Financial Crisis and External Debt Management in Nigeria

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1 Financial Crisis and External Debt Management in Nigeria Bamidele, T.B Ph.d & *Joseph, A.I Department of Economics, Ajayi Crowther University, Oyo, Oyo State, Nigeria. Abstract The study examines the effect of financial crisis, external debt management on the economic growth of Nigeria. The model built for the study proxy gross domestic product as the endogenous variable measuring economic growth as a function of FDI, external debt, external reserve, inflation, and exchange rate proxy as the exogenous variables. Annual time series data was gathered from the Central Bank of Nigeria Statistical bulletin from 1980 to The econometric techniques of Ordinary Least Square (OLS), Augmented Dickey-Fuller (ADF) Unit Root test and the Granger Causality test are employed in the empirical analysis. The Ordinary Least Square (OLS) result shows that a positive relationship exist between FDI and Economic Growth variables while an inverse relationship exist between External Debt and Economic growth. The findings from the granger causality test show that causality runs from GDP to FDI and external debt engender economic growth in the Nigerian economy. The study recommends that government should ensure economic and political stability that will encourage capital inflow and reduce external debt so as to lead the economy to the next stage of growth. Keywords: Financial Crisis, External Debt Management, Economic Growth, External Reserve, Exchange Rate, depression, debt, FDI 1. Introduction The global financial crisis of was the worst the world has seen since the great depression of the 1930s in both intensity and global reach. Even the emerging market countries were not immune against the global scourge that spreads like wild-fire (Abubakar, 2009). The effect of the financial crisis that began in the United States of America (USA) on emerging markets was wide-ranging and was both internally and externally induced (Nijathaworn, 2010). The initial financial crisis had affected mainly the US and Europe. However, due to the connectivity of the financial system also known as the contagion effect, most economies were affected including Nigeria (Soludo, 2011). In Nigeria, the financial crisis took place at the time when the region is slowly recovering from the negative effects of the fuel and food crisis (Aluko, 2009). Against this background, the key challenge facing Nigeria is how to manage her external debt in the paradigm of the financial crisis to ensure that it does not reverse progress made since the beginning of the new millennium and reduce the prospects of achieving the Millennium Development Goals (MDGs). It is against this background that this study is set to examine the impact of the global financial crisis on the Nigerian debt management. The current financial crisis had indeed enhanced risk aversion of investors joint. With the tightening of global credit conditions, the deterioration of the macroeconomic and political environment of some countries in the region, as well as the increased volatility of capital 16

2 markets and exchange rates have led to a reduction of portfolio inflows in sub-saharan Africa (SSA). The countries in the region mostly affected by this phenomenon have been South Africa, Nigeria and Kenya. Apart from the introduction, section 2 of the paper will deal with the review of literature. Section 3 presents the methodology while section 4 will be used for the presentation of the result and section 5 concludes and provides possible recommendations. 1.1 Statement of Problem The changes in the structure of global capital markets since the debt crisis of 80s, the continuing process of financial market integration, and the increasing role of private investment flows, have all made the developing countries highly vulnerable to the forces of the world economy. The developing countries are increasingly becoming susceptible to the vagaries of the private capital flows, largely governed by the macroeconomic uncertainties of the major economies, and the fall out of the financial innovations that basically emerged in financial systems of US and Europe. The contraction in world output and trade combined with lower inflows of foreign remittances and investment flows have increased the financing gap for several countries in the region. The financial crisis affected severely the public finances of most developing countries, determined by the extent of direct fiscal support to the banking sector, the revenue impact of falling commodity prices and discretionary fiscal stimulus to support growth ( Ajayi and Oke, 2012). As a result, debt financed fiscal stimulus has been significant in most developing economies, however, which has led to increase in public debt as well as government contingent liabilities. The increase in government debt levels and fiscal sustainability has triggered the market reactions, as the sovereign bond spreads have widened sharply, which has particularly raised the cost of borrowing from international markets. The decline in exchange rates in the region was primarily due to the reversal in capital flows impacted by the financial crisis, and easy monetary policies pursued in response to credit crunch. One question that one may then asked is that what is the impact of this financial crisis associated with debt management on the economic growth in a small open economy like Nigeria? This becomes the problem in which this study tries to examine, so as to draw up a reasonable conclusion for the study. 1.2 Justification for the Study External debt management which may be defined as policy which seeks to alter the stock, composition, structure and terms of debt with a view to maintaining at any given time, a sustainable level of debt service payment, has become an important issue in macroeconomic management (Ojo 1997). The link between external debt management and economic growth has been extensively documented in the growth literature see for example, Poirson and Ricci (2002) and Pattillo, Poirson and Ricci (2004), these studies provide empirical evidence of a nonlinear relationship between external debt and economic growth. A number of studies have dealt with the external debt-economic growth relationship during the last two decades. Most of the studies carried out so far in this area 17

