The role of exchange rates and its volatility on macro-economic performance has continued to generate interest among international finance scholars. Many experts and analysts have argued that exchange rate stability facilitate production activities and economic growth.
EXCHANGE RATES
The exchange rate plays a role in connecting the price system in different countries thus, enabling traders to compare price directly. (Obadan (2006)). Change in exchange rate has a powerful effect on imports and exports of the countries concerned through effect on relative prices of goods. He further argued that some of the factors that led to depreciation of the Nigerian exchange rate include; weak production base, import-dependent production structure, fragile export base and weak non-oil export earnings, expansionary monetary and fiscal policies, inadequate foreign capital inflows, excess demand for foreign exchange relative to supply, fluctuations in crude oil earnings, unguided trade liberalization policy, speculative activities and sharp practices (round-tripping) of authorized dealers, over-reliance on imperfect foreign exchange market, heavy debt burdens, weak balance of payment position and capital flight.
Exchange rate movements have effects on inflation, prices incentives, fiscal viability and competitiveness of exports, efficiency in resource allocation, international confidence and balance of payment equilibrium. Mordi (2006).
The Nigeria federation practiced a sort of fixed exchange rate, when the Naira was pegged against the British and later on the America dollar. However with the collapse of the Breton wood institution, a flexible exchange rate was allowed to float, with its value relative to the US dollar determined of market forces of demand and supply. Some of the policies employed to ensure exchange rate stability included among others, Second-Tier Foreign Exchange Market (SFEM), Autonomous Foreign Exchange Market(AFEM), Inter-bank Foreign Exchange Market(IFEM), the enlarged Foreign Exchange Market(FEM), and Dutch Auction System(DAS). It is pertinent to mention here that the ability and failure of individual policy to achieve stability in the exchange rate lead to the adoption of another policy.
Despite effort of the government to maintain exchange rate stability over the last 20 y4 years, the Naira has continued to depreciate against the American dollar and gone to all time low following the removal of fuel subsidy in 2023.
COMPARING EXCHANGE RATE FROM I975 TO DATE
For example, the Naira appreciated against the US dollar from N0.714 in 1970 to N0.615 in 1975 and further to N0.5464 in 1980. However, Naira’s exchange rate had a free fall throughout the 1980s. For the naira depreciated from ₦0.6100 in 1981 to ₦2.0206 in 1986 and further to ₦8.0378 in 1990. Although the exchange rate became relatively stable in the mid-1990s, it depreciated further to N102.1052, N120.9702 and N133.5004 in 2002, 2003, 2004 respectively.
Thereafter the exchange rate increased to N132.147, N128.6516, N117.968 in 2005, 2006 and 2007 respectively. The discussion on exchange rates and their management in Nigeria revolves around three main themes: excessive volatility, the overvaluation of the real exchange rate despite continuous nominal depreciation, and the quest for a market-determined exchange rate regime amidst government dominance in foreign exchange supply. Maintaining exchange rate stability is a key objective of monetary policy in Nigeria, with a historical focus on keeping the nominal exchange rate stable, generating significant interest in exchange rate policy hence the activities of the now CBN Governor Cardoso.
A key assumption of the classical linear regression model is homoscedasticity, which means that the variance of the squared residuals is constant across all levels of the independent variable, which implies that the errors have equal variability.. However, many empirical studies have shown that asset price serves exhibit heteroskedasticity, where the variance of the error term are not equal and in which error term may be expected to be the larger for some observation or periods of data than for the others. The importance of the existence of heteroskedasticity in a series is that it is condition precedence for estimation of Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model.
Engle (1982) introduced the Autoregressive Conditional Heteroskedasticity (ARCH) model to model volatility by relating the conditional variance of the error term to the linear combination of the squared error terms in the recent past. Although they are many studies that model volatility of exchange rate using GARCH models, one of the studies examined the series for ARCH process before estimation.
The series that do not follow -ARCH will not require GARCH family models. Before the central Bank of Nigeria (CBN) came into operation in July 1959 and the enactment of the exchange control Act of 1962, In other words, the private sector earned foreign exchange, and commercial banks, acting on behalf of local exporters, held these earnings in accounts outside of the country.
