Impact of Exchange Rate on the Volume of Import in Nigeria (1986-2020)
CHAPTER TWO
LITERATURE REVIEW
2.1 Definition of exchange rate
By definition, the foreign exchange market is organized as an over-the-counter market in which several dealers (banks, companies and government) stand ready to buy and sell deposits denominated in foreign currencies (Mishkin, 1997). In this era of globalization, the interconnectivity among nations has made it possible for different countries to trade its foreign currencies. Thus, Dornbusch and Giovannini (1990) was of the opinion that the worldwide financial development offers more opportunities to countries but it also comes with constraints on all economic decisions such as exchange rate, monetary or fiscal policies. Financial conditions affect the impact of nominal exchange rate fluctuations on growth stability mainly through balance sheets effects and impacts on foreign currency-denominated debt in developing and emerging countries. The net impact of exchange rate fluctuations will depend on the relative importance of competitiveness changes and costs from balance sheets effects. Financial markets development affects economic performances through efficiency in the allocation of productive resources and adjustment to shocks and may result in a more stable or unstable growth (Dornbusch and Giovannini, 1990).
The importance of exchange rate cannot be over emphasized, hence, Evan and Lyons (2005) was of the view that exchange rate is an important economic indicator that has a strategic role in an economy and say that exchange rate movements widely influence various aspects of economy, including inflation, import-export performance which in turn affects the output of economy. He concludes that in the market, there are two main forces that interact with each other, namely supply and demand and they form an equilibrium which is reflected in the price and quantity levels where supply and demand curves meet.
Different countries use several exchange rate regimes to protect their national currencies from the variation in its national currencies. The question of which exchange rate regime that a small open economy should choose has no definite answer, since such a choice depends on the objectives and focus of monetary authorities, as well as on assumptions about the structural characteristics of the economy. Structural characteristics of the economy in this sense imply the degree of openness, of capital mobility, of wage indexation, and of the level of economic growth and development.
Nations monetary policy is usually aimed at stabilizing exchange rate volatility. Such monetary policy formulation and implementation influence macroeconomic variables (hence, macroeconomic stability) in any economy be it developed or underdeveloped. The critical distinction often is the degree to which movements in the exchange rate pass through to affect domestic macroeconomic variables, most especially, consumer prices, output (as measured by the gross domestic product GDP) and private consumption. Hence the choice of an exchange rate regime is linked, to some extent, to the achievement of specific targets set by the monetary authorities. Therefore as argued by Devereux (2001) that the best monetary policy rule in an open economy is one which stabilizes non-traded goods price inflation and that policy of strict inflation targeting is much more desirable in an economy with limited pass-through. If the monetary authorities are concerned with consumer prices inflation then the flexible exchange rate regime brings some costs as well as benefits. Moreover, the same logic implies that a policy of strict inflation targeting is quite undesirable in an open economy, since it effectively amounts to a requirement of fixing the exchange rate. It stabilizes inflation at the expense of a lot of output instability.
Therefore as opined by Obaseki and Bello (1996) exchange rate policy involves three elements, the policy environment the mechanism for exchange rate determination (exchange rate system), the policy instruments designed and course of exchange rate movements hence the policy environment sets the preconditions or minimum requirements for effective exchange rate management and stability, and ultimately determines the optimal exchange rate policy to pursue as the exchange rate mechanism depicts the system of exchange rate administration while the policies applied reflect the objective of moving the exchange rate through a defined path.
2.2 Overview of exchange rate policies
The evolution of the foreign exchange market in Nigeria to its present state could be described as having been influenced by a number of factors such as the changing pattern of international trade, institutional changes in the economy and structural shifts in production. www.cbn/foreignechangemarket.org).
David and Guadalupe (2006) defining an exchange rate policy is one of the most important issues in the response of Trade Balance (TB) in term of trade or in general speaking, in Real Exchange Rate (RER) and with more than forty years literature, the impacts of currency depreciation on a country‘s trade balance have been an important and debate in the development of international economic and trade especially the traditional studied in the Marshall-Lerner condition (ML) and the J-curve theory and according to the (ML) condition, currency devaluation improves the trade balance in the long run only if the sum of the absolute values of imports and exports demand price elasticities exceeds unit hence, due to the lag dynamics structure (TB) can worsen in the short-run because of the inelastic demand for imports and exports in the immediate aftermath of an exchange rate change.
Bamidele et. al. (1998) argues that the basic objective of Nigeria’s exchange rate policy has been to ensure both internal and external balance as well as overall macroeconomic stability through the preservation of the value of the domestic currency, maintenance of favourable external reserves and price stability (see, Iyoha, 1998). 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 productive capacity. In addition, the exchange rate level has implications for balance of payments viability and the level of external debt, for example, if the exchange rate is overvalued, then this will result in unsustainable balance of payments deficits an escalating external debt stock which will in turn, lead to a declining level of investment, thus, it is imperative to let the exchange rate find its equilibrium level (Iyoha, 1998).
