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Exchange Rate Volatility and Foreign Direct Investment in Nigeria (1986 - 2018)

 Format: MS WORD   Chapters: 1-5

 Pages: 85   Attributes: COMPREHENSIVE RESEARCH

 Amount: 3,000

 May 20, 2020 |  09:41 pm |  1276

CHAPTER ONE

INTRODUCTION

1.1    Background to the Study

Foreign capital is considered by many countries (especially developing ones) as a major source of resources needed to attain economic growth and development. Foreign  Direct  Investment  (FDI)  is  a  direct  investment  by  a  corporation  in  a  commercial  venture in another country. Mallampally and Sauvant (1999) define FDI as an investment by  multinational  corporations  in  foreign  countries in order  to  control  assets  and  manage  production activities in those countries. It is seen as a means of bridging the resources gap inherent in many developing nations (Yaqub, Adam and Jimoh, 2013). It plays an extraordinary and growing role in global business by providing a firm with new markets and marketing channels for their products.  For a host country or the foreign firm which receives the investment, it provides a source of  new  technologies,  capital,  process,  products, organizational  technologies  and  modern  management  practices.  All  of  these  are presumed  to  contribute  to  economic  growth  and  development in an economy. In this regard, FDI is important not just for the developing countries but also for developed nations.

In order to attract sufficient level of FDI, the Nigerian government had made tremendous efforts through the implementation of various policies aimed at positioning the country for massive inflow of FDI. Some of the policies include for instance; the deregulation of the economy  in  the  1980s,  the  New  Industrial  Policy  of  1989,  establishment  of  the  Nigerian Investment  Promotion  Commission  (NIPC)  in  early  1990s,  and the signing of Bilateral Investment Treaties (BITs) in the late 1990s. Others were  the establishment  of  the  Economic  and  Financial  Crimes  Commission  (EFCC),  and  the  Independent  Corrupt  Practices  Commission  (ICPC). The Nigerian  Investment  Promotion   Commission,  (NIPC),  was  established  by  Decree  number  16  of  1995,  during  the  administration  of  the  late  General  Sani  Abacha. The  Agency's  mandate  is to facilitate  foreign  investments and advocate on behalf of  foreign  investors in the  areas  of  favourable  government  policies.  The agency also  helps  to  create  a  friendly investment climate so that investors can see Nigeria as an investment haven .In the case of EFCC  and  ICPC,  The  two  agencies  were  established  to  assist  in  fighting  corruption  in  Nigeria. Corruption has led to loss of confidence in Nigeria by foreigners, Nigerian citizens at  home  and  abroad  due  to  activities  of  fraudsters and corrupt  public  official. Tackling  corruption  by  the  two  agencies  would  lead  Nigeria  into  having valuable economic activities and forestalling foreign investment in the country.

Also, the floating exchange rate system has been adopted by various countries by abandoning the fixed exchange rate system with the collapse of the Bretton Woods system. With the adoption of the floating exchange rate system, the volatilities in exchange rates have become a major problem for countries. Exchange rate volatility refers to all movements and changes that are effective for the depreciation/valuation of a currency (Martins, 2015). Exchange rate volatility is an important factor that investors take into account when making investment decisions abroad. Exchange rate volatility affects the prices and quantities of the inputs and outputs of the MNCs and leads to competitiveness in the global market (Kumarasamy, 2010). Exchange rate volatility affects the expected returns of foreign direct investments (FDI), which are considered as capital transfers. For this reason, both the level of exchange rate and the level of volatility may have an effect on the investment level (Chowdhury and Wheeler, 2008. p. 2; Asmah and Andoh, 2013). Exchange rate volatility can encourage or deter direct foreign investments.

