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CHAPTER ONE

INTRODUCTION

1.1    BACKGROUND TO THE STUDY

Any country that has its own currency must decide what type of exchange rate arrangement to maintain. Exchange rate arrangements are broadly classified into three namely, fixed or pegged arrangements, flexible arrangements, and in-between category of arrangements with “limited flexibility”. Each variety or alternative have different implications which determines the extent to which countries participate in foreign exchange markets. When a monetary authority decides to fix exchanges rates against other currencies, they make a commitment to intervene in the market, buying and selling their currency whenever necessary to keep the exchange rate from changing. When, on the other hand, the monetary authority abstains completely from intervening in the market for exchange rates, they are choosing to let their exchange rates float freely.

In practice, by controlling the extent to which, and conditions under which, they intervene in exchange markets, Peter (1997); states that countries may attempt to manage their exchange rates with essentially any degree of flexibility they desire. Exchange rate policies aim at evolving Real Exchange Rate (RER) that maintains internal and external balance in any economy. Internal balance is defined in terms of the level of economic activities consistent with satisfactory control of inflation and full employment of resources. External balance on the other hand is defined in terms of Balance of payments equilibrium or sustainable current account deficit financed on a lasting basis by expected capital inflows (Pondexter,(1981) and Dernbourg, 1980). Improvements in the international competitive strength of the economy on the real exchange rates. The implication of this is very clear: any distortions in the real exchange rate will most probably lead to distortions in both internal and external balances.

One of the major goals of macroeconomic policy is rapid economic growth. As demonstrated by Zuvekas (1979), economic growth is measured by increase in output of goods and services overtime, and as stated by Akpan (2008), economic growth is said to occur when a country’s productive capacity is on the increase. Production of goods and services involve exports and imports which in turn involve transactions in foreign exchange, and exchange rate has been characterized by instability which has raised concern about its effect on economic growth. In view of the fact that exchange rate policy in Nigeria has oscillated basically between the fixed exchange 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.  Right from time immemorial, a country’s exchange rate and balance of payment is usually regarded as the sum of indices by which a nation’s strength can be measured especially its economic strength. Paul (2012) defined balance of payments as an accounting record to all monetary transactions between a country and the rest of the world.

These transactions include payments for the country’s exports and imports of goods, services and financial capital, as well as financial transfer. It summarizes the international transaction for a specific period usually one year and is prepared in single currency for the country concerned. Nzotta (2014) defined foreign exchange as the value of foreign nation’s currency in terms of the home nation currency. In finance, the exchange rates (as also known as the foreign exchange rate or forex rate) between two currencies specify how much one currency is worth in terms of the other.  Devaluation is fall in fixed exchange rate, which reduces the value of a currency in terms of other currencies. So what we are trying to do in this study is to determine  how the  reduction  value  of a currency with respect to the  currency  of another country affect the record of all monetary  transactions  between a country and another, whether visible or invisible  in a period of time. This is very important because no nation can exist on its own no matter how independent or self-sufficient it can be, it is important to have a relationship with other nations which can be

characterized by goods and services going one way and foreign exchange going the other way. When accessing the nation involved, a record of gains and losses may have been kept. As such a nation’s foreign exchange and balance of payments can help slowdown, accelerate or decelerate growth progress and development. This will also have a positive or negative effect on the citizens since it deals mainly with economic relations. Our nation Nigeria is currently facing serious problems regarding its foreign exchange rating (which is very low in comparison to other countries) and it’s balance of payment which is clearly in disequilibrium and in a deficit. As a result of this the government is retrogressing and the citizens clearly suffering.  It is in a bid to discover why this is so and how this can be solved that this study is pertinent.

1.2  STATEMENT OF THE PROBLEM

Foreign exchange and balance of payment are the key factors of a nation’s life. They are also factors to look into when comparing a country’s relationship with other nations. These factors directly or indirectly affect a host of other factors which are of severe importance in any nation. Consequently these factors can be seen as essential to the growth and development of the nation. Currently these two factors can be said to have crippled the Nigeria economy and made life uncomfortable for it’s citizens. These factors have brought the country to a level where growth and development appear to be an illusion.

