CHAPTER ONE

INRODUCTION

1.1 BACKGROUND OF THE STUDY

Most recent times, achieving stable exchange rate and balance of payment has been the aim of

most countries. Countries exchange rate and balance of payment is used to measure a countries

economic strength. Orji (2012).

Most researchers view on exchange rate is that, if the exchange rate of a country is valued, it

does not largely affect the balance of payment and also all macro-economic performance of that

country, Exchange rates are frequently used as an indicator of global competitiveness. It is often

referred to as the currency competitiveness index of any nation, and there is a negative

correlation between competitiveness and this index. Every nation's currency will be more

competitive the lower this index's value falls in that nation. Akatugba (2018).

Also, a country cannot exist on its own either it is independent or how self-sufficient it can

be, it is very important to be in a relationship with other nations, it is mirrored by the inflows and

outflows of goods and services going one way and the movement of foreign exchange in the

opposite way. When there are changes in the exchange rates of a country, the price of imported

goods will also change in value which will also affect demand and supply of imported goods &

services. Changes in exchange rate also have undeviating effect on how income and wealth are

distributed, employment, domestic products that rely on imported parts or raw materials,

inflation, Labour market and real estate sector. Exchange rate also shows the rate at which the

markets (demand and supply side) exchange one currency into another every company operating

all over the world must deal with exchange rate, so they will have to pay suppliers in other

1
countries with a currency different from its home currency. A crucial factor in determining a

nation's balance of payments (BOP) is its exchange rate. It can function as a nominal anchor for

price stability if used wisely. Changes in exchange rate have direct effect on demand and supply

of commodities, investment, employment as well as distribution of income and wealth. It was

believed that the burden on Nigeria's balance of payments would be relieved by a naira

depreciation when the country began to record massive balance of payments deficits and

extremely low levels of foreign reserve in the 1980s. The naira lost value as a result. The irony of

this policy tool is that it failed to meet the requirements necessary for a successful balance of

payments strategy because of our international trade structure. The foreign structure of the nation

is distinguished by low import and export prices, demand elasticities, and the export of crude oil

and agricultural products whose prices are set on the global market Oladipupo & Onotaniyohuwo

(2011).

According to Paul (1996) balance of payment is an accounting record of all monetary

transactions between two countries or a country and the rest of the world, all these monetary

transactions includes; export and import of goods and services, financial tranfers, and as well as

financial capital. It also shows a country international transaction over aspecific period usually a

year and it is prepared in a single currency.

According to Obawobike (1991), several nations with poor balances of payments switch to

multiple exchange rate systems instead of devaluation, which is seen as too expensive from a

political or societal viewpoint. They stress that developing nations can benefit much from a

rationalized and well-managed dual exchange rate system in terms of guaranteeing the

fulfillment of fundamental necessities, assuring fixed and balance of payments viability, and

facilitating general resource mobilization.

2
 According to Khan and Lizondon (1987), countries with balance of payments issues should

start devaluing or gradually depreciating their currency in order to solve the balance of payments

problems. This is because devaluation, or the decline of a country's value, is expected to have

considerable effect on global capital flows.

Cooper (1976) investigates how devaluation affects some emerging nations' balance of

payments. He finds that the current account of the balance of payments improved in three

quarters of the cases that were investigated. This suggests that devaluation raises exports and

decreases imports, which eventually strengthens a nation's position in the balance of payments.

On the other hand, Birds (1984) believes that the fact that the balance of payments improves

following devaluation does not imply that devaluation is invariably the cause of the

improvement.

Iyoha (1996) talks about Devaluation is the intentional lowering of a nation's currency's

value relative to other currencies. It is an increase in the exchange rate from one par value to

another, and a country with a fixed exchange rate system may use it as a tool for policy to adjust

imbalances or surpluses in its balance of payments. Exchange rate fluctuation is explained

below, the strengthening or weakening of a home countries currency through that of foreign

currency can have a higher effect on the balance of payment in a foreign country or home

country. Exchange rate is constantly fluctuating based on the market forces (demand and supply)

whether one currency is in higher demand than the other depends on the perceived value of

owning it, either to pay for goods and services or as an investment. Fluctuation in the exchange

rate also causes varying experiences with fluctuation in the current and financial account

balances. Exchange rate fluctuation could be positive or negative, the positive shocks to the

3
exchange rate shows a sudden increase in the foreign currency price of domestic currency while

negative shocks show sudden decrease in the exchange rate.

According to Ajao, Adeniyi and Omisakin (2019), increase in exchange rate volatility led

to a deterioration of the country’s trade balance, while which in turn affected its overall balance

of payment. A rise in the value of Naira relative to the US dollar will enhance Nigeria balance of

payment and economic growth while a decrease in the value of Naira relative to the US dollar

will lessen the balance of payment and economic growth. Exchange rate fluctuations are likely to

determine the balance of payment position of a country either it is in deficits or surplus and also

the economic performance.

1.2 STATEMENT OF RESEARCH PROBLEM

Exchange rate over the years, especially after the collapse of the fixed exchange rate regime (The

Bretton woods system) has had many fluctuations. Eshani et al (2009). Exchange rate policy in

Nigeria has gone through a good number of changes but rolling between two major regimes

which are; the fixed exchange rate and the flexible exchange rate regime; the fixed exchange rate

system was approved between 1960 & 1985, while the flexible system was approved from 1986

till date. Regardless of various efforts by the government to maintain a stable exchange rate, the

Nigerian Naira has depreciated throughout the 80s, it depreciated from #0.61 in 1981 to #2.02 in

1986 and further to #7.901 in 1990, against the U.S dollar. Akatugba (2018). Between 1973 and

1979, when the country was experiencing an oil boom and more than 70% of its Gross domestic

product (GDP) came from agricultural products such as cocoa, palm oil, groundnuts, rubber, etc.,

the value of the naira was relatively steady. Prior to 1986, Nigeria used a fixed exchange rate

system for determining currency rates throughout this time. The naira was very strong against the

4
dollar at that time. The currency rate was #1=$1 to one US dollar. As the need for foreign

exchange allocation aligned with the objective of maintaining domestic balance grew, the fixed

exchange rate determination system was abandoned on September 26, 1986, and the structural

adjustment program (SAP) was implemented. One of the goals of the different macroeconomic

strategies implemented as part of the structural adjustment programme (SAP) in July, 1986 was

to set a reasonable and sustainable exchange rate for the naira. The International Monetary Fund

(IMF) suggested and the government approved this exchange mechanism strategy in 1986. Ewa

(2011).

The goal of the structural adjustment programme (SAP) was the free market determination

of the naira exchange rate through an auction system. This brought about the starting of the

unstable exchange rate, the government has to establish the foreign exchange market (FEM) to

maintain the exchange rate depending on the state of the balance of payment, rate of inflation

and employment between the year 1986 to 2023, the federal government experimented with

different exchange rate policies without allowing any of them to make astounding impact in the

economy before it was changed. This inconsistency in the policies and lack of continuity in the

exchange rate fluctuation policies amassed unstable nature of the naira rate. Gbosi (1994).

During the fixed exchange rate regime, the changes in exchange rate seemed to be stable

but the economy were getting worse every day and large balance of payment deficits, the parody

of this policy instrument is that our foreign trade structure did not satisfy the conditions for a

successful balance of payment policy. Hence the adoption of exchange rate regime has not

proved good as naira deteriorates every day and many macro- economic variables like (exchange

rate) are not stable. Anifowose (1994).

