ABSTRACT
The persistent increase in demand for foreign currency, especially in recent years, exerts pressure on Nigeria's foreign exchange market. This trend is often accentuated by economic agents’ perceived loss of purchasing power and confidence in the domestic currency. Therefore, resort to holding currencies that have a relatively stable value such as the United States dollar (USD) which in turn increases the extent of currency substitution in the economy. This study investigates the existence and extent of currency substitution and how it invariably affects the demand for money in Nigeria using time series data for the 1980-2014 period. A significant contribution of this study is the consideration of the impact of crude oil price as well as the extent to which election periods contribute to currency substitution phenomenon in Nigeria. The study estimated six models that were predicated on Cuddington’s currency substitution framework. The Johansen cointegration test was employed in order to ascertain the existence of a long run relationship among the variables, and an error correction model was used to ascertain the short run adjustment dynamics. In addition to the finding that currency substitution had increased over time, albeit slowly; empirical results reveal that the expected rate of depreciation, inflation rate, election period, and crude oil price as well as foreign rate of interest determine the extent of currency substitution in Nigeria. Therefore, this study recommends that measures should be taken that will encourage and to bring back the confidence of economic agents in the domestic currency by the monetary authorities. Also, the financial system should be further deepened with liquidity to minimize vulnerability and exposure to sudden disturbances that could affect the financial system especially during election period and oil shocks.
CHAPTER ONE
INTRODUCTION
1.1 Overview
Currency substitution is often used interchangeably with dollarization. An economy is said to be dollarized when a foreign currency or foreign currencies serve as the local currency unit in all three functions of money (medium of exchange, store of value and unit of account) in an economy. Dollarization refers to the use of foreign currency as a store of value and unit of account. It refers more to the store of value role of money while currency substitution more narrowly relates to substitution between currencies as means of payment (Heimonen, 2008). Calvo and Vegh (1992) defined currency substitution as a shift away from domestic to foreign currencies and is often viewed as a safety precaution during periods of high and volatile inflation, while dollarization is viewed as one form of currency substitution where the store of value, medium of exchange and unit of account properties of the domestic money are transferred to foreign currencies.
The collapse of the Bretton Woods fixed exchange system and advent of generalized floating of currencies in the early 1970s gave rise to currency substitution. After the Second World War, the Bretton Woods system (also known as the gold exchange standard) was set up. Under this system, member countries defined their currencies relative to gold. Nevertheless, only the US dollar was relied upon for conversion to gold because of its dominant role as the international medium of exchange and store of value at the time. The collapse of the system in the early 1970s was followed by the adoption of floating exchange rate regime. Since then, the international monetary system has been based on fiat money rather than commodity standard. At the same time, international trade was increasing in the global economy and many changes in the financial world were occurring. For example, financial deregulations and new financial instruments which together with the floating system allowed for a reduction in portfolio risk and encouraged diversification (Arce-Catacora, 1997). This phenomenon also included location diversification, because capital movements from one country to another were observed and economic agents started to rely on different currencies to settle business transactions. Therefore, one may conclude that financial globalization may have contributed to the portfolio diversification and currency substitution phenomena.
Currency substitution is a prevalent phenomenon and a major feature of some developing countries, especially the emerging market economies in Latin America, Asia and African countries. Some of these countries are, in fact, fully dollarized while many others are partially dollarized. Some of the fully dollarized countries in Latin America include Ecuador, El Salvador, Panama and the Marshall Islands in which the United States (US) dollar is officially used as legal tender. Partially dollarized economies include Angola, Malawi, Nigeria, Bolivia, Uruguay, Peru, Cambodia and Turkey among others. The pattern of currency substitution in Latin American countries is related to their macroeconomic policies and institutional framework. Furthermore, they are characterized by the absence of restrictions on maintaining foreign currency deposits in their domestic financial system. Notably, weak financial markets and unstable macroeconomic environment in these countries (especially their previous inflationary history) can be attributed to the factors determining the presence of currency substitution (Selcuk, 2003; Calvo and Vegh, 1992).
In Asian countries for example, currency substitution and high dollarization accelerated due to exchange rate fluctuations. The experience of the Asian crisis led to the shift from pegged to floating exchange rate system. Loss of confidence in the domestic currency led to an unstable exchange rate and consequently, agents substitute dollars for domestic currency, thereby depleting foreign reserves and increasing devaluation pressure (Sharma, Kandil and Chiasrisawatsuk, 2005). The implementation of Structural Adjustment Programmes (SAPs) and subsequent liberalization of foreign exchange markets, led to the removal of many foreign exchange restrictions. This has resulted in a number of emerging market economies to move from fixed to flexible exchange rates. In most African countries, the late 1980s and the early 1990s were characterized by massive depreciation of their currencies as they sought to reduce and /or eliminate the influence of parallel market for foreign exchange that had existed in these countries over the years (Agenor, 2004).
