
regarding the future balance of trade and its implied currency holdings. An
important aspect of this analysis is that changes in the future expected value of a
32
currency can have an immediate impact on current spot rates. For instance, if there
is suddenly a change in the world economy that leads to expectations of a larger
trade deficit in the future- say, an international oil cartel has developed so that the
domestic economy will have to pay much more for oil imports, then forward-looking
individuals will anticipate a decrease in domestic holdings of foreign money over
time. This anticipation will cause expectations of a higher rate of appreciation in the
value of foreign currency in the future, or an equivalently faster expected
depreciation of the domestic currency, because foreign currency will be relatively
scarcer. This higher expected rate of depreciation of the domestic currency leads to
an immediate attempt by individuals and firms to shift from domestic to foreign
money. At this moment the total available stocks of foreign and domestic money
have not changed, the attempt to exchange domestic for foreign money will cause an
immediate appreciation of the foreign currency to maintain equilibrium so that the
existing supplies of domestic and foreign money are willingly held. The point is that
events that are anticipated to occur in the future have effects on prices today.
2.3 THE NIGERIAN FOREIGN EXCHANGE SYSTEM
Exchange rate management is characterized by official intervention in the
foreign exchange market because of the level of development. (Akanji: 2006) Nigeria
has practiced both fixed and flexible exchange rates. Between 1960 and 2000,
exchange rate policy in Nigeria has fluctuated from a fixed exchange rate system
(1960-1986) to a flexible exchange rate system (1986-1993). However, there was
regulation in 1994 with the pegging of official exchange rate and the reversal of
33
policy in 1995, which has been tagged ‘guided deregulation’ of the exchange market.
With this exchange rate was liberalized and a dual exchange rate mechanism was
instituted in 1997 and 1998. This policy thrust was retained except that all official
transactions, other than those approved by the President were undertaken at the
Autonomous Foreign Exchange Market (AFEM). As a result, transactions at the
pegged official exchange rate were relatively minimal.
Due to market imperfections and continuous instability in the exchange rate
of the naira, the AFEM was replaced with an Inter-bank Foreign Exchange Market
(IFEM) in October 1999, after short period of co-existence. Under the IFEM system,
oil companies were allowed to place their foreign exchange resources in commercial
banks of their choice.
The Dutch Auction System (DAS) of foreign exchange management was
introduced to replace IFEM in July 2002. The main objective of IFEM was to devalue
the naira, moderate imports, and consequently strengthen the balance of payment
while at the same time reduce the parallel market premium. Since the introduction
of DAS, the naira has lost value significantly, the parallel market premium,
narrowed, but it has not limited the appetite of Nigerian’s for foreign goods and
persistent demand for foreign exchange.
When government deregulated the economy as a result of serious economic
predicaments in 1986, the foreign exchange market was equally deregulated to
allow market forces determine the appropriate exchange rate for the naira. It was in
this era that the activity of parallel market flourished, because government through
the Central bank could not adequately provide enough foreign exchange to meet the
34
increasing demand in the market and coupled with the stringent procedures that
were involved. A lot of foreign exchange users then resorted to patronizing the
parallel market in which the rate was usually higher than the Inter bank rate. In
spite of the risk associated with transacting business in the black market, which
included buying fake currency, people still continue to patronize the market since
the official market was not able to provide enough foreign exchange to the market
(Adebiyi: 2007).
In order to ensure the stability of the naira, the Central bank introduced the
whole sale Dutch Auction System (WDAS) in 2006 and licensed more Bureau de
Change and empowered them to sell foreign exchange to interested importers. The
bank was able to ease out the problem of scarcity of foreign exchange faced by
genuine importers by designating their branches to sell directly to customers. With
these, the bank was able to stabilize the naira against other currencies.
Apart from the institution of an appropriate mechanism for exchange rate
determination, other measures increasingly applied in managing Nigeria's foreign
exchange resources included demand management and supply side policies. The
Central bank and the government have actively fostered the development of
institutions such as the Nigerian Export Promotion Council (NEPC) and the Nigerian
Export-Import Bank (NEXIM) in the drive to earn more foreign exchange.
2.3.1 THE NIGERIAN EXCHANGE RATE POLICY
Mordi (2006) describes exchange rate policy as encompassing the design and
deployment of strategies to ensure the achievement of a stable and realistic
35
exchange rate for the country’s domestic currency, consistent with overall
macroeconomic policy objectives. The main objectives of exchange rate policy in
Nigeria are to preserve the value of the domestic currency, maintain a favourable
external reserves position and ensure external balance without compromising the
need for internal balance and the overall goal of macroeconomic stability (CBN
Website).
Economic theory, in the quest for simplicity, assumes that the exchange rate
is any other price and that is determined by the forces of demand and supply in a
perfectly competitive market and in a world where free international exchange is
the rule. An extension of this theory is that such factors as net foreign exchange
earning [exports - imports], current account balances, productivity and its growth
among others, determine the exchange rate of a currency (Elumelu: 2002).
Odusola (2006) put the specific objectives of exchange rates into two broad
categories: the traditional and non traditional objectives. Traditionally, foreign
exchange management in Nigeria is aimed at three mutually exclusive objectives:
Conservation of available foreign exchange resources so as to check
expenditure and undue depletion of external reserves.
Ensuring adequacy of reserves consistent with current and future
international commitment; and
Preserving the value of external reserves through appropriate portfolio
diversification and optimal deployment into strong currencies.
The non traditional objectives include:
36
Reduction of excessive demand for foreign exchange;
Removal of distortions in the economy;
Stimulation of non-oil exports; and
Promotion of efficient allocation of foreign exchange resources through
reduction of dependence on imports and oil exports; elimination of
unfavourable capital flight and stimulation of inflows of capital; and
reduction and possibly elimination of exchange rate misalignment and
exchange rate premium. In recent times, achieving exchange rate
convergence has therefore become one of the intermediate objectives of
Central banks in many countries.
In order to achieve these, the Central bank of Nigeria has over the years
adopted different mechanisms for regulating the exchange rates. This however has
not been short of challenges. For instance the existence of the parallel foreign
exchange markets in Nigeria is primarily borne out of the inadequate supply of
foreign exchange and the desire to make illegal profit (round tripping). With these
markets and different modes of operation come differences in the rates of exchange.
On the foreign exchange market, Nigeria maintains four exchange rates; the
Wholesale Dutch Auction System (WDAS) at which the CBN transacts; an inter bank
exchange rate quoted by a group of commercial banks — the Nigerian Inter-Bank
Foreign Exchange Fixing (NIFEX); the bureaux de change rate; and the parallel
market rate.
37
2.3.2 THE OFFICIAL FOREIGN EXCHANGE MARKET
The Central bank buys foreign exchange from the Nigerian National
Petroleum Corporation, and sells foreign exchange to members of the public
through their official representatives_ the commercial banks and bureau de change
operators. The Central bank actually provides the foreign exchange through auction
sessions at which authorised dealers buy foreign exchange on behalf of importers.
Within the basic framework of market determination of the naira exchange
rate, various methods have been applied and some adjustments carried out to fine-
tune the system. Various pricing methods have been used in Nigeria, such as
marginal, weighted average and Dutch auction system and the Wholesale Dutch
auction system. The official market has a way of impacting on the inter bank and
unofficial or parallel markets. The Wholesale Dutch Auction System (WDAS) has
been in use since February, 2006. The exchange rate under the WDAS has stabilized
and continued to improve the operations of the foreign exchange market. It has
been responsible for the unification of exchange rates between the Official and
Inter-bank Markets and resolution of the multiple currency problems. This was
achieved by bringing the Bureau de change operators into the official market in
order to ensure adequate supply at the BDC/Parallel markets. It has also facilitated
greater market determination of exchange rates for the Naira in relation to other
currencies. The rates are usually lower at the official market but inaccessible to
businesses and individuals.
38
The Central bank also engages in intervention policies. Intervention is
defined as official purchases and sales of foreign exchange to achieve one or more of
the following objectives. Akanji (2006) listed them as:
Moderating exchange rate fluctuations and correcting misalignment
Addressing disorderly market conditions characterized by sharp
fluctuations in the exchange rate, high exchange rate volatility, and wide bid-
offer spreads relative to calm periods, and sudden change in foreign
exchange turnover.
Accumulating foreign exchange reserves and;
Supplying foreign exchange to the market.
2.3.3 INTER BANK FOREIGN EXCHANGE MARKET
An inter-bank foreign exchange market represents a form of market
structure where a decentralized allocation of foreign exchange is determined by
market participants (Soludo 2006). Competition in the market is fostered by
ensuring that participants are free to establish buying and selling exchange rates for
transactions with their customers and among themselves by providing for efficient
dissemination of information on bids and offers.The inter bank market is the foreign
exchange market where banks and large institutions exchange information about
different currencies they want to buy or sell. The banks can deal with one another
either directly, or through electronic brokering platforms. The market constitutes
the spot market, the forward market and SWIFT (society for world wide inter bank
financial telecommunications). Nigerian banks source their foreign exchange
39
through the Central bank, the Nigerian National Petroleum Corporation, foreign
banks with subsidiaries in Nigeria and oil companies who earn foreign exchange
from sale of crude oil.
2.3.4 BUREAU DE CHANGE MARKET
The licence of a Bureau De Change (BDC) in Nigeria confers on the holder the
rights and priviledges of an approved buyer of foreign exchange in keeping with the
standard of the financial services industry and in order to generate and maintain
public confidence in the sub sector(CBN).
