CHAPTER ONE

INTRODUCTION

1.1 Background to the Study

Many developing countries run deficits on their balance of payments (BOP) account and face difficulties in conducting monetary policy, which raise many questions for the monetary authorities. Like other developing countries, Nigeria seeks to stabilize its BOP account in order to strengthen the macroeconomic environment. One of the major purposes of the International Monetary Fund (IMF) is to help stabilize the balance of payments position of developing countries.

Over the last three decades, Nigeria's BOP has become increasingly volatile. A BOP crisis disturbs the working of the whole economy because it creates a disequilibrium between the supply of money and the demand for it. According to the IMF, BOP disequilibrium reflects disequilibrium in the money market. Recent Nigerian evidence is consistent with this view. Atoi (2020), using a monetary model for 2007–2018, finds that domestic credit is significantly and negatively related to foreign reserve assets, which implies that the balance of payments is a monetary phenomenon in Nigeria, and Ishioro (2015) reaches a similar conclusion, although he finds that the result depends on how the money demand function is specified. Monetary disequilibrium affects aggregate expenditure on goods and services, known as absorption. If the public holds an excess supply of money, it gets rid of the excess by sending cash balances abroad in exchange for goods and services. If the public wants to hold more money than it has, it achieves this by reducing absorption.

BOP disequilibrium occurs when, over a given period, a country records persistent deficits or surpluses. It follows that the exchange rate is either overvalued or undervalued on the foreign exchange market. In such situations, and particularly in the case of a deficit, corrective action is needed to prevent the economy from draining its foreign currency reserves or sinking into unmanageable debt. Disequilibrium can arise in three ways. First, imports of goods and services may exceed exports while the financial account is in deficit. Second, exports may only just exceed imports while the financial account shows a persistent surplus. Third, and exceptionally, a large current account surplus may produce an overall BOP surplus, and Japan is a relevant example of such an economy.

In 1964, fifty years after the amalgamation of Nigeria in 1914, the country was at the height of its promise. It was one of the world's leading producers of groundnuts and palm oil, and petroleum was making its debut in the national accounts. In the early 1980s the oil market weakened and substantial external and fiscal imbalances emerged. These were financed by public sector borrowing, a drawing down of international reserves and a large build-up of arrears on external trade credits, which created problems for the Nigerian balance of payments. In 1984, austerity measures were introduced to correct the persistent deficits. They included cuts in budgetary expenditure, administrative control of import licences and an upward review of tariffs. In 1986, the Structural Adjustment Programme (SAP) was introduced, combining exchange rate and trade policy reforms to promote economic efficiency and long-term growth, within stabilization policies designed to restore BOP equilibrium and price stability. Every government in Nigeria, from that of Tafawa Balewa to date, has made getting the balance of payments right its cardinal aim. This aim has shaped every major turn of policy, including the setting of bank rates, changes in taxes, regulation of incomes, restructuring of industry, the introduction of export rebates, control of the money supply and the level of local government expenditure.

The current account deficit (CAD) has been a problem for Nigeria because it adds to the country's already large indebtedness to the rest of the world. International credit is like an important drug to Nigeria. Nigerians accept it although they know the harm it does, and if the credit supply that funds the current account deficits and adds to the national debt were to dry up, the country would go cold turkey. Ayunku and Markjackson (2020) show that the external debt stock has a negative and statistically significant effect on Nigeria's foreign exchange reserves, and they advise fiscal managers to be careful in external borrowing so that debt service payments do not deplete the reserves. BOP disequilibrium has reached an unviable proportion and has become a binding constraint on the realization of government objectives. It has been aggravated by relatively poor non-oil export performance, a high import bill, stagnant agriculture, a strong taste for foreign goods and services, a continuous fall in the country's foreign exchange, inflationary pressure, an inefficient manufacturing sector and the mishandling of the oil boom. Adeyemi and Adewumi (2022) conclude that non-oil exports have not contributed positively to improving Nigeria's BOP position, and Ibrahim, Matthias and Liman (2020) find a long-run link between crude oil prices, exchange rate, oil exports and the balance of payments.

