THE IMPACT OF EXCHANGE RATE VOLATILITY ON FOREIGN DIRECT INVESTMENT IN NIGERIA

ABSTRACT 

This study examined the relationship between foreign direct investment (FDI) and the foreign exchange rate in Nigeria from 1986 to 2018. By analyzing historical data, the study aimed to identify issues related to the formulation and implementation of policies that encourage FDI inflows, specifically focusing on the movement of the FDI-exchange rate relationship. Various quantitative analytical techniques, including regression analysis, Granger causality test, correlation matrix, and descriptive statistics, were employed within an ECM (Error Correction Model) and cointegration framework. The empirical findings of this study offer significant evidence to draw meaningful conclusions.

Firstly, the causality test estimations revealed that there was no causal relationship between FDI and the exchange rate during the research period. Secondly, a substantial long-term connection between the exchange rate and FDI was identified. This implies that the relationship between foreign capital inflows and the exchange rate in Nigeria from 1986 to 2018 is both a short-run and long-run phenomenon. Additionally, the impact of capital inflows, particularly the exchange rate, is considerable and has a strong depreciating effect on FDI. Based on these findings, it is recommended to develop appropriate policies to stabilize the currency rate in order to promote foreign capital inflows while maintaining prudent regulations.

 

Keywords: FDI, Foreign Direct Investment, Foreign Investment, Exchange Rate Volatility CHAPTER ONE 

METHODOLOGY 

SUMMARY, CONCLUSION AND RECOMMENDATIONS 

REFERENCES 

According to the World Bank's criteria established in 1996, foreign direct investment (FDI) refers to an enterprise undertaken to acquire a significant business interest, often 10 percent ownership or more of a company's equity, in a corporation operating in a sovereign country other than the investor's home nation. Foreign capital flows are categorized as official development aid or export credits. Foreign private investment, on the other hand, encompasses the tangible products and financial instruments owned by foreign investors in the host country. Essentially, "capital inflows" denote the movement of financial resources between nations, which benefits the economy of the recipient country. The host country often faces limitations in investment due to low domestic savings resulting from its inherent characteristics (Odili, 2015). By 2019, international capital flows had exceeded $1.5 trillion, with over half, amounting to $635 billion, directed towards businesses in developing countries (World Investment Report, 2019).

Scholars have made substantial efforts to provide a comprehensive explanation for the competition between developing and emerging economies in attracting foreign capital from other countries. The primary argument supporting this economic choice is based on the fundamental assumption that FDI not only brings much-needed financial resources to developing nations like Nigeria but also stimulates job creation, enhances productivity, develops managerial skills, and introduces advanced technology. It is anticipated that each of these factors would contribute to accelerated economic development (Todaro, 1977). This underscores the significance of foreign capital resources as a crucial tool and a strategic driver for economic growth and development.

Despite the global increase in international investment flows, particularly towards developing nations in Sub-Saharan Africa, Nigeria has recently faced challenges in attracting foreign direct investment (FDI). Nigeria, with its high demand for goods and services, has historically been a destination for FDI. However, FDI inflows to Nigeria have experienced a decline, reaching $5.58 billion, $4.69 billion, $4.45 billion, and $2.00 billion in 2012, 2014, 2016, and 2018, respectively, following a peak of $8.8 billion. The year 2018 witnessed the most significant decline, with inflows dropping by over 42.98% compared to 2017 and more than 300% since 2011. Various factors, including the stability of macroeconomic indicators such as the exchange rate and GDP, political instability, corruption, and other socio-political elements, impact foreign capital flows (Edo, 2011).

In light of the consensus regarding the importance of FDI for the economic growth of emerging countries, economic experts have turned their attention to the variables influencing FDI inflows in developing nations. It is crucial to identify the factors responsible for this paradox, as Nigeria, a developing nation, requires a significant infusion of FDI but struggles to attract substantial amounts and maintain the FDI it does receive. Empirical data in Nigeria suggests that the behavior of the currency rate is among the various factors that could be influencing FDI movements. 

