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The study seeks to empirically analyze the impact of exchange rate instability on foreign direct investment in Nigeria from 1981 -2014. The data for the research study was extracted from CBN statistically bulletin volume 25, 2014 edition. The methodology is ordinary least square were foreign direct investment was regressed on Exchange Rate, Real Gross Domestic Product and Openness of the economy. Some econometrics test were conducted such as the unit Root, Contegration and Vector Autoregressive Model. The unit root result shows that none of the variables were stationary at level, but at first differencing they all became stationary. The contegration result shows that there is no long run relationship among the variables. The vector autoregressive model shows that exchange rate had an impact on economic growth. It is on this note that the researcher recommends amongst others that: policy makers should continue on the part of floating exchange rate policy to enable our domestic currency assume its proper level among the committee of world currencies, for purpose of establishing stability in the exchange rate of the naira, to ensure effective economic planning and sustainable growth and development.
1.1 Background of the Study
The developing countries of the world face a number of problems. The one of the major problems is scarce financial resources, with the passage of time investment needs to increase along with other things, these ne
eds in the LDCs are fulfilled by the capital inflow from the developed nations either in the form of aid or foreign direct investment (Ellahi and Ahmad, 2011). FDI is therefore, the key determinant of capital inflow that brings technological spill over in the less developed countries (LDCs) by introducing better production methods.
Exchange rates is defined as the domestic currency price of a foreign currency, matter both in terms of their levels and their volatility. Exchange rates can influence both the total amount of foreign direct investment that takes place and the allocation of this investment spending across a range of countries.
Exchange rate instability refers to the erratic fluctuation in exchange rate, which could during periods of domestic currency appreciation or depreciation. Exchange rate changes may lead to a major decline in future output, if they are unpredictable and erratic. The exchange rate is therefore, an important relative price as it has influence on the external competitiveness of the domestic economy. Volatility of exchange rate is a sort of risk challenged to international traders and investors engaged in FDI. So, we may conclude that volatility of exchange rate is a factor that curtails the trade volume and reduces the investment. This volatility when appears in developed nations causes instability all over the world (Chege, 2009). It is a wide recognized fact that exchange rate volatility in LDCs is the key factor to bring economic instability all over the world (Chege, 2009).
The 1980s witnessed increased flows of investment around the world. Total world outflows of capital in that decade grew at an average rate of almost 30%, more than three times the rate of world exports at the time, with further growth experienced in the 1990s (Kosteletou and Liargovas, 2000). Despite the increased flow of investment, especially, to developing countries, Sub-Saharan Africa (SSA) countries still lag behind other regions in attracting foreign direct investment. The uneven dispersion of FDI is a cause of concern since FDI is an important source of growth for developing countries. Not only can FDI add to investment resources and capital formation, it can also serve as an engine of technological development with much of the benefits arising from positive spill over effects. Such positive spill overs include transfers of production technology, skills, innovative capacity, and organizational and managerial practices.
Given these significant roles of FDI in developing economies, there have been several studies that tried to determine the factors that influence FDI inflows into these economies. One of such factors that recently have been a source of debate is exchange rate and its volatility. The existing literature has been split on this issue, with some studies finding a positive effect of exchange rate volatility on FDI, and others finding a negative effect. A positive effect can be justified with the view that FDI is export substituting. Increases in exchange rate volatility between the headquarters and the host country induce a multinational to serve the host country via a local production facility rather than exports, thereby insulating against currency risk (Foad 2005).
Justification for a negative impact of exchange rate volatility on FDI can be found in the irreversibility literature pioneered by Dixit and Pindyck (1994). A direct investment in a country with a high degree of exchange rate volatility will have a more risky stream of profits. As long as this investment is partially irreversible, there is some positive value to holding off on this investment to acquire more information. Given that there are a finite number of potential direct investments, countries with a high degree of currency risk will lose out on FDI to countries with more stable currencies (Foad 2005). One of the countries that fall into this category (countries with a high degree of currency risk) is Nigeria. With a population of about 130 million people, vast mineral resources, and favourable climatic and vegetation features, Nigeria has the largest domestic market in Sub-Saharan Africa. The domestic market is large and potentially attractive to domestic and foreign investment, as attested to by portfolio investment inflow of over N1.0 trillion into Nigeria through the Nigerian Stock Exchange (NSE) in 2003 (Central Bank of Nigeria, 2004). Investment income, however, has not been encouraging, which was a reflection of the sub-optimal operating environment largely resulting from inappropriate policy initiatives.
Except for some years prior to the introduction of the Structural Adjustment Programme (SAP) in 1986, gross capital formation as a proportion of the GDP was dismally low on annual basis. It was observed that aggregate investment expenditure as a share of GDP grew from 16.9% in 1970 to a peak of 29.7% in 1976 before declining to an all-time low of 7.7% in 1985. Thereafter, the highest was 11.8% of GDP in 1990, before declining to 9.3% in 1994. Beginning from 1995, investment/GDP ratio declined significantly to 5.8% and increased marginally to 7.0% in 1997 and remained there about till 2004 when 7.1% was recorded. On the average, about four-fifth of Nigeria’s national output was consumed annually. It is against this background that this study aims at investigating the impact of exchange rate instability on foreign direct investment in Nigeria.