5
 Although studies (Oladipupo & omotaniyohuwo 2011, Okeke 2018, Aniekan 2021,) have

examined the relationship between exchange rate and balance of payment. While others like,

Oladipupo and Ogbenovo (2011); Eke, Eke and Obafemi (2015); Abdullahi et al. (2016) focused

on impact of exchange rate on capital account, while Odili (2014); Olanipekun and Ogunsola

(2017), for, instance, focused on the effect of exchange rate on current account.Olufemi (2018)

studied the impact of money supply on exchange rate in Nigeria (1970-2016) Akinlade (2017)

studied the dynamic relationship between exchange rate and inflation in Nigeria, Oguntegbe

(2021)examined the link between exchange rate and economic growth(1980-2020), Adeniyi

(2018) studied the link between exchange rate and Non-export in Nigeria (1980-2016). While

this study will re-examine the impacts of exchange rate on balance of payment in nigeria

between the period (1970-2022).

1.3 RESEARCH QUESTION

This research works is led by the following research question.

1. What is the impact of exchange rate on the balance of payment in Nigeria.

2. What is the trend of exchange rate and balance of payment in Nigeria.

1.4 OBJECTIVES OF THE STUDY

Due to the above listed research question, the main objective of this study is the

determine the impact of exchange rate on balance of payment in Nigeria while the specific

objectives are to;

1. Analyze the impact of exchange rate on balance of payment in Nigeria.

2. Examine the trend of exchange rate and balance of payment in Nigeria.

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1.5 SCOPE OF THE STUDY

This research works seeks to determine the impact of exchange rate fluctuation on

balance of payment in Nigeria, this study is developed to cover a period of 52 years ranging from

1970 to 2022. This period was characterised by significant volatility in the naira’s exchange rate,

which was influenced by a number of factors including oil price fluctuations, government

policies, and economic conditions.

1.6 JUSTIFICATION TO SIGNIFICANCE OF THE STUIES

The significance of this study therefore is to make known the relationship between

exchange rate and balance of payment, policy implications and recommendations which will be

of great help to policy makers, and government especially as regard the transaction of exchange

rate and balance of payment in Nigeria. It is also of great importance to student, lecturers and

also the entire public, that are interested in the subject matter and in the utilization of it. Many

sectors operating in Nigeria would find it advantageous in making many of their operational and

investment decisions.

Additionally, it will support sectors and businesses who export in many of their

operational and investment choices. It will function as a repository of data for export sector

stakeholders and policymakers. This robust material will prove beneficial to policymakers as

they endeavor to devise flexible and dependable strategies to manage fluctuations in currency

rates, thereby impacting the efficient growth of the economy. Additionally, it would direct

government agencies' regulation of export-oriented businesses and sectors. Furthermore, the

results of this study, when included in the body of literature already in existence, will serve as a

useful manual, particularly for policymakers, and a reliable source of information for further

7
scholarly investigation. This study will make a substantial contribution to the body of knowledge

among academics by offering fresh study data that will direct future researchers in the field of

exchange rate and balance of payment.

1.7 ORGANISATION OF THE STUDY

This study will be splited into five major chapters: chapter one will discuss the

background of the study, the problem statement of the research problem, research questions,

research objectives, scope of the study justification of the sturdy, and organization of the sturdy.

Chapter two will discuss: the conceptual review, the theoretical review, the empirical review, and

the gap in literature. Chapter three will discuss: the methodology used to conduct the study, the

measurement of variables and the sources of data used in the estimation of data collected. While

chapter four consist of the data analysis with interpretation. While chapter five consist of the

summary of the data, conclusion, and policy recommendation.

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 CHAPTER TWO

LITERATURE REVIEW

2.0 Introduction

Theories of balance of payment and exchange rate proliferate in the economic literature.

The orthodox theories of balance of payment include the elasticity approach, absorption

approach and monetary approach to balance of payment. The theories show the various

implications of devaluation of a single country’s currency in the world economy on real income

and balance of payments. The elasticity approach explains devaluation's effect on the current

account balance. If the sum of foreign elasticity of demand for exports and the home country's

elasticity of demand for imports exceeds unity, devaluation improves the current account;

otherwise, it worsens deficits. Critics say this approach neglects income effects and focuses on

partial equilibrium. The absorption approach, developed by Alexander (1952) and extended by

Johnson (1958), introduces income effects. It sees the current account balance as the difference

between domestic output and spending. The impact of devaluation on the balance of payments is

influenced by the marginal propensity to absorb. If this propensity is less than unity, increased

income improves the current account. The monetary approach, pioneered by Whitman (1975)

and developed by Frenkel and Johnson (1976), dismisses the traditional distinction between

exports, imports, and non-traded goods. It views the balance of payments as a monetary flow

from disequilibrium in the money market, emphasizing that balance of payments disequilibrium

reflects monetary market disequilibrium. Krugman (1979) developed a model of balance of

payment crises, showing speculative attacks on reserves occur when investors alter portfolios,

reducing domestic currency proportions. Obstfeld (1983) expanded Krugman's theory,

9
illustrating how expectations of subsequent devaluation affect the timing of balance of payment

crises based on the transitional period of floating before a new exchange parity begins. These

theories offer insights into balance of payments and exchange rates complexities, with criticisms

over their focus on stock adjustment processes instead of flow disequilibrium.

2.1 Conceptual Framework

2.1.1 Concept of Exchange rate

Conceptually, Exchange rate is the rate at which a currency is exchanged for another

currency. It can also be said to be the price of one country’s currency in relation to another

country. It is the required number of units of a currency that can buy another number of units of

another currency. It is referred to as the ratio at which a unit of currency of one country is

expressed in terms of another currency. According to Jhingan (2004), the exchange rate between

the dollar and the pound refers to the number of dollars required to purchase a pound. The rate is

normally determined in the foreign exchange market. The foreign exchange market is a market

where currencies of different countries are bought and sold. It is a market where the values of

local and foreign currencies are determined. As noted by Jhingan (2004), the national currencies

of all countries are the stock-in-trade of the foreign exchange market, and as such, it is the largest

market to be found around the world which functions in every country.

Economic history has shown that there are two common concepts of exchange rate

namely nominal exchange rate and real exchange rate. The nominal exchange rate (NER) is a

monetary concept which measures the relative price of two countries’ moneys or currencies, e.g.,

naira in relation to the U.S. dollar (e.g., #198.00:US$ 1.00) and vice versa. But the real exchange

rate (RER), as the name implies, is a real concept that measures the relative price of two goods-

10
tradable goods (exports and imports) in relation to non-tradable goods (goods and services

produced and consumed locally) (Obadan, 2006). Also, the nominal exchange rate is the number

of units of domestic currency that must be given up to get a unit of foreign currency. In other

word, nominal exchange rate is the price of domestic currency in term of foreign currency. It is

denoted as E. The real exchange rate is the relative price of foreign goods in term of domestic

goods. In other word, it is the exchange rate adjusted for price. It is denoted as; e = Ep*/p. Where

E= nominal exchange rate, p* = foreign price and p = domestic price. There are two broad

methods of exchange rate management namely fixed and flexible exchange rate regimes.

Exchange rate regimes refer to different systems of managing the exchange of a nation's currency

in terms of other currencies. According to Obadan (1996), fixed exchange rates are to promote

orderliness in foreign exchange markets and certainly in international trade transactions. On the

other hand, a flexible exchange rate system is one which the exchange rate at any time is

determined by the interaction of the market forces of demand and supply for foreign exchange.

