Our Blog

List of recently published project topics and materials

PROJECT TOPIC – THE EFFICACY OF CENTRAL BANK INTERVENTION ON THE FOREIGN EXCHANGE MARKET IN NIGERIA

THE EFFICACY OF CENTRAL BANK INTERVENTION ON THE FOREIGN EXCHANGE MARKET IN NIGERIA

 

Abstract

This paper empirically investigated the efficacy of Central Bank intervention on the Foreign Exchange Market in Nigeria. The study utilized a probit model to ascertain the determinants of Central Bank intervention in the foreign exchange market. This model was divided into two parts. The first part was a probit model of determinants of positive intervention and the second is a probit model of negative intervention (these models were used to capture objective one). As a result of this, six regressions were run using the Ordinary Least Squares (OLS) method of estimation. This was to show that in the presence of heteroskedasticity and/or auto correlation,results of the OLS estimates may sometimes be biased and inconsistent. Consequently, to allow
for comparison, the analyses concentrated on the Two Stage Least Squares Generalized Method of Moment (for long run analysis) and Error Correction Model (for short run analysis).

The empirical evidence show that in the long run, Central Bank of Nigeria (CBN) intervention in foreign exchange market is significantly not determined by inflation but, by other variables such as: real exchange rate, real gross domestic product, and standard exchange rate. However, in the short run, it was found that last year’s foreign exchange supplies by the CBN, last two year’s foreign exchange supplies by the CBN, both last year’s and last two year’s exchange rate, and last two year’s inflation rate insignificantly determine Central Bank of Nigeria intervention in foreign exchange market while, last year’s inflation, both last year’s and last two year’s real gross domestic product, the Error Correction Mechanism, and the constant term are significant determinants of Central Bank of Nigeria intervention in foreign exchange market.

On the second methodology which was applied to examine the effectiveness of CBN intervention on exchange rate volatility (i.e objective two), OLS, robust OLS, and Two-Stage Least Squares Generalized Method of Moment were adopted. These regressions were run to also compare the results of the
estimates of OLS in the presence of heteroskedasticity and/or autocorrelation. However, to enable for comparison, the analyses concentrated on the robust OLS and the Two-Stage Least Squares Generalized Method of Moment. Consequently, the results of these models suggest that all the variables, except the constant term in regressions (2), are significant determinants of exchange rate volatility. Therefore, for CBN intervention policies to be efficacious in the
achievement of foreign exchange rate stability, it must recognize the importance of the supply channel of foreign exchange rate linkage and subsequently adopt heterodox policies while trying to intervene.

This requires the reliance on the growth of money supply and credit to manage money supply, while avoiding high interest rates policy due to its deleterious implications on production cost and the competitiveness of the emerging product globally. Finally, inflation should also be stabilized and monitored very closely by the CBN since the study showed that an increase in it increases the volatility of exchange rate.

However, in the short run, it was found that last year’s foreign exchange supplies by the CBN, last two year’s foreign exchange supplies by the CBN, both last year’s and last two year’s exchange rate, and last two year’s inflation rate insignificantly determine Central Bank of Nigeria intervention in foreign exchange market while, last year’s inflation, both last year’s and last two year’s real gross domestic product, the Error Correction Mechanism, and the constant term are significant determinants of Central Bank of Nigeria intervention in foreign exchange market. On the second methodology which was applied to examine the effectiveness of CBN intervention on exchange rate volatility (i.e objective two), OLS, robust OLS, and Two-Stage Least Squares Generalized Method of Moment were adopted.

These regressions were run to also compare the results of the estimates of OLS in the presence of heteroskedasticity and/or autocorrelation. However, to
enable for comparison, the analyses concentrated on the robust OLS and the Two-Stage Least Squares Generalized Method of Moment. Consequently, the results of these models suggest that all the variables, except the constant term in regressions (2), are significant determinants of exchange rate volatility. Therefore, for CBN intervention policies to be efficacious in the achievement of foreign exchange rate stability, it must recognize the importance of the supply channel of foreign exchange rate linkage and subsequently adopt heterodox policies while trying to intervene. This requires the reliance on the growth of money supply and credit to manage money supply, while avoiding high interest rates policy due to its deleterious implications on production cost and the competitiveness of the emerging product globally.

Finally, inflation should also be stabilized and monitored very closely by the CBN since the study showed that an increase in it increases the volatility of exchange rate. of the economy to attain optimal productive capacity (Ogiogo, 1996). The Central Bank of Nigeria purchases or sales of a foreign currency change the domestic monetary base, without additional market transactions such actions would change interest rates, exchange rates and ultimately prices of goods and services.(Ajayi,1988.)Since 1986 when the exchange rate was floated in Nigeria, the Central Bank of Nigeria (CBN) has
periodically intervened in the foreign exchange market. As part of the International Monetary Fund (IMF) conditions under the structural adjustment package, the CBN has also intervened in the form of foreign exchange purchases in order to accumulate foreign reserves for the government. Intervention entails buying and selling of a foreign currency against the local currency (Naira) based on market conditions.

