IMPACT OF BALANCE OF PAYMENTS ON EXTERNAL RESERVES. (STUDY OF NIGERIA)

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ABSTRACT

The study examined the impact of balance of payment on reserves in Nigeria using time series data from 1985 to 2019. The secondary data for the study were sourced from Central banks of Nigeria’s statistical bulletin and National Bureau of statistic of various editions. External reserves (EXTRV) is the dependent variable while current account balance (Cab), capital account balance (KAb), errors and omissions (ERO) and exchange rate (EXCR) are the independent variables. The data were subjected to Augmented Dickey Fuller and Philips-Perron test to ascertain the time series properties. Descriptive statistics was used to assess the socioeconomic characteristics of the variables. To verify the possibility of autocorrelations in the regression model. Durbin watson test was employed while ARDL approach was used to examine the likely interaction among the variables under the study in the long-run and short-run basis. The study revealed that: errors and omission had no significantly impact on external reserves, capital account balance significantly influenced external reserves while exchange rate was negative and insignificantly influencing external reserves in Nigeria within the chosen period. The coefficient of determination (R2) values of 96.6% showed high level of goodness of fit of the regression line while F-statistics value of 47.65% showed the overall significance of the regression model. In line with the findings, the study recommended that: Nigeria’s monetary authority’s efforts should be directed towards effective balance of payment management that would lead to favourable consequences on the external reserves positions in the country, domestic production should be improved to encourage export transaction in order to keep balance of payment deficit in check, government should put in place appropriate policies that would encourage diversification in the economy.






TABLE OF CONTENTS

Title page                                                                                                                    i

Declaration                                                                                                                 ii

Certification                                                                                                                iii

Dedication                                                                                                                   iv

Acknowledgements                                                                                                    v

Table of contents                                                                                                        vi

List of tables                                                                                                               vii

Abstract                                                                                                                       viii

CHAPTER 1: INTRODUCTION

1.1 Background of the Study                                                                                     1

1.2 Statement of the Problem                                                                                     3

1.3. Objectives of the Study                                                                                       4

1.4. Research Questions                                                                                             5

1.5. Research Hypotheses                                                                                           5

1.6. Scope of the Study                                                                                                                                                                                   5

1.7. Significance of the Study                                                                                    5

1.8. Limitation of the Study                                                                                                                                                                            6

1.9. Operational Definition of terms                                                                          6

CHAPTER 2: REVIEW OF RELATED LITERATURE

2.1. Conceptual Framework                                                                                       8

2.1.1 Concept of balance payments                                                                            8

2.1.1.1. Composition of balance of payment                                                             9

2.1.1.2 Balance of payment problems (Disequilibrium)                                            12

2.1.1.3 Relationship between current account capital account, errors and omission and balance of payment

2.1.1.4. Causes of Disequilibrium in the balance of payment                                    13

2.1.1.5. Measures of correcting balance of payment deficits (BOP Adjustment)    15

2.1.2.. Concept external reserves                                                                                18
2.1.2.1. Source of external reserves in Nigeria                                                          20

2.1.2.2. Composition of external reserves in Nigeria                                                 21

2.1.2.3. Reason for holding reserves                                                                          22

2.1.2.4 Management of Nigeria’s external reserves                                                   24

2.1.2.5. Objectives of external reserves management in Nigeria                               25

2.1.2.6 Role of monetary policy in a developing economy                                        26

2.1.3 Exchange rate policy in Nigeria                                                                        27

2.1.4 Factors affecting rate of exchange                                                                    29

2.1.5 Exportation as a tool for economic growth                                                       32

2.2. Theoretical Framework                                                                                       33

2.2.1. Theory of policy instruments                                                                           33

2.2.2 Income-absorption approach                                                                             33

2.2.3 Elasticity approach                                                                                            34

2.2.4 Monetary approach                                                                                            34

2.3 Review of Empirical Literature                                                                            35

2.3.1 Empirical review of research variables                                                             35

2.3.2 Balance of payment                                                                                           35

2.3.3 External reserves                                                                                               41

2.4 Summary of empirical  review                                                                             45

2.5. Gap in literature                                                                                                  52

