EFFECT OF FOREIGN EXCHANGE RATE ON NIGERIA ECONOMY

CHAPTER ONE

INTRODUCTION

1.1  BACKGROUND OF THE STUDY

Foreign exchange is the means of payment for international transactions. It is made up of convertible currencies that are generally accepted for the settlement of international trade and other external obligations. Just like every other commodity, a market is established which works more like any other market having a supply curve, a demand curve, and an equilibrium price and quantity. There are also conditions that are held constant (criteria paribus). When these conditions change, the curve shift and there is a change in the equilibrium price quantity. This market for currencies is known as the foreign exchange market. The foreign exchange market according to the central bank of Nigeria is the medium of interaction between the sellers and buyers of foreign exchange a bid to negotiate a mutually acceptable price for the settlement of international transactions. The sellers of foreign exchange constitute the supply while the buyers of foreign exchange constitute its demand. The supply of foreign exchange is derived from oil exports, non-oil export, the expenditure of foreign tourist in Nigeria, capital repatriation by Nigerians resident abroad, etc. The demand for foreign exchange, on the other hand, consist of payments for imports, financial commitments to international organizations, external debt service obligations, etc. Before 1958, when the central bank was established and the enactment of the exchange control act of 1962, foreign exchange was earned by the private sectors and held in balances abroad by commercial banks which acted as agents for local exporters. Another feature of this period was that agriculture exports contributed to the bulk of foreign exchange receipts. The fact that the British pound sterling was at par with the Nigerian pound sterling with easy convertibility delayed the establishment of an active foreign exchange market. However by 1958, when the central bank was established and subsequent centralization of foreign exchange authority. In banks,  the need for a local foreign exchange market because of paramount. Other factors that led to the evolution of the foreign exchange market in Nigeria include The changing pattern of international trade institutional changes in the economy. structural shift in production, etc. By the early 1970s, the official exchange receipt was enhanced following the sharp rise in prices and demand for crude oil exports which had by now displaced agricultural exports. The foreign exchange market experienced a boom during this period and there became a need for the management of foreign exchange resources. However, it was not until 1982 that comprehensive exchange controls were applied. The exchange control system failed to evolve an appropriate mechanism for foreign exchange allocation. This led to the development of a dual exchange rate system, comprising of the first and second-tier foreign exchange markets which were adopted in September 1986. The first tier was managed while the second tier was subjected to market forces. Not only has there been a metamorphosis of the institutional framework from the second-tier foreign exchange market (SFEM) to the foreign exchange market (FEM) to the interbank foreign exchange market (IFEM) to Autonomous Foreign Exchange Market (AFEM) etc, there have been frequent changes in operational guidelines and procedures. Various pricing methods, marginal and weighted average exchange rates determinations and the Dutch Auction System (DAS) among others have also been adopted. All those aimed at ensuring more efficient allocation and utilization of scarce foreign exchange resources, to enhance the flow of capital into the country, stimulates domestic industrial production, promote export, increase revenue to the government, help reschedule our foreign debt at more profitable terms, etc. When there are fluctuations in foreign exchange rates, various economic activities are usually affected such as the purchasing power, balance of payment, prices of goods and services, import structure, export earning, government revenue, external reserves among others. These prevailing instability in exchange rates and their effects on various economic variables will be the areas of concentration of the research work.

 

1.2    STATEMENT OF THE PROBLEM

Since September 1986, when the market-determined exchange rate system was introduced via the second tier foreign exchange market, the naira exchange rate has exhibited the features of continuous depreciation and instability. This instability and continued depreciation of the naira in the foreign exchange market have resulted in declines in the standard of living of the populace, increased the cost of production which also leads to cost-push inflation. It has also tended to undermine the international competitiveness of non-oil exports and make planning and projections difficult at both micro and macro levels of the economy. A good number of small and medium scale enterprises have been strangled out as a result of low dollar/ naira exchange rate and so many other problems resulting from fluctuations in exchange rates can also be identified. This movement of the exchange rate along the path of depreciation since 1986 has raised a lot of questions on the impact of exchange rate policies on the Nigerian economy. It is, therefore, the goal of this study to identify these problems and make recommendations that will help reverse this prevailing trend.

 

1.3       OBJECTIVES OF THE STUDY

In a highly import-dependent economy like Nigeria, the naira exchange rate has become one of the most widely discussed topic in the country today. This is not surprising as this topic has had a lot of macroeconomic impact on the Nigeria economy.

It is, therefore, the objectives of this study to:

–    Evaluate the effect of exchange rate fluctuation and management on various sectors of the Nigerian economy.

–      Identify that economic variables most affected by exchange rate fluctuations.

–      Identify the strengths and weaknesses of various exchange rate policies.

In the light of its findings, make certain recommendations which will be helpful in management, restructuring ensuring stability and appreciation in the naira exchange rate.

 

1.4      FORMULATION OF HYPOTHESIS

For meaningful findings, conclusions and recommendations, a set of testable hypotheses based on available data will be necessary. In the course of this research work, the following hypothesis would be tested.

 

HYPOTHESIS I

Ho: The continued fluctuation in the exchange rate of the naira has not reduced the purchasing power of the average Nigerian.

Hi: The continued fluctuation in the exchange rate of the naira has a significant effect on the purchasing power of the average Nigerian.

 

HYPOTHESIS II

Ho: Fluctuation in the foreign exchange rate has no significant influence on the Nigerian economy.

Hi: Fluctuation in the foreign exchange rate has a significant influence on the Nigerian economy.

 

1.5    SIGNIFICANCE OF THE STUDY

The study would identify the strengths and weaknesses of exchange rate policy and management, identify those economic variables that are mostly affected by instability in the exchange rate and provide the general public with the awareness on the foreign exchange transaction and its impact on the economy. The various findings of this would enable the government and financial authorizes to the device, modify and adopt a better foreign exchange transaction for the economy.

 

1.6    DEFINITION OF TERMS

Foreign Exchange: Foreign exchange is a means of payment for international transactions. It is made up of currencies of other countries that are freely acceptable in settling international transactions.

Foreign exchange market: This is a medium of interaction among buyers and sellers of foreign- exchange with a view of negotiating acceptable prices for settling international transactions.

Exchange rate: This is the price of one currency in terms of another

SEMI– Second-tier foreign exchange market. Under this system, the exchange rate is largely determined by market forces.

AFEM – Autonomous foreign exchange market. This exchange rate under this system is being determined essentially through market forces.

IFEM – Interbank foreign exchange market.

Dutch auction system (DAS): This is a method of exchange rate determination through action where the bidders pay the last bid rate that clears the market.

Dual exchange rate regime: This situation exists when two exchange rates are in existence in an economy.

Marginal pricing method: This is the method in which bid rates are arranged in descending order of magnitude. the last bid rate at which available foreign exchange is exhausted (marginal rate) is the applicable exchange rate.

Exchange control: This is a foreign exchange arrangement in which the government purchases all incoming foreign exchange and is the only source from which foreign exchange can be purchased legally.

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