Nzotta (2004) defines exchange rates as the price of one currency in terms of another.

Exchange rate is also the rate of transformation of one currency to another. An arbitrage in

economics and finance is the practice of taking advantage of price difference between two or

more markets, striking a combination of matching deals that capitalizes upon the imbalance, the

profit being the difference between the market prices. Arbitrage can also be seen as the

mechanism whereby speculative purchase foreign currency in a market where its price is low and

selling same in other trading centers where its price is high.

Fidelis (2009) also commented that one country’s currency becomes more expensive in

terms of another we say that the country’s currency has appreciated on the other hand when more

11
units of a domestic currency buy the other currency there is a case of depreciation. Depreciation

is also said to mean a lowering in value of a currency.

According to Yakubu (2007) appreciation and depreciation depict a situation where the

market force at demand and supply determines the exchange rates. It is often associated with a

freely floating exchange rate system. The monetary authorities may however, determine the

exchange rate decree or executive flats based on their perceptions of macro-economic condition

in the country. Devaluation exists in any situation whereby the officially declared exchange rate

is altered such that a unit of a country’s currency can buy fewer units of foreign currency. On the

other hand, when the monetary authorities alter the exchange rate such that the domestic

currency can buy more units of foreign currency, we say that a case of revaluation exists.

Devaluation and revaluation represent official response of overvaluation and

undervaluation respectively existing in a country’s currency. Overvaluation is a situation is a

situation where the exchange rate does not reflect the equilibrium exchange rate. In this situation

the exchange rate is more expensive than other currencies. Undervaluation is the reverse of

overvaluation and it should be noted that devaluation is a reduction in value of currency with

respect to other currencies.

2.1.2 Concept of Balance of Payment

The balance of payments is the record of all international financial transactions made by a

country's residents. A country's balance of payments tells you whether it saves enough to pay for

its imports. It also reveals whether the country produces enough economic output to pay for its

growth. The BOP is reported for a quarter or a year. A country’s balance of payment can either

be surplus, balanced or deficit.

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 A balance of payments deficit means the country imports more goods, services and

capital than it exports. It must borrow from other countries to pay for its imports. In the short-

term, that fuels the country's economic growth. It's like taking out a school loan to pay for

education. Your expected higher future salary is worth the investment.

In the long-term, the country becomes a net consumer, not a producer, of the world's economic

output. It will have to go into debt to pay for consumption instead of investing in future growth.

If the deficit continues long enough, the country may have to sell off its assets to pay its

creditors. These assets include natural resources, land and commodities, A balance of payments

surplus means the country exports more than it imports. Its government and residents are savers.

They provide enough capital to pay for all domestic production. They might even lend outside

the country. A surplus boosts economic growth in the short term. That's because it's lending

money to countries that buy its products. That boosts its factories, allowing them to hire more

people. In the long run, the country becomes too dependent on export-driven growth. It must

encourage its residents to spend more. They are the financial account, the capital account and the

current account. The financial account describes the change in international ownership of assets.

The capital account includes any financial transactions that don't affect economic output. The

current account measures international trade, the net income on investments and direct payments.

Here are the balance of payments components and how they work together (Kimberly Amadeo,

2018).

2.1.3 Exchange rate management in Nigeria

Exchange rate policy in Nigeria has undergone a good number of changes. It has

developed from a fixed parity in 1960 when it was solely tied with the British Pound Sterling. By

13
1967, following the devaluation of the Pound Sterling the US dollar was included in the parity

exchange. In 1972, the parity exchange with the British Pound was suspended as a result of the

emergence of a stronger US dollar. In 1973, Nigeria reverted to a fixed parity with the British

Pound following the devaluation of the US dollar. In 1974, in order to minimize the effect of

devaluation of a single individual currency, Nigerian currency was tired to both the pound and

dollar. Almost throughout the 1970s there was persistent appreciation of the nominal exchange

rate of the naira occasioned by increases in the price of oil in the international market. These

appreciations in the nominal exchange rates gave rise to over-reliance on imports with its

accompanying capital flight, discouraging non-oil exports which ultimately led to Balance of

Payments problems and depletion of external reserves. The increase in the marginal propensity to

import collapsed the agricultural sector in Nigeria Osaka, Mashe, and Adamgbe (2003). In 1978,

the naira was pegged to a basket of 12 currencies comprising Nigeria’s major trading partners.

However, the 1978 policy was jettisoned in 1985 in favour of quoting the naira against the dollar.

Before 1986, the prevailing exchange rate policies encouraged over-valuation of the naira. To

solve the problems associated with the over-valuation the naira was deregulated in September

1986 under the Structural Adjustment Programme Package. To enhance the implementation of

the Structural Adjustment Programme was the introduction of the Second-tier Foreign Exchange

Market (SFEM). SFEM was expected to usher in a mechanism for exchange rates determination

and allocation in order to ensure short term stability and long term Balance of Payments

equilibrium. As stated by Mordi (2006) the essential objectives of SFEM include to achieve a

realistic naira exchange rate through the market forces of demand and supply, more efficient

allocation of resources, stimulation of non-oil efforts, encourage foreign exchange in flow and

discourage outflow, eliminate currency trafficking by wiping out unofficial parallel foreign

14
exchange market, and lead to improvements in the Balance of Payments. Several modifications

were made in order to achieve the objectives of SFEM, from Foreign Exchange Market (FEM) to

Autonomous Foreign Exchange Market (AFEM), to Dutch Action System and, to the wholesale

Dutch Auction System. The FEM was introduced as a result of the problem arising from the first

and second tier market rates in July 1987. Bureau de change was introduced in 1989 with a view

to enlarging the scope of FEM. In 1994, the fixed exchange rate system was reintroduced. In

1995 there was a policy reversal of guided deregulation referred to as the Autonomous Foreign

Exchange Market (AFEM). In 1999 was the reintroduction of the interbank foreign exchange

market (IFEM). This brought about the merger of the dual exchange rate, following the abolition

of the official exchange rate from January 1, 1999. In 2002 was the reintroduction of the Dutch

Auction System (DAS) as a result of the intensification of the demand pressure in the foreign

exchange market and the persistence in the depletion of the country’s external reserves. Finally,

was the introduction of wholesale DAS in 2006, which further liberalized the market in an

attempt to evolve a realistic exchange rate of the naira. Up till now, exchange rate regime in

Nigeria is characterized as oscillating between fully managed and freely floating regimes.

Obadan (2006) summarized the factors that led to the misalignment of the real exchange

rate in Nigeria to 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 inflow, 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. Others include over reliance on imperfect

foreign exchange market, heavy debt burden, weak balance of payments position and capital

flight.

15
2.1.4 Balance of Payment in Nigeria

Nearly all of Nigeria's foreign exchange assets before the 1970s were held in British

pounds sterling. Under the post-World War II IMF modified gold exchange standard, which

lasted until 1973, sterling was a key currency in international trade. A country that accumulated

sterling, as Nigeria did in the twenty years before 1955, mostly years of restrictions on sterling

convertibility, essentially extended credit to Britain. During this period, Nigeria restricted

monstering imports, strengthening the balance-of-payments positions of the sterling area and

Britain's international financial position. From 1956 to 1965, Nigeria had a persistent

merchandise trade deficit, which changed to a surplus in the period between 1966 and 1977

(including the 1967-70 civil wars) with petroleum's rapid growth as an export commodity.

