IMPACT OF EXCHANGE RATE INSTABILITY ON FOREIGN DIRECT INVESTMENT IN NIGERIA (1981-2014)
CHAPTER TWO
REVIEW OF RELATED LITERATURE
CONCEPTUAL FRAMEWORK
Foreign Direct Investment is an investment made to acquire a lasting management interest, (normally 10% of voting stock) in a business enterprise operating in a country other than that of an investor, defined according to residency (World Bank, 1996). Such investors may take two forms, either “Greenfield” investment or merger and acquisition which entail the acquisition of existing interest rather than new investment.
Foreign Direct Investment is therefore a measure of foreign ownership of productive assets such as factories, mines and land. Increasing foreign investment can be used as one measure of growing economic integration and globalization (Gnansonuou, 2008).
In the past ten years, the classic definition of Foreign Direct Investment as noted above has changed considerably. This notion of a change in the classic definition however, must be kept in the proper context. Very clearly, over two third of Direct Foreign Investment is still in the form of fixtures, machinery, equipment and buildings.
Many governments, both in industrialized and developing nations, pay very close attention to Foreign Direct Investment because they believe that investment flows into and out of their economies may have a significant impact on growth (Asiedu, 2009). However there has been a dramatic increase in the number of technology start-ups and this together with the rise in prominence of internet usage has fostered increasing changes in foreign investment patterns.
2.1 CONCEPTUAL ISSUES IN EXCHANGE RATE FLUCTUATIONS
Risk in international commodity trade usually emanates from two main sources: changes in world prices or fluctuations in exchange rates. These may affect trade by increasing the uncertainties of trade or effecting a change in the cost of transaction, processing, etc. The state of the two major sources determines the eventual domestic trade price of a commodity over a period of time. In other words, a decision to produce for exports involves uncertainties about the prices in the foreign exchange that such sales will realize, as well as the exchange rate at which foreign exchange receipts can be converted into domestic currency. In a period of fixed exchange rates, the major source of concern in international trade for developing countries is the fluctuations that may arise from the world prices of primary commodities, which constitute the bulk of exports of these countries (Adubi, et al: 1999). With the increasing embrace of the structural adjustment programmes that have devaluation of currency or market determination of exchange rate and all prices as the fulcrum, the attention has shifted to the fortunes of the currencies at the foreign exchange market. Given the erratic pattern of the exchange rate in most developing countries as a result of devaluation, there has been increasing concern about the possible effects of exchange rate fluctuations on trade. In other words, for international traders with a given price, the major source of uncertainty is the exchange rate at which they can translate their sales revenue in foreign currency into local currency.
2.2 THEORETICAL LITERATURE
Since the adoption of floating exchange rate in the developing countries in 1973, the question of whether exchange rate changes/uncertainty have independent adverse effects on exports and trade has attracted a lot of attention in the literature. The introduction of Structural Adjustment Programmes by many of these countries and the attendant liberalization of exchange rates has brought the discussion of this issue further into global focus. A review of the literature shows that the issue is far from being settled, though not all studies are fully comparable.
There are two major trends of argument in the literature. The first argues that exchange rate fluctuations will impose costs on risk-averse market participants who will generally respond by favouring domestic to foreign trade at the margin. Early study of this issue focused on firm‟s behaviour and presumed that increased exchange rate fluctuations would increase the uncertainty of profits on contracts denominated in a foreign currency and would therefore reduce international trade to level lower than would otherwise exist if uncertainty were removed. This uncertainty of profits, or risk, would lead risk-averse and risk-neutral agents to redirect their activity from higher-risk foreign markets to the lower risk home market.
