CHAPTER ONE/INTRODUCTION
In today’s interconnected globe, there are very few nations that are completely isolated. Via asset or/and products markets, enabled through trade and foreign currency, the economies of all the nations in the globe are directly or indirectly connected. Understanding the development pattern of the world’s economies consequently requires knowledge of the price of foreign currencies in terms of a local currency.
In Nigeria, exchange rate schemes have existed since the early 1960s. When the Central Bank of Nigeria was established in 1958 and the Exchange Control Act was passed in 1962, the private sector generated foreign currency, which commercial banks retained in balances overseas on behalf of Nigerian exporters, according to Bakare (2011:3). In order to prevent shortages during the 1970s oil boom, it was important to control the foreign currency rate. The government had to enact a number of ad hoc measures to rein in the excessive demand for foreign currency due to shortages in the late 1970s and early 1980s. Nevertheless, effective exchange restrictions were not implemented until 1982. Back then, there was a fixed exchange rate system in use.
On September 26, 1986, the exchange control system was abandoned in favor of a new mechanism developed under the Structural Adjustment Programmes due to the rising demand for foreign currency and the exchange control system’s inability to develop a mechanism for allocating foreign currency that was appropriate and consistent with the goal of internal balance (SAP). The fundamental goals of exchange rate policy during the structural adjustment programs were to maintain the value of the native currency, a positive external balance, and the general purpose of macroeconomic stability, as well as to establish a reasonable exchange rate for the naira.
Exchange rate management uses exchange rate regulation as a key instrument. This is based on the reality that changes in the exchange rate may have a big impact on a country’s balance of payments, income distribution, and even GDP. It promotes the interchange of products and services internationally, as well as developing and sustaining global competitiveness, which guarantees a stable balance of payments situation. It acts as a stabilizing factor for domestic pricing and promotes internal equilibrium and price stability (CBN, 2011). So, it is not unexpected that monetary authorities place a high priority on a country’s foreign exchange policy given that it is believed to have a significant impact on the behavior of a number of macroeconomic indicators (Oyejide, 1989). That is especially true for Nigeria, which had started on a path of fast economic expansion with a large reliance on imports. One of the most significant costs in an open economy is the exchange rate, which is the price of one country’s currency in relation to another’s. It has an impact on the movement of capital, products, and services inside a nation and has a significant impact on the balance of payments, inflation, and other macroeconomic factors. As a result, choosing and managing an exchange rate regime is a crucial component of economic management to maintain growth, macroeconomic stability, and competitiveness (Cooper, 1999).
The macroeconomic performance of various exchange rate regimes has been the focus of ongoing study and debate. Using a three-way categorization, Ghosh et al. (1996) examined the relationship between inflation, growth, and exchange rate regimes. According to the findings, anchored exchange rates are linked to lower inflation and less volatility. Therefore, they claimed that this was caused by two factors: a discipline effect, where the political costs of failing to defend the peg induce disciplined monetary and fiscal policy; and a confidence effect, where there is a stronger willingness to hold domestic currency to the extent that the peg is credible, which lessens the inflationary effects of a given expansion in the money supply. The research also found that fixed rates are linked to slower productivity growth but greater investment. Overall, production growth is somewhat slower under fixed exchange rate regimes than it is in floating or intermediate rate regimes (Ghosh, et. al., 1996)
Similar conclusions are reported in an IMF research that extends the analysis period to the middle of the 1990s (IMF 1997). Nevertheless, Caramaza and Aziz (1998) concluded that the differences in inflation and production growth between fixed and flexible regimes are no longer substantial after analyzing the experience with increased capital market integration and the removal of fixed exchange rates in the 1990s.
Levy-Yeyati and Sturzenegger (2000) categorized the exchange rates into three categories (float, intermediate, and fixed) and examined the link between the actual (de facto) exchange rate regimes and macroeconomic performance using data from 159 countries during the 1974–1999 periods. The main conclusions are as follows: (a) fixed exchange rate regimes appear to have no discernible impact on the level of inflation when compared to pure floats, while intermediate regimes are the glaring under-performers; (b) pegs are significantly and negatively correlated with per capita output growth in non-industrial countries; (c) output volatility declines monotonically with the degree of regime flexibility; and (d) real interest rates appear to be lower under fixed rates than under floats.
