THE EFFECT OF REAL EXCHANGE RATE VOLATILITY ON BALANCE OF PAYMENTS IN NIGERIA

ABSTRACT

This study empirically examined the effect of real exchange rate volatility on balance of payments  in  Nigeria  from  1970q1-2015q4  using  the  Ordinary  Least  Squares  (OLS) technique. Autoregressive-Exponential Generalized Autoregressive Conditional Heteroskedasticity (AR-EGARCH) model was estimated to examine the real exchange rate for volatility by obtaining the conditional variance from the estimated result, which was used to proxy exchange rate volatility. Empirical results showed that real exchange rate volatility had a positive and insignificant effect on the current account of balance of payments. Also, real exchange rate volatility had positive and insignificant effect on the capital account of balance of payments. It was also found that real exchange rate volatility had negative and insignificant effect on the financial account of balance of payments. The results also showed that the Marshall-Lerner condition does not hold for Nigeria. On the basis of the above, the study recommended that currency devaluation (or depreciation) should not be seen as a major policy option to maintain the exchange rate volatility at a rate that allows adjustment of the balance of payments. Ban on some of the goods that have high degree of importation such as the ban on foreign rice could go a long way to reduce importation expenditure, boost local production in quantity and quality and could be an appropriate complement to devaluation.

CHAPTER ONE

INTRODUCTION

1.1       Background to the Study

Economic influences from abroad have powerful effects on the domestic economies and domestic economic policies have substantial effects on foreign economies as well. Economies of the World are linked through trade in goods and services; and finance. The trade linkage implies that some of the country‘s production is exported to foreign countries, while some goods that are consumed or invested at home are produced abroad and imported. The finance linkage on the other hand implies that residents, whether households, banks or corporations can hold assets in foreign countries. Portfolio managers shop around the world for the most attractive yields. As international investors shift their assets around the world, they link asset markets home  and abroad, and one of the effects is  the fluctuations in exchange rates. Research related to exchange rate still remains a primary interest to economists, especially in developing countries, despite a relatively enormous body of literature in the area. This is because the exchange rate in whatever conceptualization is not only an important relative price, which connects domestic and world markets for goods and assets, but it also signals the competitiveness of a country‘s exchange power with the rest of the world in a pure market. Besides, it determines the balance of payments of a country at the medium-to-long term (Joseph & Akhanolu, 2011; and Dornbusch, Fischer, & Startz, 2008).

The balance of payments of a country is made up of different components. This includes the current account, the capital account and the financial account. The current account records trade in goods and services, as well as transfer payments. The trade balance records trade in goods. Services include interest payments, net investment income, etc. Transfer payments on the other hand, consist of remittances, gifts and grants. A country‘s current account is in surplus if her receipts from trade in goods and services and transfers exceed payments. The capital account in contrast, records purchases and sales of assets like stocks, bonds and land. The capital account becomes surplus when a country‘s receipts of the sale of stocks, bonds, bank deposits, etc. exceed payments for purchases of foreign assets. On the other hand, the financial account tracks financial flows coming in and going out of the economy. The three major categories included in the financial account are foreign direct investment (FDI), portfolio investment (PI), and official reserve transactions (ORT). Foreign direct investment consists in long-term financial investment abroad, characterized by large ownership stakes

(over 10 percent) in foreign firms. Portfolio investment is composed of more liquid financial investments, generally undertaken in the form of stocks, bonds, and of bank balances, while official reserve transactions tracks the international currency dealings of a country’s central bank (Tang, 2013; and Dornbusch, et al 2008).

Exchange rate exerts a powerful influence on the components of a country‘s balance of payments position. Two forms of exchange rate are fixed and flexible exchange rates. Fixed exchange rate operates like any other price support scheme such as those in the agricultural market and other forms of subsidies. Given the demand and supply of the market, the price fixer has to make up the excess demand or take up the excess supply. To ensure that the exchange  rate  remains  fixed,  it  is  obviously necessary to  keep  an  inventory  of  foreign exchange  that  can  be  provided  in  exchange  for  the  domestic  currency.  If  a  country persistently runs deficits, the central bank is likely to decide to devaluate the currency. The reserve position of the devaluing country improves as a result of devaluation. This means that devaluation  improves  the  balance  of  payments,  since  an improvement  on  the  reserve position  constitutes  an  improvement  on  the balance of payments position (Oladipupo & Onotaniyohuwo, 2011). Flexible or floating exchange rate removes any form of economic rigidity and bottlenecks and it is determined exclusively by market forces.

