THE IMPACT OF EXCHANGE RATE VARIATION ON BALANCE OF PAYMENT

ABSTRACT

This study was carried out on the impact of exchange rate variation on balance of payment. The recent decline in Nigeria's balance of payments has led to a decrease in the funds available in the economy, pushing government toward heavier reliance on foreign debt. The need for the federal government to better manage its financial system, particularly the exchange rate, in order to stabilise the economy has therefore become increasingly urgent. Data was collected from the World Bank's World Development Indicators for the period covering 1986 to 2024, extended from the 2019 cut-off used in earlier versions of this kind of study so as to capture Nigeria's most recent exchange rate reforms, including the 2023 unification of the foreign exchange market. The key methods of analysis used in the research include quantile regression and the Granger causality test. The quantile regression results reveal that exchange rate and trade openness have a negative impact on balance of payment, while foreign direct investment has a positive impact on balance of payment. The Granger causality test results reveal that there is unidirectional causality running from exchange rate to balance of payment. The research therefore recommends that Nigeria's currency management authority, the Central Bank of Nigeria, should give closer attention to the analytical framework guiding exchange rate stability, as well as to the proper management of funds in circulation, as this should help improve the balance of payment position of the Nigerian economy. Additionally, government should provide a fair and favourable environment for domestic firms and businesses to thrive, in order to help the country attain the objectives of its Economic Recovery and Growth Plan, in line with the Sustainable Development Goals (SDGs) target year of 2030.

CHAPTER ONE

INTRODUCTION

1.1 Background of Study

Exchange rate arrangements in Nigeria have undergone significant changes over the past four decades. The regime shifted from a fixed exchange rate system in the 1960s and through much of the 1970s and mid-1980s, to various forms of floating exchange rate regimes from 1986 onward, following the adoption of the Structural Adjustment Programme (SAP) (Akpansung, 2021).

The most serious problem associated with this transition has been the persistent disequilibrium in Nigeria's balance of payments. This disequilibrium has, at various points, left Nigeria unable to comfortably meet its external debt obligations, making its trading partners more cautious about extending it further credit. Over the years, government's search for viable economic policies led it, at different times, to manage and pool foreign exchange earnings under strict government control.

Given the apparent imbalance in the economy and the undesirable developments that followed, government adopted fundamental economic restructuring strategies that broke with past policies, which had tended to be more protectionist in nature.

One main area of these structural reforms was aimed at checking inflation over the long term, and at allowing the price of foreign goods to better reflect their relative domestic prices, so as to expand the country's industrial base and strengthen its internal supply capacity. The introduction of SAP affected the actual exchange value of the naira relative to other trading currencies of the world.

The Second-tier Foreign Exchange Market (SFEM) was established on 26 September 1986 as a mechanism for achieving a more realistic exchange rate for the naira and for ensuring a more efficient allocation of scarce foreign exchange resources. All public and private transactions supported by appropriate documentation were expected to be financed through the market, except for certain transactions, such as debt servicing and contributions by government to international organisations, which continued to be processed through the official first-tier market. The two tiers were eventually merged on 2 July 1987 to form a single Foreign Exchange Market (FEM).

A country's external balance position is among the primary factors identified in the literature as determining the long-run fundamental value of its real exchange rate. The real exchange rate is, broadly, the rate at which one country's currency is exchanged for another; alternatively, it may be defined as the price of one unit of foreign currency in terms of domestic currency. The exchange rate plays a crucial role in international economic transactions, and, owing to its varying effects on the volume of trade, it exerts a strong influence on a country's balance of payments position. Countries that specialise in the export of primary commodities, as Nigeria has historically done, are often more exposed to unfavourable terms of trade and slower growth than countries with more diversified export bases; Agu, Obodoechi and Nebo (2023) argue that this exposure makes non-oil export diversification, alongside exchange rate stability, an important part of any strategy to correct Nigeria's persistent balance of payments disequilibrium.

The underlying intuition here is fairly straightforward. A positive steady-state net international investment position may allow a country to run persistent trade deficits; all else being equal, the capacity to sustain a negative net export balance allows a country to maintain a comparatively “strong” real exchange rate. Conversely, a debtor country that must run a trade surplus may require a surplus in its overall balance of payments whenever total receipts from exports and foreign investment fall short of total payments.

The relationship between external balance and the real exchange rate is of considerable interest to both policymakers and currency speculators. Two broad approaches are typically applied in the determination of exchange rate regimes, and a mixture of the two, such as a crawling peg or a managed float, is also possible. Several factors influence the choice of regime, the major considerations being domestic economic conditions, the external economic environment, and the effect of various random shocks on the domestic economy.

