Forecast of exchange rate determinants in Nigeria

Complete Chapter One


Title Page i
Certification ii
Dedication iii
Acknowledgement iv
Table of Content vii
Abstract x
1.1 Background to the Study 1
1.2 State of the Problem 6
1.3 Objective of the Study 9
1.4 Hypotheses of the Study 9
1.5 Significant of the Study 10
1.6 Scope of the Study 11
2.1 Definitions of Terms 15
2.2 Historical Perspective 22
2.3 The Exchange rate Management since SAP 31
2.3.1 Exchange Rate policy objectives 32
2.3.2 Institutional framework and management strategies 33
2.3.3 Trend and Outcomes of the Exchange rate management
strategies 37
2.4 Factors that led to depreciation of the Naira 40
2.5 Exchange Rate Determinant in Nigeria 41
2.6 Type of Exchange rate regimes 43
2.7 Forecasting 48
2.7.1 Forecasting Application 49
2.7.2 Forecasting Techniques 50
2.8 Determinant of Exchange Rate 52
2.8.1 Drivers of Foreign Exchange 53
2.8.2 Exchange Rate Movement and Macro economics
Aggregates 54
3.1 Theoretical Framework 56
3.2 Model Specification 59
3.3 Source of Data 62
3.4 Method of Data Analysis 63
3.4.1 Testing the Forecasting capability of the estimated model 64
4.1 Presentation of Result 70
4.2 Analysis of Result 71
4.3 Forecast Results 73
4.4 Policy Implication 80
5.1 Summary of Findings 84
5.2 Recommendations 86
5.3 Conclusion 89
Bibliography 91

It has been noted that the Nigeria economy has gone through series of transformation since independence. Her exchange rate determination has taken various shapes from administratively deformed rate to a market determined rate. These have also be associated with deficient problems. As a result of these problems, the government through the help of the CBN (Central Bank of Nigeria) tries to regulate the exchange rate system. The adoption of Structural Adjustment Programme (SAP), where main element was Second-tier Foreign Exchange Market.
The hypotheses of this study indicate that there is a significant positive relationship between Exchange Rate, Interest Rate, External Reserve and Inflation and there is a negative relationship between exchange rate, Gross Domestic Product and Balance of Payment. To validate this hypothesis data gotten from secondary sources were estimated and analyzed among the Ordinary Least Square Method (OLS) and Cochrane-Orcutt Method. The independent variables used were balance of payment, Gross Domestic Product, Interest Rate, External Reserve and Inflation, while the dependable variable was exchange rate. There was also a drive towards forecasting exchange rate.
The empirical analysis showed that about 87% of the mean value of the exchange rate is explained by the explanatory variables. This shows that the estimated model regression line is a good fit and the result of the null hypothesis for the forecast was less than the figure of the “t” take, which means it forecast well.


In an attempt to examine carefully, the political, social and economic life of Nigeria, the problem of unemployment, corruption, poverty, economic stagnancy and backwardness, foreign exchange rate, under utilization of capacities, high dependence on importation, etc becomes obvious it should however be noted that certain policies have been formulated either to tackle all or some of this problems. Hence, an individual may be pushed to seek answers to various questions, which could include: What has Nigeria done (or not done) well? What is responsible for weakening of her macro-economic variables? What could be the way forward? And how do we get there? With a bid to answer the above question, the researcher intends to focus critically on the role play by industrial sector in the economic growth of Nigeria.
Basically, the foreign exchange is one of the most Nigeria (CBN) to bring about the nation stable foreign exchange rate for economic growth and development. Foreign exchange rate is a strong economic indicator for assessing the over all performance of the strength or weakness of an economy.
According to Olukole, a persistently strong currency is a reflection of a weak and numerable economy. Exchange rate is also a powerful monetary policy tool used in achieving certain objective of a country. Foreign exchange earning from international trade transaction and external and vital for the economic transformation of Nigeria. All things being equal, foreign exchange resource so earned can induce increased factor supplies and promote the development of technical skill and knowledge all growth consequently the role of foreign exchange has traditionally been a critical element in the development planning process of Nigeria.
The Nigeria economy is a monoculture one because it depends solely on oil as its major source of foreign exchange earnings. Thus, whatever happens to the price of oil in the international market seriously affects the domestic economy. In essence, the role of foreign exchange has traditionally been a critical element in the development planning process of any country.
The analysis of foreign exchange in Nigeria has taken different dimension and has undergone series of transformation since inception. Before the creation of Central Bank of Nigeria (CBN) and enactment of the Exchanging Control Act of 1962, foreign exchange was earned by private sector and held in balance abroad by the commercial bank that acted as Agents for local exporters. The foreign exchange rates system to a market determined system.
The different exchange rate policies adopted during the pre-SEM era depended on economic situation in which the country found itself and in some cases was in response to exchange rate policies around the world.
Consequently, the following exchange rate earning landed the country on the verge of collapse, the country was faced with various kinds of adverse economic problems ranging from relatively low external reserves, to the accumulation of payments arrears pushed the country’s debt stock to uncomfortable level, real output decline, high level of unemployment, balance of payment problems and so tended to completely erode the country’s international credit worthiness thereby constraining its accessibility to international credit.
The naira exchange rate was over-valued with adverse consequences for the balance of payment. However, in order to arrest these imbalances in the economy, Nigeria adopted a comprehensive macro-economic reform programme the Structural Adjustment Programme (SAP). The major objective of SAP adopted in 1986 emphasized deregulation of the economy. For example the market determined exchange rate, adopted a realistic exchange rate policy and the liberalization of trade and payment. Just after the inception of SAP, the Second-Tier Foreign Exchange Market (SFEM) was introduced in September, 1986, the same year to correct the over-valuation of naira and to achieve a realistic exchange rate through the interplay of market force as well as the deregulation and liberalization of exchange rate and trade control. As a result of the persistent decline of foreign exchange rate, the Dutch auction was introduced in 1987, various measures have been undertaken to enhance the efficiency of foreign exchange management. Though, there has been a significant increase in real output growth but there was relatively constant and/or negative development.
Foreign exchange rate, inflation rate, money supply and money demand and so on as a strong economic tool to achieve the desired economic goals, if it is efficiently and appropriately determined. To be successful as a policy instrument, the exchange rate must be provided sufficient incentive to exports and the production of level substitutes for import on the other hand it must provide sufficient disincentive to import and capital flight. According to Owolabi, to achieve these aims, monetary authorities must strive to achieve realistic and fairly stable. Exchange rate for their national currencies so that the rate may serve as an efficient resource allocation instrument.
The purpose of this study is the reviews of how Nigeria determines its exchange rate (foreign exchange rate) and in doing so one finds it compelling and hopefully rewarding to take a general look at exchange rate.

