DOWNLOAD THE COMPLETE PROJECT

1514 Users found this project useful

The Impact Of Exchange Rate Instability On Investment In Nigeria

ABSTRACT

This research work is centered on the effects of exchange rate instability on investment in Nigeria. With special emphasis on the purchasing power of average Nigerian and the level of international trade transaction. Without exchange rate, the exchange of goods and services among trading partners will be focused with a lot of problems, which may virtually narrow it down to trade by barter. This exchange also is used to determine the level of output growth and investment of the country. Hence, the rate at which exchange rate fluctuate calls for a lot of attention. However, with the already existing exchange rate policies, a constant exchange rate has not been attained. The rate by which exchange rate fluctuates brings about uncertainty in the trade transaction, and also in the rate of naira has been unstable and continued to depreciate. This has resulted to declines in the standard of living of the population; increase in cost of production (this is because most of the raw materials needed by industries are usually imported), which resulted in cost push inflation. Many test, such as unit root test, which we made use of the battery test and also t-statistics table was used when we found out that real interest rate has a negative effect on the output growth.

CHAPTER ONE

INTRODUCTION

1.1     BACKGROUND OF THE STUDY

    Foreign exchange is the means of payment for international transaction. It is made up of convertible currencies that are generally accepted for the settlement of international trade and other external obligation. Like every other commodity, a market is established which works like any other market, having a supply curve, a demand curve, and an equilibrium price and quantity. There are also conditions which are held constant. When these conditions changes, the curve shifts and there is a change in the equilibrium price and quantity. This market for currencies is known as the foreign Exchange market.

      The foreign exchange market according to the central bank of Nigeria is a medium of interaction between the sellers and buyers of foreign exchange in a bid to negotiate a mutually acceptable price for the settlement of international transactions. The seller of foreign exchange constitutes the supply while the buyers of foreign exchange constitutes its demand. T he supply of foreign exchange is derived from oil exporter, non oil exporter, expenditure of foreign tourist in Nigeria, capital repatriation by Nigerians resident abroad etc.

       The 1980s witnessed increased flows of investment around the world. Despite the increased flow of investment to developing countries, Nigeria lagged behind in attracting foreign investment. The uneven dispersion of Foreign Direct Investment is a cause of concern since FDI is an important source of growth for developing countries. This is because not only can FDI add to investment resources and capital formation; it can also serve as an engine of technological development with much of its benefits arising from positive spillover effects. Such positive spillovers include transfers of production technology, skills, innovative capacity and organizational and managerial practices.

     Given the significant role of FDI in developing economies, there have been several studies that tried to determine the factors that influence FDI inflows into the Nigerian economy. One of such factor is exchange rate and its volatility. The existing literature has been split on this issue with some studies finding a positive effect of exchange rate volatility on FDI, and others finding a negative effect. A positive effect can be justified with the view that FDI is export substituting. Increases in exchange rate volatility between the head quarters and the host country induce a multinational to serve the host country via a local production rather than export, thereby insulating against currency risk. The negative effect of exchange rate volatility on foreign investment can be found in the irreversibility literature by Dixit and Pindyck (1994).  They stated that “A direct investment in a country with a high degree of exchange rate volatility will have a more risky stream of profits”. As long as this investment is partially irreversible, there is some positive value of holding off on this investment. Given that there are finite numbers of potential direct investments countries with a high degree of currency risk will lose out on FDI to countries with more stable currencies. Nigeria is one of the countries that fall into the category with high degree of currency risk. With a population of about 130 million people vast mineral resources and favorable climatic and vegetation features, Nigeria has the largest domestic market in sub-Saharan Africa.