CHAPTER 3: METHODOLOGY

3. 1. Research Design                                                                                                                                                                                     53

3.2. Area of Study                                                                                                                                                                                           53

3.3. Sources of Data                                                                                                                                                                                       53

3.4. Model Specification                                                 53

3.5. Method of Data Analysis                                                                                                                                                                         56

3.5.1 Description of variables                                                                                                                                                                        56

3.5.2 Dependent variables (EXTR)                                                                                                                                                                56

3.5.3 Independent variables                                                                                                                                                                            57

3.6. Pre-estimation Test                                                                                                                                                                                  58

3.6.1 Unit-root test                                                                                                                                                                                          58

3.6.2 Co-integration test                                                                                                                                                                                 59

3.7. Statistical test                                                                                                                                                                                           59

3.7.1 Test of significance                                                                                                                                                                               59

3.7.2 T-Statistic (T-test)                                                                                                                                                                                 59

3.7.3 F-test                                                                                                                                                                                                      60

3.8. Econometric procedure (test)                                                                                                                                                                  60

3.8.1 Test for multicolinearity                                                                                                                                                                       60

3.8.2 Test for autocorrelation                                                                                                                                                                         60

3.8.3 Test for normality                                                                                                                                                                                  60

3.8.4 Test for heteroscedasticity                                                                                                                                                                    60

3.8.5 Regression specification error test                                                                                                                                                        61

CHAPTER 4: PRESENTATION OF DATA, ANALYSIS AND DISCUSSIONS

4.1 Data Presentation                                                                                                  62

4.2. Test for Unit Root                                                                             64

4.3 ARDL Regression Result                                                                                     69

4.4 Hypotheses Testing                                                                                              71

4.5 Discussion of Findings                                                                                         73       

CHAPTER 5: SUMMARY OF FINDINGS, CONCLUSION AND

RECOMMENDATIONS

5.1 Summary of Findings                                                                                           75

5.2. Conclusion                                                                                                           75

5.3. Recommendations                                                                                               76

5.4. Contribution to Knowledge                                                                                 77

       References                                                                                                           78

       Appendices                                                                                                          81







LIST OF TABLES

2.1 Summary of Empirical Review                                                                              47

4.1 Data Presentation                                                                                                    62

4.2 Description Statistics                                                                                              63

4.3 Augmented Dickey Fuller (ADF) and Phillips Perron (PP) Test for Unit Root     64

4.4 ARDL Bounds Test (Null Hypothesis: No Long Run Relationships exist)           65

4.5 ARDL Co-integration and Long-Run Form for the External Reserve Model        66

4.6 ARDL Error Correction Regression                                                                        67

4.7 ARDL Regression Result                                                                                        69

 

 

 


 

 

 

CHAPTER 1

INTRODUCTION


1.1  BACKGROUND TO THE STUDY

            One of the most important objectives of monetary policy in recent years has been to maintain equilibrium in the balance of payments. The pursuit of this goal has been necessitated by the phenomenal growth in the world trade as against the growth of international liquidity. Theoretically and empirically, deficit in the balance of payments may not necessarily retard the attainment of other objectives unless deficit is chronic and persistent overtime. In the circumstance described above, deficit in the balance of payments can lead to excessive outflow of foreign exchange. A country with a net debt must be at a surplus to repay the debt over a reasonably short period of time. Once any debt has been repaid and an adequate reserves attained, a zero balance maintained over time would meet the policy objective.