In Nigeria, exchange rate arrangements have transited from a fixed regime in the 1960s to a pegged regime between the 1970s and the mid-1980s and to the floating regime from 1986 with the deregulation and adoption of SAP. This was the period when there was no restriction on holding of foreign currency by residents or non-residents in the country. Foreign currency (especially the US dollar) was used as medium of exchange, store of value as well as for unit of account in the economy (Gabriel 2012; Falana 2015). Foreign currency deposits in the Nigerian banking system as at 1986 was N0.6 billion, N2.3 billion in 1990 and was N9.04 billion in 1994. It fell to N6.1 billion in 1995 and rose to N7.7 billion in 1999. It maintained its upward trend as at 2003 with N122.6 billion, and more than quadrupled to N1, 444.3 billion, N3, 402.2 billion, N3961.8 billion in 2009, 2013 and 2014, respectively (Central Bank of Nigeria Statistical Bulletin). Thus, currency substitution generally takes place in the context of worsening economic and financial conditions that unfavorably affect the return on holding of local currency as compared to foreign currency. As such, individuals attempt to protect the value of their income and wealth from being eroded by inflation and/or exchange rate volatility (Meyer, 2000)
Although, some studies have shown that dollarization in Latin America have helped some countries reduce their hitherto out-of-control inflation and increased output growth, currency substitution can have several adverse spillover effects. These spillover effects include weakening the autonomy of monetary policy, increasing vulnerability to economic shocks arising from the host country, the potential for significant deterioration of the balance of payment account and/or exchange rate volatility (Boamah, Guy, Grosvenor and Lescott, 2012)
1.2 Statement of the Problem
The demand for money is one of the critical variables that affect the level of aggregate economic activity in the economy. With the persistent inflation and depreciation of the naira occasioned by exchange rate instability and monetary policy inconsistency, currency substitution has been a dominant, yet silent, feature of the Nigerian economy with far reaching macroeconomic implications (Effiom and Samuel, 2010). The fundamental problem is that domestic agents perceive loss of purchasing power from holding the home currency as a result of inflation risk, exchange rate risk or political instability. The use of foreign currency has become so prevalent that a large proportion of domestic trade and contracts are transacted in foreign currencies. People move freely around with dollars, rents are fixed and paid in dollars in the high-brow areas of Lagos, Abuja, Port Harcourt and other cities. While some educational institutions charge tuition fees in dollars just as contracts are also being awarded to foreign contractors and companies in dollars (Chidiebere, 2013).
The Central Bank of Nigeria (CBN) notes that the use of the US dollar as means of payment or legal tender in the local market is seriously affecting the value of naira as most Nigerians are fast losing confidence in the local currency as a store of value. Sanusi (2013), noted that the dollarization of the Nigerian economy was of serious concern to the CBN, the Economic Management Team, the President and the policy makers and that the CBN would come up with a policy to stop the practice.. For instance, in a bid to tackle the issue of dollarization in the country, the House of Representatives in 2013 passed a resolution urging the CBN to put an end to the dollarization of the economy.
Nigeria is a monocultural economy. The country depends heavily on crude oil of which the transactions are carried out in foreign currency, mainly in US dollars. Nigeria is a member of Organization of Petroleum Exporting Countries (OPEC), as such any decision taken on the international arena concerning crude oil prices could affect the country and potentially its monetary stability. The relevance of the currency substitution problem in Nigeria does not appear to be related to the choice of fixed versus floating exchange rate regime, but more to the potential problems of short-run monetary instability that currency substitution can create (Doguwa, 2014). If the demand for domestic currency is strongly influenced by foreign factors (for instance, foreign interest rate, crude oil pricesetc.), a substantial degree of instability may be imported from abroad, even if the monetary authorities follow consistent monetary and exchange rate policies. In November 2014, for instance, the CBN devalued the national currency (naira) by fixing the exchange rate at N168 to a dollar due to the falling price of crude oil in the international market. Falana (2015) noted that the CBN governor, Mr. Godwin Emefiele explained the basis of the devaluation, stating that “falling oil prices have consistently reduced the accretion to external reserves, thus constraining the ability of the bank to continually defend the naira and sustain the stability of the naira exchange rate”.
Furthermore, the unrestricted and over-bearing demand of the dollar by Nigerian politicians and business class is exerting a lot of pressure on the naira which is having an adverse effect on the strength of the naira and its purchasing power (Falana, 2015). The pressure on the dollar has been increasing especially due to unprecedented demand from politicians during election periods in the country, particularly the March and April, 2015 Presidential and gubernatorial elections. The demand for dollars had significantly increased in the periods running up to party congresses and primaries, reportedly because of the convenience it offers for moving large sums of money to facilitate transactions during the electioneering campaigns.