The search for the long-term causes of BOP fluctuation in Nigeria has focused on the economy's vulnerability to external shocks, the external debt burden and debt servicing, inflationary effects, trade openness, capital liberalization and exchange rate movements. BOP adjustment through exchange rate changes depends on the effect of relative prices of domestic and foreign goods on flows with the rest of the world. Relative price is defined as the ratio of export prices to import prices in domestic currency. For the country as a whole, it represents the quantity of imports that can be obtained in exchange for one unit of exports, and it is also called the terms of trade. The terms of trade can change because of changes in prices in the respective national currencies and because of exchange rate changes. In principle, a depreciation of the exchange rate, with domestic and foreign prices unchanged in their own currencies, makes domestic goods cheaper in foreign markets and foreign goods dearer at home. Demand for Nigerian goods and services should then rise at home and abroad, and a BOP surplus should follow. Why Nigeria still records deficits is therefore a matter of concern. The issue is not only the existence of a deficit but also the rate at which it grows every year despite the country's exportable natural endowments. The evidence on depreciation is not encouraging. Akpansung (2021), studying the period 1986–2019, concludes that real exchange rate depreciation may not be a way of improving Nigeria's balance of payments, and Prince (2020) finds that the exchange rate affects the trade balance asymmetrically and cannot confirm a J-curve effect, so that devaluation of the naira may not be a viable way of curbing the persistent trade deficit.

This work also investigates whether the type of exchange rate system, whether floating or fixed, is related to BOP stability. Nigeria's exchange rate arrangements have changed markedly over the past four decades. The country moved from a fixed regime in the 1960s to a pegged arrangement between the 1970s and the mid-1980s, and finally to various forms of floating regime after the adoption of SAP in 1986 (see also Alfa et al., 2024). A managed float, without strong commitment to defending any particular parity, has been the dominant feature of the floating regime since 1986 and still is. These changes are not peculiar to the naira, since the US dollar was fixed in gold terms until 1971, when it was delinked and then floated.

The principle of a managed exchange rate system can be explained as follows. The currency has a par value with an upper and a lower limit. If the supply of naira increases, for example because imports of goods and services rise, the supply curve shifts outward and, in a free market, the value of the naira would fall below its agreed lower limit. To hold the currency at its lower limit, demand for naira must be raised, which requires the government to use foreign exchange reserves. If the government wishes to return the naira to its par value, even greater reserves are needed.

The fixed exchange rate regime led to an overvaluation of the naira and was backed by exchange control regulations that caused serious distortions in the economy. It encouraged massive importation of finished goods, with adverse consequences for domestic production, the BOP position and the level of external reserves. The period was also troubled by sharp practices on the part of dealers and end-users of foreign exchange. These and other problems led to the adoption of a more flexible exchange rate regime under SAP in 1986.

It is argued in the theory of devaluation that devaluation raises the price of imports in domestic currency terms without a matching rise in export prices, so that the terms of trade deteriorate. A deterioration in the terms of trade represents a loss of real national income and can contribute to a BOP crisis, because more units of exports must be given up to obtain one unit of imports, or fewer units of imports are obtained for the same exports. Devaluation also raises import prices and the general price level, which reduces the real value of wealth held in monetary form, and the resulting fall in real cash balances can produce an unfavourable BOP. Inflation also matters in its own right, since Alfa et al. (2024), using data for 1980–2023, find that inflation is a drag on Nigeria's balance of payments.

Money illusion and expectation effects can also induce BOP fluctuation, because real income does not change when prices and money income rise in proportion. The direction of the effect depends on the type of money illusion, and its real effects are significant only in the short run. If people are unaware of how money illusion works, they are likely to change their absorption. Economic agents in Nigeria may regard the price increases that follow devaluation as likely to trigger further price rises, which raises direct absorption and can worsen the balance of payments.