The liberalization opened the market for the operations of private BDCs and
authorised dealer BDCs. The operations of these BDCs with Central bank window
are basically cash operation. Each licensed BDC was required, to open a Naira
Current Account with an Authorized Dealer of its choice, for the purpose of buying
foreign exchange. A Bureau-de-Change is allowed to purchase foreign exchange
from the Central bank through a presentation of the bank’s cheque issued by their
banks twice a week
The foreign currencies dealt in by a Bureau De Change shall be derived from
private sources or such other sources, including the Inter bank foreign exchange
market, as the Central Bank of Nigeria shall define from time to time for the purpose
of Business Travel Allowance [BTA] and Personal Travel Allowance [PTA]. Selling
foreign exchange to BDCs by the Central bank was a major factor in the convergence
of the foreign exchange market rates.
40
2.3.5 THE PARALLEL FOREIGN EXCHANGE MARKET (BLACK MARKET)
The parallel market for foreign exchange has been in existence since the
exchange control era of 1962. Their activities were not so pronounced nor of any
significant impact on the stability of exchange rate before the deregulation of the
foreign exchange market in 1986. When government deregulated the economy due
to serious economic predicaments, the foreign exchange market was equally
deregulated to allow market forces determine the appropriate exchange rate for the
naira. It was in this era that the activity of parallel market flourished. It has been
established that scarcity in the official sector and bureaucratic procedures
necessitated the growth and development of the parallel market. Importers and
exporters of non-oil commodities were prior to 1986 required to get appropriate
licences from the Federal Ministry of Commerce before they could participate in the
foreign exchange market. Foreign exchange users then resorted to patronizing the
parallel market in which the rate was usually higher than the foreign exchange
market rate. In spite of the risk associated with transacting business in the black
market, which included buying fake currency, people continued to patronize the
market since the official market was not able to provide enough foreign exchange to
the market.
2.3.6 EXCHANGE RATE MISALIGNMENT
A misalignment is the deviation of the nominal exchange rate from its
equilibrium value. Misalignment is determined by changes in economic
fundamentals and the expected rate of a change in the exchange rate. The
41
consequences of exchange rate misalignment are well documented in the literature.
It fosters the development of black currency markets; facilitates the rapid
depletions of the stock of foreign exchange reserves; discourages savings,
investments, and business planning; as well as encourages the growth of speculative
activities (Itsede: 2003). The distortion which results from the misalignment of the
exchange rate is particularly serious under a dual-structured foreign exchange
market. The premium between market segments creates incentive for arbitrage
activities in the market. Thus, market operators tend to exploit the differentials for
profits.
2.3.7 DIVERGENT EXCHANGE RATES
The fixed exchange regime was basically responsible for divergent exchange
rates in Nigeria. It induced an overvaluation of the naira and was supported by
exchange control regulations that were cumbersome, ineffective and engendered
significant distortions in the economy. This resulted in massive importation of
finished goods with the adverse consequences for domestic production, balance of
payments position and the nation’s external reserves level. Moreover, the period
was bedeviled by sharp practices perpetrated by dealers and end-users of foreign
exchange. A lot of traders and highly connected people saw loopholes in the system
to profit from. They bought foreign exchange from the Central bank at official rates
and sold them at exorbitant rates in the parallel market to genuine and sham users
of foreign exchange. The banks also profited from this round tripping as they
abandoned their main line of business to trade in foreign exchange which they sold
42
at inflated prices. The market then divided into many segments, each with its own
foreign exchange rate.
A multiple (divergent) exchange rate results in a distortion of the economy,
and a misallocation of resources. For instance if a certain industry in the import
market is given favourable foreign exchange rate, it will develop under artificial
conditions. Resources allocated to the industry will not necessarily reflect its actual
need because its performance has been unnaturally inflated. Profits are thus not
accurately reflective of performance, quality, or supply and demand. Participants of
this favoured sector are (unduly) rewarded better than other import market
participants. An optimal allocation of resources can thus not be achieved.
A multiple exchange rate system can also lead to economic rents for factors
of production benefiting from implicit protection. This effect can also open up doors
for increased corruption because people gaining may lobby to try and keep the rates
in place. This in turn, prolongs an inefficient system.
Multiple exchange rates result in problems with the Central bank and the
federal budget. The different exchange rates likely result in losses in foreign
currency transactions in which case the Central bank must print more money to
make up for the loss. This can lead to inflation.
2.3.8 EXCHANGE RATES VOLATILITY
Volatility or risk in international commodity trade usually emanates from
two main sources: changes in world prices or fluctuations in exchange rates. These
may affect trade by increasing the uncertainties of trade or effecting a change in the
43
cost of transaction processing (Adubi et al 1999). Exchange rate volatility refers to
the swings or fluctuations in exchange rates over a period of time or the deviations
from a benchmark or equilibrium exchange rate. The latter which also reflects the
misalignment of the exchange rate could occur when there is multiplicity of markets
parallel with the official market. The exchange rate is exogenous to money market
operators while the interest rate is exogenous to foreign exchange market and both
require having consistency in resource allocation (Akanji 2006).
Exchange rate volatility is also influenced by and correlated to domestic
economic uncertainty. From 1970-1985, the Nigerian exchange rate averaged
N0.67=US$1.00, but depreciated to an average of N2.02, N8.04 and N9.91 to US$1.00
in 1986, 1990 and 1991 respectively. It further depreciated to N17.30 and N22.05 to
US$1.00 in 1992 and 1993 respectively. The exchange rate was fixed at about
N22.00 to US$1.00 in 1994 in order to address the volatility but the dismal
performance of the economy at the end of the year compelled the authorities to
reintroduce the market based approach in 1995 under the Autonomous Foreign
Exchange Market (AFEM) until October, 1999. The exchange rate of the naira thus
depreciated from the fixed exchange rate of N22.00 to US$1.00 to a high of
N82.33=US$1.00 in 1995 and then to N84.38 and N92.65 = US$1.00 in 1998 and
1999 respectively. The average exchange rate at N111.90 = US$1.00 for 2001
depreciated to an average of N128.75 during the period 2002-2005 (Mordi: 2006)
under the Dutch Auction System and presently to an average of N150.00 (+ 3) to
US$1.00 in recent times.
44
2.3.9 IMPLICATIONS OF EXCHANGE RATE VOLATILITY
Volatile exchange rates make international trade and investment decisions
more difficult because volatility increases exchange rate risk. Exchange rate risk
refers to the potential to lose money because of a change in the exchange rate.
Traders and investors may lose money when the exchange rate changes. A volatile
exchange rate will sometimes lead to greater losses than expected, and at other
times to greater gains. In any case, it should be clear that exchange rate fluctuations
either increase the risk of losses relative to plans or increase the costs to protect
against those risks. Exchange rate volatility has real economic costs on an economy.
It affects price stability, firms’ profitability, and the country’s financial stability, as a
whole. Excessive volatility in exchange rate creates uncertainty and risks for
economic agents with destabilizing effects on the macro economy (Mordi: 2006).
The harmony between the money market and the foreign exchange market must be
strengthened to avoid such swings and the transmission effect of volatility to the
domestic sector.
Fluctuating exchange rates also make it more difficult for investors to know
where to invest. One cannot merely look at the interest rate across countries, but
must also speculate about the exchange rate change. A decision to produce for
export for instance involves uncertainties about the prices in foreign exchange that
such sales will realize, as well as the exchange rate at which foreign exchange
receipts can be converted into domestic currency.
45
2.4 EXCHANGE RATE VOLATILITY AND TRADE
The effect of exchange rate volatility on trade is ambiguous. There is no real
consensus on either the direction or the size of the exchange rate volatility- trade
level relationship. Overall a larger number of studies find that volatility tends to
reduce the level of trade, but when the effect is measured, it is found to be relatively
small. Several reasons can explain this tenuous relationship:
An increase in risk does not necessarily lead to a reduction in the risky
activity even for risk averse businesses.
The availability of hedging techniques makes it possible for traders to avoid
most of the exchange risk at little cost.
Exchange rate volatility may actually offset some other forms of business risk
and
Exchange rate volatility can create profitable trading and investment
opportunities.
There has been substantial literature on the effects of exchange rate volatility
on the volume of trade. Most of these studies focus on the argument that exchange
rate volatility increases the risk and uncertainty in international transactions and
thus discourages trade. If traders are risk averse, they will be willing to incur an
added cost to avoid the risk associated with the exchange rate volatility. Thus, a
firm’s export supply (import demand) curve will shift to the left (right) in the
presence of exchange rate volatility; for any quantity of exports or imports, the
46
corresponding price will be higher under exchange rate volatility (risk) than
without it (Qian and Varangis, 1992).
However, it has been shown that a positive impact by exchange rate volatility
on trade is also possible. Bailey and Tavlas (1988) argue that if exporters are
sufficiently risk averse, an increase in the exchange rate volatility raises the
expected marginal utility of export revenue and therefore induces them to increase
exports. Hooper and Kohlhagen (1978) could not find conclusive evidence that
exchange rate volatility has had statistically significant deterrent effects on trade.
Even in this latter group of studies, the results are inconsistent across countries;
results from Kroner and Lastrapes (1991) also indicate that for some countries,
exchange rate volatility has a negative effect on trade but for others it does not
(Adubi and Okunmadewa: 1999).
