1.1 BACKGROUND OF THE STUDY
Many developing nations are known with low level of domestic savings, which has affected the much needed investment for economic development. In order to attain a desirable level of investment that would ensure economic growth and development, developing nations need some foreign savings to close the savings-investment gap in the country. Capital inflows are transferred through foreign direct investment (FDI), foreign portfolio investment (FPI), foreign loans and credits etc. Increasing capital inflows are usually indicative of positive perceptions of a market in the global economy, or an attractive business environment due to favorable tax structures or business friendly regulations. A net flow of capital, real or financial, into a country, is in the form of increased purchases of domestic assets by foreigners or reduced holdings of foreign assets by domestic residents this is recorded as positive, or a credit, in the balance on capital account.
In the last few years, Nigeria has experienced a phenomenal increase in private inflows of capital. The major triggers were the increased tempo of reform which led to a more stable financial system and better macroeconomic environment. More fundamentally, financial developments at the world stage might also have played quite an important role. The fact that the developing economies were by and large less integrated with the rest of the world, or were thought to be relatively insulated from the crises that engulfed major financial centers made them appear like, temporary safe havens for international capital. The oligopolistic nature of markets in such economies made capital flows to them rapidly increased in 2000s to take advantage, also, of the persistent uncovered interest differentials. For instance, capital flows to the sub-Sahara Africa (SSA) increased from about $10 billion in 2000 to over $50 billion in 2007. Nigeria received nearly 30% of the FDI component of the inflows (IMF-REO, 2008). Until the 2000s, foreign direct investments (FDIs) and debt were the major kinds of inflows to Nigeria. However, as the capital market opened up, the country started to receive substantial inflows in the form of portfolio investment especially from 2004. Both the bonds and equities segments of the market have in recent years experienced unprecedented inflows. As the global financial and economic crisis intensified, inflows slightly recessed as from mid-2008 but picked in 2010.
Admittedly, the internationalization of the Nigerian stock exchange, there has been increased inflow of foreign portfolio investment into the Nigerian economy through the capital market in the form of foreign direct investment, foreign portfolio investment, overseas development assistance and bank loans. However, from the middle of the past two decades, Nigeria witnessed a quasi-metamorphosis in the composition of private capital flows to Nigeria. Foreign portfolio investment appears to have taken the centre stage and its share of private capital flows to Nigeria has been on a phenomenal increase that by 2007 FPI has surpassed every other type of capital inflows into Nigeria with official flows (ODA) and bank loans declining in real terms (CBN, 2009). Furthermore, the UNCTAD World Investment Report 2006 shows that foreign direct investment (FDI) inflow to West Africa is mainly dominated by inflow to Nigeria, who received 70% of the sub-regional total and 11% of Africa’s total. Out of this, Nigeria’s oil sector alone received 90% of the FDI inflow.
The Library of Congress-Federal Research Division report, (2008) shows that in 2006 Nigeria received a net inflow of US$5.4 billion of foreign direct investment (FDI), much of which came from the United States. FDI constituted 74.8 percent of gross fixed capital formation, reflecting low levels of domestic investment. Most FDI is directed toward the energy sector. As at August 2007, World Bank assistance to Nigeria involved 23 active projects with a total commitment value of about US$2.67 billion. Since Nigeria joined the World Bank in 1961, the World Bank has assisted it on 123 projects. Also, in 2007 Nigeria had an estimated gross domestic product (GDP) of US$166.8 billion according to the official exchange rate and US$292.7 billion according to purchasing power parity (PPP).
The GDP rose by 6.4 percent in real terms over the previous year. Recently, portfolio investment has gained prominence in Nigeria. Before the middle of 1980s, Nigeria did not record any figure on portfolio investment (inflow or outflow) in her balance of payment (BOP) accounts. This was attributable to the non-internationalization of the country’s money and capital markets as well as the non-disclosure of information on the portfolio investments of Nigerian investors in foreign capital/money markets (CBN 1997:151). On the other hand, FDI dominated Nigeria’s capital flows and its benefits are aptly captured by Sadik and Bolbol (2001) in their study. They argued that FDI is the least volatile of capital flows, and more important, can have direct and indirect effects on economic growth. Notwithstanding, large capital flows could spur economic growth or have destabilizing effect in the economy, if not well managed. The destabilizing effect of foreign capital inflow has aroused concern over their potential effects on macroeconomic stability, the competitiveness of the export sector, and external sector viability. The most serious risks are that they fuel inflation and drive the real effective exchange rate to unsustainably high levels.
