PROJECT TOPIC- CAUSAL RELATIONSHIP BETWEEN FOREIGN EXCHANGE MARKET OPERATIONS AND INTERNATIONAL LIQUIDITY IN NIGERIA
This study sought to ascertain the causality relationship existing between the foreign market (FEM) operations and international liquidity in Nigeria and the direction of causality using data for the period 1970-2014. Despite the astronomical increase in the rate of international trade and investments which has with it inherent payment deficits that must be financed with international liquidity (through the foreign exchange market), there appears to be little corresponding increase in international liquidity (InLq) to finance such international deficits and payments. There also appears to be a continuous mismatch between the foreign exchange supply and demand which tends to make the foreign exchange market illiquid thus hindering it in facilitating and driving international liquidity. There is also an unstable and volatile rate of exchange. The data were collected through secondary sources. Most descriptive statistics parameters indicated evidence of relationship among the variables, although were subjected to further statistical test. The Augmented Dickey Fuller (ADF) unit root test (URT) procedure, co integration tests and the Granger Pairwise causality tests (error correction model ECM) were then performed. The results indicate that Foreign Exchange market operations Granger cause international liquidity; there is a causal relationship between Foreign Exchange supply (FxS) and international liquidity; there is a causal relationship between Foreign Exchange demand (FxD) and international liquidity; there is no causal relationship between foreign exchange mismatch (FxM) and international liquidity, there is causal relationship between exchange rate (ExR) and international liquidity. This implies that the FEM’s operations of foreign exchange demand and supply has stimulated international liquidity since it has remained a very liquid international money market as the inherent distortions by government interference has been reduced due through deregulation of the economy. On the other hand, the mismatch between FxS and FxD and exchange rate has not stimulated international liquidity, hence the operations of the FEM has not fully impacted on the economy as there is still unstable rate of exchange. International liquidity has not stimulated the FxS and ExR due to persistent huge imbalances in the demand and supply of liquidity, since shortage of international liquidity leads to global recession while its surplus culminates in inflationary trend and persistent BOP disequilibrium. The study suggests a two-fold policy recommendation. The first includes that the operations of FEM should be left to the vagaries of the market forces of demand and supply in order to minimize market distortions and continuous monitoring of the exchange rate to detect the extent of deviation between foreign exchange demand and foreign exchange supply. The second is the diversification of the economy from mono product economy to multi product economy to cushion the shock from possible price fall of the mono product in the global market and bridge the inequality between demand and supply of foreign exchange. The economy should be geared towards the path of export- oriented and import- substitution strategy of goods and service since the recent practice of excessive importation may in the nearest future worsen the balance of payments (BOP) position and further inhibit the finance of such deficits through international liquidity.
- Background of the Study
Foreign exchange market (FEM) as an aspect of financial institutions is the major activity sector of the international money market (IMM). Anyanwu (1993) defines FEM as an international market in which national currencies are bought and sold against one another. It is a market in which foreign exchange transactions and dealings are made which, in the absence of controls, determine the rate of exchange of one currency with another.
Foreign exchange according to Fabunmi (1990) is the means of payment or instrument of short-term credits for various countries with different monetary units from the point of view of their purchase or sale against the national money, or that of their holding as reserves. FEM is a mechanism that facilitates and clears effects (that is, acts as a clearing house) among currencies to facilitate international trade and payments among countries.
FEM’s operations are the interactions, activities, actions and totality of transactions in the foreign exchange (forex) market. It is the buying and selling of foreign exchange. It involves demand and supply of foreign exchange (operational inputs), foreign exchange mismatch and exchange rate (operational output). These are expected to drive international liquidity while international liquidity is also expected to drive the operations of the FEM.
Since the operations of the FEM entails clearing effects among currencies, international liquidity (that is, the. stock of assets which are internationally acceptable in the settlement of international debts) is also affected. So development in the operations of the FEM is expected to bring about improved international liquidity position. International liquidity according to CBN (2008) represents the stock of internationally acceptable assets held by regulatory authorities (including IMF) for the purpose of both financing payments and manipulating exchange rates, and thus is generally acceptable internationally as a medium of exchange.
The components of international liquidity according to Anyanwu (1993) are Gold, Foreign currency (including Euro-currencies), International Monetary Fund (IMF) credits and borrowing (including Euro credit and Euro loan), and Special Drawing Rights (SDRs). In the domestic economy, international liquidity is the narrow money aspect of money supply (MS). It is a major contributor of economic growth and development.
It is argued that international liquidity by intervening in the FEM should drive exchange rate, finance foreign trade, investments and balance of payments deficits. Thus international liquidity stock is to drive or stimulate the operations of the foreign exchange market. The seemingly established relationship between international liquidity and foreign exchange market (FEM) operations is that balance of payments (BOP) deficits, international trade and investments payments are financed through international liquidity and is facilitated by the FEM.
