AN EMPIRICAL STUDY OF THE FOREIGN EXCHANGE RATE PREMIUM IN NIGERIA (1970-2007).

Abstract

This work evaluates the trends in the parallel  market exchange  rate premium,  its determination and impact on the foreign exchange market in Nigeria. It examines the impact of existing demand and supply gaps in the overall foreign exchange market on the determination of the parallel market premium. It further examines the impact of the  parallel  market  exchange  rate  premium  on  the  determination  of  the  official exchange rate and the parallel market rates. The study uses the stock-flow model of Kiguel and O’connel (1994) to examine the impact of the parallel market exchange rate premium  on the determination  of  the official exchange  rate and the parallel market exchange rate.

The estimation results reveal that the parallel market exchange rate premium has a significant  negative  effect on parallel  market  exchange  rate in  Nigeria.  Thus,  an increase  in the foreign  exchange rate premium tends to reduce the  next round of parallel market exchange rate. On the other hand, the parallel market exchange rate premium affects the official exchange rate positively. This is because a high premium on  the  parallel  market  exchange  rate  tends  to  increase  the  demand  for  foreign exchange at the official rate. The examination of the impact of the demand and supply gaps  in  the foreign  exchange  market  shows  that  the coefficient  of exchange  rate imbalance can be negative or positive depending on whether there is excess demand or supply condition in the market.

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

The causes, effects and policy implications of the parallel economy, in both developed and developing countries have attracted attention in recent years as the expansion of this economy has  been  found  to  have adverse  effects  on the economy.  These  effects  are  of particular concern  to  policy  makers  in  developing  economies,  who  are  confronted  with  growing informal employment, parallel markets in goods and financial assets, specifically in foreign exchange, and capital flight. Degefa (2001)

The parallel premium for foreign exchange is the percentage by which the parallel exchange rate exceeds the official exchange rate, that is, Z=[ PE\OE) _1]X100, where  Z, Pe  and Oe, respectively,  stands  for  parallel  premium,  parallel  exchange  rate  and  nominal  official exchange rate. Following the division of Ghei and Kiguel (1992), a country is said to have high parallel premium when the spread between the official and the parallel exchange rate is above 35%, moderate premium when it is between 10% and 35%, and low premium when it is below 10%. Ghei and Kiguel (1992).

The parallel market for foreign exchange has reached a remarkable size in some developing countries. The existence of a large parallel foreign exchange market in developing countries is attributed to the deficiency of the legal institutions, which make  operation in the formal sector excessively expensive.

It is argued that a large parallel market for foreign exchange with a high premium is  an indication  of  a  basic  disequilibrium  in  the  foreign  exchange  market  and  trade  regimes (Dordunoo, 1994) and, hence, involves substantial social and economic costs. The expansion of the parallel market for foreign exchange leads to the loss of government control over the economy as more and more of the official transactions are  diverted to the parallel market. The parallel premium for foreign exchange functions as an implicit tax on exports, serving at

once as a disincentive  to export production as a source of hidden fiscal revenues  (Pinto,

1988).

According to Elbadawi(1994:488).

…the parallel premium is an important relative price influencing key macroeconomic variables. Furthermore, the parallel market premium acquires  importance not only from this direct linkage, but also as an important indicator of inconsistency between macro economic policy and the foreign trade and exchange rate regimes; this signal role is likely to feed back into macroeconomic outcomes by influencing government policy   and   private   sector   expectations   of   such   policy   (e.g.   expectations   of devaluation). In addition to the often-cited efficiency costs associated with the dual regime, a high and persistent parallel market premium can substantially undermine the  allocation  role  of  the  real  exchange  rate  in  the  economy  by  exposing  the credibility problem of macroeconomic policy.

In  the  light  of  this  general  picture  of  the  linkages  of  the  parallel  market  premium  to macroeconomic variable, Elbadawi (1994) arrived at the following conclusion:

…a rising premium is shown to have negative impacts on official exports and foreign trade taxes, as well as a positive effect on capital flight. Therefore, a rising premium and  expanding  black  market  could  have  serious  fiscal  and  commercial  policy implications by squeezing the tax base in foreign trade transactions and by expanding the  opportunities  for  large  scale  rent  seeking  activities.  A  high  premium  also aggravates the debt problem and the foreign exchange constraint through its effects on  capital  flight  and  the recorded  current account  balance…controlling  inflation could become more difficult under high premium regimes. (p. 508).

Kiguel  and  O’Connell  (1995)  agree  that  the  parallel  exchange  rate  feeds  back  into  the economy through illegal trade and prices. Beside these, authors (Dordunoo, 1994) and Pinto,

1988) conclude that large premiums have detrimental effects on official exports and hence on growth  while  providing  only  limited  insulation  from  external  shocks.  Rough  estimates

indicate that a 10% premium is likely to reduce GDP growth by 0.4% points a year. While the impact wanes as the premium goes up, and a 100% premium cuts GDP growth by 2% points a year (World Bank, 1994), a high parallel premium for foreign exchange nevertheless has an adverse impact on economic growth.