Exchange rate management in Nigeria shifted from a fixed exchange rate regime in the 1960s to a pegged regime between the 1970s and the mid-1980s; these changes were not peculiar to the naira alone, as the US dollar itself was fixed in terms of gold until 1971, when the peg was abandoned and the dollar has since floated.

The fixed exchange rate regime induced a persistent overvaluation of the naira, which weighed on the competitiveness of Nigerian exports, domestic production and the country's external reserves. An Autonomous Foreign Exchange Market (AFEM) was introduced in 1995, but owing to its failure to achieve the CBN's objectives, an Interbank Foreign Exchange Market (IFEM) was introduced on 25 October 1999. It was designed as a two-way quotation system intended to encourage the funding of interbank operations from foreign exchange earned through export activity. As a result of persistent expansionary fiscal operations by government and excess liquidity in the system, however, IFEM was unable to resolve the underlying pressures on the exchange rate.

In July 2002, the Central Bank of Nigeria introduced the Dutch Auction System (DAS), an improvement on previous mechanisms, to replace IFEM, as demand pressure on the exchange rate intensified and Nigeria's external reserves continued to deplete. This reflected the extent to which foreign exchange earnings from oil remained closely tied to output and employment conditions in the countries from which Nigeria sourced most of its imports.

The overriding objective of the CBN throughout this period has been to maintain a realistic exchange rate capable of achieving internal and external balance simultaneously, and of facilitating sustainable economic growth and development.

More recently, the CBN introduced a managed floating exchange rate regime in June 2016, in response to renewed demand pressure on the naira, and complemented it with instruments such as the Investors' and Exporters' (I&E) window and naira-settled foreign exchange futures aimed at improving market liquidity and transparency. This managed float regime remained largely in place until June 2023, when the administration of President Bola Ahmed Tinubu, acting through the CBN, collapsed all segments of the foreign exchange market into a single, unified window operating on a “willing buyer, willing seller” basis (Briggs, 2025; Ozili, 2024). While the reform was intended to improve price discovery, boost foreign exchange supply and restore investor confidence, it was also followed by a sharp depreciation of the naira and a marked rise in imported inflation; Briggs (2025) reports that the naira weakened from around ₦458 to the US dollar in May 2023 to roughly ₦1,530 by May 2025, while Aminu, Ado and Umar (2025) found that the resulting exchange rate differentials had a significant negative effect on food inflation in the period following unification. These developments make it especially important that any current study of exchange rate variation and Nigeria's balance of payments extend its data coverage well beyond 2019, so as to capture the effects of this most recent, and arguably most far-reaching, phase of exchange rate reform.

1.2 Statement of Research Problem

Nigeria, like other developing countries, has experienced persistent balance of payments disequilibrium. There has been persistent inflation, a high rate of unemployment, an increase in imports, a fall in export earnings from key commodities, and a general decline in the growth of gross domestic product (GDP) at various points over the past four decades.

The federal government has, at different times, tried to correct this imbalance by borrowing, both domestically and from abroad, and this borrowing has itself, in some respects, added to Nigeria's balance of payments disequilibria (Bernard, Oniore, Onogbosele, Eze & Pam, 2024).

Every economy aims at achieving a favourable external balance of payments position in its international relations. The attainment and maintenance of external balance depends on an accurate understanding of the effects of real exchange rate movements on the balance of payments position.

Economists and policy analysts have yet to reach a firm agreement on the most appropriate exchange rate policy for developing countries. The history of less developed countries generally, and of Nigeria in particular, has at various points been marked by political unrest and social disorder, arguably linked, at least in part, to high and unstable exchange rates, balance of payments disequilibria, and unemployment. George-Anokwuru (2024) similarly found that persistent exchange rate volatility, alongside inflation, continues to have a measurable adverse effect on Nigeria's balance of payments position.

This study intends to analyse the effect of the exchange rate and other macroeconomic variables on the balance of payments position in Nigeria, extending the analysis to capture developments up to and including the CBN's 2023 exchange rate unification reform.

1.3 Objective of the Study

The main objective of this research work is to investigate and determine the impact of exchange rate variation on Nigeria's balance of payments position and to determine the relationship between the exchange rate and Nigeria's external balance. More specifically, the study intends to:

1. determine the effect of foreign exchange rate changes on the balance of payments (BOP);

2. determine the impact of the exchange rate on foreign reserves in Nigeria;

3. determine the impact of foreign reserves on economic growth in Nigeria; and

4. examine the effect of Nigeria's 2023 exchange rate unification reform on the country's balance of payments position.

