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1.1 Background to the Study

A country’s foreign exchange policy is derived from the perceived overall economic objectives to be achieved and the expected direction of growth. Consequently, non-conflicting sectored policies are conceived within the ambit of the overall policy framework such that, the sectored policies reinforce each other. While the stated objectives of foreign exchange policy continued to be the achievement of a healthy balance of payment position and the attainment of a realistic and sustainable exchange rate for the economy.

Exchange rates and a foreign exchange market exist because different countries use different currencies to pay for internal trade. The movement of goods and services across national frontiers in one direction involves the movement of foreign exchange in the opposite direction.  This creates the need for a rate of exchange between the currencies of two trading partners to settle indebtedness arising from trade involving them (Nzotta, 2004).

Exchange rate is a price at which a currency is regulated in the market, which varies at one time or the other. Powell (1991), defines exchange rate as the external price of a country’s currency, expressed in terms of an artificial unit such as the U.S. dollar, or gold, or indeed in terms of an artificial unit such as a weighted average of a sample or basket of leading trade currencies. Simply put, exchange rate is the number of units of one country’s currency that can be exchanged for a unit of that of another.

In macroeconomics modeling exchange rate is commonly endogenised in developing countries. This arises from the historical exchange rate control prevalent in these economies. Similarly, in the modeling of exchange rate, researchers are faced with some challenges which include the extent to which exchange rate movement is explained by economic variables; the focus of the time series property of exchange rate and the behavior of economic agents operating in the market (Devereux, 1997; and Aron, 1997).

Basdevant  (2000), revealed that exchange rate movement in Russia was explained by expectations and interest rate differentials; while modeling of exchange rate in Kenya was in line with uncovered interest rate parity condition with the possibility of over-shooting (Geda, 2001). Some factors which cause variations in the exchange rate are government policy, interaction of demand and supply, activities of the Nigerian Stock Exchange (NSE), international trade oil glut and recession.

In  the  70s  and  80s,  agricultural  products  like  cocoa,  palm  oil,  groundnut,  rubber  etc  contributed majorly to the foreign earnings in Nigeria. However, there were inadequacies in the exchange control system as a major control mechanism. This led to the introduction of the Second-Tier Foreign Exchange Market (SFEM) in 1986. The SFEM was a market established by law for the buying and selling of foreign exchange at market determined rates.

According to Adekanye (2010), the objectives of the  SFEM  was  to  evolve a realistic market-oriented exchange rate for the naira, so as to reduce the demand for foreign exchange to the available supply, reduce the pressures on the balance of payments in order to stop  further  accumulation  of  trade  debts,  reduce  imports, stimulate export and pave the way to a self-reliant and sustainable growth. The dividing foreign exchange earnings, according to Obadan (2006), has been as a result of some factors like weak capital market, poor  management of diversified  risk and weakness on the part of Bureau De Change in earning a stable and efficient exchange rate in the Nigerian economy.

The external sector on the other hand, mirrors the relative strength of a country’s economy vis-à-vis her trading partner’s economies through the financial transactions between the residents and the rest of the world (CBN, 1999). Nigeria’s external sector reflects the economic transactions between the residents of Nigeria and the rest of the world. The sector can be in equilibrium or disequilibrium (surplus or deficit).

A deficit outcome represents a situation where receipts are inadequate to accommodate the payments, while a surplus position reflects a situation where receipts are in excess of the payments. An ideal external sector is one that is stable and in equilibrium over time. Equilibrium is achieved when external receipts and payments are equal, the exchange rate is stable and external reserves are adequate. However, in more practical terms, such a perfect system hardly exists.

Analysis of external sector of the Nigerian economy as measured by the overall balance of payments revealed instability since 1960 due to persistent high demand for foreign goods and services in the face of dwindling foreign exchange earnings. Structurally, the sector, which had been dominated largely by crude oil export remain unaltered for over three decades. The sector was dominated largely with export of crude oil.

For instance, crude oil exports accounted for 93.8, 98.4, 95.8 and 96.6 per cent of the total exports in 1979, 1999, 2009 and 2011, respectively (CBN, 2000, 2011). For the same periods, the volume of imports has been consistently on the increase. Dependence on oil exports, exposed Nigerian economy to the vagaries of the international crude oil market. Despite the strategic role of the external sector on the overall performance of the Nigerian economy, past analysis of developments in the sector had been largely aggregative and devoid of in-depth empirical analysis, (Akinlo and Yinusa, 2007).

The desire to have a better understanding of the workings of the external sector and its impact on the Nigerian economy motivates this study. Reliable qualitative information and appropriate policy would address constraints facing the external sector of the economy. Thus, well-articulated model of this nature would provide a strong basis for future projections on the sector. The framework for external sector model is based on the balance of payments account that captures the transactions on goods, services and financial flows between a domestic economy and the rest of the world.

With this framework, equations on the external sector are specified from key variables such as imports, exports (oil and non-oil), exchange rate, foreign direct investment and external reserves. The external sector is important because of its relationship with the other sub-sectors of the economy. Specially, it occupies a unique place in the formulation and implementation of macroeconomic policies. In order to implement appropriate policy measures to improve the external sector performance some indicators like exchange rates, balance of payments, external reserves and external debt must be explained.

