Table of Contents

DECLARATION………………………………………………………………………………………………………… iii

CERTIFICATION………………………………………………………………………………………………………. iv

DEDICATION……………………………………………………………………………………………………………. v

ACKNOWLEDGEMENT…………………………………………………………………………………………….. vi

Table of Contents……………………………………………………………………………………………………… vii

LIST OF TABLES………………………………………………………………………………………………………. ix

LIST OF FIGURES……………………………………………………………………………………………………… x

ABBREVIATIONS…………………………………………………………………………………………………….. xi

ABSTRACT……………………………………………………………………………………………………………… xii

CHAPTER ONE………………………………………………………………………………………………………….. 1

INTRODUCTION……………………………………………………………………………………………………….. 1

• Background to the Study………………………………………………………………………………………. 1
  • Statement of Problem…………………………………………………………………………………………… 5
  • Research Questions……………………………………………………………………………………………… 6
  • Objective of the Study…………………………………………………………………………………………. 6
  • Formulation of Hypothesis…………………………………………………………………………………… 7
  • Justification of the Study……………………………………………………………………………………… 7
  • Scope of the Study………………………………………………………………………………………………. 7
  • Plan of the Study………………………………………………………………………………………………… 8

CHAPTER TWO…………………………………………………………………………………………………………. 9

Literature Review………………………………………………………………………………………………………… 9

• Theoretical Review……………………………………………………………………………………………… 9
  • Theories of Exchange Rate……………………………………………………………………………. 10
  • Balance of Payments Equation………………………………………………………………………. 13
  • Empirical Review………………………………………………………………………………………………. 16
  • Conceptual Framework………………………………………………………………………………………. 23
    • Concept of Exchange rate…………………………………………………………………………….. 23
    • Concept of Balance of Payment…………………………………………………………………….. 23
  • Exchange Rate Regimes in Nigeria……………………………………………………………………….. 24

CHAPTER THREE……………………………………………………………………………………………………. 27

RESEARCH DESIGN AND METHODOLOGY……………………………………………………………… 27

• Theoretical Framework………………………………………………………………………………………. 27
  • Methodology…………………………………………………………………………………………………….. 27
    • Model Specification…………………………………………………………………………………….. 27
    • A Priori Test……………………………………………………………………………………………….. 28
  • Estimation Technique and Procedure……………………………………………………………………. 29
    • Descriptive Statistics and Graphical Analysis…………………………………………………… 30
    • Stationarity Test (Unit Root)………………………………………………………………………….. 30
    • Cointegration Test……………………………………………………………………………………….. 31
    • R²-Coefficient of Determination……………………………………………………………………. 32
    • Test of Normality………………………………………………………………………………………… 32
    • Test of Autocorrelation………………………………………………………………………………… 32
    • Test of Heteroscedasticity…………………………………………………………………………….. 32
  • Model Estimation Technique………………………………………………………………………………. 32
  • Data source and Description……………………………………………………………………………….. 33

CHAPTER FOUR……………………………………………………………………………………………………… 34

Empirical Analysis/Presentation and Interpretation of Results………………………………………….. 34

• Pre-Estimation Analysis……………………………………………………………………………………… 34
  • Summary of Descriptive Statistics………………………………………………………………….. 34
  • Graphical Analysis………………………………………………………………………………………….. 36
  • Unit Root……………………………………………………………………………………………………. 40
  • Cointegration Tests………………………………………………………………………………………. 42
  • Estimation………………………………………………………………………………………………………… 44

4.2.2 Causality Test…………………………………………………………………………………………….. 47

Table 4.2.2 Granger Causality Test………………………………………………………………………… 47

• Post- Estimation Analysis……………………………………………………………………………………. 48
  • Test for Autocorrelation……………………………………………………………………………….. 49
  • Test for Heteroskedasticity……………………………………………………………………………. 49
  • Test for Normality……………………………………………………………………………………….. 50
  • Test for Model Stability………………………………………………………………………………… 51
  • Synthesis of Study Objectives……………………………………………………………………………… 52

CHAPTER FIVE……………………………………………………………………………………………………….. 53

SUMMARY, CONCLUSION AND POLICY RECOMMENDATION………………………………… 53

• Summary of Findings…………………………………………………………………………………………. 53
  • Conclusion……………………………………………………………………………………………………….. 54
  • Implication of Policy…………………………………………………………………………………………. 54
  • Study Limitation……………………………………………………………………………………………….. 54
  • Suggestions for Further Studies……………………………………………………………………………. 55

