THE OIL PRICE AND EXCHANGE RATE VOLATILITY IN NIGERIA


THE OIL PRICE AND EXCHANGE RATE VOLATILITY IN NIGERIA  

ABSTRACT

Nigeria is a mono-product economy, where the main export commodity is crude oil, changes in oil prices has implications for the Nigerian economy and, in particular, exchange rate movements. The latter is mostly important due to the double dilemma of being an oil exporting and oil-importing country, a situation that emerged in the last decade. The study examined the effects of oil price, external reserves and interest rate on exchange rate volatility in Nigeria using yearly data from the year 1970 to 2011. The theoretical framework of this study is based on Generalized Autoregressive Conditional Heteroskedasity modeled by Tim Bolerslev (1986) and Exponential General Autoregressive Conditional heteroskedastic modeled by Daniel Nelson (1991). The models are used to estimate the relationship between oil price changes and exchange rate. Relevant descriptive and econometric analyses were employed. The econometric tests used include the unit root tests, Johansen co-integration technique and the Vector Error Correction Model (VECM) when the unit root tests were carried out; all the variables were stationary at first difference. The long run relationship among the variables was determined using the Johansen Co-integration technique while the vector correction mechanism was used to examine the speed of adjustment of the variables from the short run dynamics to the long run. It was observed that a proportionate change in oil price leads to a more than proportionate change in exchange rate volatility in Nigeria by 2.8%. I therefore recommend that the Nigeria government should diversify from the Oil sector to other sectors of the economy so that Crude oil will no longer be the mainstay of the economy and frequent changes in crude oil price will not influence exchange rate volatility significantly in Nigeria.

TABLE OF CONTENTS

CONTENT

Title page i

Certification ii

Dedication iii

Acknowledgement iv

Table of Contents v

List of Tables viii

List of Figures ix

Abstract x

CHAPTER ONE: INTRODUCTION

Background to the Study1

Statement of Research Problem3

Scope of study4

Research Questions5

Objectives of Study5

Research Hypothesis5

Definition of terms5

Significance of Study6

Research Methodology7

Data Sources7

Outline of Chapters8

CHAPTER TWO: LITERATURE REVIEW

Review of Definitional Issues9

History of Oil price10

Brief History of oil in Nigeria11

Exchange rate volatility12

Various exchange rates Management Practised In Nigeria13

Importance of Exchange rate stability17

Measuring of Exchange rate Volatility19

Oil Price and Exchange Rate21

Review of Theoretical Issues22

Review of Methodological and Empirical Issues25

CHAPTER THREE: RESEARCH METHODOLOGY

Introduction29

Theoretical Framework29

Model Specification32

Data sources and Descriptions34

Research Methodology35

CHAPTER FOUR: DATA PRESENTATION AND EMPIRICAL ANALYSIS

Introduction41

Trend and Descriptive Analysis42

Econometric Analysis44

Findings and economic interpretation48

Conclusion49

CHAPTER FIVE: SUMMARY, CONCLUSION AND RECOMMENDATIONS

Summary51

Policy Recommendations51

Limitation of Study53

Suggestions for further study53

Conclusion53

REFERENCES 54

APPENDIX 59

LIST OF TABLES

Table 1: Variables and Data sources

Table 2: Descriptive Statistics of Variables

Table 3: ADF Test and Phillips Perron Test for Unit Root

Table 4: Unrestricted Cointegration Rank Tests Table 5: Normalized Co-integrating Co-efficient Table 6: Vector Error Correction Estimates

LIST OF FIGURES

FIGURE 1: Diagram showing the Graphical relationship between EXRV, OILP, ER and INT

CHAPTER ONE

INTRODUCTION

BACKGROUND OF STUDY

“There are various evidences, particularly over the post-Breton woods era, pointing to the vital role of oil price fluctuations in the determination of the path of the exchange rate” (Adeniyi et al, 2004). According to Krugman (1983), exchange rate appreciates in response to rising oil prices and depreciates with response to falling oil prices in oil exporting countries, while the opposite is expected to be the case in oil importing countries.

Volatility is the fluctuation in the value of a variable, especially price (Routledge, 2002). According to Englama et al (2010), a volatile exchange rate makes international trade and investments more difficult because it increases exchange rate risk. Exchange rate volatility tends to increase the risk and the uncertainty of external transactions and predisposes a country to exchange rate related risks (Jin, 2008).

