MONETARY POLICY AND EXCHANGE RATE FLUCTUATIONS IN NIGERIA

MONETARY POLICY AND EXCHANGE RATE FLUCTUATIONS IN NIGERIA

ABSTRACT: This study examines the Central Bank of Nigeria (CBN) monetary policy response to exchange rate fluctuations in Nigeria using time series data ranging from 1986Q1 to 2017Q4.  The study employed the Generalized Autoregressive Conditional Heteroscedasticity (GARCH) model to determine the efficacy of CBN monetary policy intervention in stabilizing exchange rate fluctuations in Nigeria. Policy interest rate, money supply, and CBN forex intervention were explicitly included in the variance equation to determine their exact effect on the conditional variance (the volatility variable). The results of the model reveal that policy interest rate, money supply, and CBN forex intervention conform to apriori expectations and are also statistically significant. This means that they are effective in stabilizing exchange rate fluctuations in Nigeria. Again, Exchange rate fluctuations in Nigeria were found to be persistent over the years as shown by the variance equation. The study concludes that monetary policy is effective in managing exchange rate fluctuations in Nigeria only when CBN uses policy interest rate, money supply, and Intervention in the forex market as monetary policy tools. Because of the persistence of exchange rate fluctuations in Nigeria, there is a continuous need for CBN to stabilize the exchange rate in Nigeria, therefore, this assumes that CBN cannot allow the exchange rate to flow freely. The current multiple exchange rate regime practiced in Nigeria makes it difficult for CBN to stabilize the naira exchange rate despite intervention in different FX windows. CBN must streamline and harmonize the different exchange rates in Nigeria to a single exchange rate against the US dollars and other foreign currencies for effective management of exchange rate fluctuations.

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CHAPTER ONE

INTRODUCTION

1.1 Background of Study

Exchange rate fluctuations have gained more attention than other core economic indices globally because it assumes an important role in managing global and local economic relations. As Mordi (2006) rightly observed, “getting the exchange rate right or maintaining relative stability is critical for both internal and external balance”. The founding of global pecuniary institutions has helped the post-war countries to manage their economies better, the pecuniary institutions were founded to reform the pecuniary arrangement and enhance economic co-operation among nations. The development and integration of the international financial market have led to an increase in the volume of trade among nations. This development has forced many countries to abandon the pecuniary system of predetermined rates in the 1970s because they were unable to continue to have a high reserve of foreign currencies. Since the liberalization of rates and the acceptance of the bendy rates system, the rate has been much more volatile than anyone could imagine. Also with the acceptance of noninterventionist trade among the first world of nations, it became very difficult for countries to static their currency. Noninterventionist trade and globalization also make countries prone to the second-round effects of any economic decisions taken in most countries of the world, especially the first-world countries. For example, the global crunch of 2008, caused by the collapse of sub-prime mortgage institutions, the aftermath of the global crunch spilled over to the world over and especially to the poorest of the poor world. Debit crisis in Eurozone and the world-anticipated Brexit in Britain also has an influence on the pecuniary institutions, especially the major’s collaborators of the Eurozone area countries.

Monetary policy refers to the tools the CBN uses to manage the economy. Monetary policy tools are MPR, Cash ratio, OMO, liquidity ratio, Cash Reserve Requirement, and CBN FX involvement in the market.

The IMF has also warned that trade wars could wipe $455billion off the world’s gross progression product in 2020. The trade war is gradually shifting from the USA-China trade war to globals trade war because the global economies are affected. In the midst of these trade wars, the give-and-take or currency conversion shall be volatile.

In the Nigerian economy, the major attributes of the shrinkage experienced in Nigeria have been surging in exchange rate oscillation. This experience has spurred a lot of debate on the ability of monetary policies to soothe exchange rate in Nigeria.  According to NBS, the Nigerian economy experienced five consecutive quarters of negative GDP progression, from Q1 of 2016 to Q1 quarter of 2017.