It is also important to note that authorities of some developing countries argue that parallel foreign exchange  markets may be socially desirable because these markets  accommodate transactors whose demand for foreign exchange is not met by official market or they increase employment  by increasing  the domestic  availability  of  imported  inputs.  But this  line  of argument has little empirical support (IMF, 1993).

However, the economy of Nigeria provides an example of a thriving and large black market for foreign exchange. This black or parallel market has co-existed with a rich menu of official policies aimed at achieving more flexible exchange rate as well as a stable  price system. What remain unclear is the amount and magnitude of distortions  caused  in the monetary policy targets and transmissions. This likely distortion raises the danger and worry about the effectiveness of foreign exchange rate market in Nigeria as a second transmission mechanism from CBN’s minimum rediscount rate MRR or policy rate PR to the real sector (changes in aggregate demand-supply gap and changes in prices).

U.J. Ekaette(2002)  noted that one major challenge that had confronted  this  administration since it assumed office in may 1999 was how to quickly put the economy back on the path of sustainable growth. According to him, most of the banks are suspected to have abandoned real banking for “round tripping” (the diversion of official foreign exchange to the parallel market). O.O Soleye(1985) then Honorable minister of Finance stated that conscious effort aimed at the management of the Nigerian foreign exchange resources began in 1962 with the inception   of  the  EXCHANGE   CONTROL   ACT  which  was  directed   at  freeing  the management of our FE from its erstwhile colonial pattern. T.A Oyejide (1985) stated that the Nigerian pound was introduced in 1959. Its external value was fixed at par with the British pound sterling which, in turn, defined its United States Dollar (USD) value as $2.80. Nigeria joined the International Monetary Fund (IMF) after Independence, and the Nigeria pound had

its parity defined, in June 1962, in terms of Gold at one Nigeria pound equals 2.48828 grams of fine Gold. This confirmed  its original USD par value. The Naira replaced  the  Nigeria pound as Nigeria’s currency in January 1973, its par value was set at half that of the pound. Hence  the  exchange  rate  became  $1.52  to  the  naira.  In  February  1978,  the  system  of determining the naira exchange rate against a basket of currencies of Nigeria’s main trading partners was finally adopted. According to Ugbebor, the Oil Glut of 1981 led to a crisis in the Foreign  Exchange  Market  (FEM)  in  1982.  in  December  1983  there  was  a  change  in government.  With effect  from January 1984  and again in May 1984 additional  exchange control measure were introduced. In September 1986, the Second_ Tier Foreign Exchange (SFEM) was introduced. Under SFEM, the exchange was floated when it became clear that a rigid or controlled  exchange rate would not ensure internal balance. The principles of the Structural  Adjustment  Programme  (SAP)  were  adopted  leading  to  a  market-  oriented approach  to price  determination.  The Second-Tier  rate was determined  by auction at  the SFEM using (a) the average rate pricing method,(b) the marginal rate pricing method, (c) the Dutch Auction System(DAS) which was introduced in April 1987, whereby CBN bought and sold FE in this market and supplied the demand of the authorized dealers in full. According to Akinmoladun (1990), the gap between the two rates began to grow shortly after. In 1995, the Autonomous  Foreign  Exchange  Market  (AFEM)  was  introduced,  under  a  policy  which allowed  for  Central  Bank  of  Nigeria  intervention  on  a  predetermined  basis  instead  of arbitrarily. Despite the introduction of AFEM, its dominance of the exchange rate market was not sustained. The official exchange rate in 1995 was N21.88/$1.00 while AFEM and parallel market rates were N79.90/$1.00 and N78.30/$1.00 respectively. Since 1999 the impact and development  in  the  parallel  exchange  market  has  become  highly  uncontrollable  as  the average  official rate was  N100.84/$1.00,  AFEM rate averaged  N94.88/$1.00  and parallel exchange rate  maintained  an average of N122.5/$1.00.  Ugbebor O.O and Olubusoye  O.E (2002)

The parallel  foreign  exchange  market  arises  as  a direct  consequence  of the  adoption  of exchange  rate controls  in many developing  economies  facing  substantial  macroeconomic imbalance.  The  existence  of  such  market  in  developing  countries  was  attributed  to  the deficiency of the legal institutions, which make operations in the formal sector excessively expensive.

Whether  parallel exchange  rate arises as an outcome  of macroeconomic  imbalances  or  a measure of exchange rate market distortion, the CBN acknowledged that it remains one of the problems  of monetary  policy operation  and  target  in Nigeria.  This  is  because,  it causes truncation  of  the  ultimate  monetary  policy  targets  by  paralyzing  the  transmission  or intermediate target instruments, CBN Monetary Policy Committee (2005:1).

This study is therefore designed to measure the magnitude of such distortions, to identify the determinants and its implication on monetary policy ultimate target variables in Nigeria.