During this period, the Nigeria pounds were tied to the British pounds Sterling .The establishment of the CBN and subsequent centralization of foreign exchange authority in the bank created the need to develop the Nigeria foreign exchange market (CBN).The Nigeria foreign exchange market experienced a boom during 1970s as a result of enhanced official foreign exchange receipts from crude oil exports and need for management of foreign to ensure that shortage did not arise. In 1982 however, comprehensive exchange controls were applied as a result of foreign exchange crisis that set in that year.
The increasing demand for foreign exchange at a time resulted to encouragement flourishing parallel market for foreign exchange rate. In September 1986, the second tier foreign market (SFEM) was introduced because of inability of the exchange control system to evolve appropriate mechanisms for foreign exchange allocation in consonance with the goal of internal balance. Asides market forces which under (SFEM), determines naira exchange rate and allocation of foreign exchange by the CBN, a couple of other factors now play key role albeit unofficial.
The foreign exchange market in Nigeria underwent significant transformations in the late 20th century. In 1989, the bureau de change (BDC) was introduced to expand the market’s scope, aiming to provide small-scale users with access to foreign exchange, manage exchange rates, combat illegal financial activities, facilitate economic growth, and inform policy decisions. However, due to exchange rate volatility, additional reforms were implemented in 1994, including the formal pegging of the naira, centralizing foreign exchange through the Central Bank of Nigeria (CBN), and reaffirming the illegality of the parallel market.
INTRODUCTION OF AFEM IN 1995
The market was further liberalized in 1995 with the introduction of the Autonomous Foreign Exchange Market (AFEM), allowing the CBN to sell foreign exchange to end-users through authorized dealers at market-determined rates. BDCs were once again authorized to buy and sell foreign exchange. In 1999, the inter-bank foreign exchange market was introduced, followed by the Wholesale Dutch Auction Sale (WDAS) in 2006 to converge official and interbank exchange rates. The CBN also allowed BDCs to participate in the official market and act as brokers in the interbank market, leading to a significant increase in the number of BDCs.
The exchange rate is a crucial concept in international trade, with various theories explaining its determination, including the Mint Parity Theory, Purchasing Parity Theory, and Balance of Payment Theory. These theories consider different factors affecting currency exchange rates, which are essential for understanding the dynamics of the foreign exchange market.
The Exchange Rate Challenge
Prior to the 1970, there was a remarkable stability in the exchange rate and change due to forces of demand and supply in Nigeria between 1960 and 1976 which is the exchange control (Opara et al (2015)).
The exchange rate was pegged at 0.71 Naira per US dollar, with the private sector generating foreign exchange earnings, which were then held in foreign accounts by commercial banks acting as agents for local exporters, thereby accumulating foreign exchange reserves abroad. The exchange rate between Nigeria and other countries’ currencies changes with time, due to changes in the supply in the foreign exchange market considering the further liberalization of the foreign exchange market introduced by the federal government, Autonomous Foreign Exchange Market (AFEM).
The factors that contributed most to these changes in exchange rate are changes in price of the commodities because we are so depended in foreign goods and services, also changes in export and imports. Whenever exports of Nigeria goods and services are more than imports, the demand for naira increases so that the rate of exchange favours Nigerian Economy. Hence, this research intend to study the rate of changes in Naira/ Us Dollar and Naira/Pounds Sterling which will enable governments, is importers, investors, exporters etc by obtaining a model that can better capture all the characteristics of exchange rate data.
Emperical Studies
Bayoumi and Eichengreen (1998) pointed out that exchange rate volatility could be explained by the relevant variables that have been used in literature, such as the difference in economic shocks, the trade links, the dissimilarity of the composition of the exports and country size.
According to Mordi (2006), Nigeria’s exchange rate management has yielded mixed outcomes, although the initial overvaluation of the Naira has been largely addressed. However, the subsequent emergence of significant fiscal deficits has undermined the Central Bank of Nigeria’s tight monetary policy, leading to persistent demand pressure on foreign exchange rates.
Despite the success achieved currently in exchange rate management and the relative stability sustained only for less than last two weeks, there is need for fiscal restraint and discipline at all levels of government and the greater coordination and harmonization of fiscal and monetary policy actions to ensure that injections of liquidity into the system are constant with macroeconomics stability. Moreover, there is need to create a truly autonomous inter-bank foreign exchange market whereby the CBN cease to be the dominate player supplying foreign exchange to banks and other authorized dealers on a predictable routine basis. Government financing should be true non-inflationary sources, mainly true the non-bank sources.