In late 1977 and 1978, demand for Nigeria's low-sulfur crude decreased as oil became

available from the North Sea, Alaska, and Mexico, and as global oil companies reacted to the

less favorable participation terms offered by the Nigerian government. Except for the period

from 1979 to 1980, when oil shortages and prices increased, demand for Nigerian crude

remained sluggish until 1990. From 1978 through 1983 the trade deficit continued. In early 1984,

the Nigerian government closed Nigeria's land borders and international airports for several days,

replaced all old naira notes with new currency bills, and introduced tough exchange-control

regulations designed to reduce the repatriation of naira smuggled abroad and prevent future

convertibility to other currencies. From 1984 through 1986 and in 1990, Nigeria had surpluses,

but not because of export expansion, but because an economic breakdown forced Nigeria to

adopt severe import restrictions. Nigeria's structural adjustment under World Bank auspices

brought some stability in the domestic and international economy but at the expense of falling

16
real wages and decreased government social spending for much of the late 1980s (The Library of

congress countries studies, 1991).

The Nigerian Economic Summit Group, NESG, on April 2017, gave an insight into why

Nigeria experienced trade deficit of N290 billion in 2016, even as it projected that the economy

will experience a Gross Domestic Product, GDP growth rate of 0.6 per cent. Speaking during the

21st Annual General Meeting of the NESG, chairman of the Group, Mr. Kyari Bukar, said that

the lower crude oil prices and inability of the country to finance its rising import bills in the face

of plummeting non-oil export led Nigeria’s trade balance to a deficit of N290 billion while

balance of payment deficit climbed to N1.8 trillion in the third quarter of 2016.

Bukar hinted that aside from the foreign exchange crisis, the inability of government to respond

swiftly and appropriately to economic challenges worsened the situation.

For instance, the delayed passage of the 2016 budget and cloudy policy direction

increased the level of uncertainty in the business environment. This also resulted in a decline in

foreign direct investments which closed below $1 billion in the year. Major economic sectors

such as construction, manufacturing and oil and gas also contracted by six percent, four percent

and 14 percent respectively in the year. In terms of competitiveness, Nigeria fell three places to

127th in the 2016- 2017 World Economic Forum Global Competitiveness Rankings. According

to the GCR report, the five most problematic factors for doing business in Nigeria are inadequate

supply of infrastructure, corruption, access to financing, foreign currency regulations and policy

instability.” (Prince Okafor; 2017).

17
2.1.5 Impact of Exchange Rate on Balance of Payment

The impact of exchange rates on the balance of payments encompasses a spectrum of

economic dimensions. At its core, a country's trade balance is significantly influenced by the

relative strength or weakness of its currency. A depreciation often acts as a catalyst for increased

exports, providing a competitive edge in global markets. Conversely, an appreciating currency

can raise the cost of imports, potentially leading to trade deficits.

Beyond the current account, exchange rate movements influence capital flows and financial

accounts. Interest rate differentials and perceptions of currency stability attract or deter foreign

investments, contributing to fluctuations in the overall balance of payments. Policy responses,

both monetary and fiscal, play a pivotal role in shaping exchange rates, subsequently impacting a

nation's economic equilibrium.

In a globalized economy, the interconnectedness of nations amplifies the effects of exchange rate

dynamics. External shocks or economic crises in one region can reverberate globally, affecting

exchange rates and, consequently, balance of payment positions. Moreover, the value of external

debt is intricately tied to currency movements, influencing a country's debt dynamics.

Understanding the nuanced relationship between exchange rates and the balance of payments is

crucial for policymakers, economists, and businesses alike. It requires a careful consideration of

both short-term and long-term implications. While exchange rate movements can provide

opportunities for enhancing competitiveness, they also pose challenges that demand strategic

responses to ensure economic sustainability and resilience in an ever-evolving global economic

landscape.

18
2.1.6 Benefit of Exchange Rate

Exchange rates, the relative values of currencies, wield considerable influence on the

dynamics of national economies. Their impact extends across various facets, providing both

direct and indirect advantages.

At the forefront, exchange rates play a pivotal role in shaping a nation's trade dynamics.

A favorable exchange rate can substantially enhance a country's export competitiveness, opening

up new opportunities and contributing to economic expansion. Conversely, a well-managed

exchange rate can mitigate import costs, ensuring reasonable prices for goods and positively

impacting consumer purchasing power. The implications of exchange rates extend beyond trade.

They are instrumental in attracting foreign investment, with stable rates creating an environment

conducive to economic development. The tourism industry, too, reaps benefits as favorable

exchange rates attract international visitors, bolstering foreign currency inflows and supporting

local economies.

Moreover, exchange rates contribute to economic stability by providing a framework for

businesses to plan effectively. Predictable exchange rates reduce uncertainties in international

trade, fostering an environment conducive to sustainable economic growth.

In essence, the benefits of exchange rates resonate across trade, investment, and overall

economic stability. Their influence is intricate, weaving into the fabric of global economic

interactions and playing a vital role in the prosperity of nations in the interconnected world.

19
2.2 Theoretical Framework

Exchange rate is one of the basic economic tools that are used to correct a number of

economic misalignments facing nations. It has been widely applied in most structural adjustment

programmes across the world. It has been used as a strategic policy vehicle for directing the

direction of flow of economic resources (skilled labour, Capital, managerial know-how, and

foreign exchange) into import and export sectors. However, for this to result to sustainable

economic growth and development stability must be maintained in exchange rate regime

(Schaling, 2008). Moreover, some countries use dual exchange rates systems because of their

weak balance of payments situations, rather than devaluation of their currency, this approach

sometimes prove costly from a political and social point of view. However, if managed properly,

this dual exchange rate policy can be valuable for improving balance of payments of developing

countries. These approaches include automatic price adjustment under gold standard, automatic

price adjustment under flexible exchange rates (price effect), the elasticity approach, the

absorption approach and the monetary approach (Oladipo, 2011). The Purchasing Power Parity

(PPP) in its simplest form asserts that in the long run, changes in exchange rate among countries

will tend to reflect changes in relative price level.

Kamin&Klau, (2003) are of the view that if exchange rates are floating, the observed

movement can be explained entirely in terms of changes in relative purchasing power while if it

is fixed, equilibrium can be determined by comparing satisfactory methods for: Explaining the

observed movements in exchange rates for countries whose rates were floating, Determining

equilibrium parity rates for whose countries whose surviving rates were out of line with post war

market conditions, Assessing the appropriateness of an exchange rate. Despite criticisms of PPP

theory, the theoretical foundation and explanation may sound reasonable and acceptable but its

20
practical application in real situation may be an illusion, especially in the long run (Grigorianm,

2004).

Exchange rate is the price of one currency in terms of another. It is the amount of foreign

currency that may be bought for one unit of the domestic currency or the cost in domestic

currency of purchasing one unit of the foreign currency (Soderstine, 1998). It is the rate at which

one currency exchanges for the other, and it is used to characterize the international monetary

system (Iyoha, 1996).

Obadan and Nwobike (1991) opine that some countries with a weak balance of payments

position adopt multiple exchange rate systems as an alternative to devaluation, which is viewed

as too costly from a political or social perspective. They emphasize that a rationalized and

properly administered dual exchange rate system can be very helpful to developing countries for

ensuring the satisfaction of basic needs, ensuring fixed and balance of payments viability and

general resource mobilization.

