AN ANALYSIS OF THE RELATIONSHIP BETWEEN REAL EXCHANGE RATE AND DOMESTIC CONSUMPTION IN NIGERIA

economic

Economics of Recovery and Recovery of Economics: A Peep into Nigeria – THISDAYLIVE

ABSTRACT

This dissertation analyses the real exchange rate-domestic consumption relationship in Nigeria using the Smooth Transition Autoregressive (STAR) model from 1981 to 2016. Findings shows that domestic consumption determines the regime shift in real exchange rate suggesting a nonlinear linkage of real exchange rate and domestic consumption with clearly distinct regimes.

Exchange rate is shown to have significant linear effect from previous exchange rate. On the other hand, current foreign consumption is positive but has no significant impact on the exchange rate in the linear part of the model. In the nonlinear part of the model, we found evidence of a significant negative relationship between real exchange rate and domestic consumption, thus supporting the proposition by standard International Real Business Cycle (IRBC) Model. In the face of the wide disparity in literature trying to establish the prediction of IRBC model, we found evidence of bi-directional nonlinear granger causality between real exchange rate and domestic consumption. The study concludes that the relationship between real exchange rate and domestic consumption is indeed nonlinear and that fiscal and monetary authorities should develop policies that will help strengthen domestic production to further reduce import component in domestic consumption.

Table of Contents

DECLARATION ……………………………………………………………………………………………………………………….. CERTIFICATION ……………………………………………………………………………………………………………………….

DEDICATION ………………………………………………………………………………………………………………………….. ACKNOWLEDGEMENT ………………………………………………………………………………………………………………

ABSTRACT ………………………………………………………………………………………………………………………………

Table of Contents …………………………………………………………………………………………………………………

List of Tables ……………………………………………………………………………………………………………………….

List of Appendices …………………………………………………………………………………………………………….

CHAPTER ONE ……………………………………………………………………………………………………………………… INTRODUCTION …………………………………………………………………………………………………………………..

Background to the Study ………………………………………………………………………………………

Statement of Research Problem ……………………………………………………………………………

Research Questions ……………………………………………………………………………………………..

Research Objectives ……………………………………………………………………………………………

Research Hypothesis …………………………………………………………………………………………

Justifications of the Study …………………………………………………………………………………

Scope of the Study …………………………………………………………………………………………….

Organization of the Study ………………………………………………………………………………………

CHAPTER TWO ……………………………………………………………………………………………………………………

LITERATURE REVIEW …………………………………………………………………………………………………………..

2.0. Introduction ……………………………………………………………………………………………………………….

2.1. Conceptual Issues …………………………………………………………………………………………………….

2.2. Overview of Exchange rate Management in Nigeria …………………………………………………….

2.3. Theoretical Issues ……………………………………………………………………………………………………

2.4. Review of Previous Empirical Literature ……………………………………………………………………

2.4.1. Gap in the Literature ………………………………………………………………………………………………..

CHAPTER THREE ………………………………………………………………………………………………………………….. METHODOLOGY ……………………………………………………………………………………………………………….

3.0. Introduction ……………………………………………………………………………………………………………….

viii 3.1. Theoretical Framework ………………………………………………………………………………………………

3.2. Model Specification …………………………………………………………………………………………………..

3.3. Estimation Strategy and Techniques ……………………………………………………………………………..

3.4. Robustness Tests ………………………………………………………………………………………..

3.5. Data and Sources of Data ……………………………………………………………………………………………

3.6. Apriori Expectations ………………………………………………………………………………………………..

CHAPTER FOUR …………………………………………………………………………………………………………………..

PRESENTATION OF RESULTS, ANALYSIS AND DISCUSSION ………………………………………………………

4.1. Test for Stationarity and Lag Length Selection ……………………………………………………………

4.2. Result of Cointegration Test ……………………………………………………………………………………..

4.3. Results for the Smooth Transition Autoregression (STAR) ……………………………………………..

4.3.1. Linear Part (Low Exchange rate regime) ……………………………………………………………………..

4.3.2. Nonlinear Part (High Exchange Rate Regime) ………………………………………………………..

4.4. Linear and Nonlinear Granger Causality Test Results ……………………………………………………..

4.5. Nonlinearity in Nigeria ………………………………………………………………………………………………

CHAPTER FIVE …………………………………………………………………………………………………………………….

SUMMARY, CONCLUSION AND RECOMMENDATION ……………………………………………………………..

5.1. Summary ……………………………………………………………………………………………………………….

5.2. Conclusion ………………………………………………………………………………………………………………..

5.3. Policy Recommendations …………………………………………………………………………………………..

REFERENCES ………………………………………………………………………………………………………………….