2.5 THE DEMAND FOR FOREIGN EXCHANGE
The demand for foreign exchange arises from all international transactions
that require payments in foreign exchange and debits in the balance of payment
accounts. It is represented by external debt service obligations; personal home
remittance by foreign nationals resident in the country; financial commitments to
international organizations and the country's embassies overseas; purchasers of
foreign securities and investments; payment for imports and other invisible out
payments by the private sector. Other factors that induce the demand for foreign
exchange are the activities of speculators and the Central bank. The bank might
decide that its holdings of a particular currency are too low, and then decide to buy
47
that currency on the open market. They might also want to have the exchange rate
for their currency decline relative to another currency. They put their currency on
the open market and use it to buy another currency.
Official information shows a steady increase in the demand for foreign
exchange in Nigeria. From a figure of 49.52(US$ Million) in December of 1996, it
rose to 259.89(US$ Million) and 768.09(US$ Million) in December of 1999 and 2001
respectively. It also rose from 786.22(US$ Million) in December of 2002 to
805.63(US$ Million) and 1,401.40(US$ Million) in December of 2003 and 2006
respectively. A lot of increase in foreign exchange demand in recent times is also
traceable to the almost near dependence of fuel and food imports for local
consumption.
It is no more an assumption that the various foreign exchange management
process in the country in the past twenty years have met without stable results. The
reason is that much of the plans to achieve the desired targets were based on factors
which are not under the control of the economy. The continued application of the
process has reflected mere gestures as the variables in the economy have remained
largely beyond the capacities of the trends that ruled the Nigerian economy. The
relative weakness of Nigeria's entire economy does not seem favourable to the
status quo. The GDP is relatively small compared to industrialized nations and this
negates the stability and international purchasing power of the naira. The amount of
importation overwhelms the economy and a low return of foreign exchange due to
inadequate exports to generate foreign exchange.
48
The crux of the matter is that the demand for dollars is extremely high among
Nigerian banks. Nigeria does not generate enough foreign exchange to satiate local
consumption. Therefore the demand for dollar drives the value of Naira that is
ubiquitous and weak. Nigerian source of dollars and foreign exchange comes only
from the export of oil and its overdependence for foreign exchange from oil can be
largely unstable due to unsteady international oil prices. An increasing demand for
foreign exchange puts unusual pressure on the available supplies which lead to a
rise in exchange rates.
2.5.1 FACTORS AFFECTING DEMAND FOR FOREIGN EXCHANGE
The demand for foreign exchange is a derived demand. Foreign exchange is
not demanded for its own sake but for the services it could be used to render or for
the foreign products it could acquire. The demand for foreign exchange is affected
by a myriad of factors which includes the foreign exchange rate as earlier
highlighted. At the most fundamental level, a currency price will change because
there is more or less demand for it. Increased demand for foreign exchange places
pressure on the available supply bringing about an increase in the rates of foreign
exchange. The higher the rates, the lower the quantity of foreign exchange
demanded and vice versa. Other factors which affect foreign exchange demand
include the following:
Changes in total income and employment: When people receive more income
they would have more money to spend after satisfying their basic needs. Such
increased income would be used to acquire foreign products (cars and electronic
49
gadgets, etc) and engage in foreign tours thereby increasing the demand for foreign
exchange.
Interest Rates: The interest rate influences the demand and supply of currencies on
the foreign exchange markets. A good deal of the trade in foreign currencies is for
speculative purposes - traders moving funds from one currency to another to take
advantage of price movements or to take advantage of better returns in different
countries. If the rate of interest in Nigeria is three percent and that of the United
States is six percent for instance, there may be advantages gained from transferring
funds in naira based securities to those denominated in dollars. (Like moving money
from a bank account paying three percent to another bank account paying a higher
rate of interest.) If this happened, there would be a move towards selling naira on
the foreign exchanges and buying dollars, with the result that the demand for
dollars would rise and the supply of naira would also go up. This would put pressure
on the price of dollar and push its value up against the naira.
Inflation: Changes in inflation rates can affect international trade activity, which
influences the demand and supply of currencies. If inflation is high, prices of
products are rising fast and the economy will have a lot of money to buy foreign
products. If they buy foreign products, there is need for currencies other than the
currency they have, so demand for foreign exchange rises.
Views on Impending government regulation: A lot of activities in the foreign
exchange market is based on speculation about future events. If the participants
believe that there would likely be a devaluation of the local currency by the
monetary authorities for instance, they would buy more foreign exchange today to
50
hedge up the possible risk of losses, devaluation would bring to their businesses and
vice versa.
Availability of substitutes: Availability of competitive local substitutes can be a
deterrent to importation or patronage of foreign products. If local substitutes are
now available and can compete favourably with international markets, consumers
would patronize local products in exchange for foreign substitutes reducing the
demand for foreign exchange indirectly by ensuring such foreign products are no
longer imported or importation is reduced.
Population and changes in taste: Increase in population generally leads to
increased demand for particular products over time including the demand for
foreign exchange.
Also consumer preferences and tastes for a variety of products change over
time. In Nigeria at present, there is usually preference for foreign made goods. This
is based on the belief that foreign goods are durable and of high quality. Such
consumer tendencies could marginally affect the quantity of foreign exchange
demanded in an economy at a given time.
2.6 IMPORTATION IN NIGERIA
This is a major factor that affects the demand for foreign exchange. The
Nigerian economy is highly dependent on imports for both consumption and
production. A major percentage of official foreign exchange demand is used for
importing goods into the country. Virtually all the major industrial raw materials
are sourced from abroad while the country depends wholly on foreign supply for
51
intermediate and capital goods. Nigeria's aggregate imports have grown
substantially since the country's independence in1960; from an average growth rate
during the 1960s’ of 2.5% to an average of 33% per annum between 1970 and 1989
(Egwaikhide: 1999). The growth of imports is attributable to several factors. These
include the need to pursue economic development, the expansion in crude oil export
that considerably raised foreign exchange earnings and the over-valuation of the
local currency, which artificially cheapened imports in preference to local
production. The astronomical expansion of domestic demand is a key factor as well;
during this period goods were in short supply.
Available statistics of Nigerian annual imports show that non-oil imports
rose from 704.20(=N=Million) to 8,868.20(=N=Million) within 1970 to 1980 and to
12,719.80(=N=Million), 5,069.70(=N=Million) and 39,644.80(=N=Million) in 1981,
1986 and 1990 respectively. It also increased from 81,716(=N=Million) to
599,301.8(=N=Million) and to 764,204.7(=N=Million) in 1991, 1995 and 2000 and
estimated 1,121,073.50(=N=Million) to 2,987,468.70(=N=Million) and
4,282,291.30(=N=Million) in 2001, 2005 and 2007 respectively. This shows an
astronomical increase in the rise of imports at a time when the exchange rates were
also rising astronomically. A break down of this figure by sections shows a large
percentage of imports represented by chemicals, manufactured goods and
machinery and transport equipment. These three sections jointly accounted for
about 70.54 percent of major imports for 2007. (Appendix 1 shows value of major
imports by S.I.T.C section for 1960-2008)
52
A similar analysis of non-oil exports shows a figure of 375.4(=N=million),
554.4(=N=Million) and 3,259.60(=N=Million) in 1970, 1980 and 1990 and
24,822.90(=N=Million) 113,309.40(=N=Million) and 169,709.70(=N=Million) in
years 2000, 2004 and 2007 respectively.
An initial assessment clearly shows the high dependence of Nigeria for
foreign made goods to the detriment of locally manufactured goods. Production for
exports is highly inelastic because the major non-oil export products are basically
primary produce whose prices have been on the downward trend and exogenously
determined. These exports are slow in responding to rates adjustments. Most
importantly, output of manufacturers is relatively low with most of the output
consumed locally leaving little for export. The implication is that the economy is
highly prone to external shocks and in the event of a crash in oil price, the economy
may face decline in foreign exchange earnings which may destabilize the exchange
rate. (Mordi: 2006)
The high level of imports to meet domestic needs also puts severe pressure
on the foreign exchange market and may result in the depletion of the external
reserve. The Central Bank, in a recent communiqué signed by CBN governor, Lamido
Sanusi, at the end of the seventy fourth Monetary Policy Committee meeting held in
January, said that the fundamental structural problem of the country as an import-
dependent economy was largely responsible for the continuing depletion of the
external reserves, and raised concerns about its effect on inflation (Oronsaye: 2010).
In this context, measures aimed at diversifying the products and export base
through incentives to promote exports of semi-manufactured and manufactured
53
goods will help increase the foreign exchange earnings by the private sector. This
will help reduce the demand pressure and ensure exchange rate stability. Nigeria’
foreign trade statistics for the years 1960 to 2008 is shown in appendix 2. The
information includes imports for the oil and non oil sectors for the period.
ANALYSIS OF FOREIGN EXCHANGE UTILISATION
The Central bank’s sectoral utilization of foreign exchange for transactions
valid for foreign exchange for the years 1997-2009 are presented in appendix 3.
Modified tables are presented below.
