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CHAPTER ONE
INTRODUCTION
1.1 Background of the Study
Since the breakdown of the Bretton Woods fixed exchange rate system in the early 1970s, the effect of exchange rate volatility on trade flows and other macroeconomic variables has attracted a lot of attention. Exchange rate is simply the rate at which one currency exchanges for another and its volatility is a statistical measure of the exchange rate tendency to rise and fall sharply within a short period and is important in understanding foreign exchange market behavior. Be it nominal or real exchange rate, volatility creates uncertainty in macroeconomic policy formulation, investment decisions and international trade flows. (Anthony Musonda 2008).
The role of exports in economic development has been widely acknowledged. Exports refer to goods and services a country sends to other countries for sale. It affects the current account balance of an economy positively and its payment involves converting one currency into another via exchange rate. Ideally, export activities stimulate growth in a number of ways including improvement of balance of payment, production and demand linkages, economies of scale due to large international markets, increased efficiency, adoption of superior technologies embodied in foreign produced capital goods, learning effects and improvement of human resources, increased productivity through specialization as well as creation of employment (Maureen Were 2002). According to Giles and Williams (2000), while practical evidence in support of Export Led Growth (ELG) may not be universal, rapid export growth has been important feature of East Asia’s remarkable record of high and sustained growth. In particular, the wave of growth in the four countries (Hong Kong, South Korea, Singapore and Taiwan) and the newly industrialized countries (such as Malaysia, Indonesia and Thailand) has been used to support the argument that carefully managed openness to trade through an export-Led growth is a mechanism for achieving rapid growth.
Exchange rate volatility has acquired a special interest in the research works on international trade and investment. Given the central role of exchange rate in an economy generally, and its importance to investment and international trade in particular, the Nigeria national government has increasingly felt the impact of this volatility on their own policies towards the achievement of macroeconomic objectives. Some of the economic variables often mentioned as being influenced by exchange rate volatility are trade flows, foreign direct investment, currency crisis, debt servicing cost and commodity prices (Okenyi 2010). Exchange rate volatility refers, to the erratic fluctuations in exchange rate which could occur during periods of domestic currency appreciation or depreciation. Much variation in Exchange rate may lead to a major decline in future output if they are unpredictable and erratic. The exchange rate is therefore an important relative price as it has influence on the external competitiveness of the domestic economy.
The foreign exchange market is by far the largest financial market in the world with daily turnover exceeding $1000 billion in 1995, up from only $200 billion in 1986 (Sanusi 2004). This impressive increase is expected with an increase in cross-border investments. Trading in foreign exchange market generally involves mainly the US Dollar because of the depth and importance of the US Dollar currency market and the associated lower transaction cost. A Nigeria importer for instance, wishing to buy yen to pay a Japanese exporter, would sell Naira for Dollar and then buy yen with the proceeds. In view of this and for the fact that Nigeria is an import dependant country, exchange rate volatility has a great impact in her macroeconomic performance. The appreciation and depreciation of currency determines the volatility of exchange rate which will directly or indirectly result in volatility of macroeconomic variables.
Furthermore, research related to exchange rate management still remains of interest to economists, especially in underdeveloped and developing countries like Nigeria, despite a relative enormous body of literature in the area. This is largely because the exchange rate in whatever conceptualization is not only an important relative price which connects domestic and world markets for goods, assets and services, but it also signals the competitiveness of a country′s exchange power visà-vis the rest of the world market.
Thus, study of this nature that determines the influence of exchange rate volatility on export is imperative, especially in developing country like Nigeria. For maximum benefit from export in Nigeria there is need for incentives and suggestions that boost exports in the economy like careful management of exchange rate.
1.2 Statement of Problem
Although there is a growing body of literature on the impact of exchange rate volatility on export and trade generally, empirical evidence has been ambiguous both within developed and developing countries and across countries (Cote 1994 and Musonda 2008). Many empirical findings support the hypothesis that an increase in exchange rate volatility leads to a decrease in trade flows because in most international transactions, sales are demonstrated in terms of currency of either the exporting or importing country. Therefore, unanticipated variation in exchange rate should adversely affect export and trade flows generally through the effects on profits. There are also some conflicting evidences on the relationship between exchange rate volatility and trade, which suggest that exchange rate volatility, has a positive impact on trade. This could be as a result of methodological or systemic errors or otherwise. Given such contradictions, the debate on the impact of exchange rate volatility on trade, remains inconclusive.
A realistic exchange rate has been one of the most important factors for economic growth in the economies of South-East Asia while volatility in exchange rates has been one of the major obstacles to economic growth of many African and Latin American economies (Keshab and Mark 2005). It is interesting therefore to investigate whether correcting the exchange rate system could solve some of the structural rigidities, imbalances in trade and slow growth performance of the Nigeria economy.
There is widespread presumption that volatility of the exchange rate is one of the main sources of economic instability of the developing countries around the world. For instance, an influential group of which includes, among others, Paul Volker and George Soros, among others, have recently stated that ……. “The impact of the global economy on emerging countries is driven significantly by swings among the currency of the economic power (see Allaire 1999).
If firms hedge against exchange rate risk, one could not expect to find a strong negative effect of exchange rate on trade. Hedging against risk can be done via future or forward markets. A forward market represents, in effect, a guaranteed forecast of the exchange rate that will prevail at the end of the contract period, which a trader can take advantage of by payment of a small margin around the forward rates. Since currency uncertainty can be removed from the short-term trading transaction by payment of this margin, the cost of such uncertainty cannot be higher than the cost of purchasing insurance against it. Unfortunately, the forward market is absent in Nigeria and the possibility of hedging via this route is remote. In fact, most studies have not taken hedging possibilities into account. It has been argued that hedging foreign exchange rate via future/forward markets is an imperfect and costly method of avoiding exchange rate risk. This is because, hedging transactions have a cost: Secondly, several studies (Cumby and Obstfeld, 1981, Frenkel 1981, Hakkio and Rush 1989, Adubi 1991 etc) have indicated that the forward rate is a poor indicator of the future spot rate. Thus even in the presence of forward markets for exchange rates and hedging, trade is likely to be hurt. The IMF (1984) argues that forward/future markets can be used to hedge against nominal exchange rate risk in the short run at small cost. However, longterm export oriented activities would be exposed to higher and possibly unchangeable risks.
It therefore follows that, hedging notwithstanding, exchange rate volatility which tends to increase the risk and uncertainty in international transactions, may adversely affect trade and investment flows. This will further increase risk on supply of exports. Exchange rate risk measures the volatility and erratic pattern of exchange rate movements: the more volatile the movement, the higher the risk. Producers of exports are not only concerned with the magnitude of the price they receive; they also bother about the stability of such prices as it relates to earning consistent income. (Adubi and Okunmadewa 1999).
Furthermore, it is imperative to look at influence of exchange rate volatility on Nigeria exports in its entirety. Studies reviewed concentrated on one angle or the other. For instance, Osuntogun 1993, Oluremi 1998, and Aliyu 2008 all studied the impact of exchange rate volatility on Nigeria’s non-oil exports. Adubi and Okunmadewa 1999 looked at its impact on Nigeria’s agricultural exports.
Despite the good number of literature in this study area, there are no much recent research works known to me on the relationship between exchange rate volatility and exports in Nigeria.