The exchange rate regime therefore, plays a key role in reducing the risk of fluctuations in the Real Exchange Rate (RER) which will affect the rate of inflation, balance of payments and hence the whole economy. The theoretical literature provides broad guidance on this choice. In accordance to the theory of optimal currency areas, real shocks are better dealt with through  flexible  exchange  rates,  and  nominal  shocks  through  fixed  exchange  rates.  In Nigeria, fixed exchange parity had been maintained with the British Pound from the immediate post-independent period. However from 1986, attention shifted from fixed to flexible exchange rate system (Adelowokan, 2012;Akpan & Atan, 2012; and Rey, 2006).

A criterion by which one can judge a type of exchange rate is a matter of how sensible trade flows is to exchange rate variability. High sensitivity implies that a good exchange rate arrangement must permit to limit the negative impact on trade flows of an excessive variability.  Two  types  of  exchange  rate  variability  are:  volatility  and  misalignment. Volatilities manifest in different forms. These include fluctuations in terms of trade and real exchange rate. The real exchange  rate  measures  international   exchange  of  goods  and services,   the competitiveness of an economy to international trade and   ensures   viable

balance   of   payment   position. Misalignment, on the other hand, refers to the unrelenting departure of an exchange rate from its long run competitive level (Adelowokan, 2012; and Rey, 2006).

Exchange rate plays an important role in international trade and investment as it affects the price of internationally traded goods and services. Exchange rate movements reflects the economy-wide effect of changes in trade flows, world commodity prices, and capital flows between economies that are highly integrated, both with each other and with global goods, services and financial markets. Exchange rate fluctuations therefore affect consumers and producers of internationally traded goods and services and firms with assets and liabilities dominated  in  foreign  currencies  and  the  balance  of  payment  positions  of  the  trading countries. Since exchange rates are shared macroeconomic variables, such fluctuations for any  internationally  integrated  economy  have  counterpart  effects  in  its  trading  partners‘ balance of payments (Makin, 2002). Specifically, as exchange rate depreciates (falls), BOP position will improve since net export balance is increased. Considering the reverse, an exchange rate appreciation makes a country‘s products more expensive relative to foreign goods and services and therefore leads to a shift of global demand away from domestic products towards foreign ones. This implies a reduction in exports and an increase in imports, resulting overall in deterioration in the trade balance and thus a reduction in the net trade. This therefore affects the balance of payments.

The effect of devaluation on trade balance depends on the elasticity of exports and imports. Devaluation makes the exchange rate to depreciates and, in turns make goods imported to be more  expensive  than  goods  exported.  The  volume  of  Production  would  be  adjusted  to respond to changes in prices which result to deterioration in the balance of trade in the short run. The is called the price effect of exchange rate depreciation. On the other hand, in the long run, cheaper exported goods could lead to increase in demand for domestic goods and services and the volume of production increases (Omojimite & Akpokodje, 2010; and Sek & Har, 2014). In other words, in the long run, the quantity effect could improve the balance of trade and the improvement in the balance of trade could results to better balance of payments positions. Such a situation where exchange rate depreciation improves the balance of trade in the long run is called the Marshall-Lerner condition.

The Marshall-Lerner condition explains the conditions under which a devaluation or depreciation will improve a country‘s balance of trade and, thus, the balance of payments.

The Marshall-Lerner condition states that exchange rate depreciation improves balance of trade in the long run, if the sum of the elasticities of demand for exports and imports (in absolute sense) is greater than one. The Marshall-Lerner condition is a condition that determines if a country’s foreign exchange market is stable or not. If the Marshall-Lerner condition holds (quick adjustment of the relative exchange rate over time to changes in demand for exports), then, the Marshall-Lerner condition shows a stable market (Thi Van & Lin, 2011). It is determined by a flexible exchange rate system since currency devaluation reduces a deficit or corrects balance of payments surplus. This is related to this study because exchange rate volatility could influence revenue from  exports, balance of trade and the balance of payments.

1.2       Statement of the Problem

Exchange rate connects domestic and world markets for goods and assets; signals the competitiveness of a country‘s exchange power with the rest of the world in a pure market; and an anchor which facilitates sustainable internal and external macroeconomic balances over the medium-to-long term. Countries all over the world, therefore allow their exchange rate policy to undergo substantial transformations from time to time (Adelowokan, 2012; and Omojimite & Akpokodje, 2010).