The exchange rate can be understood as the price of a foreign currency in relation to one's domestic currency, both in terms of levels and changes. Consequently, the behavior of exchange rates has implications for both the distribution of investment expenditure among different countries and the overall volume of foreign direct investment (FDI) (Goldberg, 2006). On the other hand, an exchange rate regime encompasses a set of regulations, structures, and agreements that govern the internal financial transactions of nation-states. In Nigeria, a flexible exchange rate system, known as the flexible rating system or the gold exchange standard, is currently in use. This system relies primarily on market mechanisms driven by supply and demand pressures. According to Jhigan (2005), factors such as a country's exports, imports, and structural considerations influence the currency rate. When a country's exports exceed its imports, the demand for its currency rises, resulting in an appreciation of the exchange rate. Conversely, if imports outweigh export sales, there is an increased demand for foreign exchange, leading to a depreciation of the exchange rate

Foreign direct investment is generally viewed as a forward-looking activity, based on investor projections of future returns and their confidence in those prospects. Exchange rate instability can deter FDI as it introduces uncertainty, hampers investment, and makes foreign investors more cautious about entering a country (Saidu, Nnanna, and Oko, 2018). Specifically, fluctuating exchange rates can impact both the total volume of FDI and its distribution among different countries (Goldberg, 2006). This is because a depreciating currency can have two negative effects on foreign direct investment. Firstly, it reduces labor and manufacturing costs compared to those of competitors in other countries. Holding other factors constant, a nation experiencing a significant currency depreciation gains a heightened "locational advantage" or attractiveness as an investment market for productivity gains. Foreign investors considering offshore investments in such a country would benefit overall from the currency weakening, using the so-called "relative wage" approach (Goldberg, 2006).

The impact of currency value on foreign direct investment (FDI) often relies on a few key assumptions. Firstly, any change in the exchange rate must be accompanied by a corresponding shift in average production costs among countries, which cannot be offset solely by wage and manufacturing cost increases in the target market for capital investment. The significance of the "relative wage" channel may diminish if anticipated exchange rate fluctuations are factored in, leading to our second point. Under interest rate parity conditions that equalize risk-adjusted projected investment returns across countries, anticipated changes in exchange rates could raise the cost of financing capital projects (Goldberg, 2006). This argument suggests that the impact of exchange rate fluctuations on FDI is more pronounced when such fluctuations are unanticipated and not accounted for in the projected costs of project financing for the FDI. However, the direct impact of exchange rate fluctuations on FDI remains uncertain.

While the exchange rate is a crucial macroeconomic factor used to assess FDI inflows and international competitiveness, recent volatility in the domestic exchange rate has raised significant concerns in Nigeria. Essentially, exchange rate swings are driven by the demand and supply sides of a country's currency, making it a reflection of the desirability of the currency. There is often an inverse correlation between a country's currency competitiveness and its exchange rate value. In other words, a country's currency becomes more competitive as its exchange rate depreciates. Exchange rate instability directly affects the attractiveness of imports and exports, as well as influencing production levels, balance of payments, and reserve holdings. Import prices, export revenues, and balance of payments outcomes can all be influenced by exchange rates. Local investors have significant opportunities for substantial returns through currency operations, particularly when investing in foreign currencies. Investors, like foreign exchange traders, prefer a system with minimal discrepancies between real and anticipated exchange rate values. Given the crucial role of exchange rates in maintaining macroeconomic stability, it is evident that they have a substantial impact on attracting foreign investment to a home country. 

The relationship between foreign direct investment (FDI) inflows and exchange rates in poor countries, including the Nigerian economy, has received limited attention despite the various macroeconomic issues associated with exchange rate fluctuations resulting from significant capital inflows. Most studies in this field have focused on examining how changes in currency rates impact FDI flows in Nigeria. This lack of attention is frustrating, considering the numerous challenges Nigerian policymakers face in attracting the much-needed FDI to catch up with wealthier economies, which undermines confidence in Nigeria's economic development and progress. Furthermore, the existing structure of FDI inflows is often skewed towards mining and mineral exploration, indicating a focus on resource-seeking FDI rather than addressing concerns regarding market breadth (Soumyananda, 2014). Fluctuations in foreign private capital inflows into the Nigerian economy since the implementation of the reform program (SAP) in 1986 have underscored the potential risks posed by unstable exchange rates to the domestic economy (Odili, 2015).