Evidence has shown that, with suitable country investment climate and policies, foreign direct investments (FDI) have the potential to play a significant role in economic development, especially in developing countries. FDI provides a major source of capital which brings with it up-to-date technology and offers the prospects of a greater diversification of the industrial base and exports which contribute to the integration of economies to the rest of the world. Over time, FDI associates with many positive externalities in the form of employment generation, skills transfer, technological progress, and enhanced productivity and efficiency. Ultimately, these factors have a positive impact on economic growth and consequential poverty reduction. Given the benefits of FDI inflows, attracting FDI has become an important policy objective of many countries. Recent empirical evidence suggests that a sustained rate of economic growth of between 8 and 10 percent is necessary for Africa to reverse the spread of poverty to meet the millennium development goals in 2015. In this respect, an increase in FDI is deemed necessary to close the development financing gap characteristic of Sub-Saharan Africa which generally attract a very small share of FDI inflows relative to other developing regions (Asiedu, 2005). Apart from traditional economic factors such as host country’s macroeconomic policies, legal system, political stability, and market size availability of raw materials, foreign exchange volatility has also emerged as critical in attracting FDIs.

The withdrawal of FDI, thus have a positive influence on economic growth and has become an important policy target for many countries. FDI has many positive externalities such as providing foreign currency inflows, increasing capital accumulation, creating employment, providing technology and skill transfer, and increasing productivity. According to Husek and Pankova (2008), the depreciation of the currency of the host country will attract FDI inflows for two reasons. First, the depreciation of the currency reduces the production costs (labor and other productive inputs) in the home country, thus makes the home country attractive for FDI seeking production efficiency. Second, the depreciation of the currency of the host country lowers the value of assets in the host country in other currencies, including the currency of the home country. According to this, the cost of FDI in foreign currency is decreasing and the host country is becoming attractive for FDI (Andoh, 2013). FDI can also affect exchange rate volatility. FDI can increase productivity in the traded good sector and thus reduce real exchange rate volatility by balancing the relative prices of non-traded goods. FDI inflows lead to appreciation of the real exchange rate by increasing the capital stock in the host country. FDI increases existing capital stock and causes technology to spread. Technology spillovers lead to increased production and lower prices of non-tradable goods. Thus, FDI leads to depreciation of real exchange rate. However, the increase in the production of non-traded goods increases the disposable income and thus the exchange rate appreciates (Dasgupta, 2012).

It is against this background that this study tends to consider how volatility in exchange rate can affect the inflow of foreign investment into a country like Nigeria.

1.2    Statement of the Research Problem

The 1980s witnessed increased flows of investment around the world. Total world outflows of capital in that decade grew at an average rate of almost 30%, more than three times the rate of world exports  at  the  time,  with  further  growth  experienced  in  the 1990s (Kosteletou, 2000). Despite the increased flow of investment, especially to developing countries, Sub-Saharan Africa (SSA) countries still lag behind other regions in attracting foreign direct investment. The uneven dispersion of FDI  is a  cause  of concern since FDI  is an important source  of growth for developing countries. Not only can FDI add to investment resources and capital formation,  it  can  also  serve  as  an  engine  of  technological development with much of the benefits arising  from positive spillover effects. Such positive spillovers include transfers of production technology, skills, innovative capacity, and organizational and managerial practices. Given these significant roles of FDI in developing economies there have been several studies that tried to determine the factors that influence FDI inflows into these economies. One of such factors that recently have been a source  of debate is  exchange rate and its volatility.  The existing literature has been split on this issue, with some studies finding a positive effect of exchange rate volatility on FDI, and others finding a negative effect. A positive effect can be justified with the view that  FDI is export substituting. Increases in exchange rate volatility between the headquarters and the host country induce a multinational to serve the host country via a local production  facility  rather  than  exports,  thereby  insulating  against currency risk (Foad, 2005).

 

Justification for a negative impact of exchange rate volatility on FDI can be found in the irreversibility literature pioneered by (Pindyck, 1994). A direct investment in a country with a high degree of exchange rate volatility will have a more risky stream of profits.