            The balance of payments is an important aggregate in appreciating the flow of resources in international trade. Balance of payments is a country’s state of affairs in international trade. According to Nzotta (2015), balance of payments is defined as a systematic record of economic transactions between residents of a country and non-residents for a given year. Balance of payments is the periodic statement of accounts (usually annual) showing the status of a country’s transactions with other countries and institutions (Ezirim, 2005). In the words of Imoisi (2012), balance of payments is defined as a systematic statistical record that summarizes a country’s international transactions with the rest of the world for a given period of time say one year. It summarizes a nation’s financial transactions with the outside world for any particular year. These transactions involve the provision and receipts of real resources- goods, services and income, the specific changes in claims on and liabilities to the rest of the world. Specifically,  the balance of payments records transactions in goods and services and income, changes in ownership and other changes in an economy’s holding of monetary gold, Special Drawing Rights (SDRs), unrequited or unilateral transfers.

            Foreign exchange is a means of effecting payments for international transactions. When foreign exchange disbursements or expenditures are lower than foreign exchange receipts, the surplus gives rise to foreign reserves. Thus, foreign reserves represent balances of foreign exchange surpluses of a country that accumulated over time.

            IMF defined international reserves as “consisting of official public sector foreign assets that are readily available to, and controlled by the monetary authorities for direct financing of payment imbalances, and directly regulating the magnitude of such imbalances, through intervention in the exchange markets to affect the currency exchange rate and/or for other purposes.”  According to Onoh (2007), external reserves consist of the surplus or the surpluses of the balance of payments of the past periods of transactions between Nigeria and the rest of the world. They as well consist of foreign exchange and other approved near liquid foreign assets.

In the 1990s, the foreign exchange reserves of developing countries as a group were a small percentage of the volume of cash in the hands of the public. The monetary authorities in many countries therefore did not have to issue interest-yielding securities on a large scale to finance reserves accumulation. The financial implications of intervention were consequently limited. One simple indication of this is the movement in the difference between the local currency value of foreign reserves and currency held by the public.

            The need to accumulate foreign reserves is important, especially if it is to act as precautionary motive for the absorption of external shocks. Reserves increase significantly in countries with unlimited exchange rate flexibility, as economies with flexible exchange rate are not expected to maintain currency peg, thereby requiring fewer amount of foreign exchange reserves. Countries hold international reserves to stabilize exchange rates and to sustain the random disturbances in resources flows. Reserves are held to finance shortfalls in foreign exchange receipts and to safeguard the international value of the domestic currency. Countries still hold reserves as an important monetary tool and a means of self-insuring, against major financial crisis.

            In the words of Jhingan (2014), international liquidity provides measure of a country’s ability to finance its deficit in balance of payments without resorting to adjustment measures. Holding external reserves can help to give confidence in the country’s ability to pay.


1.2  STATEMENT OF THE PROBLEM

            Balance of payments deficits and low level of foreign reserves have been the concern of government and have been subjected to extensive empirical research. The issue of current account balance has gained a significant attention of researchers especially with the recent persistent current account balance deficit witnessed in the country since the last two decades. For proper policy framework, it is crucial to understand the source of fluctuation in current account considering the fact that the level of current account balance provides a signal on the total external reserves in Nigeria. However, fluctuations in current account balance over the years is clear pointer to dwindling external reserves in the country.   

            Also, one of the major obstacles of the growth of capital account balance in the country which is assumed to have adverse effect on external reserves is policy distortions resulting from the trade which turned the country into an import dependent economy (Imoisi, 2012). The import of the country grew from N0.7billion in 1970 to over N562 billion in 1996 and later increase to ₦1,266 billion in 2001 and currently in 2023 to 5.56 trillion while export is 6.49 trillion in 2023 which huge balance in capital account that supposed to allocated to external reserves have been used for import and this is assumed to have negative effect on external reserves in the country (Bosede and Olomola, 2019).

            Furthermore, since the introduction of  fixed exchange rate regime and adoption of floating system by the industrialized countries in 1973, most countries including Nigeria, have experimented with various types of exchange rate arrangement ranging from the peg system to weighted currency basket, managed floating and more recently to the monetary zone arrangement. Inconsistent management of the various exchange rate regimes adopted so far by the country to help check volatility appears to have jeopardized the external reserves of the country. The degree of volatility and the extent of stability maintained affect external reverses of the country.