Nigeria's external debt burden and debt servicing over the past three decades have been blamed by many authors for the negative profile of the BOP. A potentially significant source of demand deflection after currency depreciation in developing countries is its effect on debt servicing. The Nigerian external debt obligation is clearly large, and interest payable has risen over the years. Debt service expenditure reduces wealth and the resources available to improve real activity, which is detrimental to the BOP. Ademola (2023) finds that external debt servicing, the exchange rate and external debt all have significant but adverse effects on Nigeria's economic growth, while external reserves have a positive effect, and that inflation, trade openness, government spending and the exchange rate are significant factors in Nigeria's external debts.

The inflationary effects of currency depreciation can be expected to reduce expenditure, but a reduction in real expenditure occurs only if appropriate monetary policy is pursued at the same time. Over the years, inflation policies and targets in Nigeria have failed to achieve their purpose of correcting BOP disequilibrium because of mis-specified macroeconomic policies and insufficient time lags. Osisanwo, Tella and Adesoye (2019), using data for 1980–2015, find that money supply has the strongest long-run effect on BOP adjustment among the monetary variables, while domestic credit, exchange rate, inflation and output are negatively related to the balance of payments. The monetary approach to the balance of payments treats the monetary implications of exchange rate depreciation as crucial. In this view, depreciation affects the BOP by raising the domestic price level and thereby raising the demand for nominal money balances, and depreciation becomes unnecessary if enough time, in the form of financing, is available for automatic correction to occur.

These and other factors may explain the negative profile of Nigeria's balance of payments, which this work seeks to reveal. This is the main concern of the research.

1.2 Statement of the Problem

Every society desires growth, and balance of payments stability is one of the ways of achieving it. Fluctuation in the exchange rate distorts not only international transactions but also the domestic prices of goods and services. In reality, BOP stability is more or less a mirage. Fluctuation in the BOP, whether a surplus or a deficit, brings varying benefits and harms. A BOP surplus means that sources of funds, such as exported goods and services and bonds sold, exceed uses of funds, such as payments for imported goods and foreign bonds purchased. A BOP deficit exists when sources of funds are less than uses.

In theory and in practice, a prolonged misalignment of the exchange rate in the foreign exchange market tends in the medium term to harm economic performance. The authorities should therefore intervene in good time to keep the exchange rate in equilibrium. The monetary authorities usually do so through monetary policy actions and operations in the money market, so as to move the exchange rate in the desired direction and preserve the competitiveness of the domestic economy. In Nigeria, maintaining a realistic naira exchange rate is crucial, given the structure of the economy and the need to minimize distortions in production and consumption, increase non-oil export receipts and attract foreign direct investment. The persistent problems of import dependency, capital flight and the absence of incentives for backward linkages in production must also be addressed.

Under a fixed exchange rate system, the central bank accommodates international flows by buying any net inflow of funds into the country, or by supplying foreign currency to the foreign exchange market to match any outflow, so that these flows do not affect the exchange rate between the domestic currency and others. The net change in the central bank's foreign exchange reserves in a year is then sometimes called the balance of payments surplus or deficit. The alternatives to a fixed system are a managed float, in which some exchange rate movement is allowed, and, at the other extreme, a purely floating or purely flexible exchange rate. Under a pure float, the central bank does not intervene at all to protect or devalue its currency, and its foreign exchange reserves do not change.

Exchange rate appreciation arises from a BOP surplus, which raises demand for a country's currency and reduces its supply, since a surplus goes with rising exports and falling imports. However, the appreciation makes the country's goods and services expensive in international markets and foreign goods cheap relative to domestic ones, because the currency is overvalued. If this is not checked, unemployment will rise, leading to a fall in output and in GDP per head. If, on the other hand, a country has a BOP deficit, the reverse applies and inflationary tendencies follow.