As long as this investment is partially irreversible, there is some positive value to holding off on this investment to acquire more information. Given that there are a finite number of potential direct investments, countries with a high degree of currency risk will lose out on FDI to countries with more stable currencies (Foad, 2005). One of the countries that fall into this category (countries with a high degree of currency risk) is Nigeria. With a population of about 130 million people, vast mineral resources, and favorable climatic and vegetation features, Nigeria has the largest domestic market in Sub-Saharan Africa. The domestic market is large and potentially attractive to domestic and foreign investment, as attested to by portfolio investment inflow of over  N1.0 trillion into Nigeria through the Nigerian Stock Exchange (NSE) in 2003 (Central  Bank of  Nigeria,  2004).  Investment income, however, has not been encouraging, which was a reflection of the sub-optimal operating environment largely resulting from inappropriate policy initiatives. Except for some years  prior  to  the introduction  of  the  Structural Adjustment Programme (SAP) in 1986, gross capital formation as a proportion of the GDP was dismally low on annual basis. It was observed that aggregate investment expenditure as a share of GDP grew from 16.9% in 1970 to a peak of 29.7% in 1976 before declining to an all-time low of 7.7% in 1985. Thereafter, the highest was 11.8% of GDP in 1990, before declining to 9.3% in 1994.  Beginning  from  1995,  investment/GDP  ratio  declined significantly to 5.8% and increased marginally to 7.0% in 1997 and remained thereabout  till  2004 when  7.1% was recorded. There was a decrease to 6.3% in 2010 and another marginal increase of 8.1% in 2015 and it has been on 8.6% in 2018. On the average, about four-fifth of Nigeria’s national output was consumed annually (CBN Statistical Bulletin).

The sub-optimal investment ratio in Nigeria could be traced to  many  factors  including  exchange  rate  instability,  persistent inflationary  pressure,  low  level  of  domestic  savings,  inadequate physical  and  social  infrastructure,  fiscal  and  monetary  policy slippages,  low  level  of  indigenous  technology  as  well  as  political instability.  A  major  factor  was  exchange  rate  instability,  especially after  the  discontinuation  of  the  exchange  rate  control  policy.  The high  lending  rate,  low  and  unstable  exchange  rate  of  the  domestic currency and the high rate of inflation made returns on investment to be  negative  in  some  cases  and  discouraged  investment,  especially when financed with loans. The Naira (Nigerian currency) exchange rate witnessed a continuous slide in all the segments of the foreign exchange market

(that  is,  official,  bureau de  change  and  parallel  markets). In the official  market,  the  exchange  rate  depreciated  progressively  from 8.04 naira per US dollar in 1991 to 21.89 naira per dollar in 1995 and further to 129.22 naira in 2003 and 133.00 naira in 2004. It further depreciated to 154.80 naira in 2010 and to about 194 naira in 2014 and about 362 naira in 2019.  Similarly, it depreciated from 9.62 naira and 9.61 naira  per  dollar  in  1990  to  141.36 naira and  141.07 naira per dollar in 2003 to about 180.01 and 195 in 2010 to between 310 1nd 370 in 2016 and presently about 365 and 372 in 2019. These are the exchange rates as we have them in the bureau de change and parallel market, respectively.  Consequently, the premium between the official and parallel market remained wide throughout the period. This high exchange rate volatility in Nigeria, among others, led to a precarious operating environment which can be attributed to the  reason  why  Nigeria  was  not  only  unable  to  attract  foreign investment  to  its  fullest  potentials but  also  had  a  limited  domestic investment.  As  such, despite  the  vast  investment  opportunities  in agriculture, industry, oil and gas, commerce and infrastructure, very little  foreign  investment  capital  was  attracted  relative  to  other developing  countries  and  regions  competing  for  global  investment capital.

As a result of the above, it becomes relevant for a study like this  to  investigate  if  there  exist any  relationship  between  FDI  and exchange rate volatility in the  Nigerian economy. It also investigates the  magnitude  and  direction  of  the  effect  of  exchange  rate  and  its volatility on foreign direct investment.

1.3    Research Questions

This study shall be guided by the following research questions.

1.   What are the relationships among exchange rate fluctuation, foreign direct investment, in Nigeria?

2.   What is the effect and direction of causality between exchange rate fluctuation and foreign direct investment in Nigeria?

3.   What is the effect and direction of causality between exchange rate volatility and foreign direct investment in Nigeria?

