1.1 Background of the Study
Exchange rate is the price of one country’s currency expressed in terms of some other currency. It determines the relative prices of domestic and foreign goods, as well as the strength of external sector participation in the international trade. According to Dornbusch (2004), exchange rate is the rate at which one country’s currency is exchanged for the currency of another country. While Mankiw (1997), defined it as the price at which exchange between two countries takes place.
The role of exchange rate and its effects on macroeconomic performance has continued to generate interest among economist. Many economists argue that exchange rate stability facilities production activities and economic growth. Exchange rate regime and interest rate remain important issues of discourse in the international Finance as well as in developing nation with more economics embracing trade liberation as a requisite for economic growth (Obansa et al, 2013). The relationship it has with other macroeconomic variables has been argued among economists. They are also of the view that misalignment in real exchange rate could distort production activities and consequently hinder exports growth and generate macroeconomic instability (Mamta Chowdhury, 1999). Mordi (2006) argued that the exchange rate movements have effects on inflation, prices incentives, fiscal viability, competitiveness of exports, and efficiency in resources allocation, international confidence and balance of payment equilibrium.
Prior to the late 1980s, fixed exchange rate was practiced in Nigeria, when the Naira was pegged against the British Pound and later on the American Dollar. After this period, flexible exchange rate policy was adopted and exchange rate was allowed to float which was determined by demand and supply forces. Since then the naira rate of exchange against the dollar has experienced significant fluctuations, such that naira/dollar rate of exchange moved from 0.6091, 0.6369, 3.3166, 9.001, 84.5, 92.52 in 1980, 1981, 1986, 1990, 1995 and 1999 respectively to 132.6, 147.6 and 156.35 in 2004, 2009 and 2013 respectively. Some of the policies employed to stabilize exchange rate in Nigeria include: Second Tier Foreign Exchange Market (SFEM), Autonomous Foreign Exchange Market (AFEM), The Dutch Auction System (DAS) etc. The policies were tried but still were unable to proffer a solution to exchange rate stability. The Naira continued to depreciate against the American dollar.
Some economists have attributed the recent depreciation to the decline in the nation’s foreign exchange reserves. Others argued that the activities of some market operators (speculators) and banks are responsible for the recent decline in the values of naira, while some argued that the over dependency on importation, heavy debt burden, weak balance of payments position and capital flight have explained the reasons for the behavior of exchange rate in Nigeria from the period of regulation to deregulation.
Entrenching a realistic and sustainable macroeconomic policy in Nigeria has been a huge challenge for years. Although successive administrations have considered carious macroeconomic policies to strengthen the economy, reduce inflation and stabilize the Naira. Economists believe that much still needed to be done to get it right. Economists believe that many of the measures by previous administrations did not yield the desired results, as the Naira remained unstable. Despite efforts by government to maintain a stable exchange rate, the naira rate of exchange still remains volatile (Benson and Victor 2012, Aliyu 2011. This calls for further research efforts to determine the variable that account for levels of exchange rate in Nigeria. Against this background, this research study intends to investigate the empirical analysis of the determinants of exchange rate in Nigeria over a period of 35 years (1980 – 2014)
1.2 Statement of the Problem
Since the fall of Bretton – wood system in 1970s and the subsequent introduction of floating exchange rates, the exchange rates have in some cases become extremely volatile. It may be quite interesting to note that the naira remained quite stable in the mid 90s i.e. 84.57, 74.6, 84.3 and 92.53 against the American dollar in 19955, 1996, 1997, 1998 and 1999 respectively. In early 2007, the Naira depreciated to N117.968 against the American dollar which could be attributed to decline in foreign exchange reserves and sovereign wealth fund. In a nutshell, the exchange rate of Nigeria Naira to American dollar has been volatile and fluctuating over time. According to Obadan (2006), some of the factors that led to the depreciation of the Nigerian exchange rate include over importation and fragile export base economy.
Since the adoption of the Structural Adjustment Programme in 1986, Nigeria has adopted different types of exchange rate regimes to fixed/pegged regimes but it has not solved the problem of exchange rate fluctuation and maintaining both internal and external balance. As part of the measures taken to stabilize exchange rate in Nigeria could be forced to cut further the amount of oil revenue it uses for government spending if the global crude price continued to plummet. Another measure by CBN stipulates that customers who purchase foreign currency through interbank market or an authorized trader must use the funds within 48 hours. None of these could stabilize the naira against other major currencies.
Past specific Nigerian studies made attempts at determining the variables that account or levels of exchange rate in Nigeria. Some of these include; Udoye (2009), which examined the determinants of exchange rate in Nigeria for period of 1970 to 2006, using the Nigeria time series data. The result suggests that one year past value of exchange rate and immediate past value of trade openness are the major determinants of exchange rate in Nigeria. The result further indicates that there is evidence of long-run relationship between rate and two explanatory variables (gross domestic product growth and trade openness). Again, Ejim (2010) investigated the empirical analysis of the determinants of exchange rate in Nigeria for the period of 1989-2010 and found out that inflation is a key determinant of exchange rate in Nigeria.
According to Jhingan (2005), to maintain both internal and external balance, a country must control its exchange rate. This requires good knowledge of the variables that shape the levels of exchange rate. Therefore, given paucity of empirical evidence on this macroeconomic issue, it becomes necessary to reexamine the determinants of exchange rate in Nigeria. To do this, the study shall be guided by the following research question;
1.3 Objectives of the study
The general objective of the study is to empirically determine the determinant of exchange rate in Nigeria for the period of 1980 – 2014.
Specifically:
1.4 Statement of Hypothesis
1.5 Scope and Significance of the Study
This research work is being carried out to empirically find out the determinants of exchange rate in Nigeria. The findings of this work will be great use to government ministries like, ministry of education and department and agencies at federal, state and local level in solving some macroeconomic problems even intellectual researchers who may be willing to improve the work subsequently.
The scope of the study covers a span of 35 years which is 1980 – 2014 and it is within the geographical area of Nigeria.
1.6 Definition of Terms
Exchange Rate: Exchange rate is the rate at which one country’s currency is exchanged for the currency of another.
Inflation: is a sustained increase in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy.
In other words, can refer to either an increase in the money supply or a sustained increase in the general price level of goods and services in an economy over a period of time, normally owing to an increase in the money supply. In this study, inflation rate is expected to be negative because a moderate inflation will encourage investors. It is also one of the independent variables.
Interest Rate: is the proportion of a loan that is charged as interest to the borrower, typically expressed as an annual percentage of the loan outstanding. Higher interest rates attract foreign capital and cause the exchange rate to rise.
In other words, it is the amount of intrest due per period as a proportion of the amount lent, deposited or borrowed (called the principal sum). In this study, it is expected to be negative because a positive outcome depreciates the foreign exchange rate.
Trade Openness: It is a measure of economic policies that either restrict or invite trade between countries. For example, if a country sets a policy of high trade tariffs, thus restricting the desirability of international trade, it will inhibit other countries from sundry exports and accepting imports from the country.
In other words, this concerned with the degree at which the economy is left to interact, trade and mingle with other countries. If the economy is totally open, it has an effect on the balance of payment. Conversely, if the economy is allowed to be closed, the effect would also be seen on the economic activities of such country. In this study, the variable is expected to be negative hence, it appreciates foreign exchange rate with other countries.
Fiscal Viability: it is the ability of an entity to continue to achieve its operating objectives and fulfill its mission of continuous effectiveness.