1.2 STATEMENT OF THE PROBLEM

There is a growing concern especially by the monetary policy committee MPC of CBN about the relative high premium between the DAS exchange rate and the parallel market exchange rate of the naira to the US dollar. This was partly attributed to the fact that CBN has become more effective in controlling the “round-tripping” (buying currency low from the central bank and selling it high to interested buyers at the parallel market).

Before now, the size of the Nigerian parallel exchange rate market turnover was estimated to be between US$1.52 billion, bureau de change  US$250-500  million and  the pure parallel market was about US$6-8.5 billion. This means that a total of  foreign exchange of about US$6-8.5 billion is outside the control of inter-bank foreign exchange rate market (IFEM) thus, escaping and truncating the monetary policy targets of the CBN. CBN (2000)

In an attempt to control the growth of parallel exchange rate market, and narrow the  gap between the official and parallel exchange rate market, the CBN in 2006 introduced managed float exchange rate system which allows CBN to intervene in the operation of market system mode of exchange  rate (guided  fixed  exchange  rate system).  Following this  new  policy measures the CBN in June, 2006 liberalized  the foreign  exchange market and announced measures  to  supply  a maximum  of $30.00  million  into  the  parallel  market  every  week through the bureau-de-change. CBN also suspended the issuance of licenses to new primary

mortgage  institutions  (PMIS),  Bureau  de Change  (BDCS)  and  finance  companies,  citing measures aimed at a comprehensive package  for the sub-sectors under the on-going banking sector  reform  programme.  Among  the measures  was  the admission  of bureau-de-change (BDCS) into the wholesale Dutch Auction System (WDAS) through the inter bank foreign exchange market. This will allow BDCS to buy foreign exchange in the official market and sell to end users in the parallel market.

Despite these attempts to curtail the activities of the parallel marketeering, the premium of the black market exchange rate remains attractive. This is possibly because of economic and non-economic  reasons  like accessibility  and possibly because  parallel  market  for foreign currencies has become common phenomena in developing countries, with parallel exchange rate deviating in some cases considerably from the official rates. One common trend in the emergence of these parallel markets has been the imposition of foreign exchange controls by some government officials (the higher the controls over  parallel exchange rate market the more attractive it becomes). Others ignore the  developments in the black or even in many instances legalize them. Legalized black market rates are called parallel rates.

Perhaps, we should aptly begin to look at parallel exchange rate market as a vicious spiral with economic  growth which exists as an informal  activity in a down turn of  economic activities  in one direction;  and an activity that causes economic  distortion  by paralyzing monetary policy intermediate targets and transmission mechanism on another hand. If these two  prepositions  are  correct,  then  it  will  be  a  profitable  venture  to  ask  the  following questions;

1.   What are the impacts of exchange rate premium on parallel exchange rate and official exchange rate in Nigeria?

2.   What is the impact of demand and supply imbalance on parallel exchange market?

1.3      OBJECTIVE OF THE STUDY

The general objective of this study is to determine the impact of a parallel exchange rate on

Nigeria’s economy. Specifically, the work addresses the following objectives:

1.   To examine the impacts of exchange rate premium on the parallel exchange rate and the official exchange rate.

2.   To examine the impact of demand and supply imbalance on parallel exchange market.

1.4      SIGNIFICANCE OF THE STUDY

According  to  Elbadawi  (1994),  the  parallel  foreign  exchange  premium  is  an  important relative price influencing key macroeconomic variables. It acquires importance not only from this direct linkage but as an important indicator of inconsistency between macroeconomic policy and the foreign trade and exchange regimes, a role which is likely to feed back into macroeconomic outcomes by influencing government policy and private sector expectations of such policy (e.g. expectation of devaluation). In addition to the efficiency costs associated with  a  dual  exchange  rate  regime,  a  high  and  persistent  parallel  market  premium  can substantially  undermine  the allocation  role of the real exchange  rate in the economy by exposing the credibility problem of macroeconomic policy. Therefore, a rising premium and expanding black market could  have serious fiscal and commercial  policy implications  by squeezing the tax base in foreign trade transaction and by expanding the opportunities for large rent seeking activities.

Controlling  inflation  could  also  become  more  difficult  under  high  premium   regimes

(Elbadawi, 1994:P. 508).

It is the hope of the researcher that the research work will be of immense benefit to policy makers  and  monetary  authorities  that are  charged  with  the responsibility  of  maintaining monetary stability, growth and external sector viability. Therefore, this study will contribute to the series of literatures and research work focusing on the  dynamics of parallel foreign exchange market in developing countries.

This study is thus, amongst some of the vast literature and research works available for the study  on  the  dynamics  of  parallel  foreign  exchange  markets  of  developing  countries especially in West Africa.

1.5 SCOPE AND LIMITATION OF THE WORK

This research work evaluates the impact of parallel foreign exchange market on  selected macroeconomic  performance  in Nigeria.  The work covers  the period  from1970-2007  and takes the premium in parallel market as the difference between official rate and parallel rate. As this gap widens, black market becomes more attractive.

₦5,000.00 – DOWNLOAD FULL PROJECT DOWNLOAD FULL PROJECT Added to cart

---

---

---

---

Related Project Topics :