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AN ANALYSIS OF THE IMPACT OF THE FIXED AND FLEXIBLE EXCHANGE RATE SYSTEMS ON THE NIGERIAN ECONOMY

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CHAPTER ONE: INTRODUCTION

 

1.1    Background of the Study

International trade arose as a result of differences in resource endowment among nations. While some nations have more than they need, others do not have. In addition, while some nations are very efficient in the production of some goods. Others are less so. These problems have been reconciled through international trade. That is, it is anchored on comparative advantage in production and gains from trade as well as specialisation.

Through trade (and international trade in particular), nations can now purchase those goods they need but which they cannot produce, for one reason or another while exporting those they can produce in abundance to other countries. To import what a nation needs will involve payment for that item in foreign currency, this being the major difference between home trade and foreign trade which is otherwise known as international trade.

This necessarily involves the determination of the rate at which the home currency of the importer will exchange for that of the exporter’s for instance, if a Nigerian buys goods from a seller in Belgium, the problem of foreign exchange is involved. The buyer would want to make payment in naira, but the seller would like to be paid in the Belgian franc. Another problem would be how much naira would be exchanged for the Belgian franc? That is there will be need to determine the rate of exchange between the two currencies involved.

That rate at which one national currency exchanges for another in the foreign exchange market is known as the exchange rate of the currency in question. The foreign exchange market by definition is that international market in which one national currency can be exchanged for another.

Two exchange rate systems are identifiable, namely, the fixed exchange rate and the floating of flexible (fluctuating) exchange rates. In a fixed exchange rate regime, national governments agree to maintain the convertibility of their currencies at a fixed exchange rate. Under a regime of fixed exchange rate, governments are committed to intervention in the foreign exchange market to maintain nominal exchange rate (Begg, et al, 1984). In a floating (flexible) exchange rate regime, the exchange rate is allowed to attain its free market equilibrium level without any government intervention through transaction that increase or reduce the foreign exchange reserves (Begg et al 1984). That is, the forces of demand and supply are allowed to establish the exchange rate of one currency against another.

Only very few countries do permit the value of their national currencies to be determined by the interaction of the forces of demand and supply. Thus, throughout the 19th and 20th centuries, countries have sought to maintain a pattern of relatively fixed exchange rates. The gold standard and the gold-exchange standard (Bretton woods system) both of which were fixed had been based on the when international currency values are kept as stable as possible by government intervention in exchanges markets. (O’connor and Buesco 1990).

According to Ammer and Ammer (1984) from the end of World War I until 1971, the major trading nations preferred a fixed rate of exchange, with each country setting a par value for its currency (known as the official rate)”. They further observed that in practice, this rate varied slightly. Before World War II, the par value of each major currency normally was fixed in relation to gold; in the post war period, it was set (by the International Monetary Fund) in relation to the U.S. dollar, which was itself tied to gold (the U.S Treasury was by law committed to buying gold at fixed price of $35 per ounce (Ammer. 1984)

However, in 1971, the U.S. government suspended the convertibility of the (U.S) dollar owing to the serious balance of payments deficit it had (Ammer and Ammer 1984). The result of this was that the dollar could no longer be freely exchanged for gold at a fixed price with the absence of a single stable currency unit, exchange rate then floated (fluctuated), based largely on the forces of demand and supply. But also the U.S. dollar as an international convertible currency led to the collapse of the fixed exchange rate system. With the collapse of Bretton woods system of fixed exchange system, attention shifted to the floating or flexible exchange rate system.

The members of the International Monetary Fund (IMF) who had hoped to devise some kind of stable system of currency valuation to replace fixed par values, agreed in Mid-1974 to continue to operate a managed floating rate, that is, a floating rate influenced by individual governments trading in their own currencies (pegging) in order to stabilise its market (but not imposing other, more restrictive exchange controls).

For a country like Nigeria that is heavily dependent on imports, and that has only one major source of earning foreign exchange namely, oil, interest in what constitutes an acceptable exchange rate system becomes crucial as the exchange rate has a crucial role to play in the balance of payments position of a country. The balance of payments is a measure of receipts from exports and expenditure on imports of goods and services over a given period of time usually a year. It could be favourable, meaning an excess of receipts over payments; or it could be unfavourable (deficit), meaning more payment (on imports) than receipts (from exports). The balance of payments position or the maintenance of external equilibrium is a major preoccupation of all nations.

As a member of the international community, Nigeria too has been following emerging trends in the international financial arena. Because its economy is linked to the international economic system, the country has to adjust in keeping with the mood in the international financial system. Recently, the world economy had serious problems, most countries experienced balance of payments problems, the result of fundamental problems in their national or domestic economies. Most of such countries instituted policy prescriptions recommended by the International Monetary Fund, aimed at correcting the structural defects inherent in their economies. The structural adjustment programme is one of such policies adopted, especially in the developing countries, Nigeria being one of them.