The Nigerian domestic market is large and potentially attractive to domestic and foreign investment as attested to by port folio investment inflow of over N1.0 trillion into Nigeria through the Nigerian stock exchange (NSE) in 2003 (Central Bank Of Nigeria, 2004). Investment income, however has not been encouraging which was a reflection of the sub-optimal operating environment largely resulting from inappropriate policy initiatives. Except for some years prior to the introduction of Structural Adjustment Programme (SAP) in 1986, gross capital formation as a proportion of the GDP was dismally low on annual basis.  It was observed that aggregate investment expenditure as a share of GDP grew from 16.9% in 1970 to a peak of 29.7% in 1976 before declining to an all-time low of 7.7% in 1985. There after the highest was 11.8% of GDP in 1990 before declining to 9.3% in 1994. Beginning from 1995, Investment declined significantly to 5.8% and increased marginally to 7.0% in 1997 and remained there about till 2004 when 7.1% was recorded.

      For a developing country like Nigeria that is highly dependent on trade, the exchange rate which is the price of foreign exchange plays a significant role in the ability of the economy to attain its optimal productivity. In addition, the exchange rate level has implications for balance of payments viability and the level of external dept. For example, if the exchange rate is overvalued, then this will result in unsustainable balance of payments deficits and escalating external debt shock. These will in turn lead to a declining level of investment. Thus it is imperative to let the exchange rate find its equilibrium level. It is only when the equilibrium exchange rate prevails that there is viability of the balance of payment position. In general, a stable foreign exchange rate regime will lead to macroeconomic stability and encourage investment and growth. An overvalued exchange rate tends to encourage capital flight. Stability of the exchange rate regime will therefore reduce capital flight and encourage capital inflow in the form of foreign private investment.

      However, exchange rate volatility is being increasingly recognized as a disincentive to the choice of Nigeria as Foreign Direct Investment destination because it adds to the list of risks inherent in the country. Exchange rate volatility is driven largely by inflation, nominal and foreign reserves shocks in the country. Exchange rate and FDI policy coordination, with a view to minimizing the harmful effect of exchange rate volatility and FDI on each other is therefore, a challenge to fiscal and monetary authorities must face. Exchange rate volatility generates air of uncertainty as the variance of expected profits rises and its net present value falls. This could cause investors to hesitate about committing significant resources to FDI, thus serving as a serious disincentive for investment and compounding the existing political and economic risks.                         

         In 1989, the Bureaux de change was established to accord small users’ greater access to foreign exchange. In order to further reduce instability in the foreign exchange market, the Inter- bank procedure was modified in December 1990 when the Dutch Auction System was introduced. Since instability in the foreign exchange market could not be stemmed, the model weighted average method of exchange rate determination was introduced in August 1991. Under this system, the rates tending towards the models were used to determine the market exchange rate. Although this system succeeded in reducing the fluctuation in the official exchange rate, instability soon set in and the parallel market commenced process of sustained depreciation, leading to a widening gap between the parallel and the official market. For example the parallel market premium reached 99.2% in February 1992, compared with 35.5% in 1991 and the internationally accepted standard of 5.0%. The CBN completely floated the Naira on March 5, 1992 in a bid to arrest the drift with this, the parallel market premium was narrowed to a level below 10% but as a result of renewed demand pressure and speculative activities, the premium started to widen again.

        In 1993, the federal government pegged the official exchange rate at #21.9960 =$1.00. The re-regulation of the economy in 1994, instead of appreciating the value of the naira and stabilizing the foreign exchange market, further reduced the value of the naira and resulted in a self sustaining phenomenon of exchange rate depreciation in the parallel market. The foreign exchange market was deregulated in 1995 under a policy guided by deregulation in order to build-up external reserves to improve the credit worthiness of the Nigerian economy and its competitive, strengthen the naira and gradually move the currency towards convertibility. The policy measures were retained in 1996. The dual exchange rate system was returned in 1998. By 2002, the IFEM was deregulated and the IFEM was reformed to allow Bureaux de change to source their foreign exchange requirements. In July 2002 the CBN replaced the 33 months old IFEM with the Dutch Auction System (DAS) and the following achievements have been recorded: Improvements in the external reserves position of about US $ 20 billion as at December 2004 which has increased to US $ 3 billion at January 2006.

