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ACC00129 - THE EFFECT OF EXCHANGE RATE FLUCTUATION ON THE NIGERIA ECONOMIC GROWTH (2006-2016)


CHAPTER ONE

INTRODUCTION

  • Background to the study

The Nigerian economy ambitiously aspires to become one of the twenty largest economies in the world by 2020and the 12th largest economy by 2050 (CBN, 2009). One of the surest ways to achieve the afore-stated goal is to pursue vigorously rapid and sustainable economic growth and development via well managed exchange rate policy. In recognition of this role, Rodrick(2007) argues that poorly managed exchange rates can be disastrous for economic growth.

The exchange rate thus, serves as an international price for determining the competitiveness of a country. Exchange rate is the price of one country’s currency in relation to another country. It is the required amount of units of a currency that can buy another amount of units of another currency. Takaendesa(2006) explains that exchange rate plays a crucial role in guiding the broad allocation of production and spending in the domestic economy between foreign and domestic goods. Exchange rate 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. The choice and management of an exchange rate regime is a critical aspect of economic management to safeguard competitiveness, macroeconomic stability, and growth. Therefore, the impact of the exchange rate regime on economic performance is probably one of the most controversial issues in macroeconomic policy with empirical studies providing mixed results. One strand of the literature provides evidence that floating regimes are associated with higher growth (see, for instance, Odusola and Akinlo2001; Eichengreen and Leblang, 2003; Levy-Yeyati and Sturzenegger, 2003; Reinhart and Rogoff 2004; Miles, 2006; and Rano-Aliyu 2009).

Among all macroeconomic variables, effects of changes in nominal and real exchange rates onmacroeconomic conditions have become important due to the integration of financial markets and acceleration of capital flows. The end of the Bretton Woods system has been strictly followed by the adoption of floating exchange rate system in major industrial economies and the other emerging countries over time. Since then, the issue of exchange rate fluctuations given its impacts on price and aggregate output has attracted great attention.

Economists have developed several explanations for the prominent factors of exchange rate fluctuations which have hindered the potential positive outcomes of efficient macroeconomic management strategies as one of the major determinants of aggregate demand and supply. Empirical reasons of these fluctuations have generally been concentrated on two main approaches. First one suggests that real exchange rate fluctuations result from nominal shocks referring the variation in relative prices of traded goods across countries (Dornbusch, 1976; Krugman, 1990, 1993; Engel, 1993; Eichenbaum& Evans, 1993; Bayoumi&Eichengreen, 1994; Engel, 1999; Roger, 1999). In this vein, Clarida and Gali (1994) obtained similar results, exposing thatmonetary policy authority affects the real exchange rate by changing price level and nominal exchange rate viaits policy instruments. The second insight from empirical researches emphasizes that real shocks, namely productivity-motivated surges, clarify the fluctuations in either real or nominal exchange rates (Balassa, 1964; Samuelson, 1964; Lastrapes, 1992; Inoue &Hamori, 2009). The potential causes of exchange rate fluctuations has also lead to examination of the theoretical basis of exchange rates determination since exchange rates fluctuations partly reflect deviations from the ground on which exchange rates are determined.

Exchange rate regime and interest rate remain important issues of discourse in the International finance as well as in developing nations, with more economies embracing trade liberalization as a requisite for economic growth (Obansa, Okoroafor, Aluko and Millicent, 2013). In Nigeria, exchange rate has changed within the time frame from regulated to deregulated regimes. Ewa, (2011) agreed that the exchange rate of the naira was relatively stable between 1973 and 1979 during the oil boom era and when agricultural products accounted for more than 70% of the nation’s gross domestic products (GDP).

Previous research on the impact of exchange rate on economic growth has reached contrasting results. For instance, Empirical evidence showed that real exchange rate variations can affect growth outcomes. Edwards and Levy Yeyati (2003) found evidence that countries with more flexible exchange rate grow faster. Faster economic growth is significantly associated with real exchange rate depreciation (Hausmann, Pritchett, and Rodrik 2005). Rodrik (2009) argued that real undervaluation promotes economic growth, increases the profitability of the tradable sector, and leads to an expansion of the share of tradable in domestic value added. He claims that the tradable sector in developing countries can be too small because it suffers more than the non-tradable sector from institutional weaknesses and market failures. A real exchange rate undervaluation works as a good policy to compensate for the negative effects of distortions by enhancing the sector’s profitability. Higher profitability promotes investment in the tradable sector, which then expands, and promotes economic growth.

  • Statement of the Problem

Foreign exchange is said to be an important element in the economic growth anddevelopment of a developing nation. Foreign exchange policies influence theeconomic activities and to a large extent, dictate the direction of the macroeconomicvariables in the country. The mechanism of exchange rate determinationare different systems of managing the exchange rate of a nation’s currency interms of other currencies and this should be properly done in a way that will bringabout efficient allocation of scarce resources so as to achieve growth anddevelopment. Jhingan (2005) posited that to maintain both internal and externalbalance, a country must control its exchange rate.