Experts have extensively examined the impact of exchange rate volatility on non-oil export flows in Nigeria. Aliyu (in 2010) conducted a study using quarterly data from 2003, which revealed a significant long-run equilibrium relationship between non-oil exports and fundamental variables like exchange rate volatility, terms of trade, and index of openness. The findings showed that a 1% increase in naira exchange rate volatility led to a 3.65% decrease in non-oil exports, while US dollar and Pound sterling volatility had a positive impact, increasing exports by 5.2%. The study recommended promoting economic openness and exchange rate stability to boost non-oil exports.
In a related study, Omojimite and Akpokode (2010) investigated the effect of exchange rate volatility on exports in Commutate Finance Africana (CFA) and non-CFA countries from 1986 to 2006. Using GARCH modeling, they found that exchange rate volatility negatively impacted exports in both groups, with a more significant effect on non-CFA countries. The authors emphasized the need for monetary and fiscal policy interventions to mitigate the adverse effects of exchange rate volatility on trade and economic growth. These studies highlight the importance of exchange rate stability in promoting exports and economic development in Nigeria and other African countries.
Adelowokan (2012) proved that there is no simple answer to determine the equilibrium exchange rate and that the degree of exchange rate misalignments remains one of the most challenging empirical problems in the open economy (macro-economic). Consequently, he examined the precise channel of exchange rate in Nigeria using data range from 1970 to 2010. The empirical results of his study revealed that previous Naira/US dollar and Naira/Pounds Sterling exchange rates caused inflation in Nigeria. He concluded that interest rate channel is the significant path of exchange rate which introduced inflation in Nigeria.
Olusola and Opeyemi (2013) observed that exchange rate volatility has to do with the unusual movements of the exchange rate and that the standard theoretical justification of the investigation of the volatility in exchange rate, is that exchange rate volatility represents uncertainty and risk which will impose costs on risk-averse economic agents. Hence they examine the trend and possible causes of exchange rate volatility in Nigeria using the Exponential Generalized Autoregressive Conditional Heteroscedasity (E-GARCH) modeling technique on annual time series over the period 1986 to 2009.
The results of the study revealed that exchange rate has been volatile in Nigeria giving the fact that the standard deviation of exchange rate has been unusually high and unusually low during the period under investigation. The parametric measure of exchange rate further confirms a high degree of volatility which portrays higher risk to a risk-averse economic agent. Hence, they examine the trend and possible courses of exchange rate volatility in Nigeria using exponential generalized autoregressive conditional Heteroscedasticity (E-GARCH) modeling techniques on annual time series over the period of 1986 to 2009.
Clarida et al, (2003) reaffirmed that “from the early 1980s onwards, exchange rate forecasting is a difficult task because of the uncertainty associated with its forecast. The uncertainty associated with exchange rate forecast has made forecasting exchange rate increasingly come to be seen as a hazardous occupation and hence using a random walk model is the best specification for modeling exchange rate volatility.
Cheunge et al (2005) reviewed the theories that have dilated on the exchange rate variability. The authors used different approaches to study exchange rate volatility and they tested the prediction power of three exchange rate models for the exchange rate series of Yen, Dollars and Pounds. Their studies find out that, none of tested models outperformed the random walk model in forecasting the criterion of mean squared error. However their studies concluded that on a longer horizon, structural models on the average provided a higher forecasting performance than the random walk model
Bollerslev (1987) declared that distributional properties of speculative prices, stock returns and foreign exchange rate have important implication for several financial models including models for pricing of contingent claims. For example, in empirical tests of mean variance portfolios, theories such as the sharp-linter capital asset pricing models, variances and covariance of the asset return are used as means of dispersion or risk. However depending on the distribution of the return, the variance may not be valid or importance statistics to use. The distribution of the return also plays an important role in the black-Scholes, option pricing formula, and in the pricing of forward contracts in the foreign exchange market.
THE ARCH MODEL IN NIGERIA EXCHANGE RATE
Engle (1987) introduced autoregressive conditional heteroscedasticity as a model to recognize this type of temporal dependence. According to ARCH model, the conditional error distribution is normal, but with conditional variances equal to a linear function of past squared error. Thus, there is a tendency of extreme values to be followed by other extreme values, but of unpredictable sign. Furthermore, the unconditional error distribution of ARCH models is leptokurtic, reconciling the previous empirical findings. In addition to this extension, we also allow the current conditional variance to be a function of past conditional variances as in the Generalized ARCH (GARCH) model which was developed in 1986.