Khan and Lizondon (1987) observe that countries experiencing balance of payments

problems should embark on devaluation or gradual depreciation of her currency to effect a

change on the payment’s problems, since devaluation which is the reduction of the value of one's

country is expected to have significant impact on international capital movements.

Cooper (1976) examines the effect of devaluation on the balance of payments of some

developing countries. He discovers that three quarter of the cases examined showed that the

current account of the balance of payments improved. This implies that devaluation leads to

higher exports and lowers imports, which in the long run would improve the balance of payments

position of a country. Conversely, Birds (1984) is of the opinion that the improvements of

21
balance of payments after devaluation does not necessarily suggest that the balance of payments

always improve because of devaluation.

Iyoha (1996) considers devaluation as the deliberate reduction of the value of a country's

currency in terms of other currencies. It is an increase in the exchange rate from one par value to

another and could be used as a policy instrument by a nation under a fixed exchange rate system

to correct a surplus of deficits in its balance of payments.

2.2.1 Theories of Exchange rate

The potential causes of exchange rate fluctuations have led to examination of the

theoretical basis of exchange rates determination since exchange rates fluctuations partly reflect

deviations from the ground on which exchange rates are determined. The theories explaining the

determination of real exchange rates includes the following:

2.2.1.1 The Mint Parity Theory – This theory is associated with the working of the

international gold standard. Under this system, the currency in use was made of gold or was

convertible into gold at a fixed rate (Jhingan 2004). Here, the value of the currency unit was

defined in terms of certain weight of gold and the Central Bank of the country concerned was

always ready to buy and sell gold at the specified price. The rate at which the naira could be

converted into gold is called the mint price of gold.

2.2.1.2 The Purchasing Power Parity Theory – This Theory states that spot exchange rate

between currencies will change to the differential in inflation rate between countries. The theory

states that the equilibrium exchange rate between two inconvertible paper currencies is

determined by the equality of their purchasing power. That is, the exchange rate between two

countries is determined by their relative price levels (Obadan, 2006).

22
 The origin of purchasing power concept has been traced to the 16th century Salamanca

School of Spain. During the nineteenth century, classical economists, like Ricardo, Mill, Goshen

and Marshall endorsed and developed more or less qualified PPP views. The theory, in its

modern form, is credited to Gustav Cassel, a Swedish economist, who developed and

popularized its empirical version in the1920s (Rogoff (1996). The nominal exchange rate should

reflect the purchasing power of one currency Against another and that a purchasing power

exchange rate existed between any two countries which are measured by the reciprocal of one

country's price level against another Cassel (1916).The central tenet of the PPP is that the

equilibrium exchange rate is proportional to the relevant purchasing power parity of national

currencies involved that is exchange rate fluctuations willed stabilize the purchasing power of a

country and hence impact significantly on investment and trade(Aghevli (1991).

The condition for free trade is that the nominal exchange rate between two countries

should be equal to the ratio of the price levels in the two countries (Taylor; 1988), This approach

assumes that equilibrium real exchange rates remain constant over time and therefore, the

nominal exchange rate movement tends to offset relative price movements. The purchasing

power theory parity theory defines two equilibrium rate systems. The first is the short run

equilibrium exchange rate which is defined, in this context, as the rate that would exist under a

purely freely floating exchange rate balance. Second is the long-run equilibrium that would yield

balance of payment equilibrium over a time period in cooperating and cyclical fluctuations in the

balance of payments (including those of prevailing exchange rate from the relative purchasing

power in a currency are generally attributed to problem of arbitrage and expectations in the

goods market. Some of the assumptions of PPP theory however are quite unrealistic and

23
ambiguous, for instance the level of efficiency is different in countries as such there are deferring

cost functions. (Argy and Frenkel, 1978)

2.2.1.3 The Balance of Payment Theory – This theory stipulates that under Free exchange

rates, the exchange rate of the currency of a country depends upon its balance of payment.

According to Jhingan (2004), a favorable balance of payments raises the exchange rate, while an

unfavorable balance of payments reduces the exchange rate. Thus, the theory implies that the

exchange rate is determined by the demand for and supply of foreign exchange.

The traditional flow model is also known as the balance of payment model. In this model,

the exchange rate is in equilibrium when supply equals demand for foreign exchange,

(Olisadebe,1991:56). The exchange rates adjust to balance the demand for foreign exchange

depends on the demand domestic residents have for domestic goods and assets. On the

assumption that the foreign demands for domestic goods is determined essentially by domestic

income, relative income plays a role in determined exchange rate under the flow model. Since

assets demand can be said to demand on difference between domestic and foreign interest rates

differential is other major determinants of the exchange rate in this frame work.

This theory stipulates that under free exchange rates, the exchange rate of the currency of

a country depends upon its balance of payment. A favorable balance of payments raises the

exchange rate, while an unfavorable balance of payments reduces the exchange rate (Jhingan

2004). Thus, the theory implies that the exchange rate is determined by the demand for and

supply of foreign exchange. The major limitation of the traditional model or the portfolio balance

model is the over-shooting of the exchange rate target and the fact that substitutability between

24
money and financial asset may not be automatic; this limitation triggered the emergence of the

monetary approach.

2.2.2 Theories of Balance of Payment

To express the balance of payments theories, we look at various approaches used to

analyze the effects of exchange rate volatility on the balance of payments. These approaches

include the elasticity approach, the absorption approach and the monetary approach.

2.2.2.1 The Elasticity Approach

The elasticity approach focuses on the trade balance. It studies the responsiveness of the

variables in the trade and services account, constituting of imports and exports of merchandise

and services relative price changes induced by devaluation. The elasticity approach to balance of

payments is built on the Marshall Learner condition (Sodersten, 1980), which states that the sum

of elasticity of demand for a country’s export and its demand for imports has to be greater than

unity for a devaluation to have a positive effect on a country’s balance of payments. If the sum of

these elasticities is smaller than unity, then the country can instead improve its balance of trade

by revaluation.

This approach essentially detects the condition under which changes in exchange rate would

restore balance of payments (BOP) equilibrium. It focuses on the current account of the balance

of payment and requires that the demand elasticity be calculated, specifying the conditions under

which a devaluation would improve the balance of payments. Crockett (1977) sees the elasticity

approach to balance of payments as the most efficient mechanism of balance of payments

adjustments and suggests the computation of demand elasticity as the analytical tool by which

policies in the exchange field can be chosen, so as to form the equilibrium. In contrast, Ogun

25
(1985) is of the view that most less developed countries who are exporters of raw materials or

primary products, and importers of necessities may not successfully apply devaluation as a

means of correcting balance of payments disequilibrium, because of the low values for the

elasticity of demand.

2.2.2.2 The Absorption Approach

This approach summarily postulates that devaluation would only have positive effects on

the balance of trade if the propensity to absorb is lower than the rate at which devaluation would

induce increases in the national output of goods and services. It therefore advocates the need to

achieve deliberate reduction of absorption capacity to accompany currency devaluation. The

basic tenet of this approach is that a favourable computation of price elasticity may not be

enough to produce a balance of payments effect resulting from devaluation, if devaluation does

not succeed in reducing domestic expenditure. The approach dwells on the national income

relationship developed be Keynes and it tries to find out its implication on balance of payments

(Machlup, 1955).

