CHAPTER ONE

INTRODUCTION

• Background of the study

One of the features that distinguish international trade from domestic trade is that each nation has its own currency and its own banking system. Prices in each country rely on the country’s currency units be it dollars, naira, pounds, euro, rupees, francs, ceddis and so on.   Exchange rate refers to the price of a domestic currency in terms of a foreign currency. Exchange rate plays a key role in international economic transactions because no nation is self sufficient due to varying factor endowment as well as comparative advantages. According to Jhingan (2009), this price is as a result of the interaction of the forces of demand and supply of foreign currencies in any particular period of time. It determines the relative price of domestic goods and services as well as the external sector participation in the international trade. Dornbusch (2004), defined exchange rate as the rate at which one currency is exchanged for the currency of another country. Whereas Mankiw (1997), defined it as the price at which exchange between two countries takes place. The exchange rate has two main components; the domestic currency and foreign currency and it can be quoted directly or indirectly. In a direct quotation, the price of a unit of a foreign currency is expressed in terms of the domestic currency; the foreign currency is the base currency while the domestic currency is the counter currency. In an indirect quotation, the price of a unit of domestic currency is expressed in terms of foreign currency. In this case, the domestic currency is the base currency while the foreign currency is the counter currency. Most exchange rates use the American dollar as the base currency and other currencies as the counter currency. (1: N)  (Base: counter). In addition, there are exceptional cases such as the Euro and commonwealth currencies like British pound, Australian Dollar and New Zealand Dollar.

The exchange rate between the Nigerian naira and the American dollar is the number of naira required to purchase one dollar which is currently about N360 per dollar. The exchange rate of naira per dollar will be maintained in the world exchange market by arbitrage. Arbitrage refers to the purchase of foreign currency in a market where its price is low and to sell it in some markets where its price is high. The essence of arbitrage is to remove differences in the foreign exchange rate of currencies so that there will be a single rate in the world exchange rate market. Exchange rate has played an important role in the macroeconomic performance of a nation. Many economists argue that exchange rate stability facilitates production activities and economic growth and misalignment in real exchange rate distorts production activities and hinders export growth, generates capital flight and macroeconomic instability (MamtaChowdhury 1999).

 The exchange rate appreciated when less of naira is needed to buy a dollar, it was caused by an increase in gross domestic product, favourable balance of payment etc and it depreciates when high amount of naira is needed to buy a single dollar and it was caused as a result of over dependence on importation, heavy debt burden, weak balance of payments position and capital flight.

 Movement in exchange rates have ripple effect on other economic variables such as Foreign Direct Investment (FDI), inflation rate, interest rate, balance of trade etc. These facts emphasize the importance of exchange rate to the economic well-being of every country that opens its doors to international trade in goods, services and cross border investment. Ellsworth (1964) defined exchange rate as the rate at which a country’s currency exchanges for those of other countries measures its external values. An exchange rate is simply the value or price of one currency in terms of another and it makes no difference in which currency the price ratio is expressed (Ellsworth, 1964). Exchange rate is of two types: real and nominal exchange rate.

The real exchange rate is defined as the ratio of the price level abroad and the domestic price level where the price level is converted into domestic currency units through the current nominal exchange rate. Montiel (2003), defined real exchange rate as the relative price of foreign goods in terms of domestic goods. The real exchange rate tells us how many times, more or less goods and services can be purchased abroad. Real exchange rate determines the ratio of price in the local market to the price in the foreign market. According to purchasing power parity, real exchange rates do not change. The nominal exchange rate is defined as the number of units of the domestic currency that can purchase a unit of a given currency. A decrease in this variable is termed nominal appreciation of the currency. An increase in this variable is termed nominal depreciation of the currency. Nominal exchange rate tells how many times an item of goods purchased locally can be purchased abroad. If the nominal exchange rate is high, it will benefit an economy a lot in the trading activities. If it is high, the goods and services get more foreign units. If there is a change in the real exchange rate, the nominal exchange rate is less affected as compared to the real exchange rate. There are factors that can affect exchange rate and they are: inflation rate, interest rate, balance of payments, political stability, internal harmony and these factors can lead to  either increase or decrease in exchange rate.

There are different types of exchange rate regimes practiced all over the world; from the extreme case of fixed exchange rate system to a freely floating regime, and managed floating, whichever that  suits their peculiar economic conditions. For instance, exchange rate managements in Nigeria have witnessed different significant changes over the years. Nigeria maintained fixed exchange rate from 1960 till the breakdown of the Bretton Woods Monetary System in the early 1970s. Between 1970 and 1986, Nigeria practiced a fixed exchange rate when the Naira was pegged against the British Pounds and later on the American Dollar. Nigeria exchange rate policy shifted from fixed exchange rate to flexible exchange rate to the various types of the floating regime since 1986 following the adoption of the Structural Adjustment Programme (SAP) (Sanusi, 2004). This floating was determined by the market forces of demand and supply. 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. In the 1970’s and 1980’s, the naira appreciated against the dollar but in the recent time, naira lost its value up to the extent that a dollar was 500naira. Some of the policies employed by the government to stabilize the exchange rate include: Second Tier Foreign Exchange Market (SFEM), Autonomous Foreign Exchange Market (AFEM), inter-bank foreign exchange market (IFEM), the Dutch auction market (DAS). The policies were unable to provide 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 reserve, over dependency on importation, heavy debt burden, weak balance of payments position and the market activities of speculators and banks and capital flight. 

