IMPACT OF EXCHANGE RATE FLUNCTUATIONS ON FOREIGN DIRECT INVESTMENT

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IMPACT OF EXCHANGE RATE FLUNCTUATIONS ON FOREIGN DIRECT INVESTMENT

CHAPTER ONE

INTRODUCTION

  • BACKGROUND OF THE STUDY

There is scarcely any country that lives in absolute isolation in this globalised world. The economies of all the countries of the world are linked directly or indirectly through asset or/and goods markets, made possible through trade and foreign exchange. The price of foreign currencies in terms of a local currency is therefore important to understanding of the growth pattern of economies of the world.

The history of exchange rate systems in Nigeria is traceable to the early 1960s. According to Bakare (2011:3), …before the establishment of the Central Bank of Nigeria in 1958 and the enactment of the Exchange Control Act of 1962, foreign exchange was earned by the private sector and held in balances abroad by commercial banks that acted as agents for local exporters… The oil boom experienced in the 1970s made it necessary to manage foreign exchange rate in order to avoid shortage. However, shortages in the late 1970s and the early 1980s compelled the government to introduce some ad hoc measures to control excessive demand for foreign exchange. However, it was not until 1982 that a comprehensive exchange controls were applied. Then a fixed exchange rate system was in practice. The increasing demand for foreign exchange and the inability of the exchange control system to evolve an appropriate mechanism for foreign exchange allocation in consonance with the goal of internal balance made it to be discarded in September 26, 1986 while a new mechanism was evolved under the Structural Adjustment Programmes (SAP). The main objectives of exchange rate policy under the Structural Adjustment Programmes were to preserve the value of the domestic currency, maintain a favourable external balance and the overall goal of macroeconomic stability and to determine a realistic exchange rate for the Naira.

 

In macroeconomic management, exchange rate policy is an important tool. This is derived from the fact that changes in the rate of exchange have significant implications for a country’s balance of payments position and even its income distribution and growth. It aids international exchange of goods and services as well as achieving and maintaining international competitiveness and hence ensures viable balance of payment position.lt serves as an anchor for domestic prices and contributes to internal balance in price stability (CBN, 2011).  It is not surprising therefore, that monetary authorities attach much importance to proper management of a country’s foreign exchange since its behaviour is said to determine the behaviour of several other macroeconomic variables (Oyejide, 1989). It is even more so for Nigeria which had embarked on a course of rapid economic growth with its attendant high import dependency. An exchange rate, as a price of one country’s money in terms of another’s, is among the most important prices in an open economy. It influences the flow of goods, services, and capital in a country, and exerts strong pressure on the balance of payments, inflation and other macroeconomic variables. In this way, the choice and management of an exchange rate regime is a critical aspect of economic management to safeguard competitiveness, macroeconomic stability, and growth (Cooper, 1999).

 

Macroeconomic performances under different exchange rate regimes have been a subject of continuing research and controversy. Ghosh, et. al., (1996) using a three-way classification analyzed the link between exchange rate regimes, inflation and growth. The result indicates that pegged exchange rates are associated with lower inflation and less variability. They therefore argued that this was due to a discipline effect  the political costs of failure of defending the peg induce disciplined monetary and fiscal policy and a confidence effect to the extent that the peg is credible, there is a stronger readiness to hold domestic currency, which reduces the inflationary consequences of a given expansion in money supply. The study also found that pegged rates are associated with higher investment but correlated with slower productivity growth. On net, output growth is slightly lower under pegged exchange rates compared to floating and intermediate regimes (Ghosh, et. al., 1996)

 

A study by IMF that extends the period of analysis to mid-1990s reports similar findings (IMF 1997). However, in an analysis of experience with increasing capital market integration and the replacement of fixed exchange rates in the 1990s, Caramaza and Aziz (1998) found that the differences in inflation and output growth between fixed and flexible regimes are no longer significant.

 

Also, using data from 159 countries for the 1974-99 periods, Levy-Yeyati and Sturzenegger (2000) reclassified the exchange rates into three groups (float, intermediate, fixed) and estimated the correlation between the actual (de facto) exchange rate regimes and macroeconomic performance. The main findings include: (a) fixed exchange rate regimes seem to have no significant impact on the inflation level when compared with pure floats, while intermediate regimes are the clear 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 floating rates because of lower uncertainty associated with fixed rates.

 

More recent studies both in Nigeria and abroad abound with different perspectives on the impact of exchange rate on macro-economic fundamental of a country. Yougbare (2006), investigating the effect of exchange rate regimes on growth volatility found that fixity in nominal exchange rates increases the volatility of real GDP growth. Moreover, it amplifies the adverse impact of terms of trade instability on growth volatility whereas the negative impact of exchange rate fixity on growth stability is attenuated by a higher financial development. These results also suggest that as countries develop, they would gain more in terms of reduced growth volatility by adopting more flexible exchange rate arrangements.