1.2 Statement of the Problem
The need for foreign capital to complement domestic resources in the economic growth process has been welcomed as a catalyst of development, since it is considered as the central element of the process of economic growth. In the face of resource deficiency in financing long term development, the capital-deficient economies have heavily resorted to foreign capital as the primary means to achieve rapid economic growth. Unfortunately, the growth experience of many of the economies has not been very satisfactory. Hence, they accumulate huge external debt in relation to gross domestic product and face with serious debt servicing problems in terms of foreign exchange flow and also walloping in abject poverty. Besides, the flow of funds within many developing nations are not adequate to provide infrastructures, the available local savings cannot cater for the desired investment to meet up with the developed nations. With the shortage of capital in many developing nations there is need for the inflow of capital from the foreign economy where there is excess fund to the local economy where there is shortage of fund to augment the level of desired investment.
Conversely, the experience of a small number of fast growing East-Asian newly industrialized nations has strengthened the belief that foreign capital is the central element of the process of economic development. Since it could bridge the resource gap of these economies and avoid further buildup of debt while tackling the causes of poverty directly.
However, the effect of the inflow of capital to many developing nations has proven to be double-edge sword, it has both negative and positive impact. The positive side is that there is appreciation of local currency as against the foreign currency also augmentation of the shortage of savings for investment etc. while the negative sides are inflation, lack of monetary independence (Usman, 2012) etc. Many studies have investigated the impact of some micro and macro-economic variables (Goodhart, Peiri and Tsomoscow, 2012 and CBN, 2012) on the inflow of capital, some of which are exchange rate, inflation rate, tax etc. But beyond diplomacy driven inflow of foreign fund to Nigeria, there is a need to investigate the impact of selected macroeconomic factors on foreign capital inflows to the country; hence the purpose of this study is to investigate the likely impact of selected macroeconomic variables (exchange rate, interest rate, inflation) on capital inflow to Nigeria.
1.3 Objectives of the Study
The broad objective of this study is to examine the likely impact of selected macroeconomic variables (Exchange rate, Interest rate and Inflation) on capital inflows. The specific objectives of the study are to examine:
i. The impact of exchange rate on capital inflow in Nigeria;
ii. The impact of interest rate on capital inflow in Nigeria;
iii. The impact of inflation on capital inflow in Nigeria.
1.4 Research Questions
This study is based on the following research questions:
i. What is the impact of exchange rate on capital inflow in Nigeria?
ii. What is the impact of interest rate on capital inflow in Nigeria?
iii. What is the impact of inflation on capital inflow in Nigeria?
1.5 Research Hypotheses
i. Ho: Exchange rate has no significant impacts on capital inflow in Nigeria.
ii. H0: Interest rate has no significant impacts on capital inflow in Nigeria.
iii. H0: Interest rate has no significant impacts on capital inflow in Nigeria.
1.6 Justification of the Study
Many researchers have discussed the likely impact of capital inflows on the economy some of which posited that it has positive, negative or both (Usman, 2012). Most literatures in the study agreed that it has majorly both positive and negative impact. The positive impacts explain many attractions, that capital inflow has the tendency to take an economy out of recession when it’s experiencing deficiency in demand of goods and services. The negative impacts explain that the increase in capital flows, especially the foreign portfolio investment (FPI), which have more volatile and destabilizing effects, caused the financial crises suffered notably by Mexico in 1994, East Asian countries in 1997 and Russia in 1998 (Kahler, 1998). In addition to the observed problems above, capital inflows directly relate to and is dependent on the endogenous factors of the country like domestic investment, government policy, exchange rate, local interest rate, inflation rate, fiscal deficit etc (Kahler, 1998).
Most researchers (Hecht, Razin, Shinar (2004)) posit that capital inflows affect macroeconomic variables. Not only this, they only looked at it in a direction, that is only demand side (the country requesting for it) of the capital inflow was considered. In this study, the gap will be breached by considering the macroeconomic variables that affect the demand and supply side of capital inflow and as well as the causality test between capital inflow and these macroeconomic variables. In essence, this study therefore built on the aforementioned gaps to come up with an empirical finding that will aid sound policy formulation and set a solid foundation for further research works in this area.
1.7 Scope of the Study
This study will focus on Nigeria because it is a country-based study. It will make use Ordinary Least Square (OLS) as a method of analysis. The type of data to be used will be time series spanning through the period of 1981-2013. In this study six variables will be used out of which there are four independent variables with other control variables and two dependent variables. The independent variables are exchange rate, interest rate, inflation rate, economic openness, while dependent variable is foreign direct investment and external debt.
1.8 Organization of the Study
There is going to be five chapters in this study. The first chapter deals with the introduction of the subject matter under it we have background of study, statement of the problem, objective of the study, research questions hypotheses of the study, scope of the study as well as its organization. The second chapter deals with the literature review; under it we have empirical, theoretical and methodological literature review. The third chapter will base on the theoretical framework and methodology. The fourth chapter will deal with data analyses and presentation while the last chapter will deal with summary of the work, policy recommendation and conclusion of the entire study.
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