Clark (1973) study, in many ways lays the theoretical groundwork for the traditional school by examining bilateral trade and the behaviour of risk-averse firms. Numerous restrictions are imposed, including firms that only produce goods for exports, limited hedging possibilities, contracts denominated in foreign currencies, no imported factor inputs and a perfectly competitive marketplace. He supposes that as the variance of exchange rate uncertainty increases, so does the uncertainty of profitability, where profits are expressed in the home currency. Utility is given as a quadratic function of profits
(U ( ) a b 2 ) , where b as a risk aversion parameter, is less than zero. As
uncertainty increases, Clark contends, that a risk-averse firm will reduce the supply of goods to the level where marginal revenue actually exceeds marginal cost in order to compensate for the additional risk, thereby maximizing utility.
The argument views traders as bearing undiversified exchange risk; if hedging is impossible or costly and traders are risk-averse or even risk neutral, risk-adjusted expected profits from trade will fall when exchange risk increase (Chowdhury: 1993).
Also, Qian and Varangis (1992) assert that exchange rate fluctuations increase the risk and uncertainty in international transactions and thus discourage trade; if traders are risk averse, they will be willing to incur an added cost to avoid the risk associated with the exchange rate fluctuations. Thus, a firm‟s export supply (import demand) curve will shift to the left (right) in the presence of exchange rate fluctuations; for any quantity of exports or imports, the corresponding price will be higher under exchange rate fluctuations or risk than without it.
Another traditional school examination of fluctuations and bilateral trade is that of Hooper and Kohlhagen (1978). They derive demand and supply schedules for individual firms, where the explanatory variables include the currency denomination of contracts, the degree of firms‟ risk aversion and the percentage of risk hedged in the forward market. Perhaps the most significant contribution of this study is how it allows nominal exchange rate volatility to only impact the amount of risk that remains unhedged. Their study involved a number of a priori assumptions, including the importer being a price- taker (where imports are assumed to be inputs used for producing goods that are sold domestically), the importer facing a known demand curve and exporters that sell all of their products abroad in a monopolistic market framework. They found that increased exchange rate fluctuations lead to both downward-shifting supply and demand curves, where quantities and prices decline when importers face the exchange rate risk (depending on demand elasticity and their degree of risk-aversion), and quantities decline and prices increase when exporters (suppliers) bear the risk.
Other studies in support of this idea include: Chusman (1983, 1988), Kenen and Rodrik (1986), Kroner and Lastrapes (1991), Thursby and Thursby (1987), Akhtar and Hilton (1984), and Isitua and Neville (2006). In other words, their studies indicate a significant depressive effect of exchange risk on international trade.
Some studies such as Caballero and Corbo (1989), Kumar and Dhawan (1991), concluded that due to the political economy, effects of exchange rate fluctuations, its increase was responsible for the slowdown in trade in the 1970s. In essence, the flexible exchange rate led to misalignments of major currencies, which led in turn, to adjustment problems in the tradable goods sector and political pressures toward protectionism.
Côté, (1994), in her comprehensive review of the literature, pointed out that the traditional school (theories that exchange rate fluctuations affects trade negatively) has examined not only the presence of risk, but also its degree, which in turn depends upon such factors as whether production inputs are imported, the opportunity to hedge risk and the currency in which contracts are denominated.
One of the main objections to the traditional school is that it does not properly model how firms manage risk, not only through the use of derivatives, but also as an opportunity to increase profitability. For this reason the argument turns to the risk- portfolio school. What is referred to here as the risk-portfolio school is not a unified body of thought, but is comprised rather of multiple theories, varying in complexity, but united in the opinion of the traditional school as unrealistic.
This second strand of the literature argues that traders benefit from exchange rate fluctuations or risk. According to these studies, trade can be considered as an option held by firms - like any other options, such as stocks, the option value of trade can rise with fluctuations Bredin, et al (2003).
De Grauwe (1988), in a straight forward attack on the former school, convincingly argues that due to the convexity of the profit function, exporters‟ return from favourable exchange rate movements and the accompanying increased output outstrip the decreased profits associated with adverse exchange rates and decreased output, and therefore: “As a result, risk-neutral individuals would be attracted by these higher profit opportunities”. Although the convexity of the profit function may imply a positive correlation between trade and exchange rate risk, the more prominent tenet of the risk-portfolio school examines exchange rate risk in light of modern portfolio diversification theory.