3 have focused mostly on the impact of external debt on foreign direct investment and economic growth. The rationale behind this study is therefore to; empirically examine the effects of external debt management on sustainable economic growth and development in the era of global financial crisis. It is hoped that this study will add to the existing literature as only few of this kind of study have been done in Nigeria and also serve as a reference to intending researchers willing to delve in this area of study. 2.0 Conceptual Framework Financial crisis is a situation in which the supply of money is outpaced by the demand for money. This means that liquidity is quickly evaporated because available money is withdrawn from banks, forcing banks either to sell other investments to make up for the shortfall or to collapse. According to Abubakar (2008) financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. However, in the 19th and early 20 th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics. Other situations that are often called financial crises include stock market crashes and the bursting of other financial bubbles, currency crises, and sovereign defaults (Kindleberger and Aliber, 2005, Laeven and Valencia, 2008). Debt on the other hand is created by act of borrowing. It is defined according to Oyejide et al (2004) as the resource or money use in an organization that is not contributed by its owner and does not in any other way belong to them. It is a liability represented by a financial instrument or other formal equivalent. External debt therefore refers to the resources of money in use in a country that is not generated internally and does not in any way come from local citizens whether corporate or individual. The World Bank (1998, cited in Oke, 2012) described external debt as the amount of money at any given time disbursed and outstanding contractual liabilities of residents to pay interest, with or without principal. The external problem facing Nigeria has been receiving increasing attention in which adequate solutions are yet to be found. A clear and persistent lesson of debt crisis has been that adequate debt management is essential if external resources are to be used efficiently. Many developing countries resort to external borrowing to bridge the domestic resource gap in order to accelerate economic development. It means that the processes are utilized in a productive way that facilitates the external servicing and liquidation of the debt. 2.2 Theoretical Review The impact of public debt (both positive and negative) cannot be overemphasized. This assumption is not far-fetched when it comes to the analysis of the relationship between capital investment and debt in the growth and development process of developing countries of the world. In this line of thought this study will be incomplete without a proper review of some growth theories as well as theories of debt and economic performance in an attempt to have a better understanding of the subject matter. All Economists believe in the equality 18

4 of saving and investing, in the production process (Jhigan 2004). But they differ as to the manner in which this equality is brought about Theories of growth The Classical View The classicists are of the opinion that there is the existence of fully employed economy where saving and investment are always equal (both being the function of interest rate) That is S = ƒ (r) and I = ƒ (r) Therefore S = I They argued further that when interest rate rises saving rises and investment fall. On the other hand when interest rate fall, saving falls and investment rises The Keynesian View There are two views with regard to the saving-investment equally as put forth by Keynes. These are a) Accounting or definitional equality. This tells us that actual saving and actual investment are always equal all time and at any level of income. In order to show it he defined saving and investment in such a manner as to establish their equality. Both saving and investment in the current period are defined as the excess of current income over current consumption (Y t C t ) so they are necessarily equal. S t = Y t C t..i I t = Y t C t II Since Y t C t is common to both equation Then S t = I t Where S is saving, I is Investment, Y is income, C is consumption and t is current period b) Functional equality. This stipulates that saving and investment are equal only at the equilibrium level of income. i.e. saving and investment are not only equal but also in equilibrium. This is brought about by the adjusting mechanism of income as distinct from the classical view of variations in the rate of interest. Here, income is functionally related to saving and investment. When saving is more than investment income falls and when investment is more than saving income rises, this dynamic process will continues till saving and investment are equal but are also in equilibrium Harrod Domar Model Harrod and Domar assign a key role to investment in the process of economic growth, being one of the major goals of macroeconomic policy of modern government. But they lay emphasis on the dual character of investment. Firstly, it creates income (i.e. demand effect of investment), and secondly, it augments the production capacity of the economy by increasing its capital stock (supply effect of investment). They worked on the influence of money on economic growth within the context of the classical thesis of a) Price Flexibility b) Full employment. 19

