NAIRA DEVALUATION AND SMES PERFORMANCE IN NIGERIA
CHAPTER TWO
LITERATURE REVIEW
Introduction
Devaluation is a deliberate downward adjustment to the value of a country’s currency, currencies or standard. In other words, devaluation is a reduction in the value of a currency with respect to those goods, services or other monetary units with which that currency can be exchanged (Yioyio, 2015).
According to Cooper (1971), currency devaluation is one of the most traumatic economic policy measures that the government may undertake and as a result, most governments are reluctant to devalue their currencies. However, a country can be forced into devaluation by an ominous trade deficit. Thailand, China, Mexico, Czech republic- all devalued strongly, willingly or unwillingly after their trade deficit exceeded 8% of the real gross domestic product (RGDP). One reason a country may devalue its currency is to combat trade imbalances and it is decided by the government issuing the currency and is the result of governmental activities. Devaluation causes a country’s exports to become less expensive making them more competitive on the global market. This in turns means that imports are more expensive, making domestic consumers less likely to purchase them. By making domestic currency relatively cheaper (i.e. devaluation), local production and exportation of commodities are encouraged. This helps to enhance the level of output growth of the economy (Yioyio, 2015).
According to Yaqub (2010), governments of different countries devalue their currencies only when they have no other way to correct the economic problem. While devaluation can be seen as an attractive option, it can have negative consequences because by making imports more expensive it protects domestic industries which may then become less efficient without the pressure of foreign competition. Also Higher exports relative to imports can also increase aggregate demand which can lead to inflation.
Aguiar (2005) states that a nation experiencing the balance of payment deficit has to adopt both short and long term measures to correct the disequilibrium, and one of the measures is to devalue the nation’s currency relative to another currency, group of currencies or standard. The effect of currency devaluation on the economy has long been recognized in literature. While the traditionalist argued that devaluation would promote trade balance, alleviate balance of payments difficulties and accordingly expand output and employment, provided the Marshal-Lernar conditions are met. The Marshal- Lernar conditions states that – devaluation would lead to expansion in output if the sum of price elasticity of demand for export and the price elasticity of demands for imports is greater than unity. The mechanism behind these positive effects, according to Imimole and Enoma (2011) is that devaluation switches demand from imports to domestic produced goods by increasing the relative prices of imports and making export industries more competitive in international market, thus stimulating domestic production of tradable goods and inducing domestic industries to use more domestic inputs. The monetarists on the other hand, argued that devaluation has no effect on real variables in the long-run.
The monetarist view is that exchange rate devaluation affects real magnitudes mainly through real balance effect in the short-run but leaves all real variables unchanged in the long-run. This approach is based on the assumption that the purchasing power parity (PPP) holds. It predicts that in the short- run, an increase in the exchange rate leads to increase in output and improves the balance of payments but in the long-run, the monetary consequence of the devaluation ensure that the increase in output and improvement in the balance of payment is neutralized by the rise in prices.
These arguments are continuous and therefore require further investigations. Nigeria’s GDP was recently rebased with the result placing the country as Africa’s largest economy with an annual GDP of $510 billion. Nigeria’s population and the size of the market has remained an attraction for FDI inflow with the current population estimated projected at 183million people in 2015 (growing at a projected rate of 2.82%). The country is currently ranked the 7th most populous country in the world and has enjoyed a positive GDP growth rate in the last 10 years and a relatively stable exchange rate regime. Between the first quarter of 2013 and the last quarter of 2014, Nigeria posted an average GDP growth rate OF 5.8%, a single digit inflation of 8.2% in the last quarter of 2014 and a relatively stable exchange rate regime (CBN, 2015).
The Nigerian government is thus in dilemma of the effect of further devaluation of Naira as the former CBN governor, Sanusi Lamido and some other renowned Nigerian economists are clamoring for it while others like Tella, Teriba and Utomi see this as no solution to the economic problem facing the country. Also in 2015, the Central Bank of Nigeria Governor, Godwin Emefelie announced the devaluation of the Naira against the dollar with the aim of strengthening the currency (Naira) in the course of the dwindling oil price ( Osundiana & Osundiana, 2016).
According to Akpan and Atan (2012), the government of the day relies on foreign exchange reserve generated from crude oil to manage excessive volatility in exchange rate that exerts severe strain on the foreign exchange earnings. It is evident that the demand for foreign exchange has continuously been on the rise in the past few years as a result of factors like dependence on imported finished products, reversal of capital flow by investors and high speculative demand which has caused uncertainty in the foreign exchange market which also is caused by increased demand for foreign exchange in the face of unstable supply. Also the increasingly adverse balance of payment position and the inflationary pressures which the economy finds itself in which also affected the Real Gross Domestic Product (RGDP) of the economy has left the researcher in search for solution and how this myriad of economic
challenges can be successfully tackled.