As summarized by Farrell, et al (1983), economic agents maximize profitability by diversifying the risk levels in their investment portfolios by simultaneously engaging in low, medium and high-risk activity with corresponding potential rates of return. Greater exchange rate fluctuations resulting in higher risk would then not discourage risk-neutral agents from engaging in trade, but would present an opportunity to diversify their risk portfolios and increase the likelihood of profitability.
Frankel (1991) argues that if exporters are sufficiently risk-averse, an increase in exchange rate fluctuations may result in an increase in the expected marginal utility of export revenue which serves as incentive to exporters to increase their exports in order to maximize their revenues.
Dellas and Zilberfarb (1993), examine trade decisions in the framework of a portfolio-savings decision model under uncertainty. Their theoretical model assumes a small open economy with an individual domestic agent importing, exporting and consuming two products in two time periods, where asset markets are incomplete and the agent makes trade decisions with incomplete knowledge of price risk. Their study examines the effects of uncertainty both in the absence of a forward market and with complete and incomplete hedging opportunities. Without a forward exchange market, the individual maximizes utility by choosing a quantity of exports X such that:
q Eu(Y X , PX )
where Y X is the consumption of the exportable good and P is the real exchange
rate, with first order condition:
E(u1 Pu2 ) 0.
The effect of increased exchange rate fluctuations on trade depends on whether the
function
g u2 P U1 is concave or convex, which in turn is determined by a degree of
risk-aversion in the utility function. With a forward exchange market, the domestic agent maximizes utility, Eu(C1,C2 ) , subject to the constraints:
C1 Y1 X1 X 2
C2 P1 X1 P2 X 2
With two products and incomplete forward market opportunities ( X 1 representing an exportable good subject to risk and
X 2 completely hedged), they find that the effects of fluctuations on trade are ambiguous depending on the risk parameter a . With complete hedging possible and costless, individuals can insulate themselves from exchange rate risk and increased fluctuations do not depress trade levels. They then extend these findings to producers selling to both domestic and foreign markets and find results consistent with those for the individual domestic agent.
Broll and Eckwert (1999) theoretical model demonstrates how higher exchange rate fluctuations increase the potential gains from trade. Their study uses an international firm that sells its product either entirely at home or abroad, and must also determine which market to choose with incomplete knowledge of exchange rate fluctuations. Their theoretical construct results in a generally positive relationship between the variance of the foreign spot exchange rate and the volume of output and total export. As with Dellas and Zilberfarb, the increase in the value of the firm‟s option to export depends on the convexity of the relationship between profits and the exchange rate, and ultimately upon the degree of the firm‟s risks aversion.
2.2.1 Alternatives
De Grauwe suggests a third, political-economic theory. This approach proposes that nations that have flexible exchange rate systems and experience exchange rate misalignments are susceptible to lobbying from failing industries to create or increase protection from trade. As a result, greater exchange rate fluctuations would decrease trade flows as a result of protectionist legislation or executive order. Critics of this approach, such as Côté, point out that:
i.an industry‟s vulnerability due to adverse exchange rates often reflect deeper competitiveness issues and;
ii.flexible rates help absorb the output and unemployment costs of misalignments.
These counter-arguments speak more to the welfare effects of De Grauwe‟s theory than to its validity. It is not difficult to produce modern examples of U.S. industries, even those industries suffering from non-exchange rate induced competitiveness problems, e.g. steel, that have successfully lobbied the federal government to increase tariffs on imports whose prices were argued to be artificially low. That firms successfully lobby governments to restrict imports (trade) is evident.
A more salient problem with De Grauwe‟s political-economic theory is how to quantify the degree of misalignment and the resulting effects of exchange rate induced lobbying on trade flows.
Other supporters of this argument include: IMF (1984), Chambers and Just (1991), and Klein (1990). Their studies indicate that exchange rate fluctuations catalyse trade flows.