In Nigeria, the exchange rate policy has been subjected to substantial transformations from a fixed regime in the 1960s to a pegged regime between the 1970s and the mid-1980s and finally, to the various variants of the floating regime from 1986 with the deregulation and adoption  of  the  structural  adjustment  programmes  (SAP)  (Akpan  &  Atan,  2012).  In September 1986 for example, the Second-Tier Foreign Exchange Market (SFEM) was introduced on an auction basis. Also, was the deregulation of Naira exchange rate on Sept.

29, 1986. The institutional framework of the market witnessed a noticeable transformation from the Second Tier Foreign Exchange Market to Foreign Exchange Market (FEM), Nigeria had as well operated several variants of the auction system. These include the Dutch Auction System on July 22, 2002; Wholesale Dutch Auction System on February 20, 2006; and Retail Dutch Auction System, to serve the triple purposes of reducing the parallel market premium, conserve the  dwindling  external  reserves  and  achieve  a real exchange rate for the naira to US dollar (Akpan & Atan, 2012; and Usman & Adejare, 2012).

Before the introduction   of   structural adjustment programme (SAP) and the adoption of market   determined   exchange   rate   and   managed floating   rate   policy in 1986, Nigeria

adopted  a  fixed  exchange rate  policy. During this regime, there was a massive importation of finished goods from foreign countries. This caused adverse effects on domestic production, balance of payments position and the nation‘s external reserves level and made  the  foreign exchange  market  in  the fixed  exchange  rate period  to  be  characterized  by high  demand for  foreign  exchange  that  cannot  be adequately met with the supply of foreign exchange via  the  Central  Bank  of  Nigeria  (CBN). The records revealed that between the periods

1981-1985, the average exchange rate was 108.6. At this period, the average balance of payment current account balance (-1,951.3) showed an increase in reserves, while that of the capital account balance (950.6) showed a decrease in reserves. These among other reasons led to the adoption of the market determined exchange rate and managed floating rate policy in 1986, with the view of correcting internal and external imbalances (Adedayo, 2012; and CBN Statistical Bulletin, 2012).

One expects that after the adoption of the market determined exchange rate and managed floating rate policy, the problems with the fixed exchange rate system will be a thing of the past. However, it was discovered that most of the problems were still present. The economic considerations underpinning the exchange rate policy had important repercussions for the structural evolution of the economy, and the balance of payments accounts. Between 1986-

1990;  and  1991-1995,  the  average  exchange  rate  falls  from  108.6  in  the  pre-market determined  exchange  rate  and  managed  floating  rate  regime  to  19.2  and  3.4  and  has continued to be volatile since then. The corresponding average balance of payment current account  balances  (10,231.0  and  -41,159.9)  showed  a  decrease  and  then  an  increase  in reserves. But the average capital balances (-23,311.7 and -35,596.1) exhibited steady increase in reserves.  On the other hand, when the average exchange rate increases drastically from 3.4 to 47.7 in 1996-2000 to 96.9 in 2001-2005; the average current account balance showed consistent decrease in reserve of 213,450.0 to 1,555,699.0 and the average capital account balance revealed a consistent increase in reserve of -265,025.7 to 983,083.1 within the corresponding periods (Adedayo, 2012; and CBN Statistical Bulletin, 2012). The exhibition above therefore puzzles one about the impact real exchange rate volatility has especially on the sub-accounts of balance of payments in Nigeria.

In addition, Alfred Marshall and Abba Lerner pointed out that, when the price elasticity of imports and exports in absolute sense is greater than unity then devaluation will improve the balance  of  trade  and,  therefore,  the  balance  of  payments  accounts  in  the  long  run  will improve.  Dornbusch  (1988)  also  stated  that  the  efficacy  of  depreciation  resulting  from

devaluation in improving the balance of payments relies mainly on how demand is channeled to the appropriate direction and by the appropriate amount and also ability of the domestic economy to meet the increase demand because of increase supply. This is in addition to the fact that, though at times of relative tranquility in foreign exchange markets, the CBN can smooth out exchange rate volatility through various modest interventions, but more active policies are needed when there are more volatile exchange rates. Thus, testing the Marshall- Lerner condition is also of paramount importance in Nigeria. The policy implication is that the presence or absence of Marshall-Lerner condition is a revelation of the efficiency of Central Bank of Nigeria devaluation policy leading to depreciation and how appropriate the direction and amount. This would reveal empirically whether or not to continue with devaluation policies or to augment with more active policy measures.