Conceptual Framework
Concept of Devaluation: The term devaluation is often used loosely to mean the same thing as currency depreciation. It refers to the deliberate lowering of the value of a country’s currency in relation to other country’s currency within the context of a fixed exchange rate management system (Yilkal, 2014). Devaluation or depreciation of a country’s currency is usually triggered when the country is experiencing in adverse balance of payment/balance of trade (BOP/BOT) Crises or by worsening economic conditions transmitted into the domestic economy from the foreign market. The current devaluation of the Naira is linked to shocks emanating from the falling oil price driven by a global supply glut and a declining world demand for crude oil.
Nigeria’s economy is a mono product economy that relies on crude oil sales for over 85%-90% of her annual revenue. Between 2006 and February 2015, Bonny light crude oil price average $94/barrel while the average monthly oil price between 2010 and end of 2014 stood at $104.4/barrel. Despite positive windfall gains arising from the benchmark oil price of $79, $77.5 and $65 in 2013, 2014 and 2015 respectively, the country’s external reserves declined precipitously from $53.6 billion in 2008 to the current $30.9 billion in March 2015 (CBN, 2015). This declining trend in external reserves reflects the current concern of the CBN in devaluing the Naira as continuous defending of the Naira in the face of the dwindling reserves became unsustainable. Between October 2008 and July 2009, oil price declined slightly below $50/barrel, this was followed by rising exchange rate and a massive devaluation of the Naira.
Similarly, between October 2014 and February 2015, oil price fell below $50/barrel, this again triggered a rise in exchange rate and a massive devaluation of the Naira from N155/$1 to N199/$1. Currently, IFXEM is trading at N199.7/$1 while BDC is trading at between N225/$1 and N227/$1(CBN, 2015) Economic growth is the increase in the market value of the goods and services produced by economy overtime. It is conventionally measured as the percent rate of increase in real gross domestic product (RGDP). Between1960 and 1970, GDP recorded 3.1 percent growth annually as driven by agricultural sector, between 1970 and 1980 which is oil boom era, Nigeria recorded a remarkable increase in GDP of 6.3 percent annually.
In the early 1980’s, the growth rate reduced, but from 1986, as a result of the structural adjustment program (SAP) and economic reforms, there was an improvement because the GDP increase at the rate of 4 percent. In 2013 to 2015 the GDP averaged 1.32 percent (Osundiana & Osundiana, 2016).
The highest growth rate was achieved in the third quarter of 2015 which was 9.19 percent. Services sectors being the largest sector of the economy accounted for 50 percent of the GDP while the fastest segment is information and communication. Agricultural sector which used to be the biggest sector with high potential for employment, accounts for 26 percent and oil sector accounts for just 11 percent. The effect of the under devaluation on growth appears to be large and highly significant also stronger for developing countries (Rapetti, Skott, & Razmi, 2012).
Economic Growth and Development
Economic growth and development are measured as an increase in the market value of the goods and services produced within a given economy and income per capita GNI. Conventionally it’s measured as percent increase in real gross national product a given economy. Economic development embraces economic growth measured as changes in output distribution and economic and financial structure along with technological advancement within the country. Nigeria between 1960 and 1970, recorded GDP rate at 3.1 percent annual growth propel via the agricultural sector, from 1970 to 1980 Nigeria embraces oil boom, with a remarkable increase in GDP rate at 6.3 percent annual growth.
In the early 1980s, Nigeria witness decrease in growth. Therefore, driving the adoption of 1986, structural adjustment and economic reform, to boost the near collapse economy with GDP growth rate at 4 percent. The GDP growth rate in Nigeria from 2013 to 2015 averaged at 1.32 percent, with the highest growth rate achieved in the third quarter of 2015 at 9.19 percent. The services sector accounted for 50 percent of the GDP while the fastest segment is information and communication. The agricultural sector accounts for 26 percent and oil sector accounts for 11 percent.
