Impact of exchange rate changes on the import demand in Nigeria

CHAPTER ONE

INTRODUCTION

1.1   Background of the Study

       Since the adoption of the floating exchange system in the early 1970s, there has been an extensive debate about the impact of exchange rate changes on international trade. The theoretical literature shows that the effect maybe positive or negative. However, despite a large body of literature, few papers provide statistically convincing evidence on whether exchange rate changes affects trade flows between countries.

   There are several channels through which exchange rate volatility could affect the trade flows. First, if traders are risk averse, they could reduce their activities due to exchange rate uncertainty in order to avoid any loss. Second, exchange rate uncertainty could directly affect the trade volume by making prices and profits uncertain, especially in countries where forward markets do not exist such as the developing world. Even if forward markets do exist in some industrial countries, some studies indicate that forward markets are not very effective in completely eliminating exchange rate uncertainty (Akhtar and Hilton, 1984).

     Third, if exchange rate changes persist over a longer period of time, it could induce domestic producers to switch buying from foreign sources to domestic sources, reducing the volume of imports, especially traded inputs. Finally, exchange rate changes could also affect direct foreign investment decisions which in turn could lower the volume of import.      In Nigeria exchange rate management has undergone significant changes over the past for decades. In the 1960’s, Nigeria operated a fixed exchange rate regime. The currency was fixed at par with British bounds and it lasted till 1976 when the British pound was devalued. Owing to civil war in 1967, the monetary authority did not consider it expedient to devalue the Nigerian pounds in alongside the British pound when the British authorities devalued the pounds following international financial crisis of early 1970’s which led to the devaluation of the United states of America dollar. Nigeria abandoned the dollar peg and once again kept faith with the British pounds until 1973, when the Nigerian currency was once again pegged to the United States of America dollar. With this development, the severe draw back in pegging the Nigerian currency became obvious. A clear case was that the naira led to undergo de-facto devaluation in sympathy with the dollar when the economic fundamental dictated otherwise (e-g external reserve raise rapidly by 1000% from N10m in 1973 to N3.4 Billion in 1975).

        It was against this backdrop that the need to independently manage the exchange rate of the naira was firmly established. Hence, in 1978, the monetary authorities pegged the Naira to a basket of 12 currencies of her major trading partners. However the sharp fall in international oil price and consequent decline in foreign exchange receipts were such that the economy could not meet its international financial commitments, persistent increase in imports coupled with declining external reserve position severely compromised credit worthiness of the country abroad. To mitigate this development, the stabilization act of 1982 was implemented which led to accelerated depreciation of the Naira. However, the overvaluation of the exchange rate still persisted as the rate continued to be fixed administratively. The failure of stabilization Act to address the economic problem (unpaid trade bills and accumulation of payment of arrears consequent on the sharp fall in the oil price) led to the adoption of the structural adjustment program (SAP) in 1986, aimed amongst others at the realization of a viable and reliable exchange rate through a flexible arrangement.

        The flexible exchange rate regime produced a significant uncertainty in the exchange rate of the naira which account for fluctuation in the import bills. This arouse a great concern as exchange rate changes which sterns from shock in the financial markets, level of output, income amongst others yield conflicting result about its impact on trade. Arize, (1998). The international monetary fund (IMF) 1984 study argued that exchange rate variability tends to induce macroeconomic phenomena that are undesirable like inflation and balance of payment problems. For instance, if exchange rate changes lead to increased imports, trade adjustment program that discourages import expansion could be unsuccessful. In addition, the intended effect of trade liberalization policy may be doomed by a variable exchange rate and could precipitate a balance of payment crisis (Arize 1998).

        The problem of exchange rates are not unknown to government and for this, policies (monetary, fiscal and trade policies) have been formulated over time. Similar studies have also been carried out like Aliyu, (2009), Akpan, (2008), Oganleye, (2008), Obiora and Igwe, (2006). Aliyu(2009) for instance studied the impact of oil price stock and exchange rate volatility on economic growth in Nigeria, Obiora and Igwe (2006) investigated the likely effect of exchange rate changes and foreign direct investment in Nigeria. While Adubi and Okumadewa evaluated the nature and extent of price and exchange rate volatility on agriculture trade flows, despite these efforts changes in exchange rate still persist. Therefore, this study seeks to examine the impact of exchange rate changes on the demand for imports in Nigeria.

1.2   Statement of the Problem

The statement on exchange rate variability and changes has long divided economists. At one end, the argument supports the fiscal exchange rate, while the other, the floating system. These arguments stern from dissatisfaction with either regime. After several years of exchange rate floating among countries there is yet to emerge a consensus among academics economist regarding the impact or exchange rate changes on economic variables like imports. The traditional view is that changes in exchange rate affect domestic and foreign pricing causing expenditure shift between domestic and foreign goods (Obstfeld, 2002). The new view is that the relative prices are not much affected by exchange rate changes in the short run (Obstfeld, 2002 and Engel, 2002).

        In contrast to the debate among academic economists, business people appear convinced that exchange rate changes have real effect. Executives, especially of import firms, agonize over decline of imports when their home currency depreciates in nominal terms.

        However, apart from the aforementioned debate, there is little systematic research to the knowledge examining whether exchange rate affect Nigeria import demand. This study fills the gap by examining the impact of exchange rate changes on the import demand in Nigeria.

1.3   Research Question

  1. To determine if exchange rate changes has any significant impact on import demand in Nigeria?
  2. To identify if there is any long run relationship between exchange rate changes and import demand in Nigeria?
  3. To ascertain if there exist any causal relationship between exchange rate changes and import demand in Nigeria?

1.4   Objectives of the Study

The broad objective of this study is to examine the impact of exchange rate changes on the demand in Nigeria. Specifically, the study aims to;

  1. Examine the significant impact of exchange rate changes on import demand in Nigeria.
  2. Determine the long run relationship between exchange rate changes and import demand in Nigeria.
  3. Evaluate the relationship between exchange rate changes and import demand in Nigeria.

1.5   Hypothesis of the Study

H0:    There is no significant impact of exchange on import demand in Nigeria.

H0:    There is no long run relationship between exchange rate changes and import demand in Nigeria.

H0:    There is no causal relationship between exchange rate changes and import demand in Nigeria.

1.6   Significance of the Study

The significance of this study lies in the fact that if the cause of the unstable nature of the exchange of the naira is identified and corrected, the balance of trade of the country will tend to be favourable, leading to the rapid growth and development of the economy. Importantly, this study would help the government and the Central Bank of Nigeria to identify the strength and weakness of each foreign exchange system and hence adopt the policy that suits the economy best. This will definitely lead to a favourable balance of trade. This study will also serve as a guide to future researchers on this subject.

1.7   Scope of the Study

The scope of the study is designed to cover Nigeria’s exchange rate policies for the period of thirty-one years (1981-2012). The general over view of the profile of Nigeria’s exchange rate over the years shall also be discussed.

1.8   Limitation of the Study

The empirical investigation of the impact of exchange rate on Nigeria’s import demand is limited to the period between 1981 and 2012, a period of thirty one years.

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