Though, related studies are found, but much focus especially in Nigeria has been on real exchange rate and other macroeconomic variables and only a few has studied real exchange rate and balance of payments in Nigeria. Danmola (2013), Orji (2012), Ogbonna (2011), and Oladipupo  &  Onotaniyohuwo  (2011)  examined  the  relationship  between  the  aggregate balance of payments and exchange rate in Nigeria. But Kandil (2009) has studied the effect of exchange rate fluctuations on major components of balance of payment in 21 developing and

25 industrial countries. This study following the study by Kandil (2009) examines the effect of real exchange rate volatility on the major components of balance of payments in Nigeria. It would also show the Marshall-Lerner condition, and, therefore reveal the efficacy of CBN devaluation policy within the study period, which many related studies  in Nigeria have ignored.

1.3       Research Questions

The study seeks to answer the following research questions:

i.          Does  real  exchange  rate  volatility  affects  the  current  account  of  balance  of payments in Nigeria?

ii.         What  effect  does  real  exchange  rate  volatility  has  on  the  capital  account  of balance of payments in Nigeria?

iii.        What is the effect of real exchange rate volatility on the financial account of balance of payments in Nigeria?

iv.       Does the Marshall-Lerner condition hold for Nigeria?

1.4       Objectives of the Study

The broad objective of this study is to examine the effect of real exchange rate volatility on balance of payments in Nigeria. The specific objectives are:

i.          To investigate the effect of real exchange rate volatility on the current account of balance of payments in Nigeria

ii.         To examine the effect of real exchange rate volatility on the capital account of balance of payments in Nigeria

iii.        To determine the effect of real exchange rate volatility on the financial account of balance of payments in Nigeria

iv.       To determine whether the Marshall-Lerner condition holds for Nigeria or not

1.5        Hypothesis of the Study

The hypotheses of the study are:

H01:    Real  exchange  rate  volatility has  no  significant  effect  on  the  current  account  of balance of payments in Nigeria

H02:    There is no significant effect of real exchange rate volatility on the capital accountof balance of payments in Nigeria

H03:    Real exchange rate volatility does not significantly affect the financial account of balance of payments in Nigeria

H04:    The Marshall-Lerner condition does not hold for Nigeria

1.6        Significance of the Study

The findings of this study will be relevant to the government of Nigeria in general because it will reveal the effect of real exchange rate volatility on the various components of the balance of payments of Nigeria. The study will also be important to policy makers and the monetary authorities  as  it  will  show  what  aspect  of  the  balance  of  payment  needs  more  serious attention, which by extension will serve as a guide on the right decision on exchange rate policy. Also, Policymakers who hope to improve Nigeria’s competitive position could benefit by learning from this study, effectiveness (or not) of the devaluation policy. This could lead to the implementation of more effective economic policies. Finally, academia, researchers as

well as students shall find the study relevant because the findings of this study will serve as a reference point in further related studies.

1.7        Scope and Limitations of the Study

The study seeks to evaluate the effect of real exchange rate volatility on balance of payment in Nigeria. The study covers the period 1970q1 to 2015q4. The choice of the study period is based on first, the fact that it covers the period (1971 – 1985) in which Nigeria operated a fixed exchange rate regime and periods starting from 1986 which marked the shift from fixed to flexible exchange rate regime. Availability of data was another consideration.

A number of measures of exchange rate volatility have represented for uncertainty. These include the short run measure of volatility defined as a 12-month rolling window of the standard deviation in the past monthly real exchange rate, a similarly defined measure over 5 years to  obtain  a long  run measure of  volatility,  and  the  conditional  volatility measure estimated from a GARCH model (Thi Van & Lin, 2011). This study uses only the conditional volatility measure estimated from a GARCH model to proxy for exchange rate volatility. The superiority of this measure over the other measures however cannot be guaranteed in this study. Also, there is no consensus about the appropriateness of one measure relative to others.

1.8       Organization of the study

This study is organized into five chapters. Following this chapter one is the chapter two. In chapter two, the key concepts in this study are conceptualized. Also, relevant theories are discussed in the chapter as well as a review of the empirical literature. Chapter three presents the methodology of the study. This chapter contains the theoretical framework of the study, the models specified to capture the respective objectives of the study and the source of data for the study. Chapter four is set aside for the presentation of estimation results and findings would be discussed in the chapter. This study would be rounded off in chapter five with summary of findings, conclusion and recommendations.

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