TABLE 2.1
YEAR ANNUAL
IMPORTS
(US$’ M)
INVISIBLES
(US$’ M)
TOTAL
(US$’ M)
IMPORTS
(%)
INVISIBLES
(%)
TOTAL
(%)
1997 4,369.66 413.35 4,783.01 91.36 8.64 100
1998 4,337.52 516.02 4,853.54 89.37 10.63 100
1999 5,142.88 703.95 5,846.83 87.96 12.04 100
2000 6,072.02 1,764.22 7,836.24 77.49 22.51 100
2001 7,924.67 3,426.81 11,351.48 69.81 30.19 100
2002 8,118.35 2,112.67 10,231.02 79.35 20.65 100
2003 9,740.56 2,364.87 12,105.43 80.46 19.54 100
2004 10,195.24 1,953.23 12,148.47 83.92 16.08 100
2005 12,768.90 2,096.23 14,865.13 85.90 14.10 100
2006 14,519.39 4,159.54 18,678.93 77.73 22.27 100
2007 18,674.24 8,394.01 27,068.25 69.00 31.00 100
2008 30,148.75 18,176.66 48,325.41 62.39 37.61 100
2009 23,761.04 8,835.36 32,596.40 72.89 27.11 100
54
TABLE 2.2
Year/
Category
Industrial
Sector
(US$’ M)
Agricultural
Sector
(US$’ M)
Finished
Goods
(US$’ M)
Transport
(US$’ M)
Personal
Effects
(US$’ M)
Minerals
(US$’ M)
Oil
Sector
(US$’ M)
1997 2913.19 46.59 1,310.90 98.94 0.05
1998 2304.33 93.35 1,801.42 137.99 0.43
1999 2786.35 82.38 2,082.53 188.99 2.62
2000 3078.96 194.21 2,442.25 356.12 0.48
2001 4388.22 185.00 2,818.15 533.29 0.02
2002 4149.12 178.30 3,334.66 456.28 0.00
2003 4836.84 106.80 3,920.17 876.30 0.45
2004 4841.19 121.29 4,270.50 948.01 14.25
2005 6928.11 116.24 4,218.40 1,503.96 2.20
2006 7814.93 169.79 5,704.03 828.76 1.88
2007 9454.97 209.37 7,720.97 1,288.80 0.13
Industrial
Sector
Agricultural
Sector
Manufactured
products
Transport Food Minerals Oil sector
2008 10552.51 369.99 6810.42 1672.05 3974.49 302.15 6473.13
2009 7378.09 271.71 6027.51 1564.06 3433.79 154.74 4931.13
An analysis of the data from both tables revealed the following:
The data is divided into two basic categories_ imports and invisibles.
Imports account for over seventy percent of the utilization of foreign
exchange in Nigeria.
A percentage analysis among the two basis variables shows a decline in the
percentage of foreign exchange utilization for imports over the years when
compared to invisibles.
The data shows a continuous rise in the amount of foreign exchange used for
imports. It rose from 4,369.66 (US$’ Million) in 1997 to 6,072.02 (US$’
Million) and 7,924.67 (US$’ Million) in 2000 and 2001 respectively. It also
rose from 9740.56 (US$’ Million) in 2003 to 18,674.24 (US$’ Million) and
30,148.75 (US$’ Million) in 2007 and 2008 respectively and down to
23761.04 (US$’ Million) in 2009.
55
The second table shows further subdivision of imports into seven categories:
industrial sector, agricultural sector, finished goods, transport, personal
effects, minerals and oil sector.
From the table it is obvious that the industrial sector and finished goods
sector have a higher share of foreign exchange utilization. Nigeria spends
foreign exchange on raw material, spare parts and machinery for its
industrial sector because she is unable to manufacture these products locally.
Also finished goods included books and educational materials, detergent,
insecticides and furniture. These are ordinarily light productions that should
be manufactured with self sufficiency in Nigeria.
Oil sector and minerals were reflected in 2008 and 2009. These are probably
foreign exchange used in the importation of refined fuel into Nigeria. If the
capacity of the refineries were sufficient for utilization in Nigeria, such
demands could have been avoided.
2.7 THE SUPPLY OF FOREIGN EXCHANGE
Nigeria’s foreign exchange market is very broad on the demand-side, but
very shallow on the supply side. Unlike other jurisdictions, all licensed banks in
Nigeria are also authorized dealers in foreign exchange. The market is demand
driven and it is characterized by rent-seekers and non adherence to regulations.
Between the years 2000-2003 a total sum of US$53.9 billion was sold in the foreign
exchange market of which 65% was supplied by the CBN (Osaka et al 2004). The
supply of foreign exchange is obtained from oil and non-oil exports. It is equally
56
obtained from capital receipts including drawdown on loans, expenditure on foreign
tourists in Nigeria, repatriation of capital by Nigerians resident overseas. Other
invisible receipts by the private sector also constitute the supply of foreign
exchange. Nigeria’s foreign exchange is however mainly from the proceeds of crude
oil production and sales. Nigeria produces approximately two million barrels per
day of crude oil in joint venture with some multinational oil companies. These
companies pay different taxes to the government through the Federal Inland
Revenue Service which is deposited with the Central bank.
In the past all foreign exchange earned by multinationals was paid into an
account with the Central bank. In recent times such gains made by these
multinationals can be deposited in their bank accounts or sold at the inter bank
foreign exchange market. Banks have been permitted to contract foreign exchange
from autonomous sources. These sources are basically the foreign direct and
portfolio investment, home remittances (western union, money gram) multinational
oil companies, NNPC and foreign institutional investors. Also three foreign banks
which include Stanbicibtc Nigeria, Nigeria International bank (Citi bank) and
Standard Chartered bank are major sources of foreign exchange inflow into the
country through their parent companies.
2.8 FOREIGN RESERVES
The IMF defined international reserves as consisting of official public sector
foreign assets that are readily available to, and controlled by the monetary
authorities, for direct financing of payment imbalances, and directly regulating the
57
magnitude of such imbalances, through intervention in the exchange markets to
affect the currency exchange rate and for other purposes. The official foreign
exchange reserves are the stock of foreign-currency denominated assets that the
monetary authorities hold in order to be able to intervene in the foreign exchange
markets. Reserve management can be defined as a process that ensures that
adequate official public sector foreign assets are readily available to, and controlled
by the authorities for the purpose of meeting specific objectives of a country (Nda:
2006). The main objectives of reserve management include safety (capital
preservation), liquidity and returns.
Nigeria’s external reserves derive mainly from the proceeds of crude oil
production and sales. Nigeria produces approximately two million barrels of crude
oil per day in joint venture with some international oil companies. From 1999,
world oil prices began to rise again resulting in another boom and unprecedented
accumulation in the level of reserves from USD4.98 billion in May 1999, to
USD59.37 billion as at March 28, 2007 (CBN website). Nigeria’s dependence on oil
for over ninety percent of its foreign exchange earnings makes its capital account
vulnerable to the fluctuations in crude oil prices. This, in addition to its high import
bills contributed to the fluctuations in the level of reserves over the years and
consequently the way the reserves are being managed.
o Rationale for Holding Reserves
Global official reserves have increased significantly and quite rapidly in
recent years. This phenomenal growth is a reflection of the enormous importance
58
countries attach to holding an adequate level of international reserves. The reasons
for holding reserves include the following:
To safeguard the value of the domestic currency: Foreign reserves are held as
formal backing for the domestic currency. For most developed countries
however, this is not the prime use of reserves.
Timely meeting of international payment obligations: The need to finance
international trade gives rise to demand for liquid reserves that can readily
be used to settle trade obligations, for example to pay for imports.
Wealth Accumulation: Some Central banks use the external reserve portfolio
as a store of value to accumulate excess wealth for future consumption
purposes. Such Central banks would segregate the reserve portfolio into a
liquidity tranche and a wealth tranche, with the latter including longer-term
securities such as bonds and equities and managed against a different
benchmark emphasizing return maximization.
Intervention by the monetary authority: Foreign exchange reserves can be
used to manage the exchange rate, in addition to enabling an orderly
absorption of international money and capital flows. The monetary
authorities attempt to control the money supply as well as achieve a balance
between demand for and supply of foreign exchange through intervention
(i.e. offering to buy or sell foreign currency to banks) in the foreign exchange
markets. When the Central bank sells foreign exchange to commercial banks,
its level of reserves declines by the amount of the sale while the domestic
money supply (in naira) also declines by the naira equivalent of the sale.
59
Conversely, when the Central bank purchases foreign exchange from the
banks its level of reserves increases while it credits the accounts of the banks
with the naira equivalent, thus increasing the domestic money supply.
To boost a country’s credit worthiness: External reserves provide a cushion
at a time when access to the international capital market is difficult or not
possible. A respectable level of international reserves improves a country’s
credit worthiness and reputation by enabling a regular servicing of the
external debt thereby avoiding the payment of penalty and charges.
Furthermore, a country’s usable foreign exchange reserve is an important
variable in the country risk models used by credit rating agencies and
international financial institutions.
Economies of nations sometimes experience drop in revenue and would need
to fall back on their savings as a lifeline. A good external reserves position
would readily provide this cushion and facilitate the recovery of such
economies.
To provide a buffer against external shocks: External shocks refer to events
that suddenly throw a country’s external position into disequilibrium. These
may include terms of trade shocks or unforeseen emergencies and natural
disasters. An adequate external reserve position helps a country to adjust
quickly to such shocks without recourse to costly external financing.
60
REFERENCES Adebiyi M A (2007), "An Evaluation of Foreign Exchange Intervention and Monetary
Aggregates in Nigeria (1986- 2003)" Munich Personal RePEc Archive Paper (MPRA) No 3817, University of Lagos.