2.2.2.3 The Monetary Approach

The monetary approach focuses on both the current and capital accounts of the balance of

payments. This is quite different from the elasticity and absorption approaches, which focus on

the current account only. As pointed out by Crockett (1977), the general view of monetary

approach makes it possible to examine the balance of payments not only in terms of the demand

for goods and services, but also in terms of the demand for the supply of money. This approach

also provides a simplistic explanation to the long run devaluation as a means of improving the

balance of payments, since devaluation represents an unnecessary and potentially distorting

26
intervention in the process of equilibrating financial flows. Dhliwayo (1966) emphasizes that the

relationship between the foreign sector and the domestic sector of an economy through the

working of the monetary sector can be traced by Humes David’s price flow mechanism. The

emphasis here is that balance of payments disequilibrium is associated with the disequilibrium

between the demand for and supply of money, which are determined by variables such as

income, interest rate, price level (both domestic and foreign) and exchange rate. The approach

also sees balance of payments as regards international reserve to be associated with imbalances

prevailing in the money market. This is because in a fixed exchange rate system, an increase in

money supply would lead to an increase in expenditure in the forms of increased purchases of

foreign goods and services by domestic residents. To finance such purchases, much of the

foreign reserves would be used up, thereby worsening the balance of payments. As the foreign

reserve flows out, money supply would continue to diminish until it equals money demand, at

which point, monetary equilibrium is restored and outflow of foreign exchange reserve is

stopped.

Conversely, excess demand for money would cause foreign exchange reserve inflows, domestic

monetary expansion and eventually balance of payment equilibrium position is restored. The

monetary approach is specifically geared towards an explanation of the overall settlement of a

balance of payments deficit or surplus. If the supply of money increases through an expansion of

domestic credit, it will cause a deficit in the balance of payments, an increase in the demand for

goods and various assets and decrease in the aggregate in the economy.

27
2.2.3 The Theory of Exchange Rates on Imperfect Capital Markets

The theory of exchange rates on imperfect capital markets explores how currency

exchange rates are influenced in environments characterized by imperfect capital markets. In

such settings, factors such as information asymmetry, transaction costs, and restrictions on

capital mobility can significantly impact exchange rate dynamics. This theory delves into how

imperfections in capital markets affect the supply and demand for currencies, thereby influencing

exchange rates. It considers scenarios where market participants may not have access to perfect

information or may face obstacles in executing transactions seamlessly.

Key aspects of the theory include:

Information Asymmetry: Imperfect capital markets often involve disparities in the availability

of information among market participants. The theory examines how such information

asymmetry affects the formation of expectations and, consequently, exchange rate movements.

Transaction Costs: In imperfect capital markets, transaction costs can impede the smooth flow

of currency trading. This theory analyzes how transaction costs influence the willingness of

market participants to engage in currency transactions, impacting exchange rate equilibrium.

Capital Mobility Restrictions: Some markets may impose restrictions on the movement of

capital, limiting the ability of investors to buy or sell currencies freely. The theory explores how

these restrictions affect the overall supply and demand dynamics in the foreign exchange market.

Understanding the theory of exchange rates on imperfect capital markets is crucial for

comprehending the complexities of currency valuation in real-world scenarios. Researchers and

policymakers use this framework to assess the impact of market imperfections on exchange rate

28
fluctuations and to develop strategies to manage such challenges in international financial

markets.

2.2.4 The Comparative Advantage Theory

The trade theory was the first to indicate the importance of specialization in production

and division of labor based on the idea of theory of absolute advantage. Smith (1976) in his

famous book: “The Wealth of Nations’’ published the ideas about absolute advantage were

crucial for the early development of classical thought for international trade. It is generally

agreed that David Ricardo is the creator of the classical theory of international trade, even though

many concrete ideas about trade existed before his principles. Ricardo showed that the potential

gains from trade are far greater than Smith envisioned in the concept of absolute advantage. In

this theory the crucial variable used to explain international trade patterns is technology. The

theory holds that a difference in comparative costs of production is the necessary condition for

the existence of international trade. But this difference reflects a difference in techniques of

production. According to this theory, technological differences between countries determine

international division of labor and consumption and trade patterns. It holds that trade is

beneficial to all participating countries. This conclusion is against the viewpoint about trade held

by the doctrine of mercantilism where it is argued that the regulation and planning of economic

activity are efficient means of fostering the goals of nation. David Ricardo theory demonstrates

that countries can gain from trade even if one of them is less productive then another to all goods

that it produces.

29
2.3 Empirical Review

Different scholars and researchers have reviewed the determinants of balance of

payments in different countries. Below are some of the international and local reviews carried

out by researchers. In recent period,

Rose (2010), examined the empirical relationship between the real effective exchange

rate and aggregate real trade balance for major OECD countries in the post-Bretton Woods era.

Using a variety of parametric and nonparametric techniques, the results suggest that there is little

evidence that the exchange rate significantly affect the trade balance.

Dufrenot and Yehoue (2005) in their research discovered that devaluation of exchange

rate has an important impact on the balance of payments position because it improves the

external reserves of the countries carrying out the devaluation of their currencies. In effect,

improvement on the reserve position constitutes an improvement on the balance of payments

position. More so, Ogiogo (2016) found substantial deterioration in the balance of payments

position of developing countries is caused among other factors as, worsening terms of trade,

excessive imports and over valuation of the currencies.

Olisadebe (2016) favored exchange rate appreciation as a means of attaining favorable

balance of payments position. Dubas (2009), findings suggest that overvaluation will improve

the current account without significant import liberation.

Aliyu (2008) observed that countries experiencing balance of payments problems should

embark on devaluation or gradual depreciation of her currency to effect a change on the

payment’s problems, since devaluation which is the reduction of the value of one's country is

expected to have significant impact on international capital movements.

30
 Imoisi (2012) examined the trends in Nigeria’s Balance of Payments position from 1970-

2010 using an econometric analysis. The study carried out a multiple regression analysis using

the ordinary least square method for both linear and log linear form. The results showed that the

independent variables appeared with the correct sign and thus, conform to economic theory, but

the relationship between Balance of Payments and inflation rate was not significant. However,

the relationship between balance of payments, exchange rate and interest rate were significant.

Salasevicius and Vaicious (2013) used the VECM to test for Marshall Lerner condition in

the exchange rate-trade balance relationship in the Baltic States. The study found that Lithuania

met the Marshall-Lerner condition, but Estonia did not, while the result of Latria was ambiguous.

Ogbonna (2011) examined the empirical relationship between the real exchange rate and

aggregate trade balance in Nigeria. The study tested Marshall Lerner conditions to see if it is

satisfied for Nigeria. The result showed no co-integration for the trade balance model. The

results further revealed that depreciation/devaluation improves balance of payment and Marshall-

Lerner (ML) condition holds for Nigeria.

Mungami (2012) examined the effects of exchange rate liberalization on the BOP of a

developing country using a case of Kenya. He noted that exchange rate is one of the

macroeconomic fundamentals that play a key role in ensuring that the economy of a country

remains competitive in the international market. It plays an important role of efficiently

allocating and use of economic resources hence ensuring a country remains competitive

externally. The exchange rates are important in improvement of the balance of payments. The

results showed that the exchange rate liberalization had improved the overall BOP but it had not

improved the current account or reduced the balance of trade deficit. The study found out that the

exchange rate liberalization had a negative effect on the company’s export sales due to wide

31
fluctuations that made planning hard and losses that were incurred as a result of fluctuation. Most

companies did not employ any hedging mechanism hence bore the brunt of the upswing and

downswing of the shilling. The firms factored in their prices the adverse effect of the exchange

rate fluctuation. The study recommended that the Central Bank of Kenya use target zones to

reduce wide fluctuation of the shilling against other currencies.