REFERENCES………………………………………………………………………………………………………….. 56

APPENDIX………………………………………………………………………………………………………………. 59

LIST OF TABLES

Table 4.1.1 Descriptive Statistics Result…………………………………………………………………….. 34

Table 4.1.3a Unit Root Test……………………………………………………………………………………. 40

Table 4.1.3b Summary of Unit Root Test…………………………………………………………………… 41

Table 4.1.3c VAR Lag Order Selection Criteria………………………………………………………….. 42

Table 4.1.4.1 Bounds Test………………………………………………………………………………………. 42

Table 4.1.4.2 ARDL Cointegrating and Long Run Form……………………………………………. 43

Table 4.2 ARDL Regression Result………………………………………………………………………….. 45

Table 4.2.2 Causality Test……………………………………………………………………………………….. 47

Table 4.3.1 Test for Autocorrelation…………………………………………………………………………. 49

Table 4.3.2 Test for Heteroskedasticity…………………………………………………………………….. 49

LIST OF FIGURES

Figure 4.1.2.1 Trend between BOP and EXR…………………………………………………………… 37

Figure 4.1.2.2 Trend between BOP and GNI…………………………………………………………….. 38

Figure 4.1.2.3 Trend between BOP and INF…………………………………………………………….. 39

Figure 4.3.4    Normality Test………………………………………………………………………………….. 50

Figure 4.3.5  Model Stability………………………………………………………………………………….. 51

ABBREVIATIONS

In the course of this study, the following abbreviations were made, they vividly include:

• EXR: Exchange Rate

• BOP: Balance of Payment

• GNI: Gross National Income

• CPI: Consumer Price Index

• INF: Inflation

• ARDL: Autoregressive Distributive Lag

• ADF: Augmented Dickey Fuller Test

• PP: Phillip Perron

ABSTRACT

This study empirically examines the effects of exchange rate on balance of payment in Nigeria, using quarterly data from 1981-2017. The empirical methodology utilized the Bounds cointegration test to detect possible long-run and short-run dynamic relationship, and found no presence of long run relationship between the variables used in the model. The study employed the Autoregressive distributed lag (ARDL), to check for properties in the relationship between the variables above listed, the result showed that exchange rate positively and significantly influences balance of payment. It also utilized the Pairwise Granger Causality test to check for any causality between exchange rate and balance of payment, the findings proved that exchange rate affects balance of payment. The policy implication of these finding calls for the harmonization of exchange rate, gross national income, inflation rate, to improve the balance of payment in Nigeria.

CHAPTER ONE INTRODUCTION

            Background to the Study

Exchange rate (EXR) policy is one of the essential tools of regulation in the external sector of an economy, which also features in attaining macro-economic regulation and objectives (Echekoba, 2013). EXR influences the prices at which a country trades with the rest of the world making it an integral part of an open economy analysis and policy formulation (Ndung’u, 2000). The EXR is the price of a unit of foreign currency in terms of the domestic currency (Cavallo, 2004). Fluctuations in the exchange rate have ripple effects on other economic variables such as interest rate, inflation rate, unemployment, money supply, etc. These facts emphasize the necessity of exchange rate to the economic growth of every country that allows for international trade in goods and services (Echekoba, 2013). EXR can be fixed, managed floating and free floating or flexible or fluctuating rates. Monetary policies and EXR are key tools in economic management and in the stabilization and adjustment process in developing countries, where low inflation and international competitiveness have become major policy targets. External trade can be stimulated through several channels including: preferences, subsidies, quotas, taxes and other limitation which could be used to push the trade balance in the desired direction (Cavallo, 2004). The trade balance could be internal and external, internal balance refers to the level of economic activity consistent with the satisfactory control of inflation, while external balance means balance of payments equilibrium or sustainable account deficit financed on a lasting basis by expected capital inflow (Ogbonna, 2011).

The Balance of Payments (BOP) is a financial record of all the transactions between a particular economy (country) and the rest of the world over a period of time. It holds records of all the money flows between the economy and the rest of the world and it consists of the current account and the capital account. In the BOP, money inflows are recorded as credits and are entered with a positive sign, and money outflows are recorded as debits and are entered with a negative sign.

