Exchange Rate Fluctuations And Trade Flows In Nigeria: A Time Series Econometric Model

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Risk in international commodity trade usually emanates from two main sources: changes in world prices or fluctuations in exchange rate. Consequent upon the collapse of the Bretton Woods system and the resultant adoption of the flexible exchange rate system in 1973, economists and policy makers have been concerned about the significant effects of exchange rate fluctuations on the economy in general and trade, in particular (Isitua & Neville: 2006). One of the most dramatic events in Nigeria over the past decade was the devaluation of the Nigerian naira with the adoption of a structural adjustment programme (SAP) in 1986. A cardinal objective of the SAP was the restructuring of the production base of the economy with a positive bias for the production of agricultural exports. The foreign exchange reforms that facilitated a cumulative depreciation of the effective exchange rate were expected to increase the domestic prices of agricultural exports and hence boost domestic production. Significantly, this depreciation resulted in changes in the structure and volume of Nigeria?s exports as determined empirically by many researchers (Oyejide: 1986, Ihimodu: 1993 and World bank: 1994). The depreciation increased the prices of agricultural exports and the result indicated a marked increase in the volume of agricultural exports over the years.

The two major strands of argument in the literature regarding the actual relationship between exchange rate fluctuations and trade flows are between the traditional and the risk-portfolio schools. The traditional school is of the opinion that exchange rate fluctuations have negative effects on multilateral, bilateral and sectoral trade. Higher exchange rate fluctuations lead to higher costs, risk and uncertainty of profit in international transactions, economic agents as a result, respond by favouring domestic-foreign trade just at the margin, hence, it reduces or depress the volume of trade (Clark: 1973, Chowdhury: 1993, Cushman: 1983, 1988, Kenen & Rodrik: 1986, etc). The second strand, which is the risk-portfolio school, argues that economic agents in international transactions maximize their profits by diversifying the risk levels of their portfolio, and as such, higher exchange rate fluctuations with the resulting higher risk would not discourage them from engaging in trade but rather would present an  opportunity for them to diversify their risk portfolios from high risk portfolio to low and medium risk portfolio and still increase their profit. In other words, exchange rate fluctuations promote the volume of trade (De Grauwe: 1988, IMF: 1984, Klein: 1990, and Chambers, et al: 1991).

It became a source of concern to both the economists and policy makers that despite the existence of literature on the issue, theoretical and empirical works on the subject are yet to produce a consensus. And although these studies are very important  for policy reasons, only few attempts have been made to examine them for developing countries, Nigeria inclusive. The available instances include Vergil (2002) for Turkey and Bah and Amusa (2003) and Takaendesa, et al (2005) for South Africa, Ajayi (1988), Adubi, et al (1999), Osagie (1985), Isitua and Neville (2006), and Osuntogun, et al (1993) for Nigeria.

1.2 STATEMENT OF THE PROBLEM

Fluctuations in the exchange rate movements since the beginning of the floating exchange rate regime have raised concerns particularly on the impact of such movements on trade flows. Fluctuation is a major constraint on development of an economy, making planning more problematic and investment more risky. For instance, if potential foreign investors to Nigeria are risk averse (or even risk neutral), larger exchange rate fluctuations may reduce the overall foreign direct investment inflows since it increases uncertainty over the returns in a given investment. Potential investors will invest in a foreign location only if the expected returns are high enough to cover for the currency risk (Gerardo, et al: 2002).

Most developing economies are net debtors and in consequence, changes in the trading  partners?  exchange  rates  may  affect  the  real  cost  of  servicing  their  debts.   A strong appreciation of the dollar, for example, implies a higher cost of servicing an external debt that is mainly denominated. Furthermore, for a developing country like Nigeria that is highly dependent on trade, the exchange rate, which is the price of foreign exchange, has implications for balance of payments viability and the level of external debt. For instance, if the exchange rate is overvalued, then it would result to unsustainable balance of payments deficit, encourage capital flight and escalate external debt stock, which in turn will lead to declining level of investment. On the other hand, a real depreciation raises the cost of imported capital goods, and since a large chunk of investment goods in developing countries is imported, domestic investment would be expected to fall with a real depreciation (Iyoha, 1998).  All these show that the impact  of exchange rate variability on economies especially developing ones is not only in one direction.

Therefore, understanding the behaviour of the exchange rate is very important for many reasons. First, the relationship between a country?s exchange rate and economic growth via trade is a crucial issue from both the descriptive and policy prescription perspectives. As Edwards (1994:61) asserts: “It is not an overstatement to say that the issue of real exchange rate behaviour now occupies a central role in policy evaluation and design”. A country?s exchange rate behaviour is an important determinant of the growth of its cross-border trading and it serves as a measure of its international competitiveness (Bah and Amusa: 2003). It also plays a crucial role in guiding the  broad allocation of production and spending between foreign and domestic goods. In addition, researches have shown that exchange rate stability influences importantly export growth, consumption, resource allocation, employment and private investments (Takaendesa, et al: 2005, Aron et al, 1999). The behaviour of exchange rate is a useful indicator of economic performance of an economy that needs to be understood. In other words, assessing the link between exchange rate fluctuations and Nigeria?s trade flows would have policy implication. Also, variability of the naira value in recent years calls for understanding of the factors that actually cause exchange rate to fluctuate. For example, knowledge of these would help to facilitate policies that would aid the attainment of exchange rate stability and economic growth through trade flows in the long run.

Furthermore, along the lines of the existing literature, a related question very few researchers have investigated is whether changes in exchange rate regimes or policies which can be associated with a shift in the amplitude of fluctuations cause export flows to decrease. Few others, for reasons known to them, ascertained the impact of these fluctuations on either the oil sector, excluding the non-oil sector or vice versa. Nevertheless, we know that in a country like Nigeria that is so much over-dependent on oil, assessing the effect of exchange rate fluctuations on either oil or non-oil sector trade exclusively may not really give a value judgement and the conclusion thereof.

However, to bridge this gap and also avoid the effect of Dutch disease associated with some previous findings, the current study attempts to examine the possible effect and link between exchange rate fluctuations and Nigeria?s trade flows for both the oil and the non-oil sectors.

Finally, the study covers longer period more than any of the previous studies, which is, 1980 – 2008, the time span of the previous studies were too brief to capture the long-run effects of fluctuations on trade. Hence, our results are therefore likely to be more reliable for policy purposes.