CHAPTER ONE
1.0 INTRODUCTION
The role of exchange rate and its effects on macroeconomic performance has continued to generate interest among economists. Many economists argue that exchange rate stability facilitates production activities and economic growth. They are also of the view that misalignment in real exchange rate could distort production activities and consequently hinders exports growth and generate macroeconomic instability (Mamta Chowdhury, 1999)Exchange rate policy guides investors on the, best way they can strike a balance between their trading partners, and investing at home or abroad (Balogun, 2007). Mordi (2006) argued that the exchange rate movements have effects on inflation, prices incentives, fiscal viability, and competitiveness of exports, efficiency in resource allocation, international confidence and balance of payments equilibrium.
Exchange rate is one of the key 'barometers' of economics performance, indicating growth (output), demand conditions, the levels and trends in monetary and fiscal policy stance (Afolabi, 1991). Exchange rate policy emerged as one of the controversial policy instruments in developing countries in the 1980s, with intense opposition for fear of its inflationary impact, among other effects. Nigeria faced such a situation and there has been interest, therefore, in economic performance and the role of the exchange rate in the process (Afolabi1991).
The exchange rate, when applied in conjunction with other macroeconomic policies is expected to lead to the achievement of the goals of price stability, improved and sustained economic growth, reduced unemployment and balance of payment stability. An optimal and stable exchange rate has to be right and stable since it is an important relative price that influences other prices. When the exchange rate is not optimal, however, the achievement of these objectives becomes different and often impossible according to Afolabi 1991. For example, if the exchange rate is not in equilibrium, it allows rent-seekers and speculators to exploit the subsidy element involved. The situation is worse when a parallel market develops as a result of restriction in the official market and inability of the market to satisfy the demand for foreign exchange. Thus, the opportunity cost of transacting business in the official market is the value of the subsidy or the premiums that would otherwise be lost by the official sector but gained by third party arbitrators and speculators. The disability nature of foreign exchange subsidy (premium) is the fundamental reason why unification of exchange rate is canvassed as a short to medium term objectives of exchange rate management. The smaller the parallel market relative to the official market, and the higher the demand and supply elasticity of foreign exchange in the official market relative the closer the unified equilibrium rate is likely to be the official rate. However, if there is a large unsatisfied demand in the official market which cannot be diverted to the parallel market because of administrative restrictions, the equilibrium rate in a unified market would tend to be closer to the parallel market rate or could even be beyond it (John, IMF, 1985). The retention of a dual exchange rate system for a long time would be counter productive in the long run by undermining the objective of exchange rate stability and structural reform of an economy. The continued existence of dual or multiple rates would be encouraging wasteful allocation of resource, thereby stunting economic recovery and groups. Foreign exchange liberalization, accompanies by appropriate demand management policies targeted at ensuring macro economic stability is necessary for exchange rate convergence, if the costs(subsidy) are to be reduced. This is because the burden of adjustment is often borne by the official exchange rate.
One of the broad objectives of the Structural Adjustment Programme (SAP)
introduced in Nigeria 1986 was to achieve macroeconomic stability by reducing the level of inflation through the achievement of a stale and realistic exchange rate. Towards this and government deduced to deregulate exchange rate determination and the foreign exchange allocation system by relying largely on market focus. In this regard, various allocation mechanism, beginning from the second-tier foreign exchange market (SFEM),the interbalance foreign exchange market (IFEM), the Dutch, Auction system (DAS) to the pro-rate system and, lately, fixing of the official exchange rate and application of a free market exchange rate for purely commercial transactions, were adopted in order to achieve the goals of policy.
Nigeria is currently the second largest oil exporting country in the Organization of Petroleum Exporting Countries (OPEC) and is heavily reliant on its crude oil exports which accounts for 95% of its exports and foreign exchange earnings and about 80% of government revenue annual budgets (EIA, 2010). Oil has been the dominant factor in Nigeria's economy since its discovery in 1956 (Budina et al, 2006). Oil exporting nations may experience exchange rate appreciation when oil price rise, conversely exchange rate of oil exporting nations may depreciate when oil price falls.
From 1980 to 1985 following the oil price increase, it has be observed that an upward trend with the real exchange rate appreciating significantly leading to loss of competitiveness for the Nigeria economy. In 1986, Nigeria experiences a sharp decline in its real exchange rate following declining oil prices and the Structural Adjustment Programme (SAP) which led to the devaluation of the Nigerian currency - the naira. Between 1993and 2000, there were substantial movements in the real exchange rate. Since then, the real exchange rate index fluctuated around a constant trend with evidence of mild appreciation of the real exchange rate. In recent years, owing to rising global oil prices and increased oil exports, Nigeria experienced large foreign exchange inflows. The real exchange appreciate could be described to be a response to the large foreign exchange inflow that characterized the Nigerian economy or it could as well be a response to productivity gains.
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