The effect of undervaluation on growth appears to be large and highly significant, also, stronger for developing countries. Exchange Rate Regime in Nigeria: Nigeria from 1959-1973 adopted British pound as an official exchange to Naira. The economy in 1971 was in devaluation dilemma either to devalue Naira or not. The Naira was not devalued during the American dollar devaluation process which results in dollar appreciation, the exchange rate at $2.80- $3.80 to the Naira pound. In 1973 Nigeria devalued at the same rate with the US exchange rate at $1.52. In 1986 the exchange rate policy in Nigeria was transformed giving birth to the introduction of the structural adjustment program to address the structural imbalance in the economy [6]. In 1994, exchange rate was fixed at $22 to a US dollar which implies a shift from the flexible regime of 1986 to fixed regime of 1994 with the foreign exchange market liberalized in 1995 paving way for the introduction of autonomous foreign exchange market (AFEM) for sale and purchase of foreign exchange dedicated by the government [6]. On October 25, 1999, the Inter-Bank Foreign Exchange Market (IFEM) was introduced with it operation experiencing similar problems and setbacks as that of AFEM. The CBN thus, re-introduced the Dutch Auction System (DAS) to replace the IFEM [6]. The implication of currency devaluation on the Nigerian economy: Currency devaluating totally is an end product of monetary decision to improve the nations near collapse economy.
A devaluation is an attractive option for nations in a recession like Nigeria. Devaluation with its positive results also embraces negative consequences as such making imports more expensive, domestic industries are protected thereby making them become less efficient and effective without the pressure of competition. Business parameters in Nigeria are adversely affected by the increase in the rate of inflation, thus reducing the purchasing power of the populace along high unemployment rate. The 2016 cum first and second quarter of 2017 devaluation, according to CBN was to cut down negative speculations in the foreign exchange (forex) market and move the mid-point of the official window of the (forex) market by 100 basis points from 12 percent to 13 percent, to tightened monetary policy framework and allow a degree of flexibility in exchange rate, curtail speculative activities and foreign reserves depletion which, as at October, stood at N 37.1trillion. Criticisms against devaluation Over time lots of implication has been established and put forward to why devaluation is not desirable in Nigeria. Some of the reasons will be scrutinized. The expensive nature of import basically raw materials and finished goods. This is more critical since Nigeria is an import-dependent country with key raw materials and consumable goods not manufacture in Nigeria. Increase Monetary Policy Rate (MPR) taking its toils on the real sector with the cost of investable funds increasing with a direct consequence on development becoming counterproductive. Hence, there is an indirect correlation between increased in interest rate and job creation.
Theoretical Framework
Mundell- Fleming Model
The conventional answer to currency devaluation is analyzed within the Mundell-Fleming model and the result is a positive effect on the account. Thus, devaluation is expansionary in terms of gross domestic product (GDP), since exports increase more than imports.
The Mundell-Fleming model, which is commonly known as IS-LM-MOP model is an economic model set forth by Robert Mundell and Marcus Fleming as an extension of the IS-LM model. The tradition ISLM model deals with economy under autarky, while the modern Fundell-Fleming model describes a small open economy.
The Mundell-Fleming model shows the short-run relationship between an economy’s nominal exchange rate, interest rate and output in contrast to the closed-economy is LM model which focuses only on the relationship between the interest rate and output. The argument that an economy cannot simultaneously maintain a fixed exchange, free capital movement and an independent monetary policy has been solved by Mundell-Fleming model. This principle is frequently called the “impossible Trinity” “unholy trinity” “irreconcilable trinity” “inconsistent trinity” or the “mundell-fleming trilemma”. This model uses the following variables: ‘Y’ is GDP, ‘C’ is consumption, ‘I’ is physical investment, ‘G’ is government spending (an exogenous variable), ‘M’ is the nominal money supply, ‘P’ is the price level, ‘i’ is the nominal interest rate, ‘L’ is liquidity preference (real money demand), ‘T’ is taxes and ‘NX’ is net exports.
Marshall-Lerner Condition Model
Devaluation reduces balance of payment deficit but may not be true in all cases. Thus the effectiveness of devaluation depends on Marshall-Lerner condition which states that when the sum of price elasticity of the demands for imports of any two countries trading their goods between them is greater than unity, then devaluation increases exports and decreases imports (Dwivedi, 2001). He states further that devaluation reduces balance of payment (BOP) deficit when the sum price of elasticity of A’s demand for imports and price elasticity of B’s demand for A’s exportable, in absolute terms is greater than unity. Also it increase BOP deficit when the sum of price elasticity of demand for imports of a country and the price elasticity of demand for its exportable in absolute terms is less than unity. Further, when the sum of price elasticity of demand for importable of a country and the price elasticity of demand for its exportable in absolute equals one, then devaluation leaves the trade balance unchanged and hence BOP remains unaffected. The empirical evidence shows that in the short run, devaluation causes deterioration in the BOP, this is due to the tendency for import prices to rise faster in the domestic market immediately after devaluation than the export prices, without much changes in the quantities imported or exported.