1.2 Statement of the Problem
Since the world has moved towards higher financial integration, a degree of openness for foreign investments in many countries becomes higher. As both developed and emerging economies continue to open their markets to attract foreign capital flows and investors are becoming interested in diversifying their fund flows internationally, the role of foreign investment is increasingly important.
The exchange rate level effects on FDI through this channel relying on a number of basic considerations. First, the exchange rate movement needs to be associated with a change in the relative production costs across countries, and thus should not be accompanied by an offsetting increase in the wages and production costs in the destination market for investment capital. Second, the importance of the “relative wage” channel may be diminished if the exchange rate movements are anticipated. Anticipated exchange rate moves may be reflected in a higher cost of financing the investment project, since interest rate parity conditions equalize risk-adjusted expected rates of returns across countries. By this argument, stronger FDI implications from exchange rate movements arise when these are unanticipated and not otherwise reflected in the expected costs of project finance for the FDI.
The sub-optimal investment ratio in Nigeria could be traced to many factors including exchange rate instability, persistent inflationary pressure, low level of domestic savings, inadequate physical and social infrastructure, fiscal and monetary policy slippages, low level of indigenous technology as well as political instability. A major factor was exchange rate instability, especially after the discontinuation of the exchange rate control policy. The high lending rate, low and unstable exchange rate of the domestic currency and the high rate of inflation made returns on investment to be negative in some cases and discouraged investment, especially when financed with loans. The Naira (Nigerian currency) exchange rate witnessed a continuous slide in all the segments of the foreign exchange market (that is, official, bureau de change and parallel markets). In the official market, the exchange rate depreciated progressively from N8.04 per US dollar in 1990 to N81.02 per dollar in 1995 and further to N129.22 in 2003 and N133.00 in 2004. Similarly, it depreciated from N9.62 and N9.61 per dollar in 1990 to N141.36 and N141.07 per dollar in 2003 in the bureau de change and parallel market, respectively.
Consequently, the premium between the official and parallel market remained wide throughout the period. This high exchange rate volatility in Nigeria, among others, led to a precarious operating environment which can be attributed to the reason why Nigeria was not only unable to attract foreign investment to its fullest potentials but also had a limited domestic investment. As such, despite the vast investment opportunities in agriculture, industry, oil and gas, commerce and infrastructure, very little foreign investment capital was attracted relative to other developing countries and regions competing for global investment capital. As a result of the above, it becomes relevant for a study like this to investigate if there exist any relationship between FDI and exchange rate volatility or instability in the Nigerian economy. It also investigates the magnitude and direction of the effect of exchange rate and its volatility on foreign direct investment.
Despite all efforts, volatility in exchange rate still persists. Could the persistence of the problem due to inappropriate policies or gaps in the studies already carried out? This is what this study seeks to address and in this regards, provide evidence of the impact of exchange rate instability on foreign direct investment in Nigeria.
1.3 Research Questions
This research work will seek to answer the following questions;
Ø Is there any significant impact of exchange rate instability on foreign direct investment in Nigeria?
Ø Could there be bi-directional relationship between exchange rate instability and foreign direct investment in Nigeria?
Ø Does long-run relationship exist between exchange rate instability and foreign direct investment in Nigeria?
1.4 Objectives of the Study
The objectives of this research work are stated as follows:
1. To ascertain how the Nigerian exchange rate instability has contributed in the optimization of output and stabilization in the Nigerian economy.
2. To evaluate the degree of causality existing between exchange rate instability and foreign direct investment in Nigeria.
3. To ascertain the extent to which long-run relationship exists between exchange rate instability and foreign direct investment in Nigeria.
1.5 Hypotheses of the Study
H0 There is no significant impact of exchange rate instability on foreign direct investment in Nigeria
H0: There is no bi-directional relationship between exchange rate instability and foreign direct investment in Nigeria.
H0: There is no long-run relationship existing between exchange rate instability and foreign direct investment in Nigeria.
1.6 Significance of the Study
This research work is multifaceted in purpose and significant in:
Helping to document and analyse the current trend in the role of foreign direct investment and exchange rate instability in the growth of the Nigerian economy and evaluating the progress made from it during the past decade in attaining long-term objectives of sustainable economic growth and improvement in the quality of living future populations.
This research work will be of great intellectual value to students of economics and other discipline who would want to make further research on the impact of foreign Direct Investment on the economic growth of Nigeria.
Lastly, it will add to already existing body of knowledge on this topic as it will provides a new window for further research.
1.7 Scope and Limitation of the Study
The study would cover the impact of exchange rate instability on foreign direct investment (FDI) in Nigeria within the period of 1981 - 2014. This period was chosen based on the available data. The researcher encountered the following constraints in the course of this work, financial constraint, data constraint, limited information due to the type of research work and time constraint.
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