 

Bacchetta and Wincoop (2009) posit that it is well known from anecdotal, survey and econometric evidence that the relationship between the exchange rate and macro fundamentals is highly unstable. This could be explained when structural parameters are known and very volatile, neither of which seems plausible hence they argue 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.

 

Junye-Li and Weiwei-Yin (2008), investigated the relationship between short-run exchange rate dynamics and macroeconomic fundamentals by adopting a no-arbitrage international macro-finance approach, under which the macroeconomic fundamentals enter into the exchange rate dynamics in a nonlinear form and having been amplified by the time-varying market prices of risks, the macroeconomic innovations help capture large volatility of exchange rate changes. The foreign exchange risk premium can largely alleviate the forward premium anomaly.

 

Mahmood, Ehsanullah, and Ahmed (2011) posit that the role of exchange rate in affecting the macroeconomic performance of any country is of leading nature. Hence, their study was conducted to investigate whether uncertainty or fluctuations in exchange rate affect the macroeconomic variables in Pakistan. If so, what is the direction of this effect will be? Although, there are large numbers of macroeconomic variables, but out of these only four variables i.e, GDP, FDI, growth rate and trade openness was included in this study. Finding of this study confirmed the impact of exchange rate volatility on macro economic variables in Pakistan. It was also concluded that exchange rate volatility positively affects GDP, Growth rate and trade openness and negatively affects the FDI.

 

Locally, in Nigeria, several works also exist. Ofurum and Torbira, (2011) examined the effect of the demand and supply of foreign exchange on the gross domestic product of the Nigerian economy over a fourteen (14) year-period (1995-2008), it was revealed that supply of foreign exchange has a positive and significant relationship with output level of Gross Domestic Product while the demand for foreign exchange has a negative relationship with gross demand product. This study implies that the growth in supply of foreign exchange has resulted in an increase in the Gross Domestic Product in Nigeria hence the determinants of the demand for foreign exchange should be annualized in order to understand what occasioned the negative relationship with Gross Domestic Product.

 

Looking at the impact of exchange on the manufacturing sector of Nigeria, Opaluwa, Umeh and Ameh (2010) argue that fluctuations in exchange rate adversely affect output of the manufacturing sector. This according to them is because Nigerian manufacturing is highly dependent on import of inputs and capital goods. These are paid for in foreign exchange whose rate of exchange is unstable. Thus, this apparent fluctuation is bound to adversely affect activities in the sector that is dependent on external sources for its productive inputs. The study actually shows adverse effect and is all statistically significant in the final analysis. They therefore advocated that there is the need to strengthen the link between agriculture and the manufacturing sector through local sourcing of raw materials thereby reducing the reliance of the sector on import of inputs to a reasonable level.

 

Examining the impact of different exchange rate regimes on macroeconomic performance particularly on private domestic investment, Bakare (2011) posits that empirical cross-country studies have yielded ambiguous results. Hence, his study extended this body of knowledge by carrying out an empirical analysis of the consequences of the foreign exchange rate reforms on the performances of private domestic investment in Nigeria. The study findings and conclusion support the need for the government to dump the floating exchange regime and adopt purchasing power parity which has been considered by researchers to be more appropriate in determining realistic exchange rate for naira and contribute positively to macroeconomic performances in Nigeria.

 

A cursory look at literature on exchange rate and macro-economic fundamentals indicate that most studies are on exchange rate volatility and its impact on these macro-economic indices (Choo, Lee and Ung, 2011; Canales-Kriljenko and Habermeier, 2004). Where the study is not on volatility of exchange rate, it involves uncertainty in foreign exchange market on the domestic output of nations (see, Dunne, Hau and Moore, 2007), macro-economic and institutional factors (Claessens, Klingebiel, and Schmukler, 2003)  impact on stock market indices (Gan, Lee, Yong and Zhang, 2006), development of government bond markets (Claessens, Klingebiel, and Schmukler, 2003), on alternative wage-setting regimes (Kouretas, 1991), exchange rate and inflation (Ghosh, Gulde, Ostry, and Wolf, 1996; Imimole and Enoma, 2011), exchange rate volatility, stock prices and lending habits of banks (Mbutor, 2010; Subair and Salihu, 2010). This study is an attempt to impact of exchange rate flunctuations on foreign direct investment. It is against this background that this study investigates the impact of foreign exchange rates on major macro-economic variables in Nigeria.