Currency redesign were seen as the cornerstone for further fortifying the macroeconomic framework, particularly monetary transmission. The greater the population’s reliance on the local currency as opposed to U.S. dollars, the greater the government’s ability to influence the macroeconomic environment policy. Nigeria’s currencies have been introduced and redesigned over the years, with the CBN playing pivotal roles in preserving its stability (Naseem, 2012). The operations and performance of this sector directly affect achieving macroeconomic objectives and boosting the economy. Recently, the Central Bank of Nigeria (CBN 2022) announced that plans to redesign the Naira have been completed. The unusual decision was made, according to the CBN Governor, in large part due to money hoarding, inflation, and counterfeiting. According to the CBN, of the N3.23 trillion in currency in circulation in Nigeria, approximately N2.73 trillion is stored outside of bank vaults. This represents around 85% of the entire amount of money in use. Also, the Naira lacks the necessary security since it is simpler to counterfeit the N500 and N1000 denominations.
Experts in policy, including economists, lawyers, and others, have been debating this subject in depth. Many of them believe that these policy changes will have little or no economic impact for the populace and are only a diversion from the nation’s dire economic woes. According to the CBN’s most recent report, the 2020 Currency Report, 67,265 counterfeit notes totaling N56.83 million in nominal value were seized in 2020, representing a 20.80% decline in volume and 12.18% fall in value compared to 84,934 pieces valued at N64.71 million in 2019. 100 is the global average for counterfeits per million. In 2020, there were 13 pieces of counterfeit currency for every million banknotes in circulation, down from 20 pieces per million in 2019.
This demonstrates that the problem of counterfeit money is not as pervasive as would need a modification of the currency. For instance, Afghanistan recently saw a drop in the value of its currency. As a result, a new Afghanistan design was released, eliminating several zeros. In many ways, Turkmenistan’s 2008 complete and orderly makeover of its monetary system, which prevented civil war in Afghanistan from breaking out, serves as a role model for other nations. Renovating current currencies is a serious undertaking. Hyperinflation, exchange rate collapse, widespread currency counterfeiting, war, anxieties, and political instability are all potential drivers. Alternatively it may be a deliberate move, like deciding to join a monetary union like the European Monetary Union. A highly political choice, changing a country’s currency is. The demands of the economy are sometimes not addressed by the current currency. The typical currency reform candidate is a cash-based, heavily dollarized economy with many currencies in circulation.
Recently, a number of nations have debated the relative merits of “Dollarization,” or using the currency of an anchor nation. Literature emphasizes that the costs of dollarization are inversely related to the correlation between rising productivity, wealth, and capital accumulation. One of the main potential costs of dollarization is that macroeconomic stability may be reduced by the loss of monetary policy autonomy. As a result, the home nation suffers from dollarization to the point that it experiences idiosyncratic shocks. In order to assess the scope of these stability costs, a number of academic studies on currency changes and their impact on national monetary policy were reviewed.
Several viewpoints on the influence of exchange rate on a country’s macroeconomic fundamentals have been explored in many more recent research conducted in Nigeria and overseas. Yougbare (2006) discovered that fixity in nominal exchange rates increases the volatility of real GDP growth when looking at the impact of exchange rate regimes on growth volatility. Moreover, it intensifies the negative effects of terms of trade instability on growth volatility while attenuating the negative effects of exchange rate fixity on growth stability. These findings also imply that by implementing more flexible exchange rate policies, developing nations will benefit more in terms of lower economic volatility.
According to Bacchetta and Wincoop (2009), the link between the exchange rate and macro fundamentals is quite unstable, and this is widely recognized from anecdotal, survey, and econometric data. They contend that large and frequent variations in the relationship between the exchange rate and macro fundamentals naturally develop when structural parameters in the economy are unknown and change very slowly. This could be explained when structural parameters are known and very volatile, but neither of these scenarios seems plausible.