Côté likened this approach to derivative markets, where trade is viewed as an option that becomes more valuable as the exchange rate becomes more volatile.
Abel (1983) showed that if one assumes perfect competition, convex and symmetric costs of adjusting capital, and risk neutrality, investment is a direct function of price (exchange rate) uncertainty.
Others found no evidence to suggest that exchange rate fluctuations have any significant impact on trade; e.g. Aristotelous (2001). Given today's well-developed financial markets, one may argue that traders (at least to some extent) should be able to reduce or hedge uncertainty associated with exchange rate volatility. The relationship between exchange rate volatility and trade may then be weak, if not completely absent.
McKenzie (1999) gave a thorough review of the literature and discussed several empirical issues that may be important when determining the impact of exchange rate fluctuations on trade. These issues are mainly related to which exchange rate fluctuations measure to use, which sample period to consider, which countries to study, which data frequency and aggregation level to employ and which estimation method to apply in each specific study at hand. As pointed out by him, each of these issues and how they are handled may be part of the explanations for the inconclusive findings in the literature.
2.4 THEORETICAL FRAMEWORK
Policy in the Mundell–Fleming Model
The model developed to extend the analysis of aggregate demand to include international trade is the Mundell-Fleming model, which is an open economy version of the IS-LM model.
The key macroeconomic difference between open and closed economies is that, in an open, a country‟s spending in any given year need not equals its output of goods and services. In other words, a country can spend or consume more than it produces by importing from abroad, or can consume less than it produces and exports the rest abroad.
To understand this fully, we take a look at the expenditure approach of national income accounting. In a closed economy, all output is sold domestically, thus, expenditure is divided into three components: consumption (C), investment (I), and government purchases (G).
2.4.1 Policies Influence on Trade balance/Net Exports
Fiscal Policy at Home and Net exports: Suppose the economy starts in a position of balanced trade, a fiscal policy change (increase in government purchases or reduction in taxes) that increases consumption reduces national saving, (because S = Y – C – G), investment remains the same since the world real interest rate is unchanged. Thus, the fall in saving (S) implies a fall in net exports (NX). In other words, a change in fiscal policy that reduces national saving, leads to a trade deficit and vice versa.
Fiscal Policy Abroad and Net export: A fiscal expansion in a foreign economy large enough to influence world saving and investment, raises the world interest rate. The higher world interest rate raises the cost of borrowing and thus, reduces investment in the small open economy. Thus, domestic saving now exceeds investment. Since NX = S – I,
the reduction in investment stimulates NX. Hence, fiscal expansion abroad through fiscal policy leads to a trade surplus at home.
The Real Exchange Rate and Net Exports: Suppose that the real exchange rate is lower, domestic goods are less expensive relative to foreign goods, domestic residents purchase few imported goods and foreigners buy many domestic goods. As a result of both of these actions, the net exports are greater. The opposite occurs if the real exchange rate is high. The relationship between the real exchange rate and net exports can be written as:
NX = NX(e)
The equation states that net exports are a function of the real exchange rate.
Trade Policies and Net Exports: Suppose that government through a tariff or quota prohibits the importation of foreign cars. For any given real exchange rate, imports would now be lower, thus, this leads to increase in net exports. In other words, a protectionist trade policy stimulates the trade balance or net exports.
Exchange Rate Fluctuations and Trade flows: The traditional theory is of the opinion that exchange rate fluctuations depress trade. Fluctuations in exchange rate lead to costs, risk and uncertainty of profit in international transactions. As a result of this, economic agents who are only but price-takers in the market; rather than involving in international transaction with uncertainty of profit in the face of fluctuations would prefer to redirect their activity from international or foreign trade to home trade and avoid the risk and cost associated with foreign trade. In other words, exchange rate fluctuations reduce the volume of international trade.