APPENDICES …………………………………………………………………………………………………………………………

List of Tables

Table 1.

Results for Unit Root Tests

Table 2.

Optimal Lag Order Selection Results

Table 3.

Result of Cointegration Test

Table 4.

Linearity vs Nonlinearity Test

Table 5.

The Smooth Transition Autoregressive Model Results

Table 6.

Linear and Nonlinear Granger Causality Test Results List of Appendices Appendix

A: Episodes of Exchange rate Policy in Nigeria 1957-2016 Appendix

B: Summary of Empirical Review Appendix

C: Unit Root Tests Appendix

D: Lag Order Selection Results Appendix

E: Cointegration Test Results Appendix

F1: Test for Linearity and Transition Variable Determination Result Appendix

F2: STR Grid Search Results Appendix

F3: STR Results for Linear and Nonlinear Parts Appendix

F4: Test of No Error Autocorrelation Appendix

F5: Test of No Remaining Nonlinearity Appendix

F6: Parameter Constancy Test Appendix

G: Granger Causality Test 1

CHAPTER ONE

INTRODUCTION

1.1 Background to the Study Over the last few decades, issues relating to exchange rate and macroeconomic fundamentals have posed a number of questions and challenges across the globe. Trade among economies is facilitated by exchange rate as a measuring tool for valuing goods and services internationally.

Globally, exchange rate instability is seen as a common issue, which has implications for domestic consumption through the prices of consumer goods and services. Therefore, changes in exchange rate could impede or distort the movement of goods and services globally. Besides, one of the fundamental concerns in international macroeconomics is the effect of high volatility of the real exchange rate on macroeconomic fundamentals. Hence, there has been growth in literature on the factors determining exchange rate instability in international business cycle models (Tretvoll, 2018).

Exchange rate volatility has also been seen to have effect on domestic economic performance in many developing countries, including Nigeria. It has implications for virtually most economic activities in both home and abroad. Most developed and developing economies of the world have experienced different episodes of exchange rate volatility translating to high degree of uncertainty which serves as an impediment to the attainment of macroeconomic objectives. The incidence of large fluctuations in exchange rates has informed the need for a better understanding of its pass through into import and domestic prices; and consumption (Aliyu, Yakub, Sanni & Duke, 2009). Exchange rate is one of the economic indicators that affects consumption directly through prices of consumer goods and indirectly through the prices of intermediate goods.

2 From the foregoing, there is also a wide acceptability that exchange rate affects domestic consumption (Alexander, 1952; Bahmani-Oskooee, Kutan & Xi, 2015; Bahmani-Oskooee & Xi, 2012; and Iyke & Ho, 2017) particularly in this age of globalization. As such, the role of exchange rate in the macroeconomic objectives of an economy cannot be overlooked. This gives justification public policy makers, investors and households to pay a lot of attention to the exchange rate management in the economy.

Owing to the fact consumption is an important variable in economies of the world, it is crucial to the apparatus that makes an economy run efficiently (Goodwin, Nelson, Ackerman, & Weisskopf, 2008) as well as crucial to exchange rate determination, particularly, a small open economy that depends on importation. Central to the issue of consumption is the welfare implications of exchange rate fluctuations on one hand, and the effect of consumption on exchange rate deviations from the “Purchasing Power Parity (PPP)” equilibrium on the other hand. Macroeconomists are interested in “aggregate consumption” because it determines aggregate saving that translate to capital through the financial markets (Ezeji & Ajudua, 2015). Hence, an economy’s long-term productive capacity is significantly influenced by both aggregate consumption and saving behaviour accounting for most of the GDP. Therefore, it is imperative to study the dynamics of aggregate consumption expenditure not only for macroeconomic objective and the business cycle (Gerstberger & Yaneva, 2013), but also for determining the state of consumption favourable to optimal exchange rate determination. It is imperative to know the relationship between consumption and exchange rate as well as the extent to which an economy should consume imported products or nontraded goods to safeguard its domestic currency, since welfare depends partially, at least, upon household consumption. In developing countries like Ni3 geria, consumption is “the standard measure of material well-being because consumption standards were behind the original setting of the poverty line” (Meyer & Sullivan, 2003). Consequently, the welfare of household is linked to exchange rate in any given economy.