Adubi A, Okunmadewa F (1999), "Price, exchange rate volatility and Nigeria’s agricultural trade flows: A dynamic analysis," African Economic Research Consortium (AERC) research paper 87. Akanji O (2006), "The achievement of convergence in the Nigerian foreign exchange
Market," CBN Bullion Volume 30 No 3. Bailey M J and Taulas G S (1988), “Trade and investment under floating exchange rates: The U.S. experience,” The Cato Journal, Volume 8: 2. Central Bank of Nigeria (2002), "Guidelines for Bureaux de Change in Nigeria," Other Financial institutions department. Central Bank of Nigeria, "Reserve Consumptions and Future savings: What options," (International Operations: CBN Website).
Central Bank of Nigeria (2008), "Section D: External sector statistics," CBN Statistical Bulletin, Volume 17. Egwaikhide F O (1999), "Determinants of imports in Nigeria: A dynamic
specification" African Economic Research Consortium (AERC) research paper 91.
Elumelu T (2002), "Interest and Exchange Rates Management in Nigeria: A Macroeconomic Implication". Excerpts from a speech delivered at the Inaugural Lecture of the Alumnus Guest Lecture Series of the Department of Economics, Ambrose Alli University, Ekpoma on June 24. Holly J (2010), "History of foreign currency exchange," Ehow contributor. Hooper P and Kohlhagen S W (1978), "The effects of exchange rate risk and uncertainty on the prices and volume of international trade” Journal of International Economics, 8: 483-511. Itsede (2003), "Exchange Rates Behaviour and Competitiveness," Journal of West African Institute for Financial and Economic Management (WAIFEM) Vol 1, No 1, p 1 – 34.
61
Kroner K F and Lastrapes W D (1991), "The impact of exchange rate volatility on international trade: Reduced from estimates using the GARCH-in-mean model” Manuscript, University of Arizona. Lipsey R and Chrystal A (2007), "Economics," Eleventh edition, Oxford University Press, pp. 37-63, 497-540, 610-633. Mordi C (2006), "Challenges of exchange rate volatility in economic management in Nigeria," CBN Bullion Volume 30 No 3, July-September. Nda M (2006), "Effective reserves management in Nigeria: Issues, challenges and Prospects," CBN Bullion Volume 30 No 3. Odusola A (2006), "Economics of exchange rate management," CBN Bullion Volume 30 No 3. Oronsaye S (2010), "Foreign exchange demand falls as demand rises," Next, February 10th. Osaka G C, Oputa N C, Tule M K, Sanni H T, Odey L I, Sanni G K (2004), "The impact of Regulatory sanctions on banks for non- compliance with foreign exchange Guidelines: a case study of 25 banks," Research Department, CBN Copyright © 2004. Qian Y and Varangis P (1992), “Does exchange rate volatility hinder export growth?" The World Bank Working Papers on International Trade WPS 9 11, May. International Economics department. Soludo C (2006), "Programme for further liberalization of the foreign exchange market in Nigeria," Press briefing in March. Spaulding W (2005), "Foreign Exchange History," Copyright© 2005-2011.
62
CHAPTER THREE
RESEARCH METHODOLOGY
3.1 INTRODUCTION
This chapter outlines the procedures for analyzing the variables including
ways of collecting and handling statistical observations and data. It expresses both
the structure of the research problem and plan of investigation used to obtain
empirical evidence for the conclusions reached. It adopts the scientific method in
ascertaining whether the theory of demand for foreign exchange is amenable to the
situation in Nigeria.
3.2 RESEARCH DESIGN
The ex post facto research design is suitable for this type of research. It is the
examination in retrospect of the effects of a naturally occurring event on a
subsequent outcome with a view to establishing a causal link between them. Here
the variables have already occurred and the researcher starts with the observation
of the dependent variable and to the independent variable(s) in retrospect for
possible relationship to and effects on the dependent variable.
3.3 POPULATION OF THE STUDY
The population of the study consists of the aggregate demand for foreign
exchange over time in Nigeria. It is not possible to ascertain the exact amount of
foreign exchange effectively demanded in Nigeria historically and so the population
is uncountable. The study by implication has an infinite population.
63
3.4 SAMPLE AND SAMPLING TECHNIQUE
The study will be conducted with a sample size that would be representative
of the entire population subject to standard error. The sample size adopted for this
study is the annual official aggregate demand for foreign exchange in Nigeria
covering a period of twenty four years from 1986 to 2009.
The sampling technique adopted for this study is the judgemental sampling
which is a non probability sampling technique. It involves selecting a data size from
the available population that is best suited to provide information required. It is
based on the population parameters. The choice of 1986 begins a period when the
Nigerian foreign exchange market was liberalized to 2009, the limit of reach of
available official data.
3.5 SOURCES OF DATA
The study relies on historical quantitative data, which are available in
secondary form. It included the reviews of literature relating to the subject matter
under study and the collating, sorting and preview of official data for analysis and
test of hypothesis. The main source of data is from the trade and exchange
department of the Central Bank of Nigeria. Data obtained for the study includes the
annual disbursement of foreign exchange in Nigeria measured in the United States
Dollars and the annual average official exchange rate of the naira in relation to the
United States dollars. This information is available on the website of the Central
Bank of Nigeria.
64
3.6 MODEL SPECIFICATION
The theoretical foundation on which the model one predicated is the multiple
linear relationships between foreign exchange demand as the dependent variable
and the exchange rates, inflation rates and demand for imports as independent
variables. The models are presented below:
DFX (ER, INF, IM) = 0 ………….. (1)
FR (MDFX) = 0 ….……………….. (2)
Where DFX is Annual demand for foreign exchange (Annual disbursement),
MDFX = Monthly demand for foreign exchange
ER represents exchange rates,
FR stands for foreign reserves,
IM represents imports
INF is for inflation rate.
If we assume a linear relationship (logarithm), then the model equations
become:
Log DFX (Log ER, Log INF, Log IM) = 0………….. (3)
Log FR (Log MDFX) = 0……………………………….... (4)
3.7 METHOD OF DATA ANALYSIS
The data would be analysed for possible correlation with the Statistical
Package for Social Sciences (SPSS). Data would be transformed into logarithmic data
to take into effect the size of some variables and the varying scales of measurement.
The transformed data would be sorted out according to the models for the study and
65
presented. The independent and dependent variables are keyed into SPSS with the
requisite instructions. The output data would be produced. Results of the imputed
data would be analysed. The hypotheses would be tested by comparing the
calculated values with the tabulated values to determine if the probability value is
sufficiently different from zero as to reject the null hypotheses.
66
CHAPTER FOUR
PRESENTATION AND ANALYSIS OF DATA
4.1 PRESENTATION OF DATA
The data for the study are presented below:
Table 4.1
YEAR FOREIGN EXCHANGE DISBURSEMENT (US’
$ Million)
ANNUAL IMPORTS (N’ Million)
ANNUAL OFFICIAL
EXCHANGE RATES (N/US$1.00)
ANNUAL INFLATION RATES
(%) 12 MMA
1986 6481.9 5,983.6 2.0206 5.4
1987 5312.8 17,861.7 4.0179 10.2
1988 5200.6 21,445.7 4.5367 56.0
1989 5837 30,860.2 7.3916 50.5
1990 7437.6 45,717.9 8.0378 7.5
1991 8206.1 89,488.2 9.9095 12.7
1992 8056.9 143,151.2 17.2984 44.8
1993 5621.4 165,629.4 22.0511 57.2
1994 5177.3 162,788.8 21.8861 57.0
1995 20456.5 755,127.7 21.8861 72.8
1996 17181.5 562,626.6 21.8861 29.3
1997 9995.3 845,716.6 21.8861 10.7
1998 10781.1 837,418.7 21.8861 7.9
1999 10129.8 862,515.7 92.6934 6.6
2000 11810.9 985,022.4 102.1052 6.9
2001 14737.2 1,358,180.3 111.9433 18.9
2002 13110.2 1,512,695.3 120.9702 12.9
2003 16314.4 2,080,235.3 129.3565 14.0
2004 15342.2 1,987,045.3 133.5004 15.0
2005 24307.5 2,800,856.3 132.1470 17.8
2006 24321.6 3,153,669.2 128.6516 8.2
2007 24356.7 3,984,888.4 125.8331 5.4
2008 47024.5 5,248,455.3 118.5669 11.6
2009 32596.41 5,022,162.6 148.9017 12.4
The table above represents data collated from secondary sources for analysis
and test of hypothesis. The data for annual imports and annual foreign exchange
disbursement and annual imports are presented in appendices 2 and 5 respectively
while data for annual average exchange rates and inflation rates are presented in
appendix 6 and 7 respectively.