Umoru and Odjegba (2013) analyzed the relationship between exchange rate

misalignment and balance of payments (BOP) mal-adjustment in Nigeria over the sample period

of 1973 to 2012 using the vector error correction econometric modeling technique and Granger

Causality Tests. The study revealed that exchange rate misalignment exhibited a positive impact

on the Nigeria’s balance of payments position. The Granger pair-wise causality test result

indicated a unidirectional causality running from exchange rate misalignment to balance of

payments adjustment in Nigeria at the 1 percent level.

Dare and Adekunle (2020) investigated how exchange rate policy affects balance of

payment in Nigeria. They adopted Autoregressive Distributed Lag (ARDL) model, similar to

Nwanosike et al (2017).

Olanipekun and Ogunsola (2017) to examine both the short run and long run relationship

between the variables from 1985 to 2018. The result of ARDL revealed that exchange rate and

trade openness have significant effect on balance of payment in Nigeria. The study further tested

for direction of causality between balance of payment and exchange rate and the empirical result

showed no causality between them.

Limbore and Moore (2019) examined the effect of exchange rates on balance of

payments using secondary data from the RBI (Central Bank of India) covering the period of

32
2001 to 2018. Variables employed are export, import, trade account balance, current account

balance and overall balance data which were analyzed using descriptive method. The study

found that exchange rate was highly unstable which negatively influenced balance of payments.

Nwanekezie and Onyiro (2018) examined the effect of volatility in exchange rate on

balance of payment in Nigeria between 1981 and 2016. However, the study ended up using error

correction model (ECM) to estimate the relationship between exchange rate and balance of

payment. Co-integration test was conducted using Johansen co-integration test and the result

showed evidence of long run relationship between the variables. The ECM result showed that

exchange rate has significant effect on balance of payment in Nigeria within the period of study.

Oladipupo, A. O. and Onotaniyohuwo, Faith Ogheneovo (2011) empirically investigated

the impact of exchange rate on the Nigeria External sector (the balance of payments position)

using the Ordinary Least Square (OLS) method of estimation for data covering the period

between 1970 and 2008. They found that exchange rate has a significant impact on the balance

of payments position. The exchange rate depreciation can actually lead to improved balance of

payments position if fiscal discipline is imposed. We also found out that improper allocation and

misuse of domestic credit, fiscal indiscipline, and lack of appropriate expenditure control policies

due to centralization of power in government are some of the causes of persistent balance of

payments deficits in Nigeria.

Azeez, Kolapo and Ajayi (2012) also examine the effect of exchange rate volatility on

macroeconomic performance in Nigeria from 1986 to 2010. The model formulated depicts Real

GDP as the dependent variable while Exchange Rate (EXR), Balance of Payment (BOP) and Oil

Revenue (OREV) are proxied as independent variables. It employs the Ordinary Least Square

33
(OLS) and Johansen co-integration estimation techniques to test for the short and long runs

effects respectively. The results show that oil revenue and balance of payment exert negative

effects while exchange rate volatility contributes positively to GDP in the long run. They

recommended that the monetary authorities should pursue policies that would curb inflation and

ensure stability of exchange rate.

Nawaz Ahmad et al (2014) conducted a study aimed at determining the impact of

exchange rate on Balance of Payment, through investigation of Pakistan Economy. Thus, in

order to ascertain the volatility of exchange rates & its tendency on balance of payment, monthly

data was collected of Exchange rate and Balance of Payment from the official website of State

Bank of Pakistan. The data comprised of seven-year time period from January 2007 to October

2013. In order to achieve the purpose various test such as unit root, ARDL and Granger causality

test are employed which helped us reached to the conclusion that there is a significant and

positive relation between Exchange rate and BOP, therefore we could conclude that Stability of

exchange rates may create a positive environment by encouraging the investment, and this can

improve balance of payment.

Martins Iyoboyi (2014) investigated the impact of exchange rate depreciation on the

balance of payments (BOP) in Nigeria over the period 1961–2012. The analysis is based on a

multivariate vector error correction framework. A long-term equilibrium relationship was found

between BOP, exchange rate and other associated variables. The empirical results are in favour

of bidirectional causality between BOP and other variables employed. Results of the generalized

impulse response functions suggest that one standard deviation innovation on exchange rate

reduces positive BOP in the medium and long term, while results of the variance decomposition

indicate that a significant variation in Nigeria’s BOP is not due to changes in exchange rate

34
movements. The policy implication is that exchange rate depreciation which has been

preponderant in Nigeria since the mid-1980s has not been very useful in promoting the country’s

positive BOP. It is recommended that growth in the real sector should be improved to enhance

exports, create employment, curb inflation and reduce poverty, while cutting non-productive

imports, attracting foreign private investment and implementing well-coordinated

macroeconomic policies that impact inflation positively and stimulate exchange rate stability.

Anthony Ilegbinosa Imoisi (2015) examined the impact of exchange rate variations and

balance of payments position in Nigeria under regulated and deregulated periods. Over the years,

attaining a realistic exchange rate and improving the balance of payments position in Nigeria.

The main objective of this study was to analyses policies initiated by the Federal Government of

Nigeria in attaining a realistic exchange rate and improving the balance of payments position. To

achieve this objective, the econometric techniques of ordinary least squares, co-integration and

error correction mechanism were used to analyze the sourced data. The results showed that

exchange rate had more impact on the balance of payments position during the deregulated

period than the regulated period in Nigeria. Based on the results, the study recommends that to

improve the balance of payments position in the country, governments should increase their

capital expenditure; exports should be stimulated and diversified in the non-oil sector such as

agriculture and manufacturing sector; a contractionary monetary policy should be implemented

to discourage importation of luxurious goods and the Naira should be devalued to make exports

cheaper in the international market.

Okwuchukwu Odili (2014) carried out a study to examine the impact of exchange rate on

balance of payment in Nigeria, using annual data from 1971 to 2012. The empirical methodology

employed autoregressive distributed lag (ARDL) co-integration estimation technique to detect

35
possible long-run and short-run dynamic relationship between the variables used in the model.

The study also tested the Marshall-Lerner (ML) condition to see if it is satisfied for Nigeria. The

results provided evidence in favour of a positive and statistically significant relationship in the

long-run and also a positive but statistically insignificant relationship in the short-run between

balance of payment and exchange rate. The results further revealed that depreciation/devaluation

improves balance of payment and that Marshall-Lerner (ML) condition subsists for Nigeria. The

study recommends policies that will discourage excessive importation and promote incentive-

based export promotion programmes. It further recommends diversification of the economy and

the promotion of entrepreneurial development in Nigeria.

Delimus, (2018) examined the effect of exchange rate on balance of payments in Nigeria

from 1999 to 2016 using Autoregressive Distributed Lag (ARDL) approach. Findings from the

study revealed that nominal exchange rate had significant effect on Nigeria’s balance of

payments.

Nwanosike., Uzoechina, Ebenyi, & Ishiwu (2017) employed multivariate regression

model to evaluate the effects of devaluation of domestic currency on balance of payments in

Nigeria using Marshall-Learner (ML) condition from 1970 to 2014. The result revealed that,

devaluation of exchange rate had negative effect on balance of payments (BOP) through balance

of trade mechanism.