The current account deals with a country’s short-term transactions or the difference between its savings and investments (Baharumshah, 2001). It records flow of goods, services, incomes and current transfers and is the sum of four balances which are: the goods balance, the services balance, the income balance and net current transfers (Baharumshah, 2001). The goods balance, also known as the balance on goods, the balance of visible trade, is derived by subtracting imports of goods from exports of goods, and is positive when exports of goods exceed imports of goods (Arize, 2004). The services balance, is computed by subtracting imports of services from exports of services, it is positive when exports of services exceed imports of services (Arize, 2004). The income balance is computed by subtracting outward income remittances from inward income remittances where income refers to wages, rent, interest and profits. The income balance is positive when inward income remittances exceed outward income remittances (Arize, 2004). Net current transfers, also known as net unilateral current transfers, are computed by subtracting outward current transfers from inward current transfers. Currents transfers are government contributions to and receipts from other economies and international transfers of money by private individuals and firms.

The capital account on the other hand is divided into both the capital and financial account, and can be seen as a record of the inflows and outflows of capital that has a significant impact on a nation’s foreign assets and liabilities. It is concerned with all international trade transactions between citizens of a particular country and those in other countries

(Baharumshah, 2001). The components of the capital account include foreign investment and loans, banking and other forms of capital, as well as monetary movements or changes in     the foreign exchange reserve. The capital account flow reflects factors such as commercial borrowings, banking, investments, loans, and capital. A surplus in the capital account indicates an increase in inflow of money into the country, while a deficit means there’s more money moving out of the country, in this case the country may be increasing or decreasing its foreign holdings(Baharumshah,2001).

A nation’s approach on foreign exchange policy is determined from the observed macroeconomic goals to be achieved and the likely trend of development within the economy. Although the acknowledged objectives of foreign exchange policy remain the attainment of a favorable BOP position as well as the achievement of a realistic EXR (Odili, 2014). EXR is an important determinant of the BOP position of any country. The foreign exchange market in Nigeria is very dependent on the demand side and less dependent on the supply side. The market is extremely demand-driven and is depicted by the non-adherence to laws, rules and regulations guiding the market by agents in the market. Due to this, it encounters the problem of exchange rates misalignment, increasing interest and inflation rates, EXR mismanagement and reduction in the nation’s foreign exchange reserves (Odusola, 2006). These alterations have negatively affected the EXR of the country’s currency in relation to other currencies of the world as well as the BOP positions of the Nigerian economy (Aniekan, 2013).

Before the oil boom of the early 1970s, Nigeria was predominantly being sustained by the agricultural sector, and agricultural products like cocoa, palm oil, groundnut, rubber etc. accounted for more than 70% of the nation’s gross domestic products (GDP) (Asher, 2012). Nigeria was less dependent on importation of finished goods since domestically produced substitutes were available at a reasonable price. The real exchange rate of the naira to a dollar was ₦0.52798-$1 (CBN bulletin, 1980). During this period, Nigeria was on a fixed EXR

determination system and the naira experienced favorable balance of payment (Asher, 2012). The oil boom era of the 1970s led to ample earnings in foreign exchange.

Naturally, oil revenue is very volatile due to wild fluctuations in oil’s spot and future US $ price per barrel and to unpredictable changes in the organization of petroleum exporting countries (OPEC) assigned oil quotes, of which Nigeria has been a member since 1958 following the commercial discovery of oil in Oloibiri, Rivers State Nigeria in 1956 (Odili, 2014). The lack of suitable fiscal policy regulations and a proper finance management framework for oil-related risks, in Nigeria’s variable oil and fiscal revenues in the 1980s and 1990s have led to a paradoxical reality of fiscal policies that have generated large and unpredictable movements in government deposits and current account balances (Odili, 2007). This led to the devaluation of the naira following the adoption of the structural adjustment programme (SAP) in 1960. The implication of the devalued naira is that Nigeria’s foreign trade structure did not satisfy the Marshall-Lerner condition for a favorable BOP adjustment (Eboreime, 2013). The key element of Structural Adjustment Programme (SAP) was the free market determination of the naira exchange rate through an auction system. This was the beginning of the unstable EXR; the government had to establish the Foreign Exchange Market (FEM) to stabilize the EXR depending on the state of balance of payments, the rate of inflation, domestic liquidity and employment (Ewa, 2011). Between 1986 and 2003, the federal Government experimented with different EXR policies without allowing any of them to make a remarkable impact in the economy before it was changed. This inconsistency in policies and lack of continuity in ER policies aggregated unstable nature of the naira rate (Gbosi, 1994). The Nigeria’s foreign exchange structure constitutes, export of crude oil whose prices are inelastic and therefore not responsive to policy instruments especially in the short run and has led to constant depreciation of domestic currency, and also an increasing import dependency

(Odili, 2014). It is therefore consequential to investigate the effects of exchange rate on the balance of payment of Nigeria and also the factors that influence exchange rate in Nigeria.

