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In the face of capital deficiency in financing long term development, the capital-deficient economies have heavily resorted to foreign capital as the primary means to achieve rapid economic growth. In the presence of the aforementioned problems this study empirically examined the impact of selected macroeconomic variables (Exchange rate, Interest rate and Inflation) on capital inflows. The study in specific terms employs a vector error correction to estimate the demand and supply of capital inflow. In addition, a pairwise granger causality test was conducted to explore the causal link between the macroeconomic variables and capital inflow. Interestingly, it was observed from the causality test that there was neither bidirectional nor unidirectional causality between the two but rather an independent relationship. The findings from the vector error correction established there is no significant short-run relationship among the variables both from the demand and supply side but in the long run the relationship is significant. The results from VECM assert that the values of lagged of interest rate, exchange rate, inflation rate and other macroeconomic variables as an insignificant factors affecting the rate of capital inflow in Nigeria. Based on the outcome of the results it was therefore suggested that care should be taken when attracting capital inflow to Nigeria (either foreign direct investment or external debt) and it should be directed to more productive sectors of the economy. Particularly, these investments should be able to create jobs, develop local skilled labour and stimulate and transfer new technologies. The government should also provide incentives in order to encourage foreign investments into labour intensive and pro poor sectors of the economy.



1.1 Background of the Study

Many developing nations are known with low level of domestic savings, which has affected the much needed investment for economic development. In order to attain a desirable level of investment that would ensure economic growth and development, developing nations need some foreign savings to close the savings-investment gap in the country. Capital inflows are transferred through foreign direct investment (FDI), foreign portfolio investment (FPI), foreign loans and credits etc. Increasing capital inflows are usually indicative of positive perceptions of a market in the global economy, or an attractive business environment due to favorable tax structures or business friendly regulations. A net flow of capital, real or financial, into a country, is in the form of increased purchases of domestic assets by foreigners or reduced holdings of foreign assets by domestic residents this is recorded as positive, or a credit, in the balance on capital account.

In the last few years, Nigeria has experienced a phenomenal increase in private inflows of capital. The major triggers were the increased tempo of reform which led to a more stable financial system and better macroeconomic environment. More fundamentally, financial developments at the world stage might also have played quite an important role. The fact that the developing economies were by and large less integrated with the rest of the world, or were thought to be relatively insulated from the crises that engulfed major financial centers made them appear like, temporary safe havens for international capital.

The oligopolistic nature of markets in such economies made capital flows to them rapidly increased in 2000s to take advantage, also, of the persistent uncovered interest differentials. For instance, capital flows to the sub-Sahara Africa (SSA) increased from about $10 billion in 2000 to over $50 billion in 2007. Nigeria received nearly 30% of the FDI component of the inflows (IMF-REO, 2008). Until the 2000s, foreign direct investments (FDIs) and debt were the major kinds of inflows to Nigeria. However, as the capital market opened up, the country started to receive substantial inflows in the form of portfolio investment especially from 2004. Both the bonds and equities segments of the market have in recent years experienced unprecedented inflows. As the global financial and economic crisis intensified, inflows slightly recessed as from mid-2008 but picked in 2010.

Admittedly, the internationalization of the Nigerian stock exchange, there has been increased inflow of foreign portfolio investment into the Nigerian economy through the capital market in the form of foreign direct investment, foreign portfolio investment, overseas development assistance and bank loans. However, from the middle of the past two decades, Nigeria witnessed a quasi-metamorphosis in the composition of private capital flows to Nigeria. Foreign portfolio investment appears to have taken the centre stage and its share of private capital flows to Nigeria has been on a phenomenal increase that by 2007 FPI has surpassed every other type of capital inflows into Nigeria with official flows (ODA) and bank loans declining in real terms (CBN, 2009).