Olanipekun and Ogunsola (2017) investigated how exchange rate changes affect total

balance of payments, current account balance and capital account in Nigeria. They authors

employed Autoregressive Distributed Lags (ARDL) bound co-integration to examine short-run

and long effects of exchange rate on trade balance. It was found that exchange rate appreciation

36
affects BOP and current account balance negatively. However, no statistically significant effect

of exchange rate on capital account was obtained while inflation rate was found to have adverse

effect on BOP in the country.

Lamsso and Masoomzadeh (2017) studied the impact of exchange rate on the balance of

payments. The results supported the existence of the J - curve in Sweden, South Africa, Bulgaria,

Iran, and Egypt such that increase in exchange rate deteriorates tourism income, and after the

primary periods, the increase improves the tourism income.

Ogbonna (2016) examined the empirical relationship between the real exchange rate and

aggregate trade balance of Nigeria. This study tests the Marshal Learner conditions to see if it is

satisfied for Nigeria. The results suggest no co-integration for the trade balance model. The

results further show that depreciation/devaluation improves trade balance and that Marshall-

Learner (ML) condition holds for Nigeria. This is in reversal with empirical the evidence for

Nigeria has been inconsistent in either rejecting or supporting ML conditions.

Imoughele and Ismaila, (2015) showed that the exchange rate has affected the balance of

payments in Nigeria; in addition, inflation has a negative effect on the balance of payments

stability in Nigeria.

Osisanwo, (2015) in his argument, showed that an increase in gross domestic product and

interest rates lead to a greater balance of payment in Nigeria. The balance of payments enhanced

economic growth in Nigeria.

Nwanosikeetal (2017) examined the effect of devaluation of the domestic currencies on

balance of payment. Therefore, this study is filling a gap as by analyzing the impact of Exchange

37
Rate (EXR) on Balance of Payment (BOP) which other studies could not fill as regards to the

scope.

2.4 Gaps in the literature

The existing literature on exchange rates and balance of payments reveals gaps that warrant

further exploration. A significant omission is the inconsistent reporting of methodologies,

hindering systematic comparison. Many studies lack details on statistical packages, impeding

replicability. Additionally, the concentration on specific countries, like Nigeria and Pakistan,

raises questions about broader applicability. Temporal limitations, focusing on narrow

timeframes, obscure understanding of long-term trends. The oversight of external factors and

limited exploration of policy implications create gaps. Neglecting non-traditional sectors and

services in relation to exchange rates is notable. There's potential for a more thorough analysis of

exchange rate volatility's consequences for balance of payments. Comparative research on how

diverse countries respond to exchange rate changes could enrich understanding. These gaps

highlight areas for future research.

38
 CHAPTER THREE

RESEARCH DESIGN AND METHODOLOGY

3.0 Introduction

The main purpose of this work is to access the effect of exchange rate on balance of

payment in Nigeria. This study aims at achieving the following objectives: To analyze the impact

of exchange rate on balance of payment in Nigeria. To examine the trend of exchange rate and

balance of payment in Nigeria. This section discusses the method and procedures for collecting

and analyzing data. Generally, the specification of the economic model is based on economic

theory and the available data relating to the study. The research essentially adopted for this

research is the ex-post facto research design. It is used when the researcher intends to determine

cause-effect relationship between the dependent and independent variables with a view to

establishing a causal link between them.

3.1 Theoretical Framework

This research model is specified from the examination of the above theoretical and

empirical context. The study employed the Ordinary Least Square (OLS) and Johansen co-

integration estimation techniques to test for the short and long runs effects respectively.

Variables includes: Capital flows, Gross Domestic Product (GDP), Trade Balances, Exchange

Rates, Inflation Rates, Interest Rates, Infrastructure, Labor Market Conditions, Balance of

Payment and Oil Revenue. The model formulated depicts Real GDP as the dependent variable

while Exchange Rate (EXR), are proxied as independent variables. The results show that oil

revenue and balance of payment exert negative effects while exchange rate volatility contributes

positively to GDP in the long run.

39
3.2 Model Specification

The paper is hinged on purchasing power parity (PPP). The idea behind purchasing

power parity is that a unit of currency should be able to buy the same basket of goods in one

country as the equivalent amount of foreign currency at the going exchange rate in a foreign

country, so that there is parity in the purchasing power of the unit of currency across the two

economies. Coakley, Flood, Fuertes, & Taylor (2005) stipulated that a very simple way of

gauging whether there may be discrepancies from PPP is to compare the prices of similar or

identical goods from the basket in the two countries.

Thus, following the model specification of Oladipupo and Onotaniyohuwo (2011) with slight

modification, the mathematical relationship between exchange rates and balance of payments is

specified as:

BOP = f (GDP, EXR, INFL, INTR, INFR, CPI, MS) …………………………… (1)

Where;

BOP = Balance of payments

GDP = Gross Domestic Product

EXR = Exchange Rates

INFL = Inflation Rates,

INTR = Interest Rates

INFR = Infrastructure

40
MS = Money Supply

CPI = Consumer Price Index

Specifying equation (1) in econometric form we have:

RBOP = β0 + β1GDPt + β2EXRt + β3INFLt + β4INTRt + β5INFRt + β6CPIt + β7MSt + t

Where;

t = Denotes the white noise error term

β0 = Is a constant parameter, while

β1, β2, β3, β4, β5, β6, β7 = Are the parameter of coefficients.

They are the slope of the graph that measures the change in the BOP as a result of a unit change

in Gross Domestic Product, Exchange Rates, Inflation Rates, Interest Rates, Infrastructure,

Money Supply, Capital Price Index.

3.3 A prior Expectation

The Apriori expectations of the explanatory variables are as expressed as: β1, β2, β3, β4,

β5, β6, β7  ; that is gross domestic product, exchange rates, inflation rates, interest rates,

infrastructure, money supply, and capital price index are expected to have a positive impact on

Nigeria’s balance of payment.

41
3.4 Measurement of variable

The measurement of economic variables involves quantifying and assessing these

variables to provide meaningful insights into the economic conditions and dynamics of a

country. The measurement methods vary depending on the specific variable, but generally

involve the use of statistical and economic indicators.

VARIABLES MEASUREMENT

Balance of Payments The BoP is measured through various

components, including the current account

(exports and imports of goods and services),

capital account (financial investments), and

financial account (assets and liabilities).

Gross Domestic Product (GDP) GDP is typically measured using three

approaches – the production approach, income

approach, and expenditure approach.

Exchange Rates Exchange rates are measured as the relative

value of one currency compared to another.

Inflation Rates Inflation rates are measured as the percentage

change in the general price level of goods and

services over a specific period.

Interest Rates Interest rates are measured as the cost of

borrowing or the return on investment.

Infrastructure Infrastructure quality is assessed based on

criteria such as transportation efficiency,

42
 communication networks, and energy

availability.

Money Supply Money supply is typically categorized into

different levels (M0, M1, M2, M3) based on

the degree of liquidity. Central banks and

financial institutions monitor and report on

these measures to understand the money

circulating in the economy.

Consumer Price Index (CPI) CPI is calculated by comparing the current cost

of the basket of goods to a reference base year.

It is expressed as an index number, and

changes in the index reflect inflation or

deflation in consumer prices.

3.5 Sources of Data

The research data employed in analyzing the impacts of exchange rate on balance of

payment positions in Nigeria were secondary data. The data were sourced from the Central Bank

of Nigeria Statistical Bulletin for the period 1970-2022.

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