5 They argued that growth in the economy depends on savings and capital output ratio. g = s/v..(1) V = k or I. k.. (2) I I Where k is change in capital The model assumes the followings. 1) Proportional savings fraction, that is saving depends on proportion of income. 2) Ignoring depreciation: It is also assumed that the rate of change in capital stock (k) is equal to flow of total investment. That is S = Sy...(1) K = I. (2) Given an accelerated type of relationship between capital and output and a fixed output ratio (V) we have K = Vy... (3) Substituting equation. (2) Into (3) we have I = vy.. (4) In equilibrium S = I.(5) Combining (1) and (4) Sy = Vy.(6) Which means that? Y/Y = S/v = g (7) Solow Growth Model Robert Solow s model of economic growth can be used to analyze saving rate, growth rate of labour supply, and improved technology affect output per worker. This model shows the linkage between saving and economy s capital-labour ratio and output per worker. A steady state is finally reached where there is no further increase in the capital-labour ratio and output per worker. This is illustrated below: s [ƒ(k)] d.k > 0 A steady state exist and there is no further increase in the capital-labour ratio and output per worker when s [ƒ(k)] = d.k For depreciation rate d and saving rate s, the capital-labour ratio at the steady state is k* =A 2 [(s 2 /d 2 )] And output per worker is y* = A k* 2.3 Empirical Review Morisset (2002) examined the effect of debt reduction within a macroeconomic framework and tested various direct and indirect relationships between external debt, investment and 20

6 economic growth. In order to explain the drastic reduction in private investment, some direct and indirect channels are considered. It is argued by most authors that if private sector is credit rationed, then the high level of foreign debt affects productive investment through a disincentive effect. Saint-Paul (1992) and Josten (2000) consider continuous-time overlapping generations models in the tradition of Blanchard (1985). In the words of Gurley and Shaw (1956), mounting volume of public debt is a necessary feature of a strong and healthy financial structure of an economy. Therefore some secular increase in public debt should be planned by every government of a market oriented economy. Ajayi (1999) traces the origin of Nigeria s debt problems to the collapse of the international oil price in the early 80 s and the persistent suffering of the international oil market and partly due to domestic lapses. As a result of the debt problem, credit facilities gradually dried up, which led to a number of project getting stalled. He advocated the revival of the economy growth as the best and most durable solution to the debt burden. The needed growth, however, is disturbed by two factors, which include, limitation imposed by inappropriate domestic policies and the external factors, which are beyond the control of the economy. Sanusi (1998) was of the view that faulty domestic policies which range from project financing mismatch, in appropriate monetary and fiscal policies was responsible for domestic borrowing problem. He believes that some of the policies were of little significance because of the perceived temporary effect of the external shocks. The expansionary policies, he believes, led to stupendous macroeconomic fallout, which encourage import and discourage export production. Kruger (1997) states that after the rise in oil prices, the oil importing developing countries faced large current account deficits. On the other hand, oil exporters had large current account surpluses, which they lent to the commercial banks, which in turn financed the deficits of oil importing countries, thus the surpluses of the oil exporting countries were used by oil importing developing countries. Bauerfreund (2000) used a computable general equilibrium model to measure the cost of external debt to the Turkish economy. His dissertation explains the issue of the debt overhang, using a multi sector, non-linear general equilibrium model. The approach taken to measure the debt overhang is to compare the growth rate of the Turkish economy following hypothetical debt forgiveness. In order for governments to pay debt obligations, they need to levy a tax on the private economy. This increasing taxation causes a decrease in the net returns of investment, resulting in a reduction of investment in the debtor countries, and a negative effect on future production and income. It is believed that indebted countries are able to achieve this by, increasing exports but in practice the experience shows that maintaining the increase in exports is very difficult. On the other hand, the ratio of imports of developing countries grows more rapidly than that of the developed countries. 21