Exchange rate has maintained consistent fluctuations in Nigeria over the years and these changes are accountable to some macroeconomic variables. It becomes pertinent to estimate the various factors that influence and determine exchange rate in Nigeria. In the light of these, this study is aimed at carrying out an empirical analysis of the determinants of exchange rate in Nigeria covering the period 1980-2016.

• Statement of the problem

Foreign exchange is said to be an important element in the economic growth and development of a nation because foreign exchange policies influence the economic activities and to a large extent, dictate the direction of the macroeconomic variables in the country. The mechanism of exchange rate determination are different systems of managing the exchange rate of a nation’s currency in terms of other currencies and this should be properly done in a way that will bring about  efficient allocation of scarce resources so as to achieve growth and development. Jhingan (2005) suggested that to maintain both internal and external balance, a country must control its exchange rate.

Over the years, exchange rate fluctuations and volatility in Nigeria has been a major macroeconomic issue and this has resulted to the introduction of many macroeconomic policies to reduce the damage caused by exchange rate fluctuations in the economy. A major and significant issue is to capture to major macroeconomic variables that influence the variations and changes in exchange rate as this will go a long way in controlling the changes. Some of the policies employed by the government to stabilize the exchange rate include: Second Tier Foreign Exchange Market (SFEM), Autonomous Foreign Exchange Market (AFEM), inter-bank foreign exchange market (IFEM), the Dutch auction market (DAS). The policies were unable to provide a solution to exchange rate stability. It was in this light that this study is motivated to evaluate the determinants of exchange rate in Nigeria covering the period 1980-2016.

•  Objectives of the study

 The main objective of this study is to ascertainthe determinants of exchange rate in Nigeria covering the period 1980-2016. In line with this general objective, the following specific objectives will be pursued:

1. To ascertain if interest rate is a major determinant of exchange rate in Nigeria.
2. To find out if inflation is a major determinant of exchange rate in Nigeria.
3. To ascertain if balance of payment is a major determinant of exchange rate in Nigeria.
4. To ascertain ifReal Gross Domestic Product (GDP) is a major determinant of exchange rate in Nigeria.

1.4   Research Questions 

The following research questions will guide this study:

1. To what extent has interest rate determined exchange rate in Nigeria?
2. To what extent has inflation determined exchange rate in Nigeria?
3. To what extent has balance of payment determined exchange rate in Nigeria?
4. To what extent has real gross domestic product determined exchange rate in Nigeria?

 1.5 Statement of Hypotheses

The following hypotheses will be tested in the course of the study.

H0₁: interest rate is not a major determinant of exchange rate in Nigeria.

 H0₂: inflation is not a major determinant of exchange rate in Nigeria.

H0₃: balance of payment is not a determinant of exchange rate in Nigeria.

H0₄: Real Gross Domestic Product is not a major determinant of exchange rate in Nigeria.

1.6 Significance of the Study  

This research work shall be beneficial to future economic researchers for this shall be a very good reference material to source information on, it will equally benefit the government in making informed decision on the issues relating to exchange rate for policy prescriptions and intervention.As exchange rate is a pure financial variable, the banking sector will find this research relevant given that it will provide clear information on exchange rate.

1.7 scope of the study

 The focus of this study is to estimate the major determinants of exchange rate in Nigeria. Some of the proposed determinants of exchange rate in Nigeria for the study are interest rate, inflation rate, balance of payments and Real Gross Domestic Product (RGDP) covering the period 1980-2016.

1.8 Limitations of the study

The challenges the researcher faced in the process of this research work include:

Time constraint: it was difficult for the researcher to combine her lectures, exams and the research work.  Furthermore, trying to gather material for this study was not an easy task as emphasis was placed on where to source the right material for the work as different textbooks and journals were consulted.

Financial constraint: the researcher found it very difficult to raised fund for her research work.

1.9 Definitions of terms

Gross domestic product: this is the monetary value of all the finished goods and services produced in a country’s borders in a specified period usually one year.

Inflation: this can be defined as the persistent and sustained increase in the general price level of goods and services in an economy over a period of time.

Balance of payment: this is the record of all economic transactions between the residents of the country and of the world in a particular period usually one year.