1.1 Background of the study

Exchange rate is the rate at which a currency is exchanged for another currency. It is referred to as the ratio at which a unit of currency of one country is expressed in terms of another currency. According to Jhingan (2004), the exchange rate between the dollar and Nigeria Naira, refers to the number of dollars required to purchase a Naira. The rate is normally determined in the foreign exchange market. The foreign exchange market is a market where currencies of different countries are bought and sold. It is a market where the values of local and foreign currencies are determined. As noted by Jhingan (2004), the national currencies of all countries are the stock-in-trade of the foreign  exchange market, and as such, it is the largest market to be found around the world which functions in every country.

Exchange rate  determination  issues have been particularly prominent in developing countries in recent years following the introduction of IMF and World Bank stabilization and adjustment policies. These frequently include devaluation and the introduction of new exchange rate management policies along with trade liberalization measures. Exchange rate policy is usually driven by two different and many times conflicting objectives. First, to support a competitive real exchange rate, and second, to serve as a nominal anchor for low inflation. The former objective is generally pursued to support the expansion of the exportable and import competing sectors, and as a way to ensure a strong position in the balance of payment. The latter objectives are important to the extent that low inflation and macroeconomic stability create a favourable environment for long term growth. The effectiveness of exchange rate policy in pursuing these two objectives depends crucially on the nature and timing of linkages between the nominal exchange rate, import price and inflation..

Prior to 1986 Nigeria was on a fixed exchange rate determination system. At that time, naira was very strong in reference to dollar. The exchange rate was one naira to one US dollar i.e. N1=$1. The increasing demand for foreign exchange and the inability of the exchange control system to evolve an appropriate mechanism for foreign exchange allocation in consonance with the goal of internal balance made it to be discarded in September 26, 1986 while a new mechanism was introduced under the Structural Adjustment Programmes (SAP). The main objectives of the new exchange rate policy were to preserve the value of the domestic currency, maintain a favourable external balance and the overall goal of macroeconomic stability and to determine a realistic exchange rate for the Naira.

Since 1986 when the new exchange rate policy has been adopted, however, exchange rate determination in Nigeria has gone through many changes. Before the establishment of the Central Bank of Nigeria in 1958 and the enactment of the Exchange Control Act of 1962, foreign exchange was earned by private sector and held in balances abroad by commercial banks that acted as agents for local exporters. The boom experienced in the 1970s made it necessary to manage foreign exchange rate in order to avoid shortage. However, shortages in the late 1970s and the early 1980’s compelled the government to introduce some ad hoc measures to control excessive demand for foreign exchange. However, it was not until 1982 that a comprehensive exchange controls were applied. These include the fixed exchange rate, the freely floating and the managed floating system among others.

In an attempt to achieve the goal of the new exchange rate policy, a transitory dual exchange rate system (First and Second –Tier – SFEM) was adopted in September, 1986, but metamorphosed into the Foreign Exchange Market (FEM) in 1987. Bureau de change was introduced in 1989 with a view to enlarging the scope of Foreign Exchange Market. In 1994, there was a policy reversal, occasioned by the non-relenting pressure on the foreign exchange market.

Further reforms such as the formal pegging of the Naira exchange rate, the centralization of foreign exchange in the CBN, the restriction of Bureau de change to buy foreign exchange as an agent of CBN etc. were all introduced in the foreign exchange market in 1994 as a result of the volatility in exchange rates. Still, there was another policy reversal in 1995 to that of “guided deregulation”. This necessitated the institution of the Autonomous Foreign Exchange Market (AFEM) which later metamorphosed into a daily two ways quote Inter-Bank Foreign Exchange Market (IFEM) in 1999. The Dutch Auction System was reintroduced in 2002 as a result of the intensification of the demand pressure in the foreign exchange market and the persistence in the depletion of the country’s external reverses. Finally, the wholesales Dutch Auction System (W-DAS) was introduced in February 20, 2006. The introduction of the WDAS was also to deepen the foreign exchange market in order to evolve a realistic exchange rate of the Naira.

1.2 Statement of  the  Problem

The exchange rate between naira and other currencies of the world especially dollar is now very volatile. It fluctuates on weekly, daily and even on hourly basis and there is no limit to its variability. These are due to various factors which have affected the determination of rate of exchange of Naira to other currency. This fluctuation has made naira to be very unstable and its value reduced to the barest minimum. This problem of exchange rate variability and it determinant became too disturbing after the emergence of the generalized floating system in the early 1970’s. It was not however surprising that six different systems were tried between 1986 and 2008. The introduction of   Dutch auction system in 2006 further deepens foreign exchange market in order to evolve a realistic exchange rate for the naira. As result, the Central Bank of Nigeria had to intervene on two occasions in order to moderate the amplitude of fluctuation in the exchange rate through  exchange rate determination. In addition to the generalized floating exchange rate determination system in Nigeria, a number of other factors have contributed to the dwindling fortune of Naira. These includes  money supply,  parallel market premium, interest rate, inflation weak production base and undiversified nature of the economy; import dependent production structure; sluggish foreign capital inflows; unguided trade liberalization policy; over reliance on the imperfect market system, weak balance of payment position, loss of monetary policy and more importantly, poor foreign exchange management system etc.  All these are some of the problems in exchange rate fluctuation in Nigeria.

1.3 Research Question 

The following research questions posed will examine  to what extent

  1. Money supply determines exchange rate?
  2. Interest rate determine exchange rate?
  3. Inflation rate determine exchange rate ?
  4. Parallel market premium determine exchange rate?

1.4 Objectives of the Study

The general objective of study is to determine the determinate factors of exchange rate in Nigeria. The specific objective are  as follows

  1. To ascertain the extent Money supply determines exchange rate.
  2. To investigate the extent Interest rate determine exchange rate.
  3. To investigate how Inflation rate determine exchange rate?
  4. To ascertain how Parallel market premium determine exchange rate.

1.5 Research Hypotheses

The following hypotheses are formulated to guide the study

H01: Money supplied in the economy is not a significant determinant of Nigeria exchange rate.

H02: Interest rate in the economy does not significantly determine Nigeria exchange rate.

H03:  Inflation rate not  significantly a determinant exchange rate in Nigeria.

H04: Parallel market premium is not significantly a determinant of exchange rate in Nigeria.

1.6 Significance of the Study

The findings of the research will enable Nigerian Government to adopt the best exchange polices which will lead to effective growth in Nigeria economy. It is also significant in that the study will serve as a reference for other fellow researchers who will like to work on exchange rate in Nigeria.