7 3.0 Model Specification Following Odugbemi and Ooyesiku, (2000). The model is specified thus; GDP = f (FDI, ED, ER, INF, EXC)... (1) Where GDP = Gross Domestic Product FDI= Foreign Direct Investment ED = External Debt ER = External Reserve INF = Inflation Rate EXC = Exchange Rate That is it can be specified as GDP = β 0 + β 1 FDI + β 2 ED + β 3 ER + β 4 INF+ β 5 EXC + U... (2) Where; β 0: is the constant or intercept. β 1: is the coefficient of foreign direct investment (FDI) β 2: is the coefficient of external debt(ed). β 3: is the coefficient of external reserve β 4: is the coefficient of inflation rate. β 5: is the coefficient of exchange rate U: is the error term 3.1 A priori Expectation A priori refers to what the theory (with regard to the different schools of thought) says about each of the variable considered in this study. Based on this we expect our independent variables to display their respective behaviours according to what theory says in relation to the dependent variables that is being specified in our model. Hence, on apriori we expect On apriori we expect, β 1 >0, β 2 <0, β 3 >0, β 4 <0, and β 5 <0. This is developed to see the overall impact of the global financial crisis on foreign debt management in Nigeria. 3.1 THE GRANGER CAUSALITY MODEL AND ESTIMATION TECHNIQUES In the study, we postulate that the link between Financial Crisis, Debt Management and Economic Growth is to be of a linear form also that the relationship portends a causal relationship. Thus, the granger causality test will also be used. A simple definition of Granger Causality; in the case of two time-series variables, X and Y: "X is said to Granger-cause Y if Y can be better predicted using the histories of both X and Y than it can by using the history of Y alone." We can test for the presence of Granger causality by estimating the following VAR model where there are two models with different dependent variables. The first one using Economic Growth (GDP) and the second one Debt Management (ED) and the Financial Crisis (FDI) as the dependent variables. GDP t = c 0 + c 1 GDP t c p GDP t-p + d 1 FDI t d p FDI t-p + v t (3) FDI t = a 0 + a 1 FDI t a p FDI t-p + b 1 GDP t b p GDP t-p + u t (4) GDP t = m 0 + m 1 GDP t m p GDP t-p + q 1 ED t q p ED t-p + n t (5) ED t = w 0 + w 1 ED t w p ED t-p + l 1 GDP t l p GDP t-p + k t (6) FDI t = x 0 + x 1 FDI t x p FDI t-p + r 1 ED t r p ED t-p + z t (7) 22

8 ED t = y 0 + y 1 ED t y p ED t-p + n 1 FDI t n p FDI t-p + j t (8) Where it is assumed that v t, u t, n t, k t, z t and j t are uncorrelated. Equation (3) represents that variable GDP is decided by lagged variable FDI and GDP, so are other equations from (4) to (8) except that its dependent variable is Y instead of X as the case may be. Then, testing H 0 : b 1 = b 2 =... = b p = 0, against H A : 'Not H 0 ', is a test that X does not Granger-cause Y. Similarly, testing H 0 : d 1 = d 2 =... = d p = 0, against H A : 'Not H 0 ', is a test that Y does not granger causes X. In each case, a rejection of the null implies there is Granger causality. Before estimating Granger Causality to test causality relationship between Trade and Exchange Rate volatility, this study will employ the unit root tests to assess the stationary properties of the time series data based on the Augmented Dickey-Fuller (ADF) test. Hence, in the presence of non-stationary variables, there might be what Granger and Charbold called a spurious regression whereby the result obtained suggest that there are statistically significant relationships between the variables in the regression model when in fact all that is obtained is evidence of a causal relations. Thus, the individual stationarity test will be carried out before conducting causality tests. The series GDP will be integrated of order d, which is GDP ~ I (d), if it is stationary after differencing it d times. A series that is I (0) is stationary. To test for unit roots in our variables, we use the Augmented Dickey fuller (ADF) test. This test is based on an estimate of the following regression: ΔGDP = β 0 + β 1t + β 2 GDP + t-j ΔGDP + e t. (11) Where β 0 is a drift, t is representing a time trend and p is a lag length large enough to ensure that e 1 is a white noise process. Adopting the results of Dickey fuller, the null hypothesis that the variable GDP is non-stationary (H : β 0 = 0) is rejected if β=0 is significantly negative. However, since ADF tests are sensitive to lag length, we determine the optimal lag length by using Akaika information criteria (AIC). The same is applicable for GDP variable. Data Description and Sources of Data This research study makes use of secondary data. The variables used are the gross domestic product (GDP), foreign direct investment (FDI), exchange rate (EXC), external reserve (ER) external debt (ED) and inflation rate (INF). The data are collected from the CBN statistical bulletin, the publication of CBN, the International Financial Statistics (IFS), and the World Development Indicators It covers the period of Results Time series data are prone to spurious regression and a way out of this is to carry out a stationarity test for all the variables. There are different test for stationarity using Unit Root such as Dickey Fuller, Augmented Dickey Fuller and Phillip Peron. For this study we employed the Augmented Dickey Fuller Unit Root test and the result obtained is presented bellow: 23