According to Nnamdi (2009), trading offers opportunities for international exchange of commodities and services. This tends to boost national economic growth when it is appreciably driven by relative advantages arising from the factor endowments prevailing in the producing regions and economies. From this premise, the foreign exchange process offers nations the opportunity to produce goods for wider markets and consequently realize higher prices compared to the prevailing domestic prices for goods and services. Greater opportunities also exist because the same country could take advantage of trade to import at lower prices, goods which under normal circumstances would attract higher prices if produced locally (Nnamdi, 2009).
Noor, Nugroho and Yanfitri (2010) examined the influence of forex demand and supply interaction on Singapore’s exchange rate. Estimation results show that the movement of rupiah is influenced by the forex supply and demand, where the foreign players are dominating. Furthermore, the demand and supply of foreign exchange is asymmetric. Also, the study also shows the impact of exchange rate movements on output is only in the short term with a more significant influence to the import, while the depreciation of the Singaporean currency has a larger impact than its appreciation (Noor, Nugroho and Yanfitri, 2010).
Rime (2007) was of the view that the order flow accumulation is empirically proven by that affects the exchange rate hence, the main explanation of explanatory power is an order containing a lot of information potentially affects the exchange rate, thus before ordering, the buyer has to obtain information, including information concerning macroeconomic fundamentals from various sources and then process (analyze) such information that eventually create future expectation of exchange rate.
Mundell (1963) and Fleming (1962) recognized and analyzed the different effects that stabilization policies can have on output and exchange rate of a small open economy when perfect capital mobility prevails in the world. Their analysis was done within the traditional Keynesian fixed wage – price world. Their results are well known today, namely, that fiscal policy is completely ineffective in stimulating output due to the complete crowding out generated by the appreciation of the exchange rate, while monetary policy is an expansionary policy, since an initial decline in the interest rate forces a depreciation of the exchange rate and a further increase in output. The Mundell and Fleming results had therefore provided the policy prescription for the years to come. However, the recession of 1974-75 which was attributed to rising oil prices and restrictive fiscal and monetary policies in the western economies, has caused concern amongst several economists of how appropriate it is to treat wages and prices constant in a world of accelerating inflation (Mundell, 1963; Fleming, 1962)
The management of the Exchange Rate has been a critical issue for the economic policy and researchers, especially in developing countries. In the seminal study of (Rose, 1991), he examined the empirical relation between real effective exchange rate and trade balance of major five OECD countries in the post-Bretton Woods era and found that the exchange rate as insignificant determinant of balance of trade.
The research done by Rose and Yellen (1989) could not reject the hypothesis that the real exchange rate was statistically insignificant determinant of trade flows. They examined the bilateral trade flows between the United States and other OECD countries using quarterly data. Furthermore, the studies of (Singh, 2002) find that real exchange rate and domestic income explain a significant influence while foreign income shows an insignificant impact on trade balance, this result for Indian data. Singh‘s study also demonstrates a very significant effect (+2.33) of real exchange rate and domestic income (-1.87) on Indian trade balance (Singh, 2002).
2.3 Foreign exchange management in Nigeria
The concern with exchange rate management policy in Nigeria can be traced back to 1960 when the country became politically independent, even though the Central Bank of Nigeria and the Federal Ministry of Finance had come into being two years earlier (Ogiogio, 1996). Management of exchange rate can be traced to two divisions/phases; pre-Structural Adjustment era of 1960-1985 and post-Structural Adjustment era 1986 – till date. The above binary classifications occasioned a closely historical sequence of about five phases, namely:
Phase I: Fixed parity between the Nigerian pound and the British pound (1960-1967)
There was a fixed parity of a one-to-one relationship between the Nigerian pound (N£) and the British pound sterling (B£) until the British pound was devalued in 1967.
Phase II: Fixed parity between the Nigerian pound and the American dollar (1967-1974)
This time, there was a fixed parity with the USD. As a result of the international financial crisis of the early 1970s, which constrained the US President Nixon to devalue the dollar, Nigeria then abandoned the US dollar and re-kept its currency at par with the British pound. During this stage of Nigeria’s exchange rate policy it became apparent that there were drawbacks in pegging the naira to a single currency which led to its abandonment.
Phase III: Independent exchange rate policy (1974-1976);
Neglecting the peg policy of naira to a single currency of US dollar in 1974-1976, CBN opted to an independent exchange rate management policy that pegged the naira to either the US dollar or British pound sterling, whichever currency was stronger in the foreign exchange market (see Ogiogio, 1996).
Phase IV: Pegging the naira to an import-weighted basket of currencies (1976-1985)
Here, import-weighted basket experiment was carried out between 1976 and 1985. Due to oil boom of mid ‘70s, naira was deliberately depreciated, and, so as to ensure stability and viability of the naira, it was pegged to a basket of currencies which comprises the seven currencies of Nigeria’s major trading partners; the American dollar (USD), the British pound sterling (GBP), the German mark, the French franc (CFA), the Dutch guilder, the Swiss franc (CHF), and the Japanese yen (JPY). The 1986-1985 global economic crises led to unavailability of exchange rate while naira was grossly over-valued against the US dollar and gave FGN two options; one is to continue with the overvalued naira as a result of fixed exchange rate while the second alternative is to adopt the IMF-World Bank imported SAP which enshrined market forces (free hands of DD and SS). The Federal Government of Nigeria chose the second option and introduced the Second-tier Foreign Exchange Market (SFEM) which later transformed to foreign exchange market (FEM) in September 1986 during IBB regime.