      The whole sale Dutch Auction System was introduced on February 2006 replacing the retail DAS, the liberalized foreign exchange market witnessed unprecedented stability most of which include the following:                    ―Unification of exchange rates between the official and inter-bank markets and resolution of the multiple currency problems.

― Facilitation of greater market determination of exchange rates for the Naira vis-à-vis other currencies.

     The table below shows the historical value of one US Dollar in Nigerian Naira since 1989 to 2009. Pm = parallel market

Date                              Naira per US $ dollar

1989                              N7.39     (10.70)

1990                              N7.39     (10.70)

1991                              N8.04     (9.30)

1992                              N9.91

1993                              N17.30    (21.90)

1994                              N22.33    (56.80)

1995                              N21.89    (71.70)

1996                              N21.89    (84.58)

1997                               N21.89   (84.58)

1998                               N21.89   (84.70)

1999                               N21.89   (88-90)

2000                              N85.98     (105.00)

2001                             N99 -  N106 (104-122)

2002                             N109-  N113 (122-140)

2003                             N114- N127 (135-137)

2004                             N127- N130   (137-144)

2005                             N132- N136    (140-146)

2006                             N128.50- N131.80   (141-146)

2007                             N120- N125        (141-146)

008                             N115.50- N120     (145-151)

2009                             N145- N171        (151-153)

`      The sub-optimal investment ratio in Nigeria is traced to many factors which include exchange rate instability, persistent inflationary pressure, and low level of domestic savings, inadequate physical and social infrastructure etc. A major factor is exchange rate instability, especially after the discontinuation of the exchange rate control policy. The high lending rate, low and unstable exchange rate of the domestic currency and the high rate of inflation made returns on investment to be negative in some cases and discouraged investment, especially when financed with loans.

         The Naira (Nigerian currency N) exchange rate witnessed a continuous slide in all the segments of the foreign exchange market (that is official, Bureau de change and parallel markets). In the official market, the exchange rate depreciated progressively from N8.04 per US dollar in 1990to N81.02 per dollar in 1995 and further to N129.22 in 2003 and N133.00 in 2004. In Bureau the change and parallel market it depreciated from #9.62 and #9.61 per dollar in 1990 to N141.36 and N141.07 per dollar in 2003.

         Consequently, the premium between the official and parallel market remained wide throughout the period. This high exchange rate volatility in Nigeria among others, led to a precarious operating environment which can be attributed to the reason why Nigeria was not only unable to attract foreign investment to its fullest potentials but also had a limited domestic investment. As such, despite the vast investment opportunities in agriculture, industry, oil and gas, commerce and infrastructure, very little foreign investment capital was attracted relative to other developing countries and regions competing for global investment capital.

      Since the democratic dispensation of Obasanjo administration, Nigeria renewed interest in flexible exchange rate that is exchange rate determined by the forces of demand and supply drawing from the advantages of high oil prices and huge accumulation of foreign reserve. Many analysts have argued that incessant changes associated with flexible exchange rate regime and the ability of Central Bank to control such changes will hurt manufacturing export. Olebune (2008). This controversy led to the abandonment of the new naira policy proposed by CBN governor in August 2007. Exchange rate has really been a big problem to the Nigerian economy, especially since the introduction of SAP in 1986, which allowed the exchange rate to be determined through price mechanism that is, the interaction of demand and supply.

1.2     STATEMENT OF THE PROBLEM:

This research work is meant to emphasize on the issue of exchange rate instability and its impact on investment in Nigeria.

         Some of the problems which cause instability on exchange rate on investment in Nigeria can be seen below:

― The wide premium between the official and parallel market in the foreign exchange market. The high exchange rate volatility in Nigeria led to a precarious operating environment which is attributed to the reason why Nigeria was not only unable to attract foreign investment to its fullest potentials but also had a limited domestic investment.

