The Impact of Exchange Rate Variation on Balance of Payment

The Impact of Exchange Rate Variation on Balance of Payment

ABSTRACT

This study was carried out to ascertain the effect of exchange rate variation on the balance of payment in Nigeria from (1979 – to 2008) exchange rate and the interest rate used as a proxy for the balance of payment in Nigeria. Policymakers and some researchers argued on exchange rate variations have a significant factor. Some have found negative, positive, significant, and insignificant results on the impact of exchange rate variations on the balance payment. The F – test result suggested that the model is statistically significant. Based on this work, using an econometric test of cointegration we achieved that there is a positive and significant relationship between exchange rate and balance of payment in the Nigerian economy. This means that the exchange rate is not a major problem facing the balance of payment, other variables like money supply interest rate can affect the balance of payment. The R2 is used for solving the level of change that can be accounted for in the independent variable. This study recommends that the exchange rate value needs to be sustained at the free market

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF STUDY

Exchange rate arrangements in Nigeria have undergone significant changes over the last four decades. It shifted from a find regime in the 1960s and the mid-1980s, and finally to the various types of floating regimes since 1986 following the adoption of the structural adjustment programme (SAP).

The most serious problem is the disequilibrium in the balance of payment. The disequilibrium has led to Nigeria being unable to meet the debt obligation and as a result, her trading partners become so skeptical about extending further credit to her. The search over the years by the government for economic policies portion viable, so they handled and enforced exchange earnings in a pool under government control.

Given the apparent unbalance in the economy and consequent undesirable development, the government adopted fundamental economic restricting strategies, which implied breaking with the past policies that have intended to be more protective.

One main area of the structural reforms included checking inflation in a long term and making the price of foreign goods reflect their relative domestic prices to expand the internal industrial-based? And to mercies internal supply capacity. The introduction of the structural adjustment programme (SAP) affected the actual exchange rate of the naira and other trading currencies of the world.

The second-tier foreign exchange market (SFEM) was established on the 28th of September 1987 as a mechanism for achieving a realistic exchange rate for the naira and ensuring a more efficient allocation of scarce foreign exchange resources.

All public and private transactions supported by appropriate documents were expected to be financed through the market except for certain transactions such as debt serving, contributions by governments to international organizations, and executed before the commencement of the second-tier foreign market (SFEM) and for which approval had to be received. Such exceptions, however, to be executed through the official first-tier market were both merged on 2nd July 1987 to firm the foreign exchange market (FEM).

A country’s eternal balance position is among the primary factors identified in the literature that seeks to determine a long-run fundamental value of us real exchange rate.

The real exchange rate is the rate at which one country’s currency is exchanged for another. Alternatively, the exchange rate may be defined as the price of one unit of the foreign currency in terms of the domestic currency. Exchange rate players a crucial role in international economic transactions. Thrilwall (2003) argues that gains from trade are unequally disturbed between developing countries that specialize in primary products and developed countries as they are likely to experience unemployment, a decline in terms of trade, and slower economic growth. However, he doesn’t deny the necessity for developing countries to trade. Also due to its varying effect on the volume of trade, the exchange rate exerts a strong influence on a country’s balance of payment position.

The underlying intuition is straightforward. A positive steady-state net international investments position may allow a country to run persistent trade deficits. In turn, all things being equal the capacity to sustain a negative net export balance allows the maintenance of a “strong” real exchange rate. Conversely, a debtor country that must run a trade surplus may require a surplus in its balance of payment when total receipts from exports and foreign investment exceed total payment.

The relation between external balance and the real exchange rate to policymakers and currency speculators. The two broad methods of determination are usually applied in exchange rate regimes. It could also be a mixture of two regimes. Examples are the crawling peg and the managed float several factors influence the major consideration is the internal economic condition or essentials, the eternal economic environment, and the effect of various random shocks on the domestic economy.

Over the past decades, exchange rate management in Nigeria has undergone significant changes. It shifted from a fixed exchange regime in the 1960s to a pegged regime between 1970 and mid-1980, these changes are not pearlier to the naira alone as the US dollar was fixed in gold terms until 1971 when it was debunked and has since been floated.

The fixed exchange rate regime induced an overvaluation of the naira of finished goods with payment position, domestic production, and the nation’s external reserves.

The autonomous foreign exchange market was introduced in 1995, but due to its failure to achieve the objective of the CBN, an interbank foreign exchange market was introduced on the 25th of October 1999. It was designed as a two-way quotation system within the economy by encouraging the finding of inter-bank operations from priority earned foreign exchange. As a result of the persistent expansionary fiscal operations of the government and excess liquidity in the system, the IFEM was unable to proffer any solution.

In July 2002, The Central Bank of Nigeria (CBN) introduced the Dutch Auction System (DAS) (Which is an improvement over the previous mechanisms trends) to replace IFEM as demand premises on the exchange rate intensified and a depletion in the external reserves level persisted. This was because the foreign exchange earnings from oil contained to general output and employment goals in the countries from which Nigeria’s imports originated.

The major objective of the CBN has been the need to maintain a realistic exchange rate, which would result in the simultaneous achievement of internal and external balances and facilitate the achievement of sustainable economic growth and development.

1.2 STATEMENT OF RESEARCH PROBLEM

Nigeria, like other developing countries, has been an expedient balance of payment disequilibrium. There has been a persistent inflection, a high rate of unemployment, an increase in imports, a fall in export commodities also a general decline in the gross domestic product (GDP).

The federal government has tried to correct this imbalance by borrowing from both aboard have added to Nigeria’s balance of payment disequilibria.

Every economy aims at achieving a favorable external balance of payment position in its international relations. The attainment and maintenance of external balances depend on an accurate understanding of the effects of the real exchange rate movement on the balance of payment position.

Economists and policy analysts are yet to reach an agreement on the best exchange rate policy. The history of less developed countries and Nigeria, in particular, is best with the incidence of political unrest and social disorder emanating arguably from a high rate of foreign exchange, the balance of payment disequilibria, and unemployment.

This study intends to analyze the effect of the exchange rate and other macroeconomic variables on the balances of payment position in Nigeria.

1.3 OBJECTIVE OF THE STUDY

The main objective of this research work is to investigate and determine the impact of exchange rate variation on Nigeria’s internal balance position and to also determine the relationship between the exchange rate and Nigeria. More specifically the study intends to achieve the following.

i. To determine the effect of foreign exchange rate changes on the BOP

ii. To determine the impact of the exchanges rate on foreign reserves in Nigeria.

iii.  To determine the impact of foreign reserves on economic growth in Nigeria.

1.4 STATEMENT OF HYPOTHESIS 

The hypothesis tested in this research includes:

i. There is no significant relationship between exchange rate and (BOP).

ii. Exchange rate has no significant impact on foreign reserves

iii. Foreign reserves have no significant impact on economic growth in Nigeria.

1.5 SIGNIFICANCE OF THE STUDY

The research work will help identify the actual impact of exchange rate variation on the balance of payment. It will also examine the exchange rate management policy because the exchange rate management policy is an evolving process and a challenge before the balance of payment.

The significance of this study is that the result would help policymakers to adopt exchange rate policies that would not be detrimental to the balance of the payment position, which is one of the macroeconomic goals.