One implication of these events is the potential increase in the currency substitution index (CSI) or the dollarization ratio (DR) in Nigeria. Based on the data obtained from CBN Statistical Bulletin, the trend of currency substitution in Nigeria started at a slower pace and is moving gradually at an increasing rate. In 1986, for instance, CSI was 2.85%, but increased to 4.5% and 5.29% in 1990 and 1994, respectively. It fell to 2.98% in 1995 and peaked up in 1996 to 3.3% and has continued to fall to 1.57 in 1999. The low dollarization experienced in 1999 can be attributed to the period of general election which brought about the transition of military rule to democratic rule in the country. In 2002, it rose to 9.6% and this may be explained by the reintroduction of the Dutch Auction System (DAS). The ratio continued to increase as follows: 10.04% in 2004, 19.69% in 2013 and 24.49% in 2014.
Therefore, this study sets out to examine the existence, determinants and extent of currency substitution and the demand for money in Nigeria, and how it invariably affects the demand for domestic currency.
1.3 Research Questions
The foregoing discussion has prompted the following questions that this study seeks to answer:
- What is the trend and extent of currency substitution and the demand formoney in Nigeria?
- What is the impact of crude oil price on currency substitution and the demand for money in Nigeria?
- To what extent do political cycles (election period) contribute to currency substitution and the demand for money in Nigeria?
1.4 Objectives of the Study
The broad objective of the study is to ascertain the existence and determinants of currency substitution within the context of money demand in Nigeria. Specifically, the study seeks to;
- examine the trend and extent of currency substitution and the demand for money;
- analyze the impact of crude oil price on currency substitution and the demand for money; and
- assess the extent to which political cycles contribute to currency substitution and the demand for money in Nigeria.
1.5 Justification for the Study
A primary objective of central banks is the attainment of exchange rate stability. Over the years, efforts have been made to achieve this objective through the use of various policy prescriptions in country. The Nigerian economy is not immune to currency substitution, as it is a prevalent phenomenon in the country. The Nigerian economy has witnessed tremendous changes, especially since the return of the country to democratic rule. Some of the changes relates to policies put in place in order to put an end to the growing dollarization in the country which affect the monetary stability of the economy. Policies have been made in several ways to address the issue of which it was not successful. Thus, there is need to reevaluate the currency substitution phenomenon in the light of current economic realities. The growing rate of currency substitution in Nigeria with its significant effect on domestic money demand motivated this research.
Studies carried out in Nigeria on currency substitution include those of (Yinusa and Akinlo 2008; Effiom and Samuel 2010; Doguwa 2014; Aigheyisi 2015). The first two studies relied on Cuddington‟s Portfolio balance model while the other study used variants of the money demand function. However, none of the studies accounted for oil price in their models which is an important factor in influencing and enhancing dollarization of the economy. This study will not only account for oil price but election periods in its model by using the Cuddington‟s portfolio balance model.
Furthermore, contribution of the present study comes from the use of co-integration approach as it helps in determining the presence of co-integration among the variables while accounting for possible exogenous structural breaks which previous studies have ignored. Notably, other researches have relied on co-integration tests, Error Correction Model (ECM), Autoregressive Distributive Lag (ARDL) models or combination of these to estimate currency substitution models. Based on the modifications to the theoretical and methodological issues, it is expected that this study has provided new empirical evidence on the dynamics of currency substitution in Nigeria. In addition, it is expected that this research has provided requisite inputs for the formulation and implementation of policies. Reliable estimates of a currency substitution model in Nigeria are important to the monetary authorities in formulating appropriate and well-coordinated monetary policies via the monetary transmission mechanism.
1.6 Scope/Limitation of the Study
The study focused on currency substitution and the demand for money in Nigeria using two samples of annual data for the period between 1980 to 2014 and 1986 to 2014. The choice of this period coincides with the adoption of flexible exchange rate system and also captures the major crude oil price shocks as well as election years. The limitation of this study comes from the results obtained from the currency substitution index, which must be taken with caution because the index represents the lower bound of currency substitution in Nigeria. As sizable amounts of foreign currency are held in form of cash and cross border deposits, which cannot be captured in this study for lack of data.
1.7 Organization of the Study
The study has been organized in five chapters. Chapter one is the introduction, problem statement, and the study objectives. While the second Chapter contains review of related literature based on the concept, theories and empirical results. Chapter three presents the methodology and theoretical framework on which the model is specified. Chapter four consists of trend analysis and the presentation and discussion of results. While Chapter five comprises the summary, conclusion and recommendations of the study.