― The instability and continuous depreciation of the naira in the foreign exchange market. This problem has been in existence since September 1986, when the market determined exchange rate system was introduced via the second tie foreign exchange market. This instability and continued depreciation has resulted in decline in the standard of living of the populace. 

― Jhingan (1997) emphasized that exchange rate fluctuation cause uncertainty and impede international trade. This uncertainty and impediment on international trade transaction pose a lot of problem such as inflation, which determine the internal balance of a country. In view of this, a stable exchange rate system will speed up domestic production, reduce inflationary speed and guarantee the attainment of internal balance. Obasikene (2006).

It has also tended to undermine the international competitiveness of non oil exports and make planning and projections difficult at both micro and macro levels of the economy, some small and medium scale enterprise have been strangled out as a result of low dollar naira exchange rate.                                                                                Considering these general situation, we shall now be faced with such questions as:                                                                                 

―  having adopted some policies, have they been able to maintain a constant exchange rate?

 ― to what extent has Nigeria gone in maintaining a constant exchange rate?

― how does exchange rate instability cause inflationary bias and to what extent has inflation impeded on international trade?

1.3     OBJECTIVE OF THE STUDY

In a highly dependent economy like Nigeria, the naira exchange rate has become one of the most widely discussed topics in the country today. This is not surprising as this topic has had a lot of macroeconomic impact on investment in Nigeria. It is therefore the objective of this study to:

― Evaluate the effect of exchange rate instability on investment in Nigeria.

― To trace the transmission of structural shock among exchange rate instability and its determinant.

― To examine if the continuous fluctuation of exchange rate of naira have an impact on the purchasing power of an average Nigerian.

― To examine the extent by which money supply and interest rate affects the economy.

― To make policy recommendation based on the findings.

1.4     STATEMENT OF HYPOTHSIS

   Only the null hypothesis is tested which are in line with the objective stated above:

―H0: exchange rate instability affects investment in Nigeria negatively.

―H1: The continued fluctuation in the exchange rate of the naira has reduced the purchasing power of the average Nigerian.                                                                                                         

1.5     SIGNIFICANT OF THE STUDY

     The study will identify the strength and weakness of exchange rate policy and management, identify those economic variable that are mostly affected by instability in exchange rate and provide the general public with the awareness on the foreign exchange transaction and its impact on investment.

  The various find of this study would enable the government and financial authorities to device, modify and adopt a better foreign exchange transaction for the economy.

        In general the study benefits the following:

1 Banks especially the universal banks.

2  Policy makers of central bank of Nigeria.

 3 Importers who make payment in foreign currencies.

1.6     SCOPE AND LIMITATIONS OF THE WORK

    Although there are many economic variables that operate within the Nigeria economy, this research work is limited to the study of the impact of instability in exchange rate.

    The scope of this research work is also limited to the period between 1989-2009

1.7     DEFINITION OF TERMS

FOREIGN EXCHANGE: Foreign exchange is a means of payment for international transactions. It is made up of currencies of other countries that are freely acceptable in setting international transactions.

FOREIGN EXCHANGE MARKET: This is a medium of exchange among buyers and sellers of foreign exchange with a view of negotiating acceptable prices for setting international transaction

EXCHANGE RATIO: This is the price of one currency in terms of another.

AFEM: Autonomous Foreign market is where the exchange rates under this system are being determined essentially through market forces.

DUTCH AUCTION SYSTEM (DAS): This is a method of exchange rate determination through actions where the bidders pay according to their bid rats. The ruling rate is arrived at the last bid rate that clears the market.

EXCHANGE CONTROL: This is a foreign exchange arrangement in which the government purchase all incoming foreign exchange and is the only source from which foreign exchange can be purchased legally.

DUAL EXCHANGE RATE REGIME: These situations exist when two exchange rate are in existence in an economy.

MARGINAL PRICING METHOD: This is a method in which bid rates are arranged in a descending order of magnitude.

  DOWNLOAD THE COMPLETE PROJECT