1.4 Research Questions

1. What is the effect of foreign exchange rate changes on the BOP?

2. What is the impact of the exchange rate on foreign reserves in Nigeria?

3. What is the impact of foreign reserves on economic growth in Nigeria?

4. What effect has Nigeria's 2023 exchange rate unification reform had on the country's balance of payments position?

1.5 Significance of the Study

The research work will help identify the actual impact of exchange rate variation on the balance of payment. It will also examine exchange rate management policy, since exchange rate management remains an evolving process and a continuing challenge for the balance of payments.

The significance of this study lies in the fact that its results should help policymakers adopt exchange rate policies that are not detrimental to the balance of payments position, which remains one of the key macroeconomic goals (Chukwudi, 2025).

If fully digested, the study should provide invaluable information and guidance to various groups in different ways. To managers of the economy, it offers a guide as to the efficiency, or otherwise, of monetary and exchange rate policies in addressing Nigeria's balance of payments problems.

To foreign investors, it will provide insight into the viability of the Nigerian economy. It will also give citizens of this country a better understanding of how the economy is managed, and of the expectations they should reasonably have of government.

In particular, the study will give the authorities useful insight into the effectiveness of the policies of past administrations, which should serve as a guide for future policy initiatives, including further refinements to the 2023 exchange rate unification regime (Maku, Ishioro & Asagba, 2023).

The exchange rate and balance of payments of any nation lie at the heart of that nation's development. These remain controversial factors that have not been well managed in Nigeria. Because the economy is import-dependent, and therefore dependent on other nations, exchange rate movements affect Nigeria greatly, particularly since foreign exchange is involved in virtually every sector of the economy. The significance of this study, therefore, lies in making known the relationship between exchange rate and balance of payments, along with the policy implications and recommendations that follow, which should be of immense help to policymakers and to government, especially as regards the management of the exchange rate and balance of payments in Nigeria. It is also of importance to students, lecturers and members of the public with an interest in the subject matter.

1.6 Scope of the Study

This study was carried out on the impact of exchange rate variation on balance of payment in Nigeria, covering the period from 1986 to 2024.

The starting point of 1986 is retained because it coincides with Nigeria's adoption of the Structural Adjustment Programme and the shift from a fixed to a market-determined exchange rate regime, an inflection point that remains central to any meaningful analysis of exchange rate variation and balance of payments performance in Nigeria.

1.7 Limitation of the Study

1. A problem encountered while conducting this research was that of differentiating the impact of one policy measure from that of others. For instance, within the period under study, other policy measures, such as income policy, trade policy and fiscal policy, were at one time or another also targeted at the balance of payments. The result is that even the most rigorous analytical technique cannot fully disentangle this web of inter-relationships, or assign success or failure to each policy measure within a precise time frame. What the researcher did, in a global sense, was to adopt a lump-sum approach in evaluating the overall effectiveness of the various policy measures on the balance of payments.

2. Another important limitation was the relative scarcity of books and related literature on the subject matter written with a specifically Nigerian background; as a result, considerable reliance was placed on official publications and recent journal literature.

3. A third, and perhaps the most limiting, problem encountered was the uncooperative attitude of some academic staff and government officials who were consulted for advice. In some cases, officials and lecturers displayed limited familiarity with the subject matter; in other cases, they were simply unwilling to cooperate. For these reasons, official publications and recent empirical studies were extensively relied upon.

1.8 Definition of Terms

For the purpose of this research work, all terms and expressions used shall be attributed their ordinary interpretations unless otherwise stated. However, the following terms shall mean:

Balance of Payment: A systematic record of the economic transactions, for a given period, between residents of an economy and non-residents. These transactions include the provision and receipt of real resources, such as goods, services and income, together with changes in claims on, and liabilities to, the rest of the world.

Monetary Policy: The management of the expansion and contraction of the volume of money in circulation for the specific purpose of achieving certain declared national objectives.

Exchange Rate Policy: The choice of a foreign exchange management system, and the determination of the particular rate at which foreign exchange transactions will take place.

Managed Float: An exchange rate regime, adopted by Nigeria between June 2016 and June 2023, in which the exchange rate is largely determined by market forces but remains subject to periodic intervention by the central bank in order to limit excessive volatility (CBN, 2024, as cited in Briggs, 2025).

Exchange Rate Unification: The merging of previously segmented official and parallel foreign exchange market windows into a single market in which the exchange rate is determined by the forces of demand and supply, as undertaken by the Central Bank of Nigeria in June 2023 (Briggs, 2025; Ozili, 2024).

REFERENCES

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