67
The data above are transformed into logarithm to achieve better normal
distribution conformation. The logarithmic data is shown below:
Table 4.2
YEAR Log DFX Log IM Log ER Log INF 1986 9.811702327 9.776962554 0.305474975 0.731614475
1987 9.725323467 10.25192279 0.604003627 1.007825338
1988 9.716053452 10.33134023 0.656743252 1.748506178
1989 9.766189693 10.48939874 0.868736009 1.703004805
1990 9.871432818 10.66008627 0.905137646 0.874994903
1991 9.914136805 10.95176577 0.996051377 1.103635229
1992 9.906167973 11.15579499 1.238006563 1.651352342
1993 9.749844489 11.21913743 1.343429438 1.757132129
1994 9.714103331 11.21162452 1.340168379 1.756116385
1995 10.31083133 11.8780204 1.340168379 1.862211365
1996 10.23506108 11.75022026 1.340168379 1.466741851
1997 9.999795834 11.92722486 1.340168379 1.028277373
1998 10.03266307 11.92294265 1.340168379 0.895519479
1999 10.00560087 11.93576701 1.967048578 0.820712059
2000 10.07228299 11.9934461 2.009047896 0.84119839
2001 10.16841498 12.13295744 2.048998202 1.275751689
2002 10.11760932 12.17975147 2.082678279 1.110171498
2003 10.21257111 12.31811246 2.111788368 1.146922933
2004 10.18588764 12.29820776 2.125482567 1.176489564
2005 10.38574029 12.44729083 2.121057308 1.251574329
2006 10.38599214 12.49881614 2.109415192 0.915902256
2007 10.38661845 12.60041617 2.099794896 0.731134732
2008 10.67232419 12.7200315 2.073963526 1.063520632
2009 10.51316977 12.70089077 2.172899778 1.092760222
The data would be analysed using the Statistical Package for Social Sciences
(SPSS). Results of the data are for hypothesis 1 and 2 while data for test of the test of
the third hypothesis is presented below:
68
Year Month Foreign Reserves
(FR)
(US’ $ Million)
Monthly Demand for
Foreign Exchange
(MDFX) in US’ $ M
Log FR Log MDFX
1996 JANUARY 1,002.95 42.34 9.001280352 7.626750854
FEBRUARY 1,437.33 169.67 9.157555126 8.22960506
MARCH 1,849.15 203.99 9.266972293 8.309608878
APRIL 1,848.10 187.23 9.266725115 8.272375437
MAY 1,825.34 149.72 9.261344413 8.175279818
JUNE 2,072.76 161.23 9.316548192 8.207445854
JULY 1,811.06 244.3 9.257932839 8.387923467
AUGUST 2,218.05 197.54 9.345972279 8.295655049
SEPTEMBER 2,310.06 151.59 9.363622966 8.180670553
OCTOBER 2,808.98 191.05 9.448548524 8.281147042
NOVEMBER 3,307.90 113.74 9.519552369 8.055913224
DECEMBER 3,403.91 49.52 9.531978039 7.694780636
1997 JANUARY 4,480.52 137.37 9.65132835 8.137891898
FEBRUARY 5,352.18 330.87 9.728530407 8.519657391
MARCH 6,180.59 286.38 9.791030046 8.456942685
APRIL 5,664.65 348.49 9.753173204 8.54219032
MAY 5,372.50 311.88 9.730176567 8.493987526
JUNE 6,141.33 172.6 9.788262787 8.237040791
JULY 6,038.96 173.67 9.780962153 8.239724804
AUGUST 6,645.60 238.14 9.822534059 8.376832349
SEPTEMBER 6,773.48 277.9 9.830811752 8.443888547
OCTOBER 6,750.37 313.75 9.829327693 8.496583734
NOVEMBER 6,869.71 193.65 9.836938264 8.287017501
DECEMBER 7,222.22 202.85 9.858670437 8.307175012
1998 JANUARY 7,464.73 477.01 9.873014323 8.678527484
FEBRUARY 8,402.39 397.03 9.924403014 8.598823324
MARCH 8,319.60 263.7 9.920102221 8.42111013
APRIL 8,318.31 289.84 9.920035252 8.462158321
MAY 7,836.21 358.62 9.894105911 8.554634506
JUNE 7,947.26 333.16 9.900217266 8.522652853
JULY 7,305.16 322.32 9.863629825 8.508287254
AUGUST 7,298.06 366.44 9.863207642 8.564002874
SEPTEMBER 8,192.32 495.6 9.91340684 8.695131298
OCTOBER 7,933.69 339.88 9.899475421 8.53132561
NOVEMBER 7,651.50 256.46 9.883746465 8.409019638
DECEMBER 7,107.50 349.31 9.851716868 8.543211019
1999 JANUARY 6,549.60 579.16 9.816214777 8.762798559
FEBRUARY 6,274.90 379.61 9.797606809 8.579337644
MARCH 5,507.10 503.28 9.740922963 8.701809672
APRIL 5,115.10 465.38 9.708854129 8.667807715
MAY 4,988.90 552.29 9.698004799 8.74216718
JUNE 4,772.30 515.29 9.678727737 8.712051714
JULY 4,708.20 294.66 9.672854903 8.469321185
AUGUST 4,971.00 329.34 9.696443763 8.517644481
SEPTEMBER 5,032.10 336.75 9.701749263 8.527307604
OCTOBER 5,343.50 336.17 9.727825814 8.526558954
NOVEMBER 5,021.90 402.96 9.70086806 8.605261938
DECEMBER 5,424.60 259.9 9.73436772 8.41480628
2000 JANUARY 5,789.20 419.1 9.762618553 8.622317661
FEBRUARY 6,494.80 531.44 9.812565782 8.725454239
MARCH 6,682.80 538.75 9.824958464 8.731387283
APRIL 6,692.60 467.6 9.825594869 8.669874502
MAY 6,786.80 600.79 9.831665051 8.778722695
JUNE 7,272.40 593.77 9.861677758 8.773618251
JULY 7,634.90 718.15 9.882803353 8.856215165
AUGUST 7,958.60 618.74 9.900836678 8.791508193
SEPTEMBER 8,118.10 682.16 9.909454397 8.83388625
69
OCTOBER 8,788.50 738.03 9.943914757 8.868074016
NOVEMBER 9,484.40 655.49 9.977009862 8.816566071
DECEMBER 9,386.10 692.4 9.972485177 8.840357059
2001 JANUARY 9,705.00 1009.99 9.98699554 9.004317074
FEBRUARY 10,016.25 756.06 10.00070516 8.878556262
MARCH 10,787.50 733.05 10.03292081 8.865133598
APRIL 10,176.30 1000.14 10.0075899 9.000060797
MAY 10,353.70 687.2 10.01509558 8.837083151
JUNE 10,166.70 678.34 10.00718001 8.831447427
JULY 10,389.90 795.04 10.01661137 8.900388979
AUGUST 10,204.00 888.78 10.00877045 8.948794273
SEPTEMBER 10,563.90 765.59 10.02382428 8.883996252
OCTOBER 10,581.68 816.28 10.02455462 8.911839156
NOVEMBER 10,117.80 968.57 10.00508609 8.986131013
DECEMBER 10,267.10 768.09 10.01144779 8.885412111
2002 JANUARY 9,668.78 717.6 9.985371679 8.85588243
FEBRUARY 9,768.47 799.79 9.989826547 8.90297597
MARCH 9,546.10 673.94 9.979825979 8.828621234
APRIL 9,403.40 714.31 9.97328491 8.85388673
MAY 9,226.30 622.4 9.965027572 8.794069584
JUNE 8,674.70 661.39 9.938254464 8.820457624
JULY 8,143.03 600.33 9.910786035 8.778390047
AUGUST 8,089.20 770.01 9.907905573 8.886496365
SEPTEMBER 7,424.00 940.03 9.870637963 8.973141714
OCTOBER 7,741.90 873.14 9.888847557 8.941083884
NOVEMBER 7,737.10 803.39 9.88857821 8.904926422
DECEMBER 7,681.10 786.22 9.885423419 8.895544087
2003 JANUARY 7,134.42 937.73 9.853358672 8.97207781
FEBRUARY 7,655.06 1172.2 9.883948599 9.069001717
MARCH 8,226.16 1027.03 9.915197152 9.01158313
APRIL 8,216.82 985.31 9.914703773 8.993572891
MAY 8,269.57 878.99 9.917482928 8.943983934
JUNE 7,673.09 1278.64 9.884970292 9.106748286
JULY 7,643.95 1018.25 9.883317838 9.007854419
AUGUST 7,448.96 1386.74 9.872095642 9.141995043
SEPTEMBER 7,170.46 1285.44 9.855547017 9.10905181
OCTOBER 7,305.84 1790.76 9.863670157 9.253037385
NOVEMBER 7,489.55 1764.27 9.874455724 9.246565049
DECEMBER 7,467.78 805.63 9.873191515 8.90613563
2004 JANUARY 8,324.00 889.59 9.920331863 8.949189892
FEBRUARY 9,352.40 795.97 9.970923073 8.9008967
MARCH 9,684.49 732.55 9.986076755 8.864837273
APRIL 9,975.91 692.53 9.998952522 8.840438592
MAY 10,083.87 1076.92 10.00362724 9.032183443
JUNE 11,441.36 1131.97 10.05847765 9.053834917
JULY 12,228.31 1194.24 10.08736644 9.077091613
AUGUST 12,482.40 775.07 10.0962981 8.889340927
SEPTEMBER 13,222.90 972.53 10.12132671 8.987903007
OCTOBER 14,657.00 868.31 10.16604509 8.938674803
NOVEMBER 16,345.40 902.76 10.21339555 8.955572308
DECEMBER 16,955.02 698.91 10.22929831 8.844421254
2005 JANUARY 19,592.64 880.68 10.29209296 8.944818134
FEBRUARY 20,554.09 882.82 10.31289825 8.945872163
MARCH 21,807.98 923.86 10.33861544 8.965606164
APRIL 22,210.20 860.4 10.34655247 8.934700402
MAY 23,290.50 943.65 10.36717881 8.974810944
JUNE 24,367.12 1438.74 10.3868042 9.157982318
JULY 25,161.60 1489.61 10.40073825 9.173072579
AUGUST 26,951.24 1386.09 10.43057875 9.14179143
SEPTEMBER 28,638.24 990.07 10.45694632 8.995665901
70
OCTOBER 23,921.01 893.71 10.37877951 8.951196617
NOVEMBER 27,075.63 660 10.43257857 8.819543936
DECEMBER 28,279.06 470 10.45146497 8.672097858
2006 JANUARY 31,317.94 251.2 10.49579319 8.400019635
FEBRUARY 34,319.11 344.7 10.53553602 8.537441283
MARCH 36,201.54 447.4 10.55872705 8.65069598
APRIL 33,063.87 1178 10.51935368 9.07114529
MAY 34,094.35 1328.6 10.53268242 9.123394248
JUNE 36,479.00 371.6 10.56204292 8.570075705
JULY 38,074.22 612.8 10.58063102 8.787318757
AUGUST 39,247.82 1072.7 10.59381554 9.030478281
SEPTEMBER 40,457.86 1306.4 10.60700291 9.116076172
OCTOBER 41,477.69 1377.7 10.61781456 9.139154658
NOVEMBER 42,441.55 1758.1 10.62779124 9.245043574
DECEMBER 42,298.11 1401.4 10.62632096 9.146562113
2007 JANUARY 43,510.78 1146.3 10.63859687 9.059298292
FEBRUARY 42,550.61 1751.2 10.62890579 9.243335749
MARCH 42,633.86 1580.6 10.62975465 9.198821978
APRIL 43,530.55 1124.3 10.63879415 9.050882211
MAY 43,168.67 1863.9 10.63516867 9.270422608