As noted above, the current account deficit has been a particular problem for Nigeria because it adds to the country's large indebtedness, and the country's dependence on international credit to finance it is a serious vulnerability. The balance of payments problem has reached an unviable proportion and has become a binding constraint on the realization of government objectives. It has been aggravated by weak non-oil export performance, a high import bill, stagnant agriculture, a strong appetite for foreign goods and services, a continuous fall in foreign exchange, inflationary pressure, an inefficient manufacturing sector and the mishandling of the oil boom.

1.3 Research Questions

The problem statement above leads to the following specific questions:

1. What are the macroeconomic determinants of the balance of payments in Nigeria?
2. Does the type of exchange rate system affect balance of payments disequilibrium in Nigeria?

1.4 Objectives of the Study

The broad objective of this work is to examine the long-run determinants of balance of payments disequilibrium, drawing evidence from Nigeria. The specific objectives are:

1. To investigate the macroeconomic determinants of the balance of payments in Nigeria.
2. To examine whether the type of exchange rate system has any impact on balance of payments disequilibrium in Nigeria.

1.5 Statement of Hypotheses

In line with the objectives, the hypotheses of the study are stated as follows:

• There exist no significant macroeconomic determinants of the balance of payments in Nigeria.
• The exchange rate systems do not have a significant effect on balance of payments disequilibrium in Nigeria.

1.6 Significance of the Study

This research will contribute to ongoing policy by identifying the growth patterns of the Nigerian economy and the extent to which BOP stability can support economic growth. Given Vision 2020, which aimed to make Nigeria one of the twenty largest economies in the world by 2020, identifying the sources of BOP fluctuation is necessary because it will help to model the economy and control the variables concerned, so that other unwanted disturbances that could hinder growth are avoided. Suppose, for instance, that the economy is in BOP deficit. The exchange rate is then out of line with its equilibrium on the foreign exchange market, and corrective action is required to prevent the economy from draining its foreign currency reserves or ending hopelessly in debt. The main reason for Nigeria's BOP deficits is the increased demand of Nigerian consumers for imported manufactured goods, such as foodstuffs and capital equipment. This implies a net outflow of currency greater than the inflow of foreign reserves, which, if it continues, can lead to inflationary pressure and unwanted distortions in the system.

To correct this, the country might raise domestic interest rates as an incentive for foreign direct investment, in anticipation of higher returns. Other things being equal, higher interest rates will attract foreign capital, so that a current account deficit is offset by a capital account surplus. However, a high interest rate discourages domestic investment, which leads to unemployment and, in the long run, to higher prices of goods and services because investment has fallen. This in turn makes the country's goods and services less competitive in international markets, so that demand for net exports falls. A vicious circle may eventually arise, and BOP fluctuation that is not well controlled may lead to policy conflict and conflict among macroeconomic objectives.

For many developing economies like Nigeria, the significance for the balance of payments is that large sums were borrowed from commercial banks in the 1970s and early 1980s to fund development projects that were expected to generate future income streams, according to the Central Bank of Nigeria. Many of these projects turned out to be very poor investments. In other cases the money was spent on other things or used corruptly by recipients. The legacy is chronic balance of payments deficits, because a very large part of these countries' export earnings must be paid out each year to service the debt.

1.7 Scope of the Study

This work uses secondary data covering the period 1970 to 2011. The choice of this period was dictated by the availability of data. The study also takes the Nigerian economy as its study area.

1.8 Limitations of the Study

This research is limited by two major factors, namely, the inability to obtain funds to facilitate the work and the non-availability of data.

1.9 Structure of the Study

The work is organized into five chapters. Chapter one consists of the motivations for the study and the general conceptual framework, and it also includes the research questions, objectives and hypotheses. Chapter two presents the theoretical framework within which the model was built. Chapter three sets out the models and methodology. Chapters four and five present and analyse the results and summarize the findings, respectively.

References

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