1.1 BACKGROUND TO THE STUDY
Exchange rate pass-through refers to the effect of a change in the exchange rate to domestic prices. In other words, it is the change in domestic prices that can be attributed to a prior change in the nominal exchange rate. Balance-of-payments models normally assume a one-for-one response of import prices to exchange rates, which is known as complete exchange rate pass-through (Peter 2003). A one-to-one response of import prices to exchange rate changes is known as complete ERPT while a less than one-to-one response is known as partial or incomplete ERPT. The rate of ERPT has important implications for the effect of monetary policy on domestic prices as well as for the transmission of macroeconomic shocks and the volatility of the real exchange rate.
Trade openness otherwise known as trade liberalization is the process of reducing or removing restrictions on international trade. This may include the reduction or removal of tariffs, abolition or enlargement of import quotas, abolition of multiple exchange rates, and removal of requirements for administrative permits for imports or allocations of foreign exchange(Bhaskar, 2005). In Nigeria, trade liberalization became pronounced through the adoption of the IMF Structural Adjustment Programme (SAP) in 1986, which its primary aim was to restructure and diversify the productive base of the economy. In addition, the SAP was also designed to establish a realistic and sustainable exchange rate for the Naira through trade and payment liberalization, tariff reforms, commercialization and privatization of public enterprises (Oyejide, 1990).
In general, three factors may determine the extent of pass-through of exchange rate to domestic prices: the pricing behavior by exporters in the producer countries, the responsiveness of mark-ups to competitive conditions and the existence of distribution costs that may drive a wedge between import and retail prices (Olivei, 2002 and Campa and Goldberg, 2005). For instance, when exchange rates changes, foreign firms can choose to pass exchange rate changes fully to their selling prices in export markets (complete pass-through), to bear exchange rate changes to keep selling prices unchanged (zero pass-through), or some combination of these (partial pass-through). In reality, exchange rate pass-through is far from complete. Goldberg and Knetter (1997) argued that “a price response equal to one half the exchange rate change”. They discovered that only around 60 percent of exchange rate changes are passed on to import prices in the United States.
The main explanation for incomplete pass-through is that many importing and exporting firms choose to hold their prices constant and simply reduce or increase the mark-up on prices, when the exchange rate is changing. Dornbusch (1987) justified incomplete pass-through as arising from firms that operate in a market characterized by imperfect competition and adjusts their mark-up (and not only prices) in response to an exchange rate shock. Burstein et al. (2003) instead emphasized the role of (non-traded) domestic inputs in the chain of distribution of tradable goods. Furthermore, Burstein et al. (2005) pointed out the measurement problems in CPI, which ignores the quality adjustment of tradable goods to large adjustment in the exchange rate. Another line of reasoning stresses the role that monetary and fiscal authorities play, by partly offsetting the impact of changes in the exchange rate on prices (Gagnon and Ihrig, 2004).
1.2 Statement of the Problems
The notion that trade openness is being influenced by exchange rate fluctuations is not new in literature. The nature of the effect is also being seriously debated. In some studies, evidence are bound that a positive linkage exist between a country’s rate of exchange and its openness to international trade, and on the other hand, other studies have failed to demonstrate such linkage, (Jin, 2002; Sinha&Sinha, 1996). The crux of the differences in these results has been the differences in methodology as well as the way the openness variables were defined (Baldwin, 2002 &Ajayi, 2003).
On the other hand, the emphasis on knowing the exchange rate pass-through is underpinned by the fact that the Nigerian economy is external sector driven such that shocks from global commodity markets have serious implications on the economy. In addition, the need to make the external sector competitive through appropriate exchange rate adjustment has made the study of exchange rate pass-through in Nigeria imperative. Recent developments in the external sector of the Nigerian economy revealed that the naira exchange rate depreciated by 24.0 percent between October 2008 and February 2009 and the pressure is still on as crude oil receipts continue to dwindle due to both demand and supply factors. Concerns are what would be the implications of these developments on trade openness or the extent of exchange rate pass-through on domestic and import prices.
1.3 Research Question
1.4 Objective of the Study
The main objective of the paper is to determine the magnitude and length of exchange rate pass-through on trade openness in Nigeria.
The specific objectives are;
1.5 Research Hypotheses
H 01
H 02
1.6 Significance of the Study
This study will be of immense importance to the Nigerian Export Promotion Council because it will enable them increase foreign exchange earnings of the country by exportation of non-oil goods, create employment and reduce unemployment problems in the country through foreign trade promotion.
It will also help in further researches that will be made in the field of management science and be of assistance to tutor, students and prospective researchers in similar topic.
1.7 Scope of the Study
The scope of this study is limited to the Nigerian economy for the period 1980 – 2015. This range is chosen to ensure availability of data, meaningful analysis and also achievement of the objectives of the study, we choose to extend the study to 2015 end year to be able to capture recent development as it regards the subject matter under study in Nigeria.