According to Akpakpan (1999), the balance of payments, is a systematic record and summary of all economic transactions that takes place between the residents of the recording country and the residents of all other foreign nations of the world for a time period. Each entry in the balance of payments usually carries either a positive or negative sign. A positive sign shows an inflow of foreign currencies indicating the value of goods and services exported, whereas, a negative sign shows an outflow of foreign currencies indicating the value of imports.

Nigeria balance of payments has been under severe pressure since 1982 when the second oil shock occurred and debt burden became pronounced (Olisadebe, 1996). There is a close link between foreign exchange transactions and balance of the cash flows arising from international operations. While foreign exchange transactions reflect cash flows arising from international operations, the balance of payment s looks at actual movement of goods, services, and financial assets and liabilities (Okonkwo, 1998; Obaseki, 1991; Sobodu and Sotonwa, 1992; Obioma, 1999).

Using empirical trade experiences in most Less Developed Countries (LDC’s), Ayodele (1997), Brada and Mende (1998), and Olopoenia (1991), show how countries with floating exchange rates achieved balance of payments equilibrium through exchange rate adjustments. According to CBN (1999), external debt refers to unpaid portion of external financial resources required for development purposes and balance of payments support. When an external debt matures, payments have to be made in foreign currencies (Gbosi, 2005).

A high external debt burden hampers development efforts as a significant proportion of foreign exchange receipts are used to service accrued debts (Nwaoba, 1999). The use of a large portion of the foreign exchange resources to finance external debts exerts pressures on the external sector of the economy by causing disequilibrium in the balance of payments (Olisadebe, 1995). By external reserves, we mean the financial assets of a country that are available to the monetary authorities to meet temporary imbalance in the external payments position and to guarantee other policy measures (Gbosi, 2005).

According to CBN (1999), external reserves management involves the constant review of the country’s reserves position so that external financial obligations are met accordingly. Consequently, one of the major objectives of external reserves management is to maintain an adequate level of reserves to facilitate international transactions. Within a macroeconomic framework, certain basic relationships among key macroeconomic aggregates indicate the impact of the change in one variable on the other variables, and by implication on the entire economy.

Thus, with such a macroeconomic framework, it can be deduced that there is a close link between foreign exchange transactions and other external sector aggregates such as the balance of payments, external debt and external reserves. It is therefore the focus of this study, to critically evaluate how exchange rate policy in Nigeria has affected Nigeria’s balance of payments, external debt and external reserves.


1.2 Statement of the Problem

Various developing countries are undergoing SAPs design to revamp their economies by diversifying their productive bases, placing less emphasis on the external sector, and allowing market forces to play a dominant role in the allocation of resources. In many current macroeconomic adjustment policies in these economies, anti-inflation policies based on a restrictive rate of money supply expansion and interest rate deregulation have been adopted. Yet empirical evidence has shown that the monetarist explanation of inflation is not fully in accord with, what happens in some of these countries (Saini, 1982; Rwegasira, 1979, 1983; London, 1989).

Thus, the Nigerian economy has been managed virtually by the use of administrative controls since she gained independence in 1960 until 1987. Soon after the introduction of SAP, and the adoption of the floating exchange rate system, both external and internal values of the naira begun to fall, resulting in huge deficits in the balance of payments and a drain on foreign exchange reserves. The persistence of these problems makes it imperative for further study to unveil facts about it. It is based on this premise that the work set out to investigate how exchange rate policy in Nigeria has affected the external sector, particularly in terms of the balance of payments position, levels of external reserves and external debt. The crux of the problem is to dissect in concrete terms the behavior and performance of Nigeria’s external sector during the era of regulation vis-à-vis that of deregulation, in a bid to highlight the constraints and proffer workable action programmes.

1.3 Research Question

The following research questions guided the researcher:

(1) What is the impact of exchange rate on the balance of payments?

(2)Is there any long-run relationship among the variables?

(3) What is the causal relationship between exchange rate and balance of payments in Nigeria?

1.4 Objectives of the Study

The specific objectives of the study include the following:

(1) To examine the impact of exchange rate on the balance of payments

(2) To find out whether there is any long-run relationship among the variables

(3) To find out the existence of any casual relationship between exchange rate and the balance of payments in Nigeria.

1.5 Research Hypotheses

The study was guided by the following set of hypotheses.

Ho: there is no significant impact of exchange rate on balance of payments

Ho: there is a no long-run relationship among the variables

Ho: there is no significant causal relationship between exchange rates and balance of payments in Nigeria.                                

1.6 Significance of the Study

The significance of such study as this cannot be underestimated or ignored seeing that exchange rate policy and external sector performance in Nigeria under regulation and deregulation in Nigeria is of great commendation if such is carried out.

When the right exchange rate policy coupled with the performance of external sector activities are adopted; it will in turn, boost the GDP of the country and thereby causing growth in the economy. Significant to the external sector also is the chance of gaining recognition in the international scene. The research work will also be of utmost importance to the government and policy makers; the researchers who might find the work helpful and also the students of economics.

1.7 Scope and Limitation of the Study

This research work examines exchange rate policy and external sector performance in Nigeria under regulation and deregulation. The research work also examines the long run of exchange rate and external sector performance; thus, this work covers the period from 1981-2014

Of cause this work is not without some limitation; hitherto, the researcher encountered the under listed constraints: Financial constraint was the major setback for this work because the work was demanding. Financial constraint to travel from one place to the other in search of data. In spite of all this constraints, the researcher put in adequate effort to ensure that quality research was carried out.


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