It is pertinent to note that for the FEM to drive international liquidity, it must be liquid, however, Nirav (2012) observes that the mismatch between the components of the operations of the foreign exchange (foreign exchange supply FxS and foreign exchange demand FxD) makes the FEM illiquid. Equally, it appears that the persistent huge BOP deficits has depleted international liquidity stock and so hampers it to be a driving force to improved operations of the FEM.
Presently, the country is under serious economic challenges occasioned by global fall in prices of crude oil. The economy is under threat,.vulnerable and volatile in view of dwindling government revenue and foreign exchange earnings. Exchange rate volatility, inflation, fall in the value of the domestic currency, has exerted much pressure on the little foreign exchange available. In such a precarious economic circumstance, international liquidity should provide a succor as a buffer to intervene in the FEM to safeguard the domestic currency, bring exchange rate stability, finance balance of payments disequilibrium and international payments.
In a typical market economy, the forces of demand and supply determine prices. This is re-echoed in the Economic Theory. Therefore, the operations of the FEM entail demand and supply of foreign exchange. These two variables are thus the components of the operations of the FEM. FEM can be seen as a clearing house through which purchase and sale of foreign exchange are offset against each other.
Hence, operations of the FEM involve supply of foreign exchange and demand for foreign exchange and are the input variables while the output variables are the foreign exchange mismatch and exchange rate. Foreign exchange supply (FxS) is the aggregate domestic currency available for foreigners to exchange for their own currency. The supply of foreign currency arises from the credit side of the Balance of Payments (BoP) and according to Central Bank of Nigeria (CBN) (2011) is equal to payments made by the foreign countries to our country for goods and services imported from our country plus loans disbursed and investment made in this country. Increased FxS leads to increase in the international liquidity position
Foreign exchange demand (FxD) is the foreign currencies available for exchange by the indigenes. The demand of foreign exchange arises from the debit side of the BoP, it is equal to the value of payment made to foreign countries for goods and services purchased from it plus loans and investments made abroad. Increased FxD leads to depletion in the international liquidity position
There is equilibrium exchange rate where FxD is equal to FxS. However, this is not always the case. There is always a mismatch between them as observed by Nirav (2012). This may be positive or negative if FxS is greater than FxD and vice versa. Positive foreign exchange mismatch is synonymous with increased international liquidity while negative mismatch depletes it. The exchange rate is determined by the FxS and FxD.
This is further affirmed in the Balance of payments theory. International liquidity is used to intervene in the FEM to support the domestic currency and strengthen the exchange rate. From the above, it is obvious that FEM’s operations should drive international liquidity and international liquidity should influence FEM’ operations but the direction of causality is yet unresolved. Therefore, ascertaining the direction of causality between the operations of FEM and international liquidity in Nigeria is vital because of its significant implication for Balance of payments deficits financing.
The search for the causal relationships and interactions between FEM’s operations and international liquidity are important to the monetary authorities in initiating and implementing policy framework for stabilizing the exchange rate. Determination of both causal relationships and the interactions among them are useful to the minimization or even eliminating the mismatch between FxS and FxD.
However, the causality may be hindered. The escalating increase in the international trade and investment no doubt brings with it persistent payments imbalances that must be financed by international liquidity. There is slow growth in gold reserves in relation to the rapid growth in international trade and investments. The Bank for International Settlement (BIS) (2014) asserts that taken the gold and foreign exchange together, the reserves of monetary authorities (nations’ central banks) with the International Monetary Fund (IMF) has been growing at 2% to 3% per annum while trade between them has been growing twice as fast.
Consequently, international liquidity position of the world is deteriorating. Nigeria is not an exception. This poses some worry on the possibility of the international liquidity to drive the FEM and calls for investigation. The rate of international trade and investments has been on astronomical increase over the years. This has with it associated payment imbalances (deficit) which must be financed with international liquidity and there appears to be little corresponding increase in assets to finance such international payments. This is heightened in the face of a mismatch and inequality between the FxS and FxD (which tends to make the FEM illiquid) resulting to a volatile exchange rate.
PROJECT TOPIC- CAUSAL RELATIONSHIP BETWEEN FOREIGN EXCHANGE MARKET OPERATIONS AND INTERNATIONAL LIQUIDITY IN NIGERIA
1.2 Statement of the Problem
International liquidity is used to intervene in the FEM to safeguard the domestic currency, bring exchange rate stability, finance balance of payments disequilibrium and international payments thereby is expected to drive the operations of the FEM. Nigeria is a mono-product export (crude oil), import-oriented, and consumer based economy. The recent global glut in oil prices is unleashing devastating effects on the economy presently.
The dwindling government revenues and foreign exchange earnings, increasing foreign exchange demand has led to fall in the value of the domestic currency, macroeconomic variables instability bringing the economy to near brink of collapse. International liquidity is expected to provide a buffer and drive the operations of the FEM. Yet, international liquidity position appears to be inadequate.