 

1.2       STATEMENT OF THE PROBLEM

A major challenge facing policy makers in Nigeria and most developing countries in the world is what should be the nature of her exchange rate. Foreign exchange volatility affects the performance of macroeconomic indicators positively and negatively. Most import dependent economies like Nigeria faces the problem of foreign exchange rate volatility. Nigeria’s over dependence on volatile foreign exchange revenue from the oil and gas sector of the economy has affected the major macro economic variables such as exchange rate, inflation rate, gross domestic product growth rate etc. Obaseki (2007) argues that the Nigerian Economy has experienced a lot of setback over the years due to its over dependence on oil and gas exports which provide more than 95% of all foreign exchange earnings and most of the Government revenue. Both have been scourged by the tumbling price of crude oil, compounded by the volatility of the country’s foreign exchange rate regimes

Nigeria major foreign earning is from oil; hence, volatility of crude oil prices in the world market has made the Nigerian economy highly susceptible to the ever changing exchange rates thus affecting the prices of goods and services in the Nigerian economy. Nzekwe (2006) states that Nigeria’s failure to diversify its economy which would have helped cushion the effect of the constant changes in oil prices stems in part from weaknesses in the nation’s small and insular private sector. This has had a heavy toll on our foreign reserves and invariably, our balance of trade and balance of payment.

A proper foreign exchange rate management in many ways strives to balance the level of imports with that of exports of goods that the country has comparative advantage (Obadan, 2006). Such balance is necessary for an economy to develop to levels beyond subsistence. However,  lack of government support for the real sector of the Nigerian economy as a result of it focus on foreign exchange earned from oil  has also contributed immensely to the abysmal performance of the all other sectors especially the manufacturing sector. Manufacturers, who account for substantial contributions to Nigeria’s gross domestic product before now have been unable to produce hence the fewer jobs, are created.

The Nigerian economy is in dire need of effective foreign exchange rate management that will diversify the economy, break the dominance of the oil sector, and give more opportunities to other sectors of the economy such as the manufacturing, agriculture, solid mineral mining etc and ultimately improve its balance of payment. In this way, a stable foreign exchange management can assist policy makers and planners to reduce risks in cause by fluctuations in exchange rate.

 

 

1.3       OBJECTIVES OF THE STUDY

The general objective of this study is to investigate the impact foreign exchange rate on macro-economic variables. However, the specific objectives are to:

  1. Examine the impact of exchange rate fluctuations on economic growth in Nigerian.
  2. Assess the impact of exchange rate fluctuations on balance of payment position in Nigeria.
  3. Appraise the impact of exchange rate fluctuations on price stability in Nigeria.
  4. Evaluate the impact of exchange rate fluctuations on foreign private investment in Nigeria.

1.4       RESEARCH QUESTIONS

As a follow up to the research objectives as stated above, the following questions will be raised in this study, there are;

  1. To what extent does an exchange rate fluctuation in Nigeria have positive and significant impact on economic growth in Nigerian?
  2. How far has exchange rate fluctuations had significant positive impact on the balance of payment position in Nigeria?
  3. To what extent does exchange rate fluctuation have positive and significant impact on price stability in Nigeria?
  4. How far have exchange rate fluctuations had any positive and significant impact on foreign private investment in Nigeria?

1.5      RESEARCH HYPOTHESES

The following hypothetical statements arose, there are;

  1. Exchange rate fluctuations do not have positive and significant impact on economic growth in Nigeria.
  2. Exchange rate fluctuations do not have positive and significant impact on balance of payment position in Nigeria
  3. Exchange rate fluctuations do not have positive and significant impact on price stability in Nigeria.
  4. Exchange rate fluctuations do not have positive and significant impact on foreign private investment in Nigeria.

1.6       SCOPE OF THE STUDY

This study covered the period 1987 to 2011. Before the introduction of the Structural Adjustment Programmes (SAPs) in 1986, the country operated a fixed exchange rate regime based on trade and exchange controls, which was anchored through import license controls regime. However, Nigeria adopted the freely floating exchange rate regime in 1986 and between 1986 and 1995; different exchange rate management regimes were introduced by the various governments in power at the time, including a dual exchange rate regime in 1988, the Inter-Bank Foreign Exchange Market (IFEM) in 1989 and the reintroduction of a dual exchange rate system in 1995. Over this period, the demand for foreign exchange outstripped supply progressively. The demand for foreign exchange is expected to have an effect on all macro-economic fundamental in Nigeria; hence this study examined the impact of foreign exchange rate on major macroeconomic determinants after the introduction of SAP in 1987 to 2011 irrespective of the different exchange rate regimes in Nigeria in that period.

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