As notes by Mordi (2016) “In Nigeria, the management of exchange rate is vested in the Central Bank of Nigeria (CBN) and since the introduction of the Structural Adjustment Programme (SAP) in 1986, exchange rate management has been a core macroeconomic policy function. The overriding objective has been to achieve a realistic and stable exchange rate consistent with internal and external balance”.

One of the cores objectives of the CBN is currency give-and-take stability and low inflations. In view of these, Akanji (2006) noted that “The foreign exchange management is first and foremost management of monetary policy indicators. It is often a signal of the stance of monetary policy and if CBN is to manage price stability then efficient management of the exchange rate has a link with the price level changes and interest rate management”.

The exchange rate policy in Nigeria has evolved over time and has been known to have two regimes of exchanges. These are static and bendy currency give-and-take systems. The static exchange rate system was adopted between 1960 and 1986, while the static exchange rate system remains in use from 1986 to date, having undergone a series of modifications (Sanni, 2006).

The recent shocks to the Nigerian system saw the exchange rate went up to as high as N500/$ at the parallel market. This experience called for a rethink and necessitated an urgent step taken by CBN to bring the give-and-take or rates under control. Following the exclusion of 41 items from accessing foreign exchange at the pecuniary market and CBN has been able to hold Naira-to-US dollar at N360-365 since 2018.

In Pursuance of SWAP agreement reached between CBN and the PBC, the CBN signed a three-year currency swap deal with the PBC on April 27, 2018, to facilitate trade between Nigeria and China and cut reliance on the dollar. The BCSA is for a max amount of CNY 15billion for NGN 720billion with a 3years tenor (CBN, June 2018). CBN flagged offs its interventions in the sales of foreign exchanges in the Yuan on July 20, 2018. It sold 69.86 million Yuan ($10.16m) in its first auction of the Chinese Currency ranges between N49 to N51 (soured from Punch Newspaper, published on August 18, 2018).

These CBN also intervenes weekly in the unofficial FX market through the wholesale SMIS (Special Market Intervention Sale) and the retail SMIS. Today the Naira vis-à-vis US dollar is confirmed stable at N360-365/US$ and CNY/NGN has been stable at N49-52/CNY.

1.2 Problem Statement

Rates oscillation is toxic to the home economy, through global trade performance, and also responsible for inflation, as a result of its transmission effect. Again, rate oscillation causes uncertainty in business as such, affects future business decisions. We know that a high inflation rate affects real income (M/P), which also affects the purchasing power and welfare of households. However, in the home economy, CBN has the mandate to ensure that rates are stable and reflective of the market conditions.

The empirical literature review shows that some studies have been done to investigate the impact of pecuniary on rates oscillation (see Yagmur, 2016; Gupta and Jooste, 2014; Ostry at.al, 2012; Masha, 2011; Ndubuisi at.al, 2017; Michael, 2010; Aregha, 2010; Zafar and Sabo, 2013; Umar, 2013; and Egwaikhide et.al, 2014). The major conclusions of this study are that the pecuniary has an influence on rate oscillation.

Again, there were also studies done to discover the persistence of rate oscillation and central bank’s pecuniary response to stabilize the rates oscillation (see Syarifuddin et.al, 2014; Musyoki at.al, 2012; Benigno at.al, 2012; Adeoye and Shaibu, 2014, 2013; Umoru and Effiong, 2015; Ojo and Alege, 2014; Libman, 2017; Berument et.al, 2012; and Juvenal, 2010). These studies concluded that rate oscillation is persistent over time. None of these studies, especially those conducted in Nigeria, included monetary policy variables in their GARCH volatility model.

As noted by Brooks (2002) “most financial time series data exhibit periods of unusually large volatility followed by periods of relative tranquillity which is called heteroscedasticity phenomenon. To measure exchange –rate volatility within this phenomenon, the most popular time-series volatility model or nonlinear model widely used is the ARCH model” (Syarifuddin, et al, 2014, p. 39). “The ARCH model was developed by Engle (1982) and the GARCH model was developed by Bollerslev (1986). These models have been proven to provide a good fit for many exchange rate series in the literature. However, the GARCH model provides a better fit” (Syarifuddin, et al, 2014, p. 39).