Its operations usually check the stability of the foreign exchange rate market (Rankin, 1998). The issue of whether these interventions affect the exchange rate and how this happens has important implications for policy and has been a subject of much debate in the literature (Simatele, 2004). Distinguishing between sterilized and non-sterilized intervention is very important. On the one hand, there is general agreement that non-sterilized intervention can affect the exchange rate through its effect on money supply. On the other hand, the effectiveness of sterilized intervention is still controversial
(Danker et al., 1996; Lewis, 1988b; Humpage, 1989; Baillie and Humpage, 1994; Dominguez, 1998). The question of the effects of interventions on the exchange rate in Nigeria has both research and policy interest. Research interest because very few of such studies have been done on Africa and only one such study (for example, Simatele, 2004) exists. It is of policy interest because, if sterilized intervention has an effect on the exchange rate in Nigeria, this offers the monetary authority an additional policy tool independent from general monetary policy. In an open economy, once the exchange rate is floated, it
becomes an important component in the transmission mechanism.

The more open the economy, the greater the importance of the exchange rate in the policy process and the more important this variable becomes as an optional policy conduit. However, the figure below shows the supply of foreign exchange in Nigeria by the Central Bank of Nigeria (CBN). From the graph above, it can be seen that between 1996 and 2010, supply of foreign exchange rate (SFEX) by the CBN in Nigeria were not relatively stable because of the managed float that characterised the period. Noteworthy here is that exchange rate fluctuations in Nigeria usually affect the equilibrium
position of the money supply. For instance, when exchange rate is depreciated, inflation rate is increased and vice versa. For this reason, the stability of the exchange rate is very important for price stabilization. To ensure this, most Central Banks intervene in foreign exchange markets to smooth out short run
fluctuations of the exchange rate. However, the effects of Central Bank intervention in the foreign exchange market are not straightforward. The efficiency of the foreign exchange market matters coupled with the nature and credibility of the interventions. The effect of such interventions, therefore, is an
empirical question, which this paper attempts to address.

The interest in this paper is to determine whether foreign exchange intervention has an effect on exchange rates in Nigeria (the exchange rate in this study will be defined as the number of naira per unit of foreign exchange). We would like to determine whether or not intervention in Nigeria is indeed sterilized. This is of importance because stabilization policy in Nigeria is based on the control of money supply with M2 as an intermediate target and base money as the policy instrument. Policy implementation is conducted by minimizing deviations of M2 from target. If intervention is not sterilized, then interventions are likely to affect money supply growth and this becomes a part of monetary policy issues. Hence, this study will investigate whether or not intervention by the Central Bank of Nigeria (CBN) in the Nigerian foreign exchange market has been very effective in stabilizing the Naira exchange rate.

THE EFFICACY OF CENTRAL BANK INTERVENTION ON THE FOREIGN EXCHANGE MARKET IN NIGERIA

 

 

1.2 Statement of the Problem

Central Bank of Nigeria (CBN) intervenes in the foreign exchange market in order to achieve a variety of economic objectives. The main reason being to target the level of foreign exchange rates, dampen exchange rate volatility or influence the amount of foreign reserves (Moreno, 2005). The CBN has also
intervened in the form of foreign exchange purchases in order to accumulate foreign reserves for the government. In the past there was exchange rate depreciation which was not properly coordinated and harmonized in order to achieve a good macroeconomic stability in Nigeria. The issue of whether these interventions affect the exchange rate and how this happens has important implications for policy and has been a subject of much debate in the literature Adebayo, 2007). Evidence of the effectiveness of intervention is generally mixed (Sarno and Taylor, 2001) but unsuccessful intervention is costly. There are several significant reasons why officials have to target the level of foreign exchange rates. Firstly, Central Banks target foreign exchange rates to achieve external balance or enhance competitiveness and boost growth.

The foreign exchange rate targets have been used to prevent exchange rate misalignment and achieve external equilibrium. According to Marshall (1923), Lerner (1944) and Stern (1973), this equilibrium obtained by using depreciation is weak and depends on the elasticity of exports and imports demand and offer. From time to time, the goal has been to prevent real exchange rate appreciation and large current account deficits, and finally the officials target the level of exchange rate to prevent a crisis. The second motive for Central Bank operations in the foreign exchange market is to influence the
level of foreign exchange rate (Sack and McNeil, 2011). While some countries try to accumulate the reserves, others sought to reduce the. Three considerations guiding the policy are exchange rate impact, market friendliness, and costs and benefits. In contrast to other goals of Central Banks’ participation in the foreign exchange market which mainly focuses on maximizing the exchange rate impact, Central Banks’ goal in influencing the amount of reserves is to minimize the impact on exchange rates.

In addition, Central Banks’ policies to adjust foreign reserves have to be market friendly as government market operation can impair foreign exchange market development. The size of Central Bank presence in the foreign exchange market can discourage private sector participation and price discovery.
In Nigeria, Yaqub (2010) observed that Exchange rate policy has been identified as one of the endogenous factors that can affect the economic performance of a nation. In light of this perception, the Nigerian authority tried both the fixed and the market based exchange rate regimes so as to attain a
realistic exchange rate that would ensure efficient allocation of foreign exchange rates and pave way for a non-inflationary growth. Despite the change from one regime to another, the economic performance of Nigeria was still epileptic. Omolara (2010) observed the trends and variations in the exchange rate particularly within the Structural Adjustment Programme (SAP) periods and post-SAP periods. It was clear from the study that the

THE EFFICACY OF CENTRAL BANK INTERVENTION ON THE FOREIGN EXCHANGE MARKET IN NIGERIA

Was the material helpful? Comment below. Need the material? Call 08060755653.