Diebold (1989) explained that the difficulty of explaining exchange rate movement during the year 1973 float with purchasing power parity, monetary, portfolio balance models have become increasely apparent. The studies of seven major spot rates include Canadian dollar, French France, Deutschemark, Italian Lira, Japanese yen, Swiss France and British pound. He find out that, in the class of linear time series models, the random walk is a very good approximation to the underlying conditional mean process. Therefore he could not expect other linear models to dominate in terms of predictive performance.
However, when the class of models under consideration is broadened to allow for possible nonlinearities, he finds the strong evidence of ARCH. He also show that ARCH models may be used to generate statistically and economic effects which is the meaningful measures of exchange rate volatility. The nature, time pattern and economic effects of exchange rate volatility are recurrent topics in the literature.
The volatility of exchange rate is important because of the uncertainty it creates for prices of exports and imports, for the value of international reserves and for open positions in foreign currency as well as for the domestic wages, prices, output and employment. The study investigation whether daily changes in five major foreign exchange rates contains any nonlinearity. The research concluded that although the data contains no linear correlation, however there is the presence of substantial nonlinearity in a multiplicative rather than additive form.
Research Works and Reviews
Gujarati and Porter (2009) applied the Artificial Neural Network model to Dollar exchange rate. This is the first time microstructure variable is applied to forecast Canada/ US Dollar exchange rate. The research concluded that the introduction of the microstructure variable improved both the linear and nonlinear models of exchange rates. The research further employs the root mean square error prediction to test the predictive power of the model and concludes that the ANN model is consistently better than the random walk and other linear models for various out-of sample set sizes.
Andersen and Bollerslev (1998) conducted a study on the intraday volatility of the Deutschmark/US Dollar exchange rate, analyzing a year’s worth of five-minute returns. Their research focused on the relationships between market activity, macroeconomic announcements, and calendar effects, revealing a correlation between market activity and price variability. In a separate finding, Hasen and Lunde (2005) evaluated the performance of 330 ARCH-type models in capturing conditional variance, finding that a simple GARCH (1, 1) model was not outperformed by more complex models in describing exchange rate volatility.
Iyoha and Oriakhi (2002) examined movements in real exchange rate during the period were nominal stocks resulting from fiscal deficits.They also find out that the oil wind fall resulted in excessive fiscal expenditure in ambitious development projects, and when the windfall ended, the government resorted to financing it’s expenditure through monetary fiscal policy according to him exerted upward pressure on inflation, aggravated sharp movements in real exchange rates movements.
Ogunlege (2010) observed that the mean annual charge in real exchange rate in the country increased to 25%, subsequently reduced to 4.5% between 2000 and 2006. Therefore, favourable terms of trade, less fiscal dominance, effective monetary policy induced by more independent and transparent central bank and well managed nominal exchange rate policy contributed to foreign exchange rate volatility.
Holland et al. (2011) examined the impact of real exchange rate volatility on long-run economic growth for advanced and emerging economies over the period of 1970-2009 and found that, high (low) exchange rate volatility positively (negatively) affects real GDP growth rate. However, controlling for exchange rate volatility in a model containing levels of exchange rate misalignment render the variables insignificant suggesting that exchange rate stability is more crucial in propelling long-run growth than exchange rate misalignment. However, while finding no significant link between exchange rate volatility and long-run productivity growth, they revealed that non – linearties between real exchange rate volatility and output volatility among emerging market economies. Their findings suggest that real exchange rate volatility aids in absorbing shock as well as limit output volatility but too much of volatility in exchange rate increase output volatility.
Research experts have extensively explored the relationship between exchange rate volatility and economic growth. Aghion et al. (2009) analyzed panel data from 83 countries between 1960 and 2000, revealing that high exchange rate volatility hinders growth, particularly in economies with underdeveloped capital markets. Their findings suggest that real exchange rate uncertainty discourages investment, especially when credit constraints are high. In contrast, firms in high-income economies are more likely to effectively hedge against exchange rate risk.
Tarawalie et al. (2012) investigated the impact of exchange rate volatility on output growth and inflation in the West African monetary zone following an exchange rate regime shift. Their results showed that while exchange rate volatility led to inflation in all countries, its effect on output growth varied across countries. Specifically, volatility and depreciation negatively affected real GDP growth in Liberia and Sierra Leone but had a positive, albeit weak, impact on output in other countries. The differences in effects were attributed to varying macroeconomic conditions in each country.