This tends to hinder international liquidity to drive the operations of the FEM. Also the FEM’s operations should facilitate international liquidity as it is the most liquid money market. However, there appears to be a continuous mismatch and inequality between the quantity of foreign exchange supply and demand which tends to make the FEM illiquid thus hindering it in facilitating and driving international liquidity.
Therefore the following problems are identified- decreasing foreign exchange supply and increasing foreign exchange demand (which may have led to BOP deficits, international payments deficits), – mismatch between the foreign exchange supply and demand (foreign exchange market illiquidity), exchange rate instability, international liquidity position inadequacy. Therefore, to ascertain the direction of causality between the operations of the FEM and international liquidity in Nigeria calls for investigation. This study addresses this problem.
1.3 Objectives of the Study
The major objective of the study is-
(i) To ascertain the causal relationship between Foreign Exchange Market (FEM) operations and international liquidity in Nigeria.
Specific objectives of the study include-
(i) To ascertain the causal relationship between of foreign exchange supply and international liquidity
(ii) To ascertain the causal relationship between of foreign exchange demand and international liquidity
(iii) To ascertain the causal relationship between foreign exchange mismatch and international liquidity
(iv) To ascertain the causal relationship between foreign exchange rate and international liquidity
1.4 Research Hypothesis
To address the inherent problems indentified above, bearing in mind the objectives of the study, the following hypotheses are formulated-
Ho: 1 There is no causal relationship between quantity of foreign exchange supply and international liquidity.
HA: 1 There is causal relationship between quantity of foreign exchange supply and international liquidity.
Ho:2 There is no causal relationship between quantity of foreign exchange demand and international liquidity.
HA: 2 There is causal relationship between quantity of foreign exchange demand and international liquidity.
Ho: 3 There is no causal relationship between of foreign exchange mismatch and international liquidity
HA: 3 There is causal relationship between foreign exchange mismatch and international liquidity.
Ho: 4 There is no causal relationship between foreign exchange rate and international liquidity
HA: 4 There is causal relationship between foreign exchange rate and international liquidity.
1.5 Significance of the Study
The FEM by facilitating the international transactions enables the country to tap the benefits inherent in international trade. The direction of causality between the operations of FEM and international liquidity is vital because of its significant implication for balance of payments adjustment, development policy and exchange rate stability. Hence the business community (local and international) will benefit from the findings of the study.
Future researchers in the field of finance and related areas will also find the study of immense benefit. The study also will be significant to the government for policy formulation and implementation. The study will be relevant to the business community, researchers and the government. The business community- domestic and foreign business entrepreneurs (exporters , importers, foreign investors and lenders, hedgers, arbitrageurs, foreign exchange participants, etc) will benefit from this research.
By knowing the driving force behind the market forces and international money and liquidity in the country, these group of people will position their business projections and interactions towards their profit maximization. This no doubt will positively impact on the Nigerian economy.
Researchers – the outcome of this study will no doubt provoke thoughts and inquiries that will stimulate further investigations on such other topical issues as the unofficial market activities, foreign exchange market regimes etc. Therefore, the findings of this study will be a basis and referral focal point for researchers interested in the above-mentioned areas of interest.
The Government – one of the most important objectives of international trade policy is to achieve sustained output growth. Formation of effective BOP deficit and other international payments financing requires an examination of underlying relationship among the FEM’s operations and international money. The growing complexities of monetary management, in the context of recent global economic crisis, require that the process of policy formulation should be based on ascertaining the driving force between international market forces of demand and supply and quantum of assets for such financing.
The transmission of the global financial crisis to Nigeria has clearly demonstrated that the country has become integrated into the global business cycle. In the face of deteriorating domestic and external liquidity orchestrated by global mono product price glut and global economic recession, the policy makers and the government will benefit from this study in an effort to chart a way forward for sustainable foreign exchange market and international liquidity policy initiation and implementation.
1.6 Scope of the Study
The study ascertains the causality relationship between the foreign market (FEM) operations and international liquidity in Nigeria using data spanning from 1970 to 2014. The study covers the activities and operations of the official foreign exchange market. The operations and activities of the unofficial foreign exchange market were not captured due to unavailability and unreliability of such data. The research is an ex post facto or causal comparative hence the manifestations has already occurred and inherently not manipulated. In other words, variables are studied in retrospect for seeking possible and plausible relations and the likely effects that the changes in independent variables produce on a single or a set of dependent variables. Therefore the variables could not be scaled nor be measured by any other rate.
1.7 Limitations of the study
Research in an undeveloped and developing economy and polity is usually hampered by some problems and limitations. Infrastructural dearth and where available, is grossly insufficient, remains a clog in the wheel of research progress. Data and information needed at one time or the other may not be readily available or insufficient.
Despite these limitations, efforts were made to retrieve updated in data and information through internet sources, while available resources and infrastructure were prudently utilized.