            Statement of Problem

In recent times in Nigeria, EXR and BOP variables have been fluctuating and not stable due to the fact that Nigerians conduct their foreign transactions using the united states dollar (USD) which is only gotten as an income from the exports made to other nations. Being a mono-product export country, Nigeria tends to export oil as its major exports after its discovery in 1970s while neglecting the agricultural sector which used to be its major exports (Anifowose, 1994). The price and quantity of the oil products being exported by Nigeria however is exogenously determined (price & quantity) by the organization of petroleum exporting countries (OPEC). Although, the country is an import reliant country, as it imports 95% of the commodities consumed in the country, which means that the foreign exchange revenue generated from the export of oil cannot equate the expenses spent on the importation of foreign commodities. This tends to tilt the EXR of the Nigerian currency to that of other countries in a negative direction, which directly affects the BOP of the country negatively. This also inversely resorts the country to borrowing in order to finance their annual budget deficit and afterwards spend a voluminous percentage of the country’s revenue in financing the loans incurred (Obadan, 2006).

Following the end of the oil boom period when the Nigerian economy benefited from a steady BOP surplus, ever since then, her BOP has been fluctuating between positions of surplus and deficit. Nigeria has recorded well over fifteen deficits in her balance of payments account (Olarinde, 2014). These deficits were recorded in 1962 through 2007. The BOP problem has become a consistent constraint in the realization of the federal government of Nigeria’s macroeconomic objectives. So many reasons have been suggested for this excessive pressure

on the BOP position in the economy. According to Gbosi, (2002), these reasons are as a result of fluctuations in the prices of crude oil, poor performance of the non-oil export, increasing demand for foreign goods and services, continuous fall in the country’s foreign exchange and ineffective manufacturing sector. From the above discussion, it is evident that limited research has been conducted on the relationship between exchange rate movement and balance of payments in Nigeria. This study therefore aims at filling this research gap by answering one question: What are the effects of exchange rate on balance of payments in Nigeria?

            Research Questions

The magnitude to which EXR influences BOP in Nigeria remains uncertain and therefore forms part of the major problem which this research work intends to study considering the following questions:

• What is the causality effect of Exchange rate on Balance of Payment in Nigeria?

• What is the nature of the relationship existing between Exchange rate and Balance of Payment in Nigeria?

            Objective of the Study

In view of the above listed research questions, the basic objective of this study is to determine the effect of exchange rate on Nigeria’s Balance of payment. The specific objectives are to:

• Examine the causality effect of exchange rate on the Balance of Payment in Nigeria.

• Obtain the nature of the relationship that exists between Exchange Rate and Balance of Payment in Nigeria.

            Formulation of Hypothesis

Derived from the objective of this study, the following hypothesis will be evaluated.

• H10: Exchange rate has no causality effect on balance of payment in Nigeria.

H11: Exchange rate has causality effect on balance of payment in Nigeria.

• H20: Exchange rate has no significant relationship with balance of payment in Nigeria.

H21: Exchange rate has significant relationship with balance of payment in Nigeria.

            Justification of the Study

The general purpose of this project is to examine the effects of exchange rate on balance of payment in Nigeria, with one other specific purpose which is to determine the nature of the relationship between EXR and BOP. Meanwhile EXR volatility effects on BOP have been previously identified and studied in various research work, although no study has been able to cover up to 2017 (Odili, 2014).

This study therefore seeks to further the effects of exchange rate on balance of payment by increasing the sample size up until 2017, while answering other research questions like the nature of the relationship that exists between EXR and BOP in Nigeria, using the Autoregressive Distributed lag model, in doing so, the study will be able to find the nature of the effect of EXR on BOP. This will in fact be an analysis that has never been extended to 2017.

            Scope of the Study

The study is designed to cover a period of 36 years ranging from 1981 to 2017 using quarterly data, due to accessibility of relevant information from reliable sources.

            Plan of the Study

This study is presented in five chapters, Chapter One introduces the topic of discussion, and gives a sense what the study hopes to achieve. Chapter two through an overview of literature review centers on the context of the study. Chapter three focuses on the theoretical framework and methodology. Chapter four analytically discusses the overall results of the empirically analysis. Chapter five summarizes findings and concludes the study.

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