This is what produces a J- shaped curve which the economists call J- curve effect of devaluation (Osundina & Osundina, 2016). Davidson (2006), assets that Marshall-Lerner’s condition does not apply to a country like United States because despite a significant decline in the value of the dollar, the trade imbalance has almost doubled which may lead to depression if not properly handed.
The Purchasing Power Parity (PPP) Theory According to Jhingan (2011), this theory states that equilibrium exchange rate between two inconvertible papers currencies is determined by the equality of the relative change in the price levels in the two counties.
International competitiveness is measured by comparing the relative prices of the goods from different countries when these are measured in a common currency. The purchasing power parity path for the nominal exchange rate is the path that would keep competitiveness constant overtime. According to this theory, countries with higher domestic inflation than their competitors would face a depreciating nominal exchange rate, while countries with lower domestic inflation than their competitors would face appreciating exchange rates.
The Balance of Payment Theory
As demonstrated by Jhingan (2011), under a free exchange rate regime, a country’s exchange rate depends upon its balance of payments. A favourable balance of payments raises the exchange rates, while an unfavourable balance of payments reduces the exchange rate. By implication, exchange rate is determined by the demand and supply of foreign exchange. According to this theory, adjustments in the balance of payments can be made through devaluations and revaluations of some currencies in the case of deficits and surpluses respectively, in the balance of payments. Mckinnon and Schnabi (2003) have argued that for small open east Asian economies, fluctuations of the Japanese yen against the U.S dollar strongly affected the growth performance of the whole region. They identified trade with Japan as a crucial transmission channel.
Before, 1965, the appreciation of the Japanese yen against the U.S dollar enhanced the competiveness of the smaller east Asian economies who kept the exchange rate in the region accelerated. The strong depreciation of the yen against the dollar from 1965 into 1967 slowed growth contributing to the 1997/98 Asian crises.
The Portfolio Balance Theory
This theory developed by Benson (1975) assumes that residents distribute their wealth among three forms of assets, monetary base, domestic bonds, and foreign bonds. Exchange rate is in equilibrium when the holding of these assets are in their desired proportion. In portfolio analysis, the current account balance becomes the reflection of the government budgetary imbalance when the private sector is satisfied with the holding of financial assets. The inability of government to sell bonds to foreigners without an excessive fall in their prices reflected in BOP deficit.
Empirical Review
Momodu and Akani (2016) investigated the impact of currency devaluation on economic growth of Nigeria. The Johansen Co-integration method was used for this analysis because the study involves the use of multivariate estimations. The result from the multivariate co-integration test shows that there is at least one co-integrating vector in the relationship between economic growth and the independent variables. This implies that a long run relationship exists among these variables. The autoregressive distributed lags (ARDL) approach is used for the ECM.
The error correction mechanism result indicates that short term changes in economic growth may actually be sufficiently explained by currency devaluation and other factors selected in the model. They accepted the hypothesis of a significant short term relationship between economic growth and currency devaluation. The study shows that in the short run currency devaluation leads to increase in output and improves the balance of payments but in the long run the monetary consequence of the devaluation ensures that the increase in output and improvement in the balance of payment is neutralized by the rise in prices.
Aiya (2014) assessed people’s perception on the impact of devaluation of Nigerian currency on the performance of poverty alleviation programmes in Edo state, Nigeria using primary data and Chi square statistical analysis, he found that currency devaluation limits the performance of poverty alleviation programmes in Edo state. He recommends that there should be proper funding of poverty alleviation programs because the devaluation of currency as often recommended by the Bretton wood institutions such as IMF and the World Bank has resulted in hyper inflationary trend in the economy. Hence, devaluation is expansionary in terms of GDP since exports increases more than imports according to Mundell-Fleming model.
Saibene and Siccour (2012) concludes that devaluation is contractionary for countries with a large amount of debt dominated in a foreign currency whereas, they are not for the countries whose debt is denominated in their own currency all things being equal. They also assert that after sharp currency devaluations, the debt burden increases in real terms, leading to the following chain of events: Firms profits decrease, bank lending is constrained, and thus the amount of investment is sharply reduced, reducing also next period output.
Kogid, Asid, Lily, Mulok and Lognathan (2012), carried out a research on the effect of exchange rates on economic growth, using nominal and real exchange rate, they found out that both exchange rates (nominal and real) are considered to have similar effects on economic growth. The results of Autoregressive distributed lags (ADRL) bounds test carried out by them suggest that long-run co integration exist between both nominal and real exchange rates and economic growth with a significant positive coefficient recorded for real exchange rate. In addition, the results of ECM-based ARDL also reveal that both exchange rates have a similar casual effect towards economic growth.