Liberalization of exchange rates was one of the objectives of the structural Adjustment programme (SAP).  Accordingly, the country adopted a system of floating exchange rates, allowing the naira to find a realistic exchange rate (value) against other currencies based on the interactions of demand and supply in the foreign exchange market. However, this failed to improve the economic fortunes of the country as the balance of payment problems persisted, if not worsened.

During the 1994 fiscal year, the Head the State, in his budget speech announced that the exchange rate of the Naira had been fixed at N22 to $1 (one) U.S. dollar. The implication of this is that the floating exchange rate system of the structural adjustment years had been abandoned, and a system of fixed or pegged exchange rates instituted. However, following the emergence of Civil Rule from 1999 to date, attempts have been made to liberalise the economy with several policy measures such as the privatisation and commercialisation of Public Enterprises and the National Economic Empowerment and Development Strategy. These policy documents introduced several other changes to the economy including exchange rate policies.

This study therefore, is an attempt to look at the fixed (pegged) exchange rate system, and the floating or flexible exchange rate system in terms of their advantages and disadvantages, and hence the desirability of one over the other. In other words, this study would consider what impact fixed and flexible exchange rates have had on the Nigerian economy over the years. Their impact on Balance of Payments and Gross Domestic Product (GDP) would be the main focus.

 

1.2    Statement of the Problem

The Nigerian economy is characterised by heavy dependence on imports and an over reliance on a single product as the main source of foreign exchange earnings. Ours is an import-oriented economy we import virtually everything from raw materials to finished products. This constitutes a drain on our foreign reserves with serious implications on the badly needed foreign exchange. Here in lies the problem of our study.

The result of this has been that, over the years, we have had a persistent balance of payments problem. That is, the value of our imports has always exceeded the value of our exports.

The price of our main foreign exchange earner oil is determined independently of us, and moreover, the world market for oil has suffered a glut (excess supply) and the price has dropped sharply without any sign of recovery in sight. This has improved in recent years though!

With a persistent balance of payments problem, the question then arises, what is the way out of this quagmire? One option seems to be a re-examination of the exchange rate system presently in use.

Stated simply the problem under study borders on what impact the adoption of a particular foreign exchange rate system has on the balance of payments position of the country and on the Gross Domestic Product (GDP)

 

  • Objectives of the Study

The research work has the following objectives

  1. To determine what impact the fixed exchange rate system has had on the Nigerian economy especially on GDP and balance of payments during the period (1960 – 1985).
  2. To determine what impact the flexible exchange rate system has had on the Nigerian economy especially on GDP and balance of payments during the period (1986 – 2007).
    • Research Questions

The research questions for this study are as follows:

  1. What impact did the fixed exchange rate system have on the Nigerian economy especially on GDP and balance of payments during the period under review (1960-1985)?
  2. What impact did the flexible exchange rate system (regime) have on the Nigerian economy in general especially on GDP and balance of payment during the period under review (1986-2007)?

1.5    Hypotheses of the Study

          The hypotheses tested in this research which are stated in null form include the following:

1.5.1      H0: The fixed exchange rate system did not have a positive impact on gross domestic product.

1.5.2     H0: The fixed exchange rate system did not have a                                          significant positive impact on balance of payments (BOP).

1.5.3    HO: The flexible exchange rate system did not have a                                              positive impact on gross domestic product (GDP)

1.5.4    Ho: The flexible exchange rate system did not have a                 positive impact on balance of payments (BOP).

1.6    Scope of the Research

The research covered the period from 1960 to 2007 for which data is available on the topic. This period covers two distinct phases during which the Nigerian government experimented with both fixed and flexible exchange rate systems.

1.7    Significance of the Study       

The significance of the study derives from the fact that national policy makers are always looking for easier ways to meet domestic employment and output goals, subject to constraints, including that of a viable balance of payments. From this point of view, the interest in learning more about alternative exchange rate systems is to be able to choose one that makes their job easier.

The study therefore, will throw more light on alternative exchange rate systems, thus providing guidance to policy makers to make informed decisions concerning the economy, especially in the area of balance of payments adjustments.

The study will also be of immense benefits to the reader interested in the area of international monetary economics and finance.

Finally, it will contribute to a better appreciation of why Nigeria, has been experimenting with both the floating exchange rate system and the fixed (pegged) exchange rate system-and the impact these two systems have had on the Nigerian economy.

1.8  Limitations of the Study

A study of this nature cannot be done without one having a number of limitations or constraints. The fact that even among the experts, the field of international monetary economies and finance is a difficult one is a major constraint or limitation in so far as there is limited literature bearing on this particular topic to bail out the student.

Another constraint has been that of time to do a thorough job searching for all relevant material bearing on this topic. The most obvious of the constraints or limitations is that of financ

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