Eichengreen (2008) emphasized the importance of maintaining stable exchange rate volatility to enable countries to realize their growth potential. Excessive exchange rate volatility can reduce economic growth by creating uncertainty, undermining competitiveness, lowering production and profits, and increasing domestic prices, ultimately affecting welfare. This study aims to identify the causes of exchange rate volatility and its dynamic linkages with economic growth, highlighting the need for policies that maintain external competitiveness and domestic stability.
Soludo, now the governor of a state. proved that it is possible to get the exchange rate right or maintain relative stability which is important for both internal and external balance and consequently growth in the economy. Exchange rate is the most important price variable in an economy and performs the twin role of maintaining international competitiveness and serving as nominal anchor to domestic price. The exchange rate is subjected to variations when it is notfixed, thus floating exchange rate tends to be more volatile. Economic essentials affect the level of volatility and the extent to which favourable economic circumstances and outcome which in turn would appreciate the currency and maintain stability is caused by strong fundamentals.
Obadan, (2006) employed that swings or fluctuations in exchange rate over a period of time or deviation from a equilibrium exchange rate volatility where there is multiplicity of markets parallel with the official market. There could be deviation from the equilibrium exchange rate. Volatility over any time period interval tends to increase when supply, demand and likely factors tend to respond to large random shocks and when the elasticity of both supply and demand are low then volatility tends to below too.
Ojebiyi and Wilson (2011) revealed that in measuring exchange rate volatility, the importance of currency invoicing is to be taken into consideration. Mostly, trade between two developing countries is not invoiced in the currency of either country. A standard currency is been used mostly the Us dollar which often used as the invoicing currency. It may look like the volatility of the exchange rate between the two trade partners currencies is not the important volatility to consider .However this is wrong, forexample if trade exporters from china to Nigeria are invoiced in US dollars, it might look like the Chinese would only care about the changes between the US dollar and the Chinese Yuan, but not between the Nigeria naira and the Chinese Yuan.
Nigeria’s economy has long been dominated by the oil sector, but non-oil exports are crucial for diversification and growth. Exchange rate policies and volatility significantly affect non-oil exports, and understanding this relationship is essential for policymakers.
Hassanov and Samadova (2012) and Chukuigwe and Abili (2008) found that an appreciated real exchange rate hinders non-oil export growth, while exchange rate reforms have a positive impact on exports. Shehu and Youtang (2012) discovered that exchange rate volatility decreases non-oil exports, emphasizing the need for exchange rate stability. Omojimite and Akpokodje (2010) and Etta et al. (2011) also highlighted the importance of exchange rate stability and conducive environments for domestic production.
Akinlo and Adejumo (2014) found that exchange rate volatility positively affects non-oil exports in the long run, while Yaqub (2010) emphasized the significance of exchange rate policy in economic performance. Opaluwa et al. (2012) noted that exchange rate fluctuations adversely affect the manufacturing sector, stressing the need for local sourcing of raw materials.
Empirical studies have consistently shown that exchange rate volatility and policies significantly impact non-oil exports in Nigeria. To foster competitiveness and improve exports, it is crucial to monitor exchange rate movements and maintain stability. The Central Bank of Nigeria should continue to intervene in the foreign exchange market to achieve this goal. Additionally, promoting economic openness and strengthening links between agriculture and manufacturing are essential for Nigeria’s economic growth and diversification.
CONCLUSION AND RECOMMENDATION
As long as Nigeria remains on this track, US Dollar will continuously appreciate against Naira and the same thing is applicable to Pounds Sterling rate of increase against Naira. The presence of volatility in exchange rate of Naira over Dollar and Pounds. The trend equation for US Dollar and Pound shows that Nigeria currency (Naira) is continuously depreciating as the year goes on. The yearly exchange rate volatility modeled between naira and (US dollar and pounds) from 1960 till date, investigated using ARCH model and the specified period data can be tested by developing new and more models. From the result of the research, we have been able to show the appreciation and depreciation of naira and also forecast the expected exchange rate of naira to both foreign currencies.
RECOMMENDATIONS
- The monetary authorities should use policy prescription in order to affect positive results in overvaluation of currency.
- The Central Bank of Nigeria should reduce the supply of currency into the economy when there is high demand of foreign currency.
- The use of autoregressive conditional heteroscedasticity in this research is a good model but we recommend that another model should be use.
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