Siddig (2012) examined exchange rate devaluation in Sudan using computable general equilibrium. The paper reports the impact of devaluation on several economic indicators considering domestic commodity markets, the factors market and institutions. Reponses of specific economic variables such as prices, household demand, welfare and the balance of payment are used to describe the resulting equilibrium of the economy as a result of devaluation in the three scenarios. The results reveal that devaluation of the Sudanese pound will considerably increase most domestic commodity prices. This is desirable for producers who target the world market because their returns in the local devalued currency will tend to be higher. Accordingly, export oriented sectors, which have a larger share ofexports and in their total output, show the greatest increase in output and exports compared to other sectors. He concludes that, devaluation of Sudan’s currency would increase domestic prices of tradable goods and encourage producers to export. However, domestic consumers are unaccompanied by similar increase in household income. This could also lead domestic production to deteriorate at a certain point in time since the cost of intermediate inputs will also increase especially imported intermediate inputs.
Therefore, devaluation would encourage producers of some sector to increase output and exports, while it would hinder consumers to enjoy the previously cheaper imported and domestic commodities since domestic prices increased.
Farhi, Gopinth and Itskhoki (2012), considered the case of producer and local currency price setting with some price stickiness, as the real effects of nominal devaluations depends on whether prices are set in the producer’s currency or in local currency. Their model features two countries, home and foreign, the foreign with a passive policy of a fixed money supply and also potentially use six different fiscal instruments to achieve the policy goal that mimics a nominal devaluation but maintains a fixed nominal exchange rate: import and export tariffs, a value-added tax (with border adjustment) a payroll tax paid by producers and consumption and income taxes paid by consumers.
The authors consider various degrees of capital account openness: Balanced trade, complete risk-sharing with Arrow-Debru securities (securities that are paid in only one time period) and an arbitrary net foreign asset position. They found out that the two fiscal devaluation policies that mimic nominal exchange rate devaluations
are:
1. A uniform increase in import tariffs and export subsidies.
2. A uniform increase in value added taxes and a reduction in payroll taxes.
Eme and Johnson (2010), in their study of exchange rate movements in Nigeria for the sample period of 1986-2010, examined the possible direct and indirect relationships between exchange rate and GDP growth, using a simultaneous equation model within a fully specified (but small) macroeconomic model, coupled with a generalized method of moment (GMM) technique. The empirical results suggest that there is no evidence of strong direct relationship between changes in exchange rate and output growth. Hence, they concluded that Nigeria’s economic growth had been directly affected by monetary variables and that improvements in exchange rate management were necessary but not sufficient to revive Nigerian economy.
Maga (2004) examined the effect of exchange rate fluctuations to real output growth and price inflation in a sample of 22 developing countries. By introducing a theoretical rational expectation model, he decomposed movements in exchange rate into anticipated and unanticipated components.
The model demonstrated the effects of demand and supply channels on the output and price responses to changes in exchange rate in general, he concluded that exchange rate devaluation, both anticipated and unanticipated decreases real output growth and increase price inflation. The result confirms concerns about the negative effects of currency devaluation on economic performance in developing counties Newton (2010), while reviewing sterling devaluation between 1968 and 1970 explained the travails of the British labour government and that it took a year to convince people on the need for devaluation which paid off at last.
Using different measures of real exchange rate and different estimation techniques, Dani (2008), showed that devaluation (high exchange rate) stimulates economic growth, particularly in developing countries, while revaluation hurts economic growth. Employing the same methods, Gala (2007) arrived at similar conclusion with Dani (2008).
Odusola and Aikinlo (2001), used a six-variable VAR model consisting of official exchange rate, parallel exchange rate, prices, money supply, and interest rate for Nigeria and revealed the existence of mixed results regarding the impact of exchange rate depreciation on output. Their conclusion is that the contractionary impact of devaluation on output can only be represented in the first quarter, after which devaluation generates expansionary impact on output. Adekoya and Fagbohun (2016) examined the impact of currency devaluation on manufacturing output growth in Nigeria between 1980 and 2014. They employed Augmented Dickey Fuller for stationarity test, Engel-Granger co-integration for long run relationship, ordinary least square for long-run estimate and Granger causality test for causal relationships. The findings revealed that although all the variables are stationary at first difference, a long-run relationship exists between the variables. It further showed that all the variables except import exert positive effect on manufacturing output growth. The result suggests the need for currency appreciation rather than depreciation as the sector depends heavily on the importation of equipment’s, machineries as well as most of its raw materials. The causality test showed that there is a unidirectional causality running from, exchange rate, import and Credit to Private Sector to manufacturing output.