JUNE 42,626.20 2070.9 10.62967662 9.316159128
JULY 43,263.88 1904.1 10.63612547 9.279689753
AUGUST 45,010.40 1338.7 10.65331287 9.126683263
SEPTEMBER 47,930.22 1407.4 10.68060942 9.148417547
OCTOBER 49,209.74 920.5 10.69205107 8.964023793
NOVEMBER 49,963.62 861.3 10.6986539 8.935154447
DECEMBER 51,333.15 1035.7 10.71039792 9.015233976
2008 JANUARY 54,215.79 1752.9 10.73412579 9.243757141
FEBRUARY 56,908.42 802.1 10.75517653 8.904228516
MARCH 59,756.51 742.2 10.77638523 8.87052095
APRIL 60,815.85 826.1 10.78401678 8.917032622
MAY 59,180.14 1995.5 10.77217599 9.300051732
JUNE 59,157.15 2311.7 10.77200724 9.363931473
JULY 60,342.13 2629.8 10.78062064 9.419922721
AUGUST 60,201.74 2550.9 10.77960904 9.406693434
SEPTEMBER 62,081.86 1739.2 10.79296472 9.240349527
OCTOBER 58,534.15 5535.5 10.76740932 9.743156855
NOVEMBER 57,480.50 6103.2 10.75952054 9.785557602
DECEMBER 53,000.36 4744 10.72427882 9.67614468
The data for the monthly external reserves position is presented in appendix
4 while data for monthly aggregate demand for foreign exchange is presented in
appendix 8. The data has been transformed into logarithm. The information above
would be used for the test of the hypothesis 3.
4.2 TEST OF HYPOTHESES
This subsection would analyse data and test the hypotheses of the study
71
4.2.1 HYPOTHESIS 1
The main hypothesis for the study is reproduced below:
There is no positive association between the exchange rates and the demand
for foreign exchange in Nigeria.
This is tested against the alternate hypothesis:
There is positive association between the exchange rates and the demand for
foreign exchange in Nigeria.
The test may be stated in summary
H₀: r ≤ 0
H₁: r > 0
Results of the analysis for a one tailed test are stated below. The full analysis is
found in Appendix 9.
Correlations
Foreign
Exchange Exchange Rates Inflation Imports
Foreign Exchange Pearson Correlation 1 .767** -.282 .864
**
Sig. (1-tailed) .000 .091 .000
N 24 24 24 24
Exchange Rates Pearson Correlation .767** 1 -.239 .949
**
Sig. (1-tailed) .000 .130 .000
N 24 24 24 24
Inflation Pearson Correlation -.282 -.239 1 -.228
Sig. (1-tailed) .091 .130 .142
N 24 24 24 24
Imports Pearson Correlation .864** .949
** -.228 1
Sig. (1-tailed) .000 .000 .142
N 24 24 24 24
**. Correlation is significant at the 0.01 level (1-tailed).
72
Model Summaryb
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate Durbin-Watson
1 .886a .784 .752 .13629 1.143
a. Predictors: (Constant), Imports, Inflation, Exchange Rates
b. Dependent Variable: Foreign Exchange
From the model:
Log DFX (Log ER, Log INF, Log IM) = 0, we derive
Log DFX (Log ER, Log INF, Log IM) = 0.886
From the result above, the correlation for foreign exchange demand and
exchange rates is 0.767. The result for the test of significance is given as 0.000 in the
correlation result. This value is less than the standard 0.01 critical level and so the
value of 0.767 is statistically significant.
Also, the value from the table of critical values for Pearson’s correlation (r) at
the 0.01 level of significance and twenty two degrees of freedom is 0.472 for a one
tailed test. Since the calculated value (0.767) is greater than the tabulated (critical)
value of 0.472, the numerical evidence is strong enough to reject the null hypothesis
in favour of the alternate hypothesis which is reproduced below:
There is positive association between exchange rates and the demand for foreign
exchange in Nigeria.
4.2.2 HYPOTHESIS 2
The hypothesis is reproduced below:
73
H₀: There is no direct correlation between the demand for imports and the
demand for foreign exchange in Nigeria.
This is tested against the alternate hypothesis
H₁: There is direct correlation between the demand for imports and the
demand for foreign exchange in Nigeria.
This is summarized below:
H₀: r ≤ 0
H₁: r > 0
The information required for the second hypothesis can be retrieved from
the results of the output of the first model. The result for the correlation between
imports demand and foreign exchange demand is 0.864. The result for the test of
significance is given as 0.000 in the correlation result. This value is less than the
standard 0.01 critical level and so is statistically significant.
Also, the critical value for Pearson’s correlation (r) at the 0.01 level of
significance and twenty two degrees of freedom is 0.472 for a one tailed test. Since
the calculated value of 0.864 is greater than the critical value of 0.472, the numerical
evidence is strong enough to reject the null hypothesis in favour of the alternate
hypothesis which is reproduced below:
There is direct correlation between demand for import and the demand for foreign
exchange in Nigeria.
4.2.3 HYPOTHESIS 3
The hypothesis is reproduced below:
74
H₀: There is no association between the demand for foreign exchange and the
level of foreign reserves.
This is tested against the alternate hypothesis
H₁: There is an association between the demand for foreign exchange and the
level of foreign reserves.
This may be stated in summary
H₀: r = 0
H₁: r ≠ 0
Results of the analysis for a two tailed test are presented below as produced
by SPSS. The full analysis of the result is found in Appendix 10.
Correlations
Foreign
Reserves
Foreign
Exchange
Demand
Foreign Reserves Pearson Correlation 1 .737**
Sig. (2-tailed) .000
N 156 156
Foreign Exchange Demand Pearson Correlation .737** 1
Sig. (2-tailed) .000
N 156 156
**. Correlation is significant at the 0.01 level (2-tailed).
Model Summaryb
Model R R Square
Adjusted R
Square
Std. Error of the
Estimate Durbin-Watson
1 .737a .543 .540 .27533 .244
a. Predictors: (Constant), Foreign Exchange Demand
b. Dependent Variable: Foreign Reserves
75
From the model:
Log FR (Log DFX) = 0, we derive
Log FR (Log DFX) = 0.737
The correlation result (r) is 0.737 and it is statistically significant at the 0.01
level for a two tailed test.
Also, the critical value for Pearson’s correlation (r) at the 0.01 level of
significance and twenty two degrees of freedom is 0.515 for a two tailed test. Since
the calculated value of 0.737 is greater than the critical value of 0.515, the numerical
evidence is strong enough to reject the null hypothesis in favour of the alternate
hypothesis which is reproduced below:
There is an association between the demand for foreign exchange and the level of
foreign reserves.
76
CHAPTER FIVE
SUMMARY OF FINDINGS AND RECOMMENDATIONS
5.1 SUMMARY OF RESEARCH FINDINGS
This section summarises the general observations and results of the findings
on the analysis of data and test of hypotheses undertaken in the study. They are
itemized below:
There is positive association between foreign exchange rates and the demand
for foreign exchange in Nigeria.
There is a direct correlation between demand for import and the demand for
foreign exchange in Nigeria.
There is a positive association between the demand for foreign exchange and
the level of foreign reserves. This is a spurious correlation.
There is no significant association between the demand for foreign exchange
and the rate of inflation.
There is a weak negative correlation between exchange rates and inflation.
There is weak negative association between the rate of inflation and the
demand for imports in Nigeria.
There is significant positive relationship between the demand for imports
and foreign exchange rates. Since imports can only be effected with foreign
exchange, it goes to show that the positive correlation between the rate of
exchange and foreign exchange demand is attributable to foreign exchange
demand and not otherwise.
77
The multiple correlation coefficient for the first equation output is 0.886 and
it is statistically significant. This explains the high positive correlation
between the demand for foreign exchange on one hand and the foreign
exchange rates, inflation and imports on the other.
The coefficient of determination (adjusted R²) is 0.752 for the first model.
This suggests that 75.2 percent of the changes in demand for foreign
exchange is explained by changes in exchange rates, inflation and imports.
The remaining 24.8 percent are explained by variables not included in the
model. In other words, it is estimated that the predictors of Log DFX explain
75.2 percent of its variance while the error variance of Log DFX is
approximately 24.8 percent of the variance of Log DFX itself.