Phase V: Market determined exchange rate policy (1986 – Date)
The Nigerian fifth exchange rate management commenced during post-SAP era up to date. The first market, SFEM was established with immediate effect in September 26, 1986. The Nigerian forex market was liberalized with the introduction of an Autonomous Foreign Exchange Market (AFEM) and the Inter-bank Foreign Exchange Market (IFEM) in 1995 and 1999 respectively. The AFEM metamorphosed into a daily, two-way quote IFEM, October 25, 1999. From 16 July 2002, CBN has replaced IFEM with the Dutch Auction System (DAS) which has been in operation till date.
2.4 Types of exchange rate policies
Two views seem to be dominating literature on the types of exchange rate policies according to Montiel and Serven (2007), these are; the traditional re-allocation of resources, especially the increase in productivity due to technology and human capital transfers, from non tradables to tradable sector due to the increase in tradable prices; and the fairly novel argument that emphasizes the high savings rate channel – where a real depreciated rate leads to high interest rates for maintaining internal balance (Montiel and Serven, 2007). These high interest rates in turn lead to high savings rates that impact positively on growth as they encourage capital accumulation.
Svensson (2000) admits that monetary policy and exchange rate are keys tools in economic management and in macroeconomic stabilization and adjustment process in developing countries like Nigeria, where non-inflationary growth and international competitiveness have become major policy targets. Real exchange rate is one broad measure of international competitiveness, while inflation emanates, largely, from monetary expansion, currency devaluation and other structural rigidities in the economy.
Economist such as Tavlas (2003) offers a review about issues of exchange rate particularly the types of exchange rate regimes, and also a critique of Corden (2002) and Goldstein (2002). However, Mussa (2002) and Edwards (2002) provide synoptic reviews and analyses of the real exchange rate especially they point out that exchange rate misalignment issues are very important in the exchange rate regime literature. In other words, the fundamentals fluctuations of macroeconomic policies lead to the disequilibrium of real exchange rate; if the nominal exchange rate remains fixed the result is misalignment between the real exchange rate and the new equilibrium rate. Moreover, various studies have explored and tried to identify effective exchange rate regimes in a world increasingly characterized by high capital flow mobility.
2.5 The growth of imports in Nigeria
Nigeria’s aggregate imports have grown substantially since the country’s political independence in 1960. The nominal value of merchandise imports leapt from N432 million in 1960 to N757 million in 1970 and therefore surged to record about N9 billion in 1980. Following the foreign exchange crisis of 1986–1986, engendered by the collapse of crude oil prices, the magnitude of imports waned. From N15.7 billion in 1987, imports increased by about a factor of two in 1989. Thus, the growth rate of imports, which had averaged 2.5% annually in the 1960s, climbed to an annual average of 33% between 1970 and 1989.
The index of openness has fluctuated between 23% and 56% over the years, 1960–1989. Imports alone as a proportion of GDP did not fall below 10%, except in 1974 and 1986, throughout this period. Considering that the index of openness has been consistently above the 15%–20% mark often suggested in the literature, the Nigerian economy can be said to be relatively open. This possibly explains why any disequilibrium in the external sector is transmitted promptly and widely to the rest of the economy.
The growth of imports is attributable to several factors. These include the need to pursue economic development, the expansion in crude oil export that considerably raised foreign exchange earnings and the over-valuation of the local currency, which artificially cheapened imports in preference to local production. The astronomical expansion of domestic absorption is a key factor that should not be ignored. It has been argued by Schatz (1984) that there was inadequate supply of goods during this period. As a result, part of the growth in domestic absorption had to be satisfied by imports.
Statistics reveal that the import of consumer goods dominated aggregate imports up to 1965, though their relative share declined from 60% in 1950 to 41% by 1965. During this period, the import of capital goods which was next to consumer goods, fluctuated between 24% and 40%, while the share of raw materials generally increased from 10% to 23%. From 1970, the distributional pattern of imports changed dramatically, with the import of capital goods leading and followed by raw materials after 1980. Data show that the contribution from consumer goods fell from 40% to 27% between 1980 and 1990. The proximate determinants of this outcome can be identified. A key factor is the import substitution industrialization pursued with vigour since the late 1950s. This strategy, which equated industrialization with development, relied mainly on imported inputs, particularly raw materials. Moreover, the capital goods industrial subsector is at the threshold and weak. Of course, this meant dependency on imported machinery and equipment that are basic to production in the economy. The gradual decline in the import of consumer goods after 1980 was due largely to the foreign exchange crisis, precipitated by the collapse of crude oil prices in the world market. Following this was the implementation of import control measures. In this respect, a historical review of Nigeria’s trade policies, with particular emphasis on import control measures, will certainly sharpen the understanding of the determinants of import behaviour in the last five decades.
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