Furthermore, this study also brought to fore the SWAP agreement reached between CBN and the PBC, the CBN signed a three-year currency swap deal with the PBC on April 27, 2018, to facilitate trade between Nigeria and China and cut reliance on the dollar. The BCSA is for a maximum amount of CNY 15billion for NGN 720billion with a 3years tenor (CBN, June 2018). CBN flagged off its intervention in the sale of foreign exchange in the Yuan on July 20, 2018. It sold 69.86 million Yuan ($10.16m) in its first auction of the Chinese Currency ranges between N49 to N51 (soured from Punch Newspaper, published on August 18, 2018).

The CBN also intervenes weekly in the unofficial FX market through the wholesale SMIS (Special Market Intervention Sale) and the retail SMIS. Today the Naira vis-à-vis US dollar is confirmed stable at N360-365/US$ and CNY/NGN has been stable at N49-52/CNY.

Given the foregoing, this study attempts to examine how CBN uses pecuniary to respond to rate oscillation in Nigerian using GARCHs (1, 1) models. The variable in the model emanated from the underlining theory of Mundell-Flaming model of “Aggregate Demand in an Open Economy”, re-enforced by Dornbusch (1976) “expectation Mechanism” theory. Hence, the core variables are nominal exchange rate, PIR, M2, and CBN foreign exchange intervention.

Given the foregoing, this study intends to find the following research questions:

1. What is the relationship between Policy Interest Rate, Money Supply, CBN Forex Intervention, and exchange rate fluctuation in Nigeria?
2. What is the efficacy of Policy Interest Rate, Money Supply, and CBN Forex Intervention in stabilizing exchange rate fluctuation in Nigeria?
3. Is there a persistency of rate oscillation in Nigeria in relation to CBN monetary policy Intervention, using Policy Interest Rate, Money Supply, and CBN Forex Intervention?

1.3 Aim and Study Objective

The following are the specific objectives are to:

2. Examine the relationship between Policy Interest Rate, Money Supply, CBN Forex Intervention and exchange rate fluctuation in Nigeria;
3. Examine the efficacy of Policy Interest Rate, Money Supply, CBN Forex Intervention in stabilizing exchange rate fluctuation in Nigeria; and
4. Examine the persistence of exchange rate fluctuation in Nigeria in relation to CBN monetary policy Intervention using Policy Interest Rate, Money Supply, and CBN Forex Intervention.

1.4 Research Hypotheses

The null hypothesizes (Ho) of this study are stated as follows:

1. There is no relationship between Policy Interest Rate, Money Supply, CBN Forex Intervention, and exchange rate fluctuation in Nigeria.
2. Policy Interest Rate, Money Supply, and CBN Forex Intervention have no effect on exchange rate fluctuation in Nigeria.
3. No persistency of rate oscillation in Nigeria in relation to CBN monetary policy Intervention, using Policy Interest Rate, Money Supply, and CBN Forex Intervention.

1.5 Study Significance

Rates oscillation is at the center stage of every business decision and could lead to huge losses if not closely watched and the risk arising thereof mitigated through hedging or spontaneous action.

This study is relevant to policymakers – the CBN, Finance Ministry, Ministry of Budget and National Planning, Debt Management Office (DMO), Corporate Organizations, international organizations, SMEs, academics, investors, and the general public. Knowledge of exchange rate behavior can help them manage uncertainty arising from exchange rate fluctuations. Furthermore, Knowledge of rate oscillation will also help corporate organizations and SMEs take better business decisions. Further still, knowledge of rate oscillation will help CBN to understand the workings of rate oscillation and stabilize the oscillation and also grow the economy. More so, for investors, the knowledge of rate oscillation will help them make better investment decisions.

Also, the aim of this study will add to the existing stock of knowledge’s in the monetary economic field, while provoking further research.

1.6 Scope of the Study

The data ranges from 1986 Q1 to 2017 Q4. This study is limit to CBN monetary policy conduct and how it affects rates oscillation in Nigeria. It does not account for Bureau de Change Operators, parallel market, or unofficial rates.