However, there is a significant research gap regarding the relationship between FDI and changes in exchange rates. Among the few endogenous studies conducted on this topic are those by Nwosa and Amassoma (2014), Odili (2015), and Saidu, Nnanna, and Oko (2018). These studies indicate a negative relationship between exchange rates and the volume of foreign direct investment into Nigeria. Conversely, other researchers such as Rasaq (2013), Omorokunwa and Ikponmwosa (2014), Alobari et al. (2016), Murtala (2017), and Mokuolu (2018) have reported a positive relationship. However, these studies solely explored the impact of exchange rate instability on the inflow of foreign capital, overlooking the causal relationship between exchange rates and FDI flows. Moreover, they only considered exchange rates without incorporating other important variables that could significantly influence FDI inflows into any country. Several other studies, including those by Hasan and Salim (2017), Arawomo and Apanisile (2018), Aderemi et al. (2020), and Chukwudi et al. (2020), examine various variables capable of affecting FDI movements in Nigeria, highlighting the importance of variables such as market breadth. 

There is a divergence of opinions regarding the potential impact of domestic currency rate fluctuations on FDI flows into Nigeria. While the majority of research suggests a positive impact, some studies have found the opposite. Studies by Ellahi (2011), Omorokunwa and Ikponmwosa (2014), Alobari et al. (2016), Murtala (2017), and Mokuolu (2018) present varying perspectives on this issue. In particular, Harchaoui et al. (2005), referenced by Murtala (2017), highlight that currency fluctuations can affect foreign investment in two distinct ways. The depreciation of the local currency is expected to increase incremental profits from capital investments in both local and foreign sales. However, this positive effect is offset by rising variable costs and the increased cost of imported capital. Theoretical research does not definitively indicate which impact is more significant, and thus, empirical investigation into the overall influence of exchange rate movements on foreign capital inflows remains ongoing.

While these studies have contributed significantly to the knowledge in this field, their methodology has been criticized, and they often fail to establish a causative relationship between FDI and currency value in Nigeria. For instance, studies by Nwosa and Amassoma (2014), Odili (2015), Saidu, Nnanna, and Oko (2018), Rasaq (2013), Omorokunwa and Ikponmwosa (2014), Alobari et al. (2016), Murtala (2017), Osemene, Kolawole, and Olanpeleke (2017), Philip and Omolade (2017), Hasan and Salim (2017) have been unable to demonstrate a clear causal connection between currency rate fluctuations and FDI. Furthermore, much of the research on the relationship between exchange rates and FDI has yielded equivocal results, at times failing to establish a direct causal link between currency rate movements and FDI. 

This study distinguishes itself from others by aiming to provide a comprehensive assessment of the relationship between exchange rates and FDI inflows. Specifically, it seeks to investigate the magnitude, direction, and bidirectional causality between currency value and FDI in the Nigerian economy, taking into account the market size measured by GDP. The findings of this study will not only contribute to practical strategies for retaining foreign investments but also emphasize the critical significance of exchange rate fluctuations in shaping FDI inflows in Nigeria. Additionally, understanding the causal direction between foreign capital inflows and currency rates is relevant for policymakers in formulating policies that attract foreign investment, serving as a blueprint for proactive and effective policy development.

 

Building upon the context provided and addressing the described issue, this study is grounded in the following fundamental inquiries:

The primary aim of this study is to examine the dynamic and causal connection between foreign direct investment (FDI) and the exchange rate in Nigeria. The specific objectives of the study are as follows: 

This study is motivated by the existing economic theories that propose a significant impact of exchange rates on FDI flows in Nigeria. However, the empirical evidence on the specific consequences remains debatable. By examining historical FDI data and offering explicit insights into the magnitude of the exchange rate's effect on FDI inflows to the Nigerian economy, this study contributes a valuable novelty to the literature that holds significance for policymakers and academics alike. It aims to provide policymakers with useful information to guide the implementation of appropriate policies aimed at attracting foreign investment to the Nigerian economy. 

 

Nigeria has been selected as the focus of this study due to its significant macroeconomic volatility. The research encompasses the period from 1986 to 2018, as this timeframe captures the onset of the structural adjustment program in Nigeria, which led to various distortions in the economy. The choice of this timeframe is also based on the availability of data and significant economic structural changes that occurred during this period. The study will examine the following variables: FDI (Foreign Direct Investment), Previous FDI, EXRT (Exchange Rate), and GDP (Gross Domestic Product).

The study will be divided into five sections. The first chapter of the introduction will cover the background, problem description, objectives, justification, expected contribution, and scope of the study. The second chapter will be dedicated to the literature review, encompassing conceptual, literary, and empirical reviews. In the third chapter, the research methods will be discussed, including model formulation, estimating methodologies, and a description of the data sources. The fourth chapter will concentrate on data analysis and the interpretation of the findings. Finally, Chapter 5 will provide a summary, suggestions, conclusions, and references.