According to Adedipe (2004), when Nigeria gained politically independence in October 1960, agricultural production was the main stay of the economy, contributing about 70% of the Gross domestic product (GDP), also employing about seventy percent of the working population and responsible for about ninety percent of foreign government revenue. The initial period of post- independence till mid – 1970s witness a fast advancement of industrialized capacity and output, as the contributions made by the manufacturing sector to GDP rose from 4.8% to 8.2%. This pattern changed when crude oil became very important to the world economy.

According to Englama et al (2010), crude oil became an export commodity in Nigeria in 1958, following the discovery of the first producible well in 1956. The contribution of oil to the federal government revenue in 1970 rose to 82.1% in 1974 from 26.3% and in 2008 constituted 83% of

the federal government revenue, largely on account of increase in oil prices in the international market. The gigantic rise in oil revenue was caused by the Middle East war of 1973. It created extraordinary, surprising and unforeseen wealth for Nigeria and the naira appreciated as foreign exchange influxes offset outflows and Nigeria foreign reserves assets increased (Adedipe, 2004). The economy of Nigeria gradually became dependent on crude oil as productivity declined in other sectors (Englama et al, 2010).

Nigeria is a mono – product economy, according to OPEC statistical bulletin (2010/2011) the value of Nigeria’s total export revenue in 2010 was US$70,579 million and the revenue of petroleum exports from the total export revenue was US$61,804 million which is 87.6% of total export revenue this means that Nigeria’s economy will be vulnerable to the movements of oil prices.

During periods of favorable oil price shocks triggered by conflict in oil – producing areas of the world, the rise in the demand for the commodity by the consuming nations, seasonality factors, trading positions etc. Nigeria experiences favorable terms of trade evidenced by a large current account surplus and exchange rate appreciation. On the converse, when crude oil prices are low, occasioned by factors such as low demand, seasonality factors, excess supply, the Nigeria experiences unfavorable terms of trade evidenced by budget deficit and slow economic growth (Englama, 2010). An example was a drop in the revenue from oil exports during the global financial crisis in 2009. According to, OPEC statistical bulletin (2010/2011), oil export revenue dropped from US$74,033 million in 2008 to US$43,623 million in 2009 and the naira depreciated to N148.902 in 2009 from N118.546 in 2008.

This study attempts to discover the extent to which oil price influences exchange rate volatility in Nigeria. Oil price changes directly affects the inflow of foreign exchange into the country, therefore there is a need to investigate its impact on the naira exchange rate volatility (Englama et al, 2010).

STATEMENT OF PROBLEM

Crude Oil is a key source of energy in Nigeria and the in the world. Oil being an important part of the economy of Nigeria plays a strong role in influencing the economic and political fate of the country. Crude oil has generated great wealth for Nigeria, but its effect on the growth of the Nigerian economy as regards returns and productivity is still questionable (Odularu 2007).

From the period of the oil boom of the 1970s till now, Nigeria has neglected her strong agriculture and light manufacturing bases in favor of unhealthy dependence on crude oil. New oil wealth has led to a concurrent decline of other sectors in the economy and has fueled massive migration to cities and led to increasingly wide spread poverty especially in rural areas. Nigeria’s job market has witnessed very high degree of unemployment, small wage and pitiable working environments (Adedipe, 2004 and Odularu 2007). Between 1970 to 2000, Nigeria’s poverty rate increased from 36 percent to just fewer than 70 percent and it is believed that oil revenue did not seem to add to the standard of living at this time but actually caused it to decline (Martin and Subramanian, 2003).

Oil price fluctuations have received important considerations for their presumed role on macroeconomic variables. Higher oil prices may reduce economic growth, generate stock exchange panics and produce inflation which eventually leads to monetary and financial instability. It will also lead to high interest rates and even a plunge into recession (Mckillop,

2004). Sharp increases in the international oil prices and the violet fluctuations of the exchange rate are generally regarded as the factors of discouraging economic growth (Jin, 2008).

A very good example is the period of the global financial crisis, the price of oil fell by about two thirds from its crest of $147.0 per barrel in July 2008 to $41.4 at end of December 2008. Before the crises, oil price was high, exchange rate was stable but with the dawn of the global financial crisis (GFC) oil price crashed and the exchange rate caved-in, depreciating by more than 20 per cent. Since oil price volatility directly affects the inflow of foreign exchange into the country, there is a need to investigate if it has direct impact on the Naira exchange rate volatility (Englama et al, 2010)

The oil market has been and will continue to be an ever changing arena. This is because oil is so vital to the world economy, it is present in everyone’s daily lives and its market is truly global (El – badri, 2011).