Furthermore, the UNCTAD World Investment Report 2006 shows that foreign direct investment (FDI) inflow to West Africa is mainly dominated by inflow to Nigeria, who received 70% of the sub-regional total and 11% of Africa’s total. Out of this, Nigeria’s oil sector alone received 90% of the FDI inflow. The Library of Congress-Federal Research Division report, (2008) shows that in 2006 Nigeria received a net inflow of US$5.4 billion of foreign direct investment (FDI), much of which came from the United States. FDI constituted 74.8 percent of gross fixed capital formation, reflecting low levels of domestic investment. Most FDI is directed toward the energy sector. As at August 2007, World Bank assistance to Nigeria involved 23 active projects with a total commitment value of about US$2.67 billion. Since Nigeria joined the World Bank in 1961, the World Bank has assisted it on 123 projects. Also, in 2007 Nigeria had an estimated gross domestic product (GDP) of US$166.8 billion according to the official exchange rate and US$292.7 billion according to purchasing power parity (PPP). The GDP rose by 6.4 percent in real terms over the previous year.

Recently, portfolio investment has gained prominence in Nigeria.  Before the middle of 1980s, Nigeria did not record any figure on portfolio investment (inflow or outflow) in her balance of payment (BOP) accounts. This was attributable to the non-internationalization of the country’s money and capital markets as well as the non-disclosure  of  information  on  the  portfolio  investments  of  Nigerian  investors  in  foreign  capital/money markets (CBN 1997:151). On the other hand, FDI dominated Nigeria’s capital flows and its benefits are aptly captured by Sadik and Bolbol (2001) in their study. They argued that FDI is the least volatile of capital flows, and more important, can have direct and indirect effects on economic growth.  

Notwithstanding, large capital flows could spur economic growth or have destabilizing effect in the economy, if not well managed.  The destabilizing effect of foreign capital inflow has aroused concern over their potential effects on macroeconomic stability, the competitiveness of the export sector, and external sector viability. The most serious risks are that they fuel inflation and drive the real effective exchange rate to unsustainably high levels. 

1.2 Statement of the Problem

The need for foreign capital to complement domestic resources in the economic growth process has been welcomed as a catalyst of development, since it is considered as the central element of the process of economic growth. In the face of resource deficiency in financing long term development, the capital-deficient economies have heavily resorted to foreign capital as the primary means to achieve rapid economic growth. Unfortunately, the growth experience of many of the economies has not been very satisfactory. Hence, they accumulate huge external debt in relation to gross domestic product and face with serious debt servicing problems in terms of foreign exchange flow and also walloping in abject poverty.

Besides, the flow of funds within many developing nations are not adequate to provide infrastructures, the available local savings cannot cater for the desired investment to meet up with the developed nations. With the shortage of capital in many developing nations there is need for the inflow of capital from the foreign economy where there is excess fund to the local economy where there is shortage of fund to augment the level of desired investment.

Conversely, the experience of a small number of fast growing East-Asian newly industrialized nations has strengthened the belief that foreign capital is the central element of the process of economic development. Since it could bridge the resource gap of these economies and avoid further buildup of debt while tackling the causes of poverty directly.

However, the effect of the inflow of capital to many developing nations has proven to be double-edge sword, it has both negative and positive impact. The positive side is that there is appreciation of local currency as against the foreign currency also augmentation of the shortage of savings for investment etc. while the negative sides are inflation, lack of monetary independence (Usman, 2012) etc. Many studies have investigated the impact of some micro and macro-economic variables (Goodhart, Peiri and Tsomoscow, 2012 and CBN, 2012) on the inflow of capital, some of which are exchange rate, inflation rate, tax etc.

But beyond diplomacy driven inflow of foreign fund to Nigeria, there is a need to investigate the impact of selected macroeconomic factors on foreign capital inflows to the country;  hence  the  purpose of this study is to investigate  the  likely  impact  of  selected macroeconomic  variables (exchange rate, interest rate, inflation) on capital inflow to Nigeria.

1.3 Objectives of the Study

The broad objective of this study is to examine the likely impact of selected macroeconomic variables (Exchange rate, Interest rate and Inflation) on capital inflows.

The specific objectives of the study are to examine:

        i.            The impact of exchange rate on capital inflow in Nigeria;

      ii.            The impact of interest rate on capital inflow in Nigeria;

    iii.            The impact of inflation on capital inflow in Nigeria.

1.4 Research Questions

This study is based on the following research questions:

        i.            What is the impact of exchange rate on capital inflow in Nigeria?

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