CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND OF THE STUDY
Foreign exchange is defined by Samuelson and Mordhaus (2003) “as a currency or other financial institution that allows are country to settle amounts owed to another country” According to lisped ((2002) “the term foreign exchange refers to what is traded actual foreign currency or various claims on it.” These different definition of foreign exchange all mean or refer to the effecting payment for international transaction foreign exchange can be acquired by a country through the export of goods and service direct investment inflow draw down on external loans aids and grants and it can be extended to settle international obligations when foreign exchange expenditure is lower than foreign exchange receipt the surplus is added to external reserves. These external reserves which are also saving from foreign exchange transactions are held by the authorities to finance short falls in foreign exchange receipts and to safe guard the international value of the domestic currency A country’s external reserves are the financial assets available to the monetary authorities to meet temporary imbalance in the external payments position and to purpose other policy objectives. External reserve management is the technique of optimizing a nations external resources to meet its economic needs. As the nations apex financial institution the central bank of Nigeria (CBN) has the sole responsibility for the management of external reserves comprising monetary fund (IMT) holding of special drawing right (SDRS) and foreign exchange (CBN) 2005.
The bank started exercising this power in 1962 prior to this date the country’s external reserves were held by the federal and regional governments as well as their parastatals. This arrangement made is diicult to manage the external resaves with adverse imputations for the conduct of monetary policy in order to redress the problem the foreign exchange component of the external reeves was consolidated with the CBN in January 1962 leaving only working balance with other holders (CBN 2005). Nigeria as a member of internal community has bilateral and multilateral relations with other countries and organization which necessitate the exchange of goods and services. External reserves are kept and carefully managed to facilitate such business and diplomatic transactions. More importantly the management of the reserves eect the conduct of monetary policy and ultimately the performance of the nations economy. T his is because the exchange in net foreign assets. Influence the total money supply. External reserve management by the CBN involves the constant review of the country’s exchange position so that external financial obligation are met according One of the major objective of external reserve management is to maintain adequate level of reserves to facilitate international transaction from one asset to another incurs minimums cost in addition reserves are managed to yield income measure of adequacy of reserves used by the bank is the reserves importation. It is desired that external reserves be available to pay for at least four months of imports at the current rate of monthly import demand. In practice the standard is a guide.
Another measure as adequately used by the CBN to monitor the reserves in the reserve is total demand liabilities ration. Under the exchange control act of 1962 the CBN was required to maintain external reserves equivalent to 60 percent of total demand liabilities (CBN 2005) like the other adequacy criterion the external reserves total demand liabilities ratio is implement by the bank according to the realities of the country’s foreign exchange earnings. When there is a disequilibrum in the foreign exchange market caused by inadequate supply of foreign exchange reserves pressure. If these reserves are not adequate this may deteriorate into balance of payments problem there is therefore need to manage a nations foreign exchange resources so as to reduce the adverse eects of foreign exchange volatility The management of foreign exchange resources is further informed by the need to set an appropriate clearing price in the foreign exchange market that would guarantee adequacy of supply in relation to the demand for foreign exchange. Therefore the art of foreign exchange management is a conscious attempt to control and use foreign exchange resources dogleg them to reserve the economy and to meet other international commitments while saving some to raise the level of the country’s international reserves so as to prevent the economy from experiencing shocks to foreign exchange. Volatility. Foreign exchange resources are derived and a expanded I the course of affecting economic transactions between the residents of the country and the rest of the world in this sense there is a close the balance of payments.
While foreign exchange transaction reflects cash flows arising from international operations the balance of payment look at the actual movement of goods services and changes in financial assets and liabilities. According to types (2003) foreign exchange transaction is the difference between foreign receipts and foreign exchange disbursements. If receipts are higher than disbursements there is a set inflow or an accretion reserves. On the other hand if receipts are lower there is a net outflow and reserves would be depleted. Balance of payment position is the difference between the receipts by the residents of one economy from the rest of the world . an excess of receipt over the payment shows a balance of payment surplus while the reserves represents a deficit. When foreign exchange receipts and payment are adjusted for valuation changes in reserves the net position would be identical to the balance of payment position. Fisher et- a; (2007) defined foreign exchange market as “the market where currencies are bought and sold it is where foreign exchange rates are determined. Foreign exchange market can also be defined as the medium of interaction between the seller and buyers of foreign exchange in a bid to negotiate a mutually acceptable price for the settlement of international transactions. According to CBN 2003 the objective of such a market include the provision of an avenue for the exchange of national currencies and the creation of an effective mechanism for the allocation of foreign exchange. The foreign exchange (supply) and the buyers of foreign exchanged (demand). The major participant in the foreign exchange market are authorized dealers (banks) the public sector the private sector and correspondent banks abroad. In Nigeria the supply of foreign exchange is derived from oil exports non- oil exports capital receipt including draw- down no loans expenditure of foreign tourists in Nigeria repatriation of capital be Nigeria resident abroad and other invisible receipts by the private sector. On the other hand the demand for foreign exchange reflect payment for imports external debt services obligations and financial commitment to international organization. Foreign exchange rate are determined. Exchange rates have been defined in different ways by different authors. Fishers etal (2007) defined exchange rate as “ the amount of one country’s currency (money) that it cost to buy one unit of another country’s currency” Exchange rate is defined by lapsey (2002) as “the price at which purchases and sales of foreign currency or claims on it such as cheque and promises to pay take place it is the price of the currency in terms of another.