            Given the background above, this study focuses on the impact of balance of payments on external reserves in Nigeria. 


1.3  OBJECTIVES OF THE STUDY

            The general objective of this study is to investigate the impact of balance of payments on external reserves in Nigeria. The specific objectives are to:

1.         determine the impact of current account balance on external reserves in Nigeria

2.         examine the impact of capital account balance on external reserves in Nigeria.

3.         assess the impact of errors and omissions on external reserves in Nigeria.

4.         ascertain the impact of exchange rate on external reserves in Nigeria.


1.4   RESEARCH QUESTIONS

The research work will provide answers to the following research questions:

1.              How does current account balance affect external reserves in Nigeria?

2.              What influence does capital account balance have on external reserves in Nigeria?

3.              What is the impact of errors and omissions on external reserves in Nigeria?

4.              How does exchange rate affect external reserves in Nigeria?

 

1.5    RESEARCH  HYPOTHESES

Following the above stated objectives, the under-listed four hypotheses were tested:

Ho1:  Current account balance has no significant impact on external reserves in Nigeria.

 Ho2: Capital account balance does not significantly influence external reserves in Nigeria     .

Ho3:     There is no significant impact of errors and omissions on Nigeria’s external reserves.

Ho4:     Exchange rate has no significant impact on external reserves in Nigeria.

 

1.6   SCOPE OF THE STUDY

            This study is limited to the context as per the balance of payments impact on Nigeria external reserves. The study covers the period from 1985 – 2019, using Statistical Bulletin from CBN and National Bureau of Statistics (2019).


1.7   SIGNIFICANCE OF THE STUDY

This study will be of immense benefits to the following people:

1.         Policy makers: The research work will inform policy makers on the policy        direction to take so as to ensure a sustained increase in the reserves holding of the            country.

2.         Monetary authority: The findings and recommendations of this study are of immense use to the monetary authority in formulating lasting monetary and fiscal policies that        will stand the test of time and remedy balance of payments imbalances. 

3.         Researchers and Students: There is no doubt that this research work will serve as       a guide and reference material to future researchers and students, especially those in management sciences.

4.         General public: Finally, the findings and recommendations will enlighten the general public on the issue of reserves and balance of payments position of Nigeria.


1.8         LIMITATION OF THE STUDY

The limitation faced by the researcher in the course of this study was inadequate finance to complete this thesis work on time and was overcome by the researcher.


1.9        OPERATIONAL DEFINITION OF TERMS

To enhance easy understanding of the contents of this research study, the following terms are defined or explained:

Balance of payments (BOP): Is simply defined as a systematic record of economic transactions between residents of a country and non-residents for a given year.

Capital account: Capital account is defined as one of the primary components of the balance of payments of a nation.

Central Bank of Nigeria (CBN): Is the apex bank controlling, supervising, and          regulating the entire financial system.

Current account: current account is a country’s trade balance plus income and direct payments.

Devaluation of currency: Means a fall in the exchange value of a country currency in relation to the currencies of other countries.

External reserves: This is officially known as international reserves. They include foreign currency assets of the monetary authority, special drawing rights, reserves          position in the fund and gold.

Errors and omissions:  represent the unrecorded source of part of capital inflows from outside the economy. They are entries recorded to balance the accounts in the balance of payments.

Economic growth: Means growth in the level of output produced by a country over a certain period of time.

International Monetary Fund (IMF): Is an international monetary institution established by 44 nations under the Bretton Woods Agreement of July, 1944. Among other roles of the fund is fixing the par values of currencies of its members in terms of gold.

Monetary authority: Refers to an institution that controls and manages a nation currency, money supply and interest rates.

Monetary Policy: Refers to the credit control measures adopted by a country Central bank.

Special Drawing Rights (SDRs): Refers to supplementary foreign exchange reserve assets defined and maintained by the IMF.

Wholesale Dutch Auction System (WDAS): Refers to a bulk sale of foreign exchange currencies by the Central bank to the authorized dealers after optimal bidding price has been determined.




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