Thus, it is on this note that this research seeks to find out the effect of oil price on exchange rate volatility and its effects on the Nigerian economy, as well as suggest methods of minimizing the adverse effects it can produce on the economy as a whole.

SCOPE OF STUDY

The purpose of the study is to determine the relationship between oil price and exchange rate in the Nigerian economy. 1t covers the period between 1970 and 2011.

RESEARCH OUESTIONS

The study attempts to give answers to the following questions

1. Do oil price have a significant relationship with exchange rate volatility in Nigeria?

2. What is the long run impact of oil price on exchange rate volatility in Nigeria?

OBJECTIVES OF THE STUDY

The major objective for this research is to determine if a long run relationship exists between oil price and exchange rate in Nigeria. The specific objectives include:

1. To examine if there exists a significant relationship between oil price and exchange rate volatility in Nigeria.

2. To assess the long run impact of oil price on exchange rate volatility in Nigeria.

RESEARCH HYPOTHESIS

In effort to realize the objectives of the study, the following hypothesis will be tested:

H0: Oil price has no statistical significant effect on exchange rate volatility in Nigeria H1: Oil price has a statistical significant effect on exchange rate volatility in Nigeria

H0: There is no long run relationship between oil price and exchange rate volatility in Nigeria

H1: There is a long run relationship between oil price and exchange rate volatility in Nigeria

DEFINITION OF TERMS AND CONCEPTS

VOLATILITY: Fluctuations in the value of a variable, especially price.

OIL - PRICE: The price in dollars at which a barrel of crude oil is sold for in the international market.

EXCHANGE RATE: The price of one currency in terms of another. It can be expressed in one of two ways, as units of domestic currency per unit of foreign currency or units of foreign currency per unit of domestic currency

ECONOMIC GROWTH: This is the growth of the real output of an economy overtime.

EXCHANGE RATE VOLATILITY: It refers to the swings of fluctuations in the exchange rates over a period of time or the deviations from a benchmark or equilibrium exchange rate.

OPEC: Organization of Petroleum Exporting Countries. It consists of twelve members which includes Nigeria.

SIGNIFICANCE OF STUDY

Researches conducted in this field of study have found out that oil price influence exchange rate to a great extent, especially oil producing countries. Nikbakbt (2009) showed that real oil prices have been a dominant source of real exchange rate movement and there exist a long run and positive linkage between real oil price and real exchange rates for OPEC countries. Oil exportation has contributed positively to Nigeria GDP, local expenditure, government revenue and foreign exchange reserves (Odularu 2007). Also in the words of Adedipe (2004) the oil price influences government policy and exchange rate in Nigeria.

Although a wealth of literature exist relating oil price and exchange rate to economic growth in Nigeria, little focus on the effect of the oil price on exchange rate in Nigeria. This project seeks to fill this gap in literature as it focuses on the effect of oil price on exchange rate volatility in Nigeria and whether or not it has a significant influence on exchange rate volatility in Nigeria.

Thus, this study is of great benefit to the government and policy makers. It reemphasizes the need to diversify and promote the growth of other sectors of the economy, in other to increase economic growth and improve the standard of living for Nigerians.

RESEARCH METHODOLOGY

Econometric technique will be used to analyze the effect of Oil price on exchange rate in Nigeria. The GARCH (1, 1) model is used to measure exchange rate volatility and the conditional variance series generates the volatility data from 1970 – 2011. The method adopted in determining a long run relationship between oil price and exchange rate volatility is the Johansen co-integration technique and the Vector Error Correction Model (VECM) specifies the convergence or divergence among the variables in the model.

DATA SOURCES

The study will make use of secondary data and it will be sourced from the central bank of Nigeria statistical bulletin 2011, BP statistical review on energy 2012 and exchange rate volatility is represented by conditional variances which will be generated using E-Views 5.0

1,11 OUTLINE OF CHAPTERS

This study is divided into five chapters. Chapter one which is the present chapter, gives a general overview of the study. Chapter two reviews papers related to this topic. It includes theoretical issues, empirical issues and the results of research relating to this topic.

The third chapter focuses on the research methodology it includes, technique of estimation, model specification and it also employs statistical technique in finding statistical relationship between the variables. Chapter four involves the presentation of data, analysis and discussion of results in chapter three. Lastly, chapter five, summarizes the major findings in this research study, concludes and gives policy implications of findings.

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THE OIL PRICE AND EXCHANGE RATE VOLATILITY IN NIGERIA



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