ECONOMIC ANALYSIS OF THE DETERMINANTS OF EXCHANGE RATE IN NIGERIA.
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ECONOMIC ANALYSIS OF THE DETERMINANTS OF EXCHANGE RATE IN NIGERIA.
Chapter one
1.0 Introduction
Economists continue to be interested in the role of exchange rates and their effects on macroeconomic performance. Many economists believe that exchange rate stability promotes productivity and economic growth.
They also believe that misalignment in real exchange rates might distort industrial activity, stifle export growth, and cause macroeconomic instability (Mamta Chowdhury, 1999).
Exchange rate policy advises investors on how to find the optimal balance between their trade partners and investing at home or abroad (Balogun, 2007).
Mordi (2006) suggested that exchange rate movements affect inflation, pricing incentives, fiscal viability, export competitiveness, resource allocation efficiency, international confidence, and balance of payments equilibrium.
The exchange rate is a major ‘barometer’ of economic performance, showing growth (output), demand circumstances, and the levels and trends of monetary and fiscal policy stances (Afolabi, 1991).
In the 1980s, exchange rate policy emerged as one of the most contentious policy instruments in developing nations, with strong opposition due to concerns about inflation and other consequences.
Nigeria faced such a predicament, which sparked interest in economic performance and the function of the currency rate in the process (Afolabi1991).
The exchange rate, when combined with other macroeconomic policies, is anticipated to achieve the goals of price stability, increased and sustained economic development, lower unemployment, and balance of payment stability.
An ideal and stable exchange rate must be accurate and steady because it is a key relative price that determines other prices. According to Afolabi (1991), when the exchange rate is not ideal, achieving these goals becomes difficult, if not impossible.
For example, if the exchange rate is out of equilibrium, rent-seekers and speculators can take advantage of the subsidy aspect. The situation is exacerbated when a parallel market emerges as a result of restrictions in the official market and the market’s failure to meet demand for foreign exchange.
Thus, the opportunity cost of doing business in the official market is the value of the subsidy or premiums that the official sector would otherwise lose but obtain from third-party arbitrators and speculators.
The disability nature of foreign exchange subsidies (premiums) is the primary reason why unification of exchange rates is being proposed as a short to medium term exchange rate management goal.
The smaller the parallel market in relation to the official market, and the greater the demand and supply elasticity of foreign exchange in the official market, the closer the unified equilibrium rate is to the official rate.
However, if there is a large unfulfilled demand in the official market that cannot be directed to the parallel market due to administrative constraints, the equilibrium rate in a unified market will tend to be closer to or even exceed the parallel market rate (John, IMF 1985).
Long-term continuation of a dual exchange rate system would be counterproductive since it undermined the goal of exchange rate stability and economic structural reform.
The continuation of dual or multiple rates would encourage wasteful resource allocation, stalling economic recovery and development. Foreign exchange liberalisation, together with suitable demand management policies aimed at guaranteeing macroeconomic stability, is required for exchange rate convergence if costs (subsidies) are to be minimised. This is because the official exchange rate frequently bears the brunt of the adjustment cost.
One of the major goals of the Structural Adjustment Programme (SAP)
Introduced in Nigeria in 1986, the goal was to create macroeconomic stability by lowering inflation levels through the establishment of a stable and realistic exchange rate.
To achieve this, the government decided to deregulate exchange rate setting and the foreign exchange allocation mechanism, depending heavily on market focus.
In this regard, various allocation mechanisms, ranging from the second-tier foreign exchange market (SFEM), the interbalance foreign exchange market (IFEM)
the Dutch auction system (DAS), to the pro-rate system, and, more recently, fixing the official exchange rate and applying a free market exchange rate for purely commercial transactions, were used to achieve policy goals.
Nigeria is currently the second largest oil exporter in the Organisation of Petroleum Exporting Countries (OPEC), and it is heavily reliant on crude oil exports, which account for 95% of its exports and foreign exchange earnings, as well as approximately 80% of government revenue annual budgets (EIA, 2010).
Oil has been the driving force in Nigeria’s economy since its discovery in 1956 (Budina et al, 2006). Oil exporting nations’ exchange rates may rise when oil prices rise, but they may fall when oil prices fall.
From 1980 to 1985, following the increase in oil prices, there was an upward trend with the real exchange rate gaining dramatically, resulting in a loss of competitiveness for the Nigerian economy.
Nigeria’s actual exchange rate falls sharply in 1986 as a result of falling oil prices and the Structural Adjustment Programme (SAP), which devalues the Nigerian currency, the naira. Between 1993 and 2000, the real exchange rate fluctuated significantly.
Since then, the real exchange rate index has followed a consistent pattern, with signs of a slight appreciation in the actual exchange rate. Nigeria has seen significant foreign money inflows in recent years as global oil prices have risen and its oil exports have expanded.
The real exchange rate appreciation could be attributed to the Nigerian economy’s huge foreign cash inflows or to productivity growth.
The approaches used to analyse the problems of exchange rate determination ranged from the traditional balance of payment approach to the modern approaches of exchange rate determination, consisting of the monetary and port-folio balance approaches (that is, after deregulation), which argue that the exchange rate, as a relative of the two natural monies, is determined primarily by the relative supplies and demands for the monies.
The approach is also known as asset market approaches to exchange rate determination, because the demand for various national currencies is influenced by expectations, income and rates of return, as well as other factors relevant to portfolio choice.
1.1 Statement of Problem
There have been several exchange rate systems in use throughout history, the first of which was the Gold Standard System. The free exchange rate system was determined by the supply and demand for foreign currencies or the demand and supply of domestic currencies. Neither of the two systems mentioned above has resulted in a stable foreign exchange market (Akinmoladun, 1990).
The exchange rate under the Gold Standard System subordinated the demand for internal balance to the vagaries of the external sector.
The rationale against the free exchange rate is similar, though it allowed for external and internal balance, but had disadvantages because the fluctuation deterred exporters.
Importers benefit from stable rates, which boosts their confidence. During the currency control regime in Nigeria, black market rates were significantly higher than official foreign exchange rates, highlighting the naira’s considerable overvaluation and the resulting deficit disequilibrium, which the black market supply was intended to fill.
Nigeria’s significant external borrowing as a result of ongoing disequilibrium in the balance of payments has created the challenge of how to fund a right exchange rate in the face of dynamic changes in the underlying conditions supporting autonomous transactions. A rate set too high undervalues the native currency, while a rate set too low overvalues the domestic currency.
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