In their 2008 study, Junye-Li and Weiwei-Yin used a no-arbitrage international macro-finance approach to examine the relationship between short-run exchange rate dynamics and macroeconomic fundamentals. Under this approach, the macroeconomic fundamentals enter exchange rate dynamics in a nonlinear form, and after being amplified by time-varying market prices for risks, the macroeconomic innovations help capture large volatility of exchange rate changes. The forward premium anomaly may be significantly reduced by the foreign currency risk premium.
According to Mahmood, Ehsanullah, and Ahmed (2011), the exchange rate has a key role in influencing the macroeconomic performance of any nation. So, the purpose of their research was to determine if exchange rate volatility or uncertainty had an impact on Pakistan’s macroeconomic indicators. If so, in what direction will it have an impact? While there are many macroeconomic indicators, this research only took into account the four following: GDP, FDI, growth rate, and trade openness. The results of this research supported the effect of exchange rate volatility on macroeconomic factors in Pakistan. Also, it was shown that exchange rate volatility had a beneficial impact on GDP, growth rate, and trade openness while having a negative impact on FDI.
Moreover, there are several local works in Nigeria. Ofurum and Torbira (2011) looked at how supply and demand for foreign exchange affected the Nigerian economy’s gross domestic product over a fourteen-year period (1995–2008). They found that while demand for foreign exchange has a negative relationship with gross domestic product, supply of foreign exchange has a positive and significant relationship with output level. This study suggests that the increase in foreign exchange supply has increased Nigeria’s Gross Domestic Product, so the factors that determine foreign exchange demand should be annualized to better understand what caused the negative relationship between foreign exchange demand and GDP.
Opaluwa, Umeh, and Ameh (2010) examine the effect of exchange on Nigeria’s manufacturing sector and contend that changes in exchange rates have a negative impact on the manufacturing sector’s output. They claim that this is due to Nigeria’s manufacturing being heavily dependent on input and capital goods imports. These are purchased using foreign currency, whose exchange rate is unstable. This apparent fluctuation will therefore unavoidably have a negative impact on activities in the sector that depends on outside sources for its productive inputs. In the end, the study’s findings are all statistically significant and demonstrate a negative impact. In order to reduce the manufacturing sector’s dependency on imports to a manageable level, they said that the relationship between agricultural and the manufacturing sector has to be strengthened via the sourcing of raw materials locally.
Bakare (2011) asserts that empirical cross-country research have produced confusing findings when examining the effects of various exchange rate regimes on macroeconomic performance, notably on private domestic investment. By conducting an empirical investigation of the effects of the foreign exchange rate changes on the results of private domestic investment in Nigeria, his work added to this body of information. The study’s findings and conclusion back up the need for the government to abandon the floating exchange system and switch to purchasing power parity, which is thought to be more suitable for determining a realistic exchange rate for the naira and to positively affect Nigeria’s macroeconomic performance.
A brief review of the literature on macroeconomic fundamentals and exchange rates reveals that the majority of research focus on exchange rate volatility and how it affects key macroeconomic indicators (Choo, Lee and Ung, 2011; Canales-Kriljenko and Habermeier, 2004). Where the study does not focus on exchange rate volatility, it considers the impact of macroeconomic and institutional factors (Claessens, Klingebiel, and Schmukler, 2003), impact on stock market indices (Gan, Lee, Yong, and Zhang, 2006), growth of government bond markets (Claessens, Klingebiel, and Schmukler, 2003), alternative wage-setting regimes (Kouretas, 1991), exchange rate volatility, and exchange rate uncertainty (Mbutor, 2010; Subair and Salihu, 2010). The goal of this research is to determine how exchange rate fluctuations affect foreign direct investment. This research examines the Effect of Naira Redesign on Foreign Exchange Rate in Nigeria given this backdrop.
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