CHAPTER ONE
INTRODUCTION
1.1 BACKGROUND TO THE STUDY
The 1980s witnessed increased flows of investment around the world. Total world outflows of capital in that decade grew at an average rate of almost 30%, more than three times the rate of world exports at the time, with further growth experienced in the 1990s (Kosteletou and Liargovas, 2000). Despite the increased flow of investment, especially, to developing countries, Sub-Saharan Africa (SSA) countries still lag behind other regions in attracting foreign direct investment. The uneven dispersion of FDI is a cause of concern since FDI is an important source of growth for developing countries. Not only can FDI add to investment resources and capital formation, it can also serve as an engine of technological development with much of the benefits arising from positive spillover effects. Such positive spillovers include transfers of production technology, skills, innovative capacity, and organizational and managerial practices.
Given these significant roles of FDI in developing economies there have been several studies that tried to determine the factors that influence FDI inflows into these economies. One of such factors that recently have been a source of debate is exchange rate and its volatility. The existing literature has been split on this issue, with some studies finding a positive effect of exchange rate volatility on FDI, and others finding a negative effect. A positive effect can be justified with the view that FDI is export substituting. Increases in exchange rate volatility between the headquarters and the host country induce a multinational to serve the host country via a local production facility rather than exports, thereby insulating against currency risk (Foad 2005).
Justification for a negative impact of exchange rate volatility on FDI can be found in the irreversibility literature pioneered by Dixit and Pindyck (1994). A direct investment in a country with a high degree of exchange rate volatility will have a more risky stream of profits. As long as this investment is partially irreversible, there is some positive value to holding off on this investment to acquire more information. Given that there are a finite number of potential direct investments, countries with a high degree of currency risk will lose out on FDI to countries with more stable currencies (Foad 2005).Â
One of the countries that fall into this category (countries with a high degree of currency risk) is Nigeria. With a population of about 130 million people, vast mineral resources, and favourable climatic and vegetation features, Nigeria has the largest domestic market in Sub-Saharan Africa. The domestic market is large and potentially attractive to domestic and foreign investment, as attested to by port folio investment inflow of over N1.0 trillion into Nigeria through the Nigerian Stock Exchange (NSE) in 2003 (Central Bank of Nigeria, 2004). Investment income, however, has not been encouraging, which was a reflection of the sub-optimal operating environment largely resulting from inappropriate policy initiatives. Except for some years prior to the introduction of the Structural Adjustment Programme (SAP) in 1986, gross capital formation as a proportion of the GDP was dismally low on annual basis.
It was observed that aggregate investment expenditure as a share of GDP grew from 16.9% in 1970 to a peak of 29.7% in 1976 before declining to an all-time low of 7.7% in 1985. Thereafter, the highest was 11.8% of GDP in 1990, before declining to 9.3% in 1994. Beginning from 1995, investment/GDP ratio declined significantly to 5.8% and increased marginally to 7.0% in 1997 and remained thereabout till 2004 when 7.1% was recorded. On the average, about four-fifth of Nigeria’s national output was consumed annually.
The sub-optimal investment ratio in Nigeria could be traced to many factors including exchange rate instability, persistent inflationary pressure, low level of domestic savings, inadequate physical and social infrastructure, fiscal and monetary policy slippages, low level of indigenous technology as well as political instability. A major factor was exchange rate instability, especially after the discontinuation of the exchange rate control policy. The high lending rate, low and unstable exchange rate of the domestic currency and the high rate of inflation made returns on investment to be negative in some cases and discouraged investment, especially when financed with loans.
The Naira (Nigerian currency, N) exchange rate witnessed a continuous slide in all the segments of the foreign exchange market (that is, official, bureau de change and parallel markets). In the official market, the exchange rate depreciated progressively from N8.04 per US dollar in 1990 to N81.02 per dollar in 1995 and further to N129.22 in 2003 and N133.00 in 2004. Similarly, it depreciated from N9.62 and N9.61 per dollar in 1990 to N141.36
and N141.07 per dollar in 2003 in the bureau de change and parallel market, respectively. Consequently, the premium between the official and parallel market remained wide throughout the period.
This high exchange rate volatility in Nigeria, among others, led to a precarious operating environment which can be attributed to the reason why Nigeria was not only unable to attract foreign investment to its fullest potentials but also had a limited domestic investment. As such, despite the vast investment opportunities in agriculture, industry, oil and gas, commerce and infrastructure, very little foreign investment capital was attracted relative to other developing countries and regions competing for global investment capital.