According to Samuelson and hardhats (2003) “Exchange rate is the rate of price at which one country’s currency is exchange for the currency of another country. Exchange rate can also be defined as other currencies (CBN 2003 ) .The worth of a nations currency depends on a number of factors including the state of the economy the competitiveness of and volume of export the level of domestic production and the quatum of foreign reserves. In a free market environment the exchange rate of a currency I determined by the inter play of supply and demand for that currency. In many cases the exchange rate may be administratively determined. This was the situation in Nigeria from independence until 2006 when a flexible exchange rate mechanism was adopted as part of the structure adjustment programme (SAP ) thereaer exchange rate determination has been largely influence by the force of supply and demand with occasional intervention by the authorities. The main objectives of exchange rate policy in Nigeria according to Umeh (2005) are to preserve the value of the domestic currency maintain favorable external reserves position and ensure price stability . exchange rate policies applied in Nigeria have traversed two main mechanism. The fixed and flexible regimes . between 1960 and 2006 the fixed exchange rate system was operated. The liability of the system to achieve the major objectives of exchange rate policy led to the reversal policy in September 2006 with the floatation of the Naira. The flexible system countries until January 2004 when the fixed exchange rate system was introduced with the pegging of the Naira relative to the us dollar some of the main instrument used in pursuit of these objectively were maintaining parity with the Birth pound sailing and the dollar fixing the Naira exchange rate independence with the dollar and sterling (depending on their relative strength) and the use of dissection (CBN 2005) This chapter discusses the management of foreign exchange in Nigeria including the policy that have been applied to reform it in two categories. Foreign exchange management before. SAP and foreign exchange management since SAP.
- Statement of problem
In a bid to emphasize the issue of fluctuating exchange rate on the Nigerian economy, we analyzed some of the problems mitigating the fluctuation of exchange rate on the Nigerian economy as seen below.
The exchange rate of the naira was relatively stable between 2005 and 2009 during the oil boom era. This was also the situation prior to 2000 when agricultural products accounted for more than 70% of the nation’s gross domestic product. However as a result of the development in the petroleum oil sector in 2000, the share of agriculture in total export declined significantly while that of oil increased.
Furthermore, since Nigeria as a nation is highly dependent on import of input and capital goods for its production process, the sectors involved in the production of goods and services have become increasingly dependent on the external sector for import of non-labour input. This indeed has affected the local content of the nation as resources lie untapped and attended to. Incessant import of raw materials and foreign goods has also led to the abandonment of the local industries, another problem worth mentioning here is that since this import of raw materials has become a way of life for the economy, the government tend to get used to it and as a result The impact of fluctuation in exchange rate on the economy has not received adequate attention from various regimes of government.
Instabilities of foreign exchange rate also pose many problems on international trade between economies. As a result exported goods from economies with unfavorable exchange rate will be of price advantage to the importing nation while imported goods from nations with formidable exchange rate will be of price disadvantage to the exporting nations with unfavorable exchange rate. This indeed will affect the balance of payment of the exporting nation negatively if the import bills becomes higher that export receipts yet if a nation must attain economic growth, it needs a reasonable level of import and inability to import therefore can impact negatively on a nation as well as its inability to export, little wonder Jhingan (2007), emphasized that exchange rate fluctuation cause uncertainty and impede on international trade.