Although, there has been rapid integration of world and thus many countries have been benefiting from increased cross-border trade investment over the past two decades, growth or economic growth in Nigeria has been abysmally (extremely bad or very low standard) (Onwuka and Eguavoen, 2007). Central to this poor growth performance in the low level of investment, attracting investment is imperative from a number of standpoints. First, the savings and foreign exchange gaps that exist would be reduced or closed due to the inflow of foreign exchange earning/resources.
Secondly, investment levels necessary for growth will be attained and thirdly; import-substituting investment exchange resources. As we recall, exchange rate refers to price of one currency (the domestic currency) in relation to another currency (the foreign currency) in which the US dollar is often used as yardsticks. Nigeria has witnessed various exchange rate movements both in the pre-SAP (fixed exchange rate regime) and the post-SAP (floating exchange rate regime) periods and various problems associated with these regimes. The fixed exchange rate induces an over-valuation of the naira and was supported by exchange control regulation that engendered significant distortion in the economy and gave rise to the massive importation of finished goods, consequent upon domestic production balance of payment, position and the external reserve level of the nation in addition, the period was characterized by sharp practices perpetrated by dealers and end-users of foreign exchange. These problems informed the adoption of a more flexible exchange rate regime since 1986. Nigeria is still witnessing the persistent problems of import dependence, capital flight and lack of motivation for backward linkage in the production process; all need to be addressed among others (Sanusi, 2004). Some factors, which affect the exchange rate in Nigeria, shall be looked at, such factor includes international firm of trade, net capital inflow, monetary policy variables and it is against the background that FDI is reviewed.

The objectives of this study are as follows:
To identify the determinants of exchange rate in Nigeria, especially Gross Domestic Product (GDP), international reserve, balance of payment position inflation rate, interest rate movement, external debt position;
To evaluate the forecasting capability of the model derived.

The hypotheses of the study are as follows:
High external reserves lead to the appreciation of the naira exchange rate in Nigeria.
There is a significant positive relationship between output growth in Nigeria GDP and exchange rate.
Foreign Direct Investment (FDI) impacts positively on the capital market, an increase in foreign direct investment brings about a resultant change or increase in market capital.

1. Exchange rate is a key macro economic variable for economic policy making, therefore, this project will be of importance to government for its economic reform programmes.
2. This will also assist the Central Bank of Nigeria, on the need to pursue a stable exchange rate objective as an essential element of its monetary policy.
3. Finally, it is expected that this study will assist financial authorities and other bodies for decision making and planning activities, such as, production planning, inventory control, advertising and import planning and budgeting.

The study shall basically be from 1980-2008. The choice of this period reflects some years of administratively determined exchange rate or fixed exchange rate. The pre-SAP period, SFEM period and the period of totally deregulate exchange rate. Also, the choice of this period gives a clear picture of analyzing and evaluating the effect of exchange rate to some important economic variable. It will also cover a few years before 1980, for better understanding. This is because, before the 1970s, there was a restrictive monetary policy, which affected money supply because people’s incomes were being curtailed by a compulsory savings directive, as a means of financing the civil war. After the civil war (1970), there was an expansionary pressure on the supply of money as a result of the rapid growth in expenditure, financed by the monetization of the petrol-naira exchange revenue.

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