 

1.4    Research Objectives.

The broad objective of this study is to examine the relationship among Exchange Rate Volatility, Foreign Direct Investment and economic growth in Nigeria. The specific objectives are to

1.   analyse the trends of exchange rate, foreign direct investment and economic growth in Nigeria.

2.   ascertain the effect and the direction of causality between exchange rate, foreign direct investment and economic growth in Nigeria.

3.   examine the impact of exchange rate volatility and foreign direct investment on economic growth in Nigeria.


1.5    Justification of Study

Since there has been growing evidence that FDI has been a veritable source of revenue for the government of a country to finance its growth targeted projects and activities and also that volatility in the exchange rate can have some negative effects on FDI inflow into the economy, when proper and intelligent policies are not formulated and implemented and thus impede the channelling FDI into a sustainable economic growth. This is because a negative impact of exchange rate volatility on FDI  can  be  found  in  the  irreversibility  literature  pioneered  by Dixit  and  Pindyck  (1994).  A direct investment in a country with a high degree of exchange rate volatility will have a more risky stream of profits.

As long as this investment is partially irreversible, there is some positive value to holding off on this investment to acquire more information. Given that there are a finite number of potential direct investments, countries with a high degree of currency risk will lose out on FDI to countries with more stable currencies (Foad 2005). One  of  the  countries  that  fall  into  this  category  (countries with a high degree of currency risk) is Nigeria. With a population of about  130 million  people,  vast  mineral  resources,  and  favorable climatic  and  vegetation  features,  Nigeria  has  the  largest  domestic market  in  Sub-Saharan  Africa.  The  domestic  market  is  large  and potentially attractive to domestic and foreign investment, as attested to by portfolio investment inflow of over  N1.0 trillion into Nigeria through the Nigerian Stock Exchange (NSE) in 2003 (Central  Bank of  Nigeria,  2004).

 there is need to determine the exact level and significance of influence that Exchange Rate volatility and FDI may exert on economic growth. This present study is very necessary as its findings and recommendations will provide the Nigerian government and policy makers with adequate knowledge that will help them formulate effective policies especially in the industrial sector in order to position the economy for optimal level of FDI inflow and make policies that can cursor the effect of volatility of the exchange rate on FDI which will help to foster economic growth and development. Also, the knowledge that will be obtained from this study will be of immense importance to the government to help them develop effective strategies for the generation, allocation and utilisation of FDI in the key sectors of the economy.

The uniqueness of this study lies in the fact that, unlike previous studies that primarily focuses on the impact of FDI on economic growth on one hand, and the impact of exchange rate volatility on economic growth on the other hand, it investigates the combine effect of FDI and exchange rate volatility and its effect on economic growth. This is expected to provide an empirical framework through which we can examine the instrumentality of exchange rate volatility in generating and transmitting FDI into economic growth. Also, the research methodology employed for the study, technique of analysis as well as its findings and conclusion of the study will help to expand the scope of economic thought and literatures on the subject matter and also provide valuable information and data that will help foster the conduct of further research on the topic.

1.6    Scope of the study

This study limits its scope to the period between 1970 and 2018 (48 years). This period is chosen for two main reasons. First is to capture the periods of pre- deregulation and deregulation in the Nigerian economy. The pre-deregulation in the economy was the period when prices of many products were fixed by executive fiat and were driven by related policies. For instance, the exchange rate regime in place was driven by the fixed exchange rate policy. Furthermore, the deregulation era started in 1986 driven by the Structural Adjustment Programme (SAP),  which marked  the  beginning  of  economic  deregulation  and  lingering  period  of liberalization.

Second is to generate adequate data for our empirical analysis and to provide up to date information. A time series data was made available for the 46 years period of this study. The data was sourced from the Central Bank of Nigeria (CBN) Statistical Bulletin (various issues)

1.7    Plan of the Study

This study consists of Five Chapters. Chapter one contains introduction of the subject matter, while chapter two consist a theoretical and empirical review of the literatures. Chapter three will present the Methodology by establishing both the theoretical and empirical framework of the study. Chapter four will contain data presentation and discussion of results gotten form the data analysis. Lastly, Chapter Five concludes with summary of findings, conclusion and recommendation.

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