This uncertainties however in trade transaction post a lot of problems such as inflation, which determine the internal balance of a country, it also tend to undermine the international competitiveness of non-oil export and make planning and projection 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 to naira exchange rate, unemployment, balance of payment problems and increase in the level of poverty. Some of the measures adopted by the government to help reduce the incessant depreciation of the naira include the introduction of IFEM in 2009, the AFEM and the re-introduction of the Dutch Auction System (DAS) in July 2002,with the objectives of realigning the exchange rate of the naira, conserving external reserves, enhancing market transparency and curbing capital flight from the country. Under this system, the Bank intervened twice weekly and end-users through authorized dealers bought foreign exchange at their bid rates. The rate that cleared the market (marginal rate) was adopted as the ruling rate exchange rate for the period, up to the next auction. DAS brought a good measure of stability in exchange rate as well a reduction in the arbitrage premium between the official and parallel market rates. Other measures adopted to enhance the operational efficiency of the foreign exchange market included the unfettered access granted holders of ordinary domiciliary accounts to their funds, while utilization of funds in the non-oil export domiciliary accounts were permitted for eligible transactions. Inspite of these measures, the value of naira has continued to cascade downwards.
- Objective of the Study
In a highly import dependent economy like Nigeria, the continuous naira exchange rate has become one of the most widely controversial issues in the country today. This is not surprising as this topic has had a lot of impact on the Gross Domestic Product (GDP). The GDP here however is an indicator of economic growth in an economy. Specifically, the objectives of this study include:
To determine the extent to which interest rate has influenced the rate of domestic growth in the economy.
To examine the nature of the relationship between the unstable exchange rate fluctuations and economic growth in Nigeria, and to determine the management of interest rate and exchange rate in Nigeria.
To investigate the relationship between the exchange rate, inflation rate, interest rate and trade openness of the Nigerian economy to her Gross Domestic Product (GDP).
To determine if the continuous fluctuation of exchange rate of naira have an impact on the standard of living of the citizen, export and to what extent.
1.4Research Hypothesis
The following hypotheses were formulated with emphasis to the objectives of this study.
H0: There is no significant relationship between exchange rate fluctuations and the Nigerian economic growth.
H1: There is a significant relationship between changes exchange rate fluctuations and the Nigerian economic growth.
1.5Significance of the Study
This study would identify the strengths and weakness of exchange rate policy and management will identify those parts that are mostly affected by instability in exchange rate, provide the general public with adequate information on the foreign exchange transaction and its impact on the Nigerian economy. In general, the study benefits the following;
- The government will benefit as it will enable them ascertain the extent of which the variation of exchange rate affect the macro-economic variables in the nation.
- The government will also determine from this study how the unstable exchange rate of the economy affects the demand for local products in contrast to foreign products.
- This study will benefit exchange rate policy makers in helping them formulate the best policy necessary to move the economy towards growth.
- The citizens will also benefit if the policies formulated as a result of the findings from this study pose a positive impact on the economy in the short or long-run.
- Future researchers will also benefit as this study will serve as a future guide.
1.5 Scope and Limitation of the Study
This research work is designed to cover a very long period that is (2000-2015). The scope consists of the regulatory deregulatory exchange rate period i.e. the fixed exchange rate and floating rate period. The study is structured to evaluate Nigerian exchange rate as the pilot of economic growth. Thus, this study is therefore limited to the effect of exchange rate fluctuation in the Nigerian economy.
1.6 Definition of Terms
1. Exchange rate: This is the currency in price terms of another currency
2. Autonomous foreign Exchange market (AFEM): this is a market where banks are allowed to source their foreign exchange and sale and used at market determined rates.
3. Current factor cost: this is used to measure the rate of Gross Domestic Product (GDP).
4. Dual exchange rate: This situation exists where two exchange rates are in existence in an economy.
5. Dutch Auction System (DAS):This is a method of determining the exchange rate through auction, where the bidders pay according to their bid rates.
6. First – Tier Foreign Exchange Market (FFEM): This was the market where government and its agencies buy foreign currency a foreign currency at officially determined rate of exchange.
7. Inter-Bank foreign Exchange Market(IFEM): This was conceived to deepen the foreign exchange market through active participation of other player’se.g. bank, oil companies, non- bank financial institutions. It is the market where banks can sale foreign exchange to one another and to other users at their own rates
8. Para.lopee market: This is also known as blank market’. It is the unofficial market where foreign currencies are bought and sold.
9. Second-tier foreign exchange market (SFEM): This was the market where non-governmental bodies buy and sale foreign exchange at a market determined exchange rate.
10. Foreign exchange: Foreign exchange is a means of payment for international transaction; it is made up of currencies of other countries that are freely acceptable in settling international transactions.