Review Of Empirical Literature
Nazima (2011) empirically studied the impact of exchange rate volatility on Foreign Direct Investment in the Pakistan economy. He adopted data on time series from secondary sources between the periods 1980- 2010 in finding both short and long run estimates of his study, the Auto Regressive Lag (ARDL) was employed and finding the direction of causality existing using the Vector Correction Model (VECM).The results of his study revealed that FDI inflow is impacted negatively on a short run and positively on a long run by exchange rate volatility.
In Obiamaka and Omankhanlen’s (2011) study, government expenditure and gross fixed capital formation were used as control variables. The study utilized a linear regression analysis technique to examine the nature of the relationship between the variables namely; inflation, exchange rate, FDI inflows and economic growth. Inflation has been hypothesized to distort the tax system which would in turn discourage investors in the long run due to money illusion (Omankhanlen 2011).
According to Resarach (2014) who conducted a study on the role of interest rate in attracting FDI in Asian economies, the results shows that the determinants of Foreign Direct Investment are interest rate, inflation GDP, exchange rate, labour cost, money growth and political rights the researcher noted that there was no significant relationship between interest rate and the inflow of Foreign Direct Investment.
Omorokunwa and Ikponmwosa (2014) examined the performance of the exchange rate volatility and Foreign Private Investment from 1980-2011 using Error Correction Model (ECM) and Ordinary Least Square (OLS). The results shows that exchange rate volatility has a weak effect on the inflows of Foreign Direct Investment to Nigeria in both short run and long run.
Odili and Okwuchukwu (2015) evaluated the exchange rate volatility, stock market performance and Foreign Direct Investment in Nigeria from 1980-2013 using OLS. Their result shows that exchange rate volatility has negative and significant effect on the inflows of Foreign Direct Investment both in short run and long run.
Adelowakan, Adesoya and Balogun (2015) empirically analyzed the impact of exchange rate volatility on investment and growth in Nigeria covering 1986-2014; using VECM, impulse response function and OLS. The findings revealed that exchange rate volatility has a negative effect on investment and growth.
Another study that is relevant to this research is Osuntogun, et al (1993). In their analysis of strategic issues in promoting Nigeria‟s non-oil exports, they determined the effects of exchange rate uncertainty on Nigeria‟s non-oil export performance as a side analysis. Their work is indeed, a pioneering effort in Nigeria to determine the effect of exchange rate risk or fluctuations on trade. However, estimates of the exchange rate risk obtained in their work are not standard. As pointed out by Pick (1990), the measure of risk as postulated by Caballero and Corbo (1989) is faulty because it over-exaggerates the risk measure, hence this was the risk measure used on Osuntogun et al.
Also, another study significant to this research is Isitua and Neville (2006). In their work, assessment of the effect of exchange rate volatility on macroeconomic performance in Nigeria, the key result emanating from their study is that exchange rate fluctuations have a negative and significant effect on Nigeria‟s exports using a standard measure of exchange rate volatility, though their research concentrated only on oil exports.
The most notable variations of this methodology are by Koray and Lastrapes (1989), who used the vector autoregressive (VAR) model, and Kroner and Lastrapes (1991), who used the generalized autoregressive conditional heteroskedasticity (GARCH) in mean model. There are three issues regarding the model. The first is how to measure exchange rate fluctuations or volatility; the second is which measure of fluctuations, nominal or real exchange rates, is proffered in modelling. The third issue is the effects of aggregate or bilateral trade data on the study.
Qian and Varangis (1992) dealt with these issues in their work and after careful examination of the previous analytical frameworks on exchange rate fluctuations and the factors discussed above, they concluded that there should be no imposed beliefs as to whether exchange rate fluctuations affect trade volumes positively or negatively; thus the model to be used has to be general and flexible in its specification to take into account all the dynamics in the data generation process of the exchange rate and international trade volume variables. The data on exchange rate should be in nominal terms and either multilateral or bilateral trade data could be used in order to investigate differences in the magnitude of the exchange rate fluctuations effects on trade.