Exchange rate volatility “refers to a situation in which a country’s actual exchange rate deviates from equilibrium” (Clement & Eze, 2017,p. 3). Therefore, exchange rate deviations from its equilibrium, a set-back to economies around the world is considered exchange rate misalignment especially in the form of exchange rate overvaluation. This has been identified as one of the obstacles to sustained economic growth (Ghura & Grennes, 1993). Exchange rate management is an important macroeconomic objective and an issue of serious concern in a developing economy (Essien, Uyaebo, & Omotosho, 2017). Indubitably, economists as well as policy makers are interested in exchange rate both in developed and developing economies. Exchange rate fluctuations or volatility affects trade among economies. These bilateral trades are threatened with the risks involved in exchange rate management, thereby passing through to domestic consumption and invariably to the welfare of households. Hence, consumption is affected by the fluctuations in the exchange rate through its inflation pass through i.e., the consumer prices channel. It also affects the price level that determines the level of household consumption as well as promotes local and foreign consumption, the value of which is determined in the foreign exchange market. Conversely, the pattern of consumption also poses a threat to the exchange rate especially when skewed to excessive consumption of imported goods, thereby, causing persistent Balance of Payment disequilibrium. For example, in a bid by the CBN to avert the consequences of our consumption on the exchange rate introduced additional trade and exchange restrictions, including a ban on supply of foreign exchange at the official rate for the import of about 41 items which constitute major consumption goods of households.

4 1.2 Statement of Research Problem Many factors have exerted some influence the evolution of foreign exchange market in Nigeria.

A sample of such factors include, “pattern of international trade, institutional changes in the economy and structural shifts in production and consumption” (CBN, 2016). “Before the establishment of the Central Bank of Nigeria (CBN) in 1958 and the enactment of the Exchange Control Act of 1962, foreign exchange was earned by the private sector and held in balances abroad by commercial banks which acted as agents for local exporters” (CBN, 2011). At that time, agricultural production and exports contributed the bulk of foreign exchange receipts. As a result of large volatility, there was introduction of reforms in the Foreign Exchange Market.

However, Nigeria depends substantially on import with oil revenue serving as the pool of wealth for settling the trade balance in international market. For instance, many industries and households in the economy import their raw materials and finished goods for production and consumption respectively. This has made the economy vulnerable to the volatility of exchange rate through its impact on aggregate consumption stemming from its implications on consumer prices of imports. The foreign exchange rate of naira to the dollar and other major reserve currencies has deteriorated due to developments in the external sector which led to dwindling crude oil receipts as a result of both demand and supply factors1. Concerns have been raised on the implications of these developments on consumer prices2 which is the major determinant of domestic consumption, and how it influences the exchange rate (Mamman, 2017).

1 Speculation, hedging, investment, exchange rates, inflation, spare production capacity, geopolitical risks, inventories, weather, global economic growth and non-OPEC supply growth.

2 With a pass-through effect from foreign prices to domestic and import prices as a result of exchange rate fluctuations.

5 The Nigerian exchange rate has been affected by numerous factors. This effect emanating from low production base of the country and undiversified structure of the economy; import dependent production and consumption structure; and excessive demand for foreign exchange in settlement for import bills (Obadan, 2006). Nigeria consumes more than it produces locally, which implies that there is spare production capacity that could be consumed domestically. This translates to a decrease in the domestic currency value of Naira. The economics of supply and demand state that when demand is high, prices tend to increase, thereby leading to the currency appreciation. On the other hand, when a country has consumption than it produces, their currency is demanded less, so prices should decline. An economy with a large demand for its goods tends to produce and export more than it consumes and imports, which increases the demand for its currency.

There are theoretical and empirical basis for nonlinearities in the exchange rate-consumption relationship. Studies on the exchange rate volatility and persistence have shown an evidence that high volatility regimes with bigger deviations from equilibrium adjust faster in speed than smaller deviations due to nonlinearity (Pavlidis, Paya, & Peel, 2017). In the same view, economic agents react to the abrupt fluctuations in exchange rate differently. Overall, the economy reacts to sudden deviations in different manner. This indicated that a negative shock to exchange rates in Nigeria overtime could trigger a higher uncertainty associated with heightened expectations.

This uncertainty can take a nonlinear path in reverting back to the equilibrium (Akpan & Atan, 2012). In other words, the behavior of exchange rate may capture asymmetry. Exchange rate in Nigeria captures asymmetries related to both positive and negative shocks. Hence, this might be the effects of exchange rate asymmetric uncertainty imposed upon by the pattern of consumption.

6 1.3 Research Questions In line with the above problems, the study seeks to answer the following questions i. Is there evidence of linear or nonlinear relationship between domestic consumption and real exchange rate in Nigeria? ii. How does domestic consumption affect real exchange rate in Nigeria? iii. Is there presence of nonlinear granger causality between domestic consumption and real exchange rate in Nigeria?