Previous research on the impact of exchange rate on economic growth has reached contrasting results. For instance, Empirical evidence showed that real exchange rate variations can affect growth outcomes. Edwards and Levy Yeyati (2003) found evidence that countries with more flexible exchange rate grow faster. Faster economic growth is significantly associated with real exchange rate depreciation (Hausmann, Pritchett, and Rodrik 2005). Rodrik (2009) argued that real undervaluation promotes economic growth, increases the profitability of the tradable sector, and leads to an expansion of the share of tradable in domestic value added. He claims that the tradable sector in developing countries can be too small because it suffers more than the non-tradable sector from institutional weaknesses and market failures. On the other hand, past studies also showed that exchange rate has no significant effect on economic growth performance. For example, Bosworth, Collins, and Yuchin (1995) provided evidence that in a large sample of industrial and developing countries, real exchange rate volatility hampers economic growth and reduces productivity growth. Ubok-udom (1999) examined the relationship between exchange rate variation and growth of the domestic output in Nigeria (1971-1995); he expressed growth of domestic output as a linear function of variations in the average nominal exchange rate. David, Umeh and Ameh (2010) also examined the effect of exchange rate fluctuations on Nigerian manufacturing industry. They employed multiple regression econometric tools which revealed a negative relationship between exchange rate volatility and manufacturing sector performance.

In addition to the exchange rate-growth nexus, various types of exchange rate mechanism have been adopted over the years by the Nigeria government but the exchange rate did not maintain both internal and external balance. However, maintaining a realistic exchange rate for the naira in Nigeria is very crucial, given the structure of the economy and its current challenge of recession.

In view of the fact that exchange rate policy in Nigeria has oscillated basically between the fixedexchange rate system since the immediate post-independence era in 1960 and then from 1986 when a market based exchange rate system was introduced in the context of the structural Adjustment Programme (SAP), there has been a controversy as regards output of goods and services under the flexible exchange rate system and under the fixed exchange rate system. Exchange rate reforms according to Bakare (2011) were expected to put the Nigerian economy on the path of macroeconomic stability, recovery and sustainable development. But rather, the country has continued to be at disadvantage in terms of macroeconomic performances. The different regimes have been accompanied by instability and uncertainties. The uncertainties in exchange rates which followed the macroeconomic reforms may be decomposed into two components. The first reflects systematic movement of the exchange rate and the second, exchange volatility. Volatility of the exchange rate impacts on economic performance through a variety of channels, including savings, lending rate and inflation. All in all, Nigeria continues to be confronted with a number of economic maladies with the exchange rate reforms. Among these problems are low level of savings and investment, high rate of inflation, high level of unemployment and poverty. Even though economic literature, if anything, seems to offer stronger arguments favouring the idea that fixed exchange rates may lead to higher growth rates, in the end, the question of whether or not there exists a link between regimes and growth can only be resolved as an empirical matter. It is therefore, the purpose of this paper to address this issue by examining the relationship between exchange rate regimes and output growth in Nigeria from 2006 to 2016.Thus, the ultimate questions which this research seeks to answer are: what determines exchange rate in Nigeria? Is there any relationship between the exchange rate and Nigeria economic growth within the study period?

  • Research Questions

Following the problems identified and stated above, the following research questions are stated.

  1. What are the determinants of exchange rate in Nigeria?
  2. What is the effect of exchange rate fluctuation on the Nigeria economic growth within the study period (2006-2016)?
    • Objectives of the Study

The general objective of this study is to examine the effect of Exchange Rate Fluctuation on the Nigerian Economic Growth within the study period (2006-2016).  The following specific objectives are formulated for further examination.

  1. To examine the determinants of exchange rate in Nigeria.
  2. To investigate the effect of exchange rate fluctuation on the Nigeria economic growth within the study period (2006-2016).
    • Study Hypothesis

The following hypothesis is formulated to be tested in this study.

H0:  There is no significant relationship between exchange rate fluctuation and Nigerian economic growth.

  • Significance of the Study

The significance of this research work lies in the fact that if the cause of the unstable exchange rate of the naira is identified and corrected, the economy will rapidly grow and develop into an advance one. The outcome of this study is expected to be of great benefit to professional practitioners, the policy makers both in the private and public sectors in their attempt to solving problems of exchange rate fluctuations. The Central bank of Nigeria will find a study of this kind useful as it attempts to provide a framework for understanding the mechanism of exchange rate. The study will enable government to prioritize policies that are necessary stabilizing exchange rate and promoting economic growth and development.

    Moreover, this study is imperative given the recent efforts by monetary authorities in Nigeria to revive the economy through the financial sector reform which among other things sought to maintain stability in exchange rate. Consequently, this study will assist the nation’s economic planners in their economic development planning. Specifically, the outcome of this study would provide a basic understanding of the dynamics of exchange rate and the key macroeconomic variables in Nigeria and it also contribute to knowledge. It will as well contribute to the existing literatures on exchange rate fluctuation and economic growth. Finally, this research study is expected to stimulate research interests in other aspects of economic growth and its related variables.

  • Scope of the Study

This study covers the impact of exchange rate fluctuation on the Nigerian Economic Growth within the study period (2006-2016).  Specifically, the study seeks to determine the examine the determinants of exchange rate in Nigeria within the study period as well investigate the relationship between exchange rate fluctuation and Nigeria economic growth within the study period (2006-2016). Variables such as exchange rate, inflation rate, interest rate and trade openness.