The standardized (beta) coefficient for imports is 1.368. It indicates the
upward movement of foreign exchange demand (log DFX) by 1.368 standard
deviations when imports (log IM) go up by one standard deviation.
The beta coefficient for exchange rate is – 0.556. It is not statistically
significant and could have occurred by chance. In other words, exchange rate
is not a good predictor of foreign exchange demand.
The beta coefficient for inflation is – 1.02 and it is not significant. It is not a
good predictor of the demand for foreign exchange in Nigeria.
The exchange rates and the demand for foreign exchange show a significant
positive correlation but the beta coefficient of exchange rates in the multiple
regression table is negative while imports demand is positive. This in effect
78
shows that the demand for foreign exchange is not affected positively by the
rate of exchange but by the demand for imports.
The regression line for the first equation is: log DFX = 5.488 – 0.259 log ER –
0.078 log INF + 0.436 log IM (Appendix 9).
The regression line for the second model is log FR = 2.496 + 0.859 log DFX.
The value 2.496 represents the point at which the regression line intercepts
the y axis of the logarithmic graph and it is a constant. The value 0.859
represents the slope of the regression line.
5.2 CONCLUSION
In closing, exchange rates do not drive the demand for foreign exchange in
Nigeria. The demand for imports does. Hence the increased demand for foreign
exchange is not determined by a rise in the prices of foreign currency but by an
increased demand for imported products.
5.3 RECOMMENDATIONS
The recommendations for this study are not implausible. Measures needed to
address the situation could be considered from the short/medium term and long
term perspectives. In the short term:
The Central bank should ease controls that bring about unnecessary pressure
on the available foreign exchange by ensuring adequate supply in any
demand location or situation to achieve stability. The stability of the naira is
of first importance and it cannot be over emphasized. It enables businesses
and corporate entities to plan ahead and avoid unnecessary speculations. It
79
would also assist in reducing the gap between the official and parallel
markets and prevent disequilibrium in the foreign exchange market.
Government should also cut heavily on unnecessary public spending
especially the award of contracts to companies outside Nigeria that would
require huge foreign exchange outflow for settlement.
The Central bank should always avoid the devaluation of the naira. The study
showed that imports drive the demand for foreign exchange. Nigeria is an
import dependent economy. Most imports are necessities from the point of
view that local substitutes are unavailable, inadequate or below standards
leaving consumers with no suitable alternatives than imported products.
Devaluing the naira will certainly bring about a hike in prices of imports in
the short run and sustained inflation in the long term. Devaluation is to say
not a better alternative for the situation.
In the long run government policy objectives in the external sector economy
should be geared towards the following:
Narrowing the gap between the official and parallel markets and preventing
disequilibrium in the foreign exchange market.
The achievement of balance of payments viability.
Maintaining a favourable external reserve position and ensuring external
balance without compromising the need for internal balance, while keeping
in view the overall goal of sustainable output, growth and employment.
Reduction of dependence on imports and diversification of the export base.
80
Elimination or reduction of incidence of capital flight.
These could be achieved by:
Diversification of the export base (portfolio): Government should make effort
towards reducing the sole dependence on crude oil as Nigeria’s main foreign
exchange earner. Crude oil accounts for approximately twenty percent of Gross
Domestic Product and over ninety percent of the country’s foreign exchange
earnings. The obvious disadvantage of having a single foreign exchange earner is the
volatility in earnings it would bring to such an economy when demand falls relative
to supply. Foreign reserves would be depleted to sustain imports when demand or
price of the product is relatively low in the International market. There is the urgent
need for government to restructure and strengthen trade support institutions like
the Nigerian Export Import Bank (NEXIM) and National Export Promotion Council
(NEPC) and small enterprises to be able to carry out exportation successfully.
Government should also focus on a few products including one or two
agricultural products with comparative advantage in order to achieve measurable
success and not having the impression that any product could be exported. The
essence of having a variety of products for exports is to ensure that foreign
exchange earnings are not unstable and to have sufficient foreign reserves to
finance over three years of imports. Having available supply of foreign exchange
would ensure that any quantity demanded can be supplied, removing unnecessary
pressure on foreign exchange earnings and achieving stability of the Nigerian
currency.
81
Investing in Infrastructure as a way of inducing Investment in the real sector.
Government should implement policies that would ensure the growth of the
manufacturing sector and imports substituting industries. The cost of transacting
business in Nigeria is unusually high. Basic infrastructures are lacking or
inadequate. Such include electricity, water, transport and raw materials. Inadequate
electric supply for instance has made Nigeria a generator driven economy. Nigeria
spends millions of dollars on importation of generators annually-another
unnecessary avenue for foreign exchange demand and subsequent depletion. The
fuels needed to run the generators are also imported as Nigeria’s refining capacity is
grossly inadequate. Recently, the Central Bank estimated the amount being
expended by corporate bodies and individuals to fuel their alternative energy
sources (generators) at over N1.66 trillion yearly. Specifically, CBN analysed that 60
million Nigerians, who own power generating sets spend 1.56 trillion to fuel them,
while corporate bodies in the private sector expend N100.8 billion (at the rate of
N1.8 billion weekly), a year on their own “mini power stations”. However, analysts
believed that the Central bank’s estimate was conservative, as they assessed that
corporate bodies spend more than the apex bank’s figure.
Having adequate and stable power supply for instance would ensure that
manufacturing challenges with heavy reliance on power are addressed. This would
reduce the cost of transacting business tremendously and free capital for other
important business uses. Local Manufacture of products at competitive prices and
comparative standards with imports would ensure that hard earned foreign
82
exchange is not wasted to import products that could be manufactured within. This
would significantly reduce the demand for foreign exchange in Nigeria.
Induce Foreign Direct Investment in the real sector of the economy: High costs
associated with inadequate power and transportation infrastructure,
underperforming or weak government institutions, corruption, safety and security
issues, restrictive import regulations, and regional unrest are Nigeria’s most critical
market challenges. According to Nigeria’s Minister of the National Planning
Commission, to adequately address infrastructure needs, the country would need to
invest from 2009 to 2015 over $100 billion in four key sectors: power generation
($18-20 billion), railways ($10 billion), roads ($14 billion), and oil and gas ($60
billion). Considering that the Government of Nigeria (GON) does not have all the
resources it needs for development, the GON is willing and ready to collaborate with
the private sector under a structured public-private partnership (PPP) model.
Currently, Nigeria generates on average less than 3000 megawatts of electricity for
its population of over 150 million people growing at an annual average with
estimates ranging from 2 to over 3 percent annually. The World Bank advised
Nigeria at the Nigerian Economic Summit in November 2009 to deal decisively with
the challenges posed by collapsing infrastructure and the rising demands of
consumers in the power sector. About $50 billion is estimated to be needed to build
the systems to generate the 20,000 mega watts of estimated current Nigerian
consumer demand. Currently, significant portions of that demand shortfall are met
by expensive “diesel off-grid power production”.
83
Foreign direct Investment would increase the supply of foreign exchange in
the market thereby strengthening the value of the naira; enhance employment and
skills level; improve technology diffusion and knowledge transfer; bring about spill
over effects to local firms and broaden the export base amongst others. Broadening
the export base would bring about supply of foreign exchange when products are
eventually exported.
Achieving sufficiency in key areas of production: Imported products that could
be manufactured locally drain huge reserves of foreign exchange annually. Nigeria
spends huge foreign exchange resources on products that she ought to have
achieved adequacy in production after fifty years of independence. Such products
include generators for alternative power supply as highlighted previously, cement
and fuel to mention a few. Taking a look at fuel importation into Nigeria over the last
few years is very alarming. Nigeria imports almost all of its required
oil products despite being one of Africa’s largest oil exporters because its four
refineries are barely operational, due to poor maintenance, theft and fire. As the
world's eighth largest exporter of crude oil, Nigeria should be exporting, not
importing, refined petroleum products. However, the gross mismanagement of the
oil industry in the last two decades has stripped the nation of its enviable position in
the global energy industry. The eighth largest producer of crude oil in the world is
totally dependent even on poorer, oil-importing nations for refined petroleum
products. Nigeria's four oil refineries have a combined built-in capacity of more than
440,000 barrels per day, but have never operated at full potential (less than 50%
combined capacity in the last decade). Nigeria consumes over 35 million litres of
84
fuel daily and spends over 10 billion dollars on fuel importation annually. Private
refineries have failed to come upstream due to investment and subsidy related
issues. Repairing the oil industry, in the context of Nigeria's wider developmental
goals, calls for several initiatives which include
Deregulation of oil prices to reduce fiscal burden on the government and to
promote private sector investment in refining operations.
Enhancing equity finance access to emerging oil refining companies and
financial incentives to attract foreign direct investment.
Empowering regulatory authorities to deal more efficiently with issues
surrounding oil operations, including violence and vandalism, labour
problems and power deficits.
Improving capacity utilisation in existing refineries by raising production
standards to cut dependence on finished petroleum imports.
Diversifying the fuel retail business by deregulating the downstream sector
and encouraging business expansion of existing players.
Enforcing environmental compliance and addressing genuine concerns of
local communities; increasing social participation and minimising conflicts.
In all self sufficiency in refined petroleum products would reduce or
eradicate fuel importation and free foreign exchange demand for other important
uses. These initiatives when fully implemented would drastically reduce demand for
foreign exchange brought about by importation of refined oil and other unnecessary
imports.