1.4 Research Objectives The broad objective of the study is to analyse the linear or nonlinear relationship between real exchange rate and domestic consumption in Nigeria from 1981Q1 to 2016Q4. Specifically, the study seeks to i) Ascertain whether there is evidence of nonlinearity in the relationship between domestic consumption and real exchange rate in Nigeria; ii) Based on question one above, analyze the effect of domestic consumption on real exchange rate in Nigeria; and iii) Examine the direction of linear or nonlinear granger causal relationship between real exchange rate and domestic consumption in Nigeria.

1.5 Research Hypothesis For the purpose of analysing the above objectives, the hypotheses of this study are formulated thus: : There is no evidence of nonlinear relationship between real exchange rate and consumption in Nigeria.

: There is evidence of nonlinear relationship between real exchange rate and consumption in Nigeria.

1.6 Justifications of the Study There exist some level of ambiguity in the real exchange rates-consumption relationship (Head, Mattina, & Smith, 2004). Examining the linkage between real exchange rates and consumption : 0 0 0 H a = : 0 1 1 H a ¹ 7 is very crucial for any economy in order to determine the level of domestic or foreign consumption that is optimal for exchange rate determination. Poor management of the exchange rate volatility could have an adverse effect on consumption and could breed other crises. To avoid this situation, it is important to review past events and put forth proper policy to forestall the effects of domestic consumption on the exchange rate as well as effect of exchange rate on consumption in Nigeria.

The adjustment process of exchange rate deviations to the equilibrium path follows a nonlinear reversion pattern which is one of the numerous reasons why research into the nonlinear relationship between exchange rate and consumption is important for developing economy (Pavlidis, Paya, & Peel, 2017). The exchange rate-consumption behaviour is appealing and the knowledge of exchange rate and consumption behaviour is important in appropriately adjusting exchange rates to ensure competitiveness in the international market and prepare an effective expenditure switching strategy (Aliyu, 2016). Despite, the form of behaviour, a large body of literature that exist on the exchange rate-consumption relationship depend on linear models (see Backus & Smith, 1993; Backus & Smith, 1993; Kollmann, 1995; Stockman & Tesar, 1995; Ravn, 2001; Chari, Kehoe, & McGrattan, 2002; Selaive & Tuesta, 2003; Head et al., 2004; Choi, 2005; Benigno & Thoenissen, 2008;Tuesta, 2013). Empirical evidence on some economies have shown that the relationship could be nonlinear (see Pavlidis, Paya, & Peel, 2015; Pavlidis, Paya, & Peel, 2017). However, the few studies that exists for Nigeria did not consider the nonlinear pattern of the relationship of exchange rate, and may have therefore missed on fundamental information of the behaviour of exchange rate (Aliyu, 2016). However, the studies of Pavlidis et al. (2015) and Pavlidis et al. (2017) on nonlinear relationship and granger causality of real exchange rates and consumption basically tested the theoretical 8 preposition of International Real Business Cycle model on OECD countries. This study focuses on the nonlinear linkage between real exchange rate and consumption in Nigeria, and test for the linear or nonlinear direction of causality. Considering the hypothesis that the relationship between the variables is nonlinear in reality, there may be potentially one challenge of the choice of linear or nonlinear models to be utilized in this study. The practice of capturing misalignment with the level of deviations from linear trends could result in misleading inferences (Mordi, 2014). In trying to resolve this issue, this study adopts the Smooth Transmission Autoregressive (STAR) Model estimation technique used by Pavlidis et al. (2017) and Pavlidis et al. (2015).

On a final note, the significance of this study emanates from the fact that exchange rate is an important tool used to maintain balance between internal and external sectors. As such, this study would guide the authorities on the right policy in managing consumption behaviour to prevent Nigeria from the excessive foreign exchange rate fluctuations for the welfare of the economy. In other words, it would also help in smoothening domestic or private consumption through its policy strategies as well as curtail the exchange rate uncertainty.

1.7 Scope of the Study The study focus shall be on the relationship between real exchange rate and domestic consumption in Nigeria using quarterly data from 1981Q1 to 2016Q4. The choice of the sample period is underpinned by the fact that under this period, the economy transits between different episodes of exchange rate management and a period when Nigeria attained its independence which will give comprehensive information in analysing the relationship. The period of study is also chosen to overcome the model limitations as well as account for changes in volatility and a number of regimes switching within the period of study because the larger the sample size, 9 the better for the STAR model to identify the abrupt change in regimes and the transition from one regime to another.

1.8 Organization of the Study This dissertation shall be structured in five chapters with the first chapter giving the general introduction comprising of the background to the study, statement of research problem, the research objectives among others. Chapter two comprises of conceptual issues, theoretical and empirical literature as well as the gap in the literature. The research methodology is explored in chapter three, while chapter four shall focus on presentation and discussion of results. Chapter five shall present the summary, conclusion and recommendation.

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