Currently the nation’s exchange rate has fallen so low due to unfavorable nature of the competing power of the nation’s currency with foreign currencies of the world. Our economy has been trying to resolve the problem of external and internal balance, which has manifested in the disequilibrium in our balance of payment and causing us a balance of payment deficit.  Much controversy had also been degenerated by the devaluation of our Naira (the national currency). Relevant literature and opinion on this issue are of the view that exchange rate policy plays an important role in maintenance of internal and external balance. On the other hands, other researchers argue that devaluation is not the best policy for the less developed country because of many diverse results.               

When Nigeria started recording huge balance of payments deficits and very low level of foreign reserve in the 1980s, it was felt that a depreciation of the naira would relieve pressures on the balance of payments. Consequently, the naira was devalued. The irony of this policy instrument is that our foreign trade structure did not satisfy the Marshall-Lerner condition for a favourable balance of payment adjustment (Umoru and Eboreime, 2013). The Nigerian foreign structure is characterized by export of crude petroleum whose prices are pre-determined in the world market. This is in addition to low import and export price elasticity of demand. Based on this, the study attempts at examining the relationship between exchange rate and Nigeria’s balance of payments.

1.3  RESEARCH QUESTIONS

This study shall seek relevant answers to the following research questions:

1. Is there any significant long run equilibrium relationship between exchange rate and Nigeria balance of payment?

2. To what extent has exchange rate exert influence on Nigerian balance of payment?

3. Is there any significant causal relationship existing between exchange rate and Nigeria balance of payment?

1.4  OBJECTIVES OF THE STUDY

The general objective of this study is to examine the impact of exchange rate  on the balance of payment of a nation with special reference to Nigeria. The specific objectives are to:

1. Investigate the extent to which long run equilibrium relationship exists between exchange rate  and Nigerian balance of payment.

2. Determine the extent to which exchange rate exert influence on Nigerian balance of payment.

3. Ascertain if exchange rate  granger causes Nigeria balance of payment.

1.5   HYPOTHESIS OF THE STUDY 

This research work shall be guided by the following hypotheses:

1. There is no significant long run equilibrium relationship between exchange rate and Nigerian balance of payment.

2. Exchange rate  does not exert influence  on Nigerian balance of payment.

3. There is no causal relationship existing between exchange rate and Nigeria balance of payment.

1.6   SIGNIFICANCE OF THE STUDY

It is the significance of this study therefore; to make known the relationship between exchange rate and balance of payments, policy implications and recommendations which will be of immense help to policy makers and balance of payments, and government especially as regard to the transaction of the exchange rate and balance of payment in Nigeria.  Specifically therefore, the following individuals and groups will find the study very useful: The government will find the study very useful as it would guide its choice of policy formation especially as it work towards achieving its vision of becoming one of the best twenty economies of the world in the year 2020. The Central Bank of Nigeria whose duty among others, is to assist government in the implementation of its monetary policy will find the study relevant as it shall form the basis for valuable pieces of advice to government on some of the dangers that may be identified by the study. Members of the academia will find the study relevant as it will also form basis for further research and a reference tool for academic works. This study shall also be significant to the private sector especially those who may have research interest as it shall guide their private investment decisions. Finally, the study shall also form reasonable tool for the private sector’s contribution to National debates.

1.7   SCOPE AND LIMITATIONS OF THE STUDY

Though the research would make reference to related studies of other economies of the world with a view to reviewing related literature on the subject matter, data for this work shall only be on Nigeria economy. Such variables shall include those related in existing literature to exchange rate and it’s impact on balance of payment with reference to the Nigeria economy. It shall be collected between wide ranges of time spanning over a period of thirty two years from 1982 to 2014. Data for this study shall be secondary;from government owned institutions like the Central Bank of Nigeria and FOS sometimes.

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