9 Table 1 The Unit Root Test Variables ADF at Level ADF at 1 st Difference ADF at 2 nd Difference GDP I(1) FDI I(1) ER I(1) ED I(1) EXC I(1) Source: Authors computation Order of Integratio n Among all the variables tested for stationarity in table 4.1, non of the variable was stationary at level. All the variables were stationary after their first differencing. Since not all the variables are integrated at levels, then we are justified to find the cointegration test of the residuals of the static regression. The residual (ECM) was found to be stationary of order zero I(0). Hence, we proceed to test for a long run relationship of the variables. Dependent Variable: GDP Method: Least Squares Date: 11/15/12 Time: 06:19 Sample: Included observations: 31 Variable Coefficien t Std. Error t-statistic Prob. C FDI ER INF ED EXC R-squared Mean dependent var Adjusted R-squared S.D. dependent var S.E. of regression Akaike info criterion Sum squared resid 2.99E+13 Schwarz criterion Log likelihood F-statistic Durbin-Watson stat Prob(F-statistic) The regression result shows a good outcome as it indicates that most of the variables turns out with the expected apriori sign. A positive and significant result exist between FDI and GDP. The result shows that increase in FDI into the economy will help to improve economic development of the country. The result shows that it is significant at 1 percent. From the 24

10 result, it shows that a 1 percent increase in FDI will lead to about 1719 percent increase in GDP. Hence, FDI inflow into the economy will help to improve economic growth of the economy. External reserve from the result also shows a positive and significant result with GDP. The result indicates that, a 1 percent increase in ER will lead to about 111 percent increase in the growth of the economy. Inflation in the result shows an inverse relationship with Economic growth. The result however was not surprising as high rate of inflation accompanied with unemployment in the country has leads to a great poverty in the country and hence reduces the economic development as more people fall into an abject rate of poverty. The result however was not significant as P>0.1. this indicates that inflation in the model is not a significant factor that determine economic development under the period studied. External debt was not only negatively significant to GDP but was also significant with P<0.1. this indicates a significant level of 10 percent. The implication of this result shows that external debt is a significant factor that determine GDP in the country. From the result therefore, high external debt accompanied with the servicing of the debt with reduce GDP in the country. Exchange rate though positively related to GDP was not significant. The result however does not conform with apriori expectation. The result also was not significant under the period studied. The R- squared value of about 97 percent explains the degree of variation between the dependent and the independent variables. The value of shows that 97.20% of variations in the dependent variable was accounted for by the explanatory variables. It follows therefore that less tnn han 2.80% of the variations were accounted for by variables outside this model. The Adjusted R - squared measures what the normal R-Square measures but it gives considerations to degree of freedom in order to appropriately measure the proportion of the variation in the dependent variable that are attributable to variations of the independent variable. The value of in the table above showed that the actual variation in the dependent variable attributed to the independent variable is 96.64% and less than 3.36% were determined outside this model. The F Statistics is test for the overall significance of the model, i.e. the goodness of the model. A model is said to be significant if its F-calculated or F-ratio is greater than the tabulated F-values, at a given level of significance. For this model, the value of was significant at 5% of significance because it exceeded the table values at this level. For the Durbin Watson econometric test which tries to examine the level of autocorrelation or serial correlation in the time series data used, the D.W value at 5% level of significance of showed that there is no positive autocorrelation among the time series data because this values is greater than zero but it is lower than the upper limit of D.W test of and also lower than the lower limit of for this model. Granger causality test Result Pairwise Granger Causality Tests Date: 11/15/12 Time: 06:23 Sample:

11 Lags: 1 Null Hypothesis: Obs F-Statistic Probability FDI does not Granger Cause GDP GDP does not Granger Cause FDI E-05 ED does not Granger Cause GDP E-05 GDP does not Granger Cause ED ED does not Granger Cause FDI FDI does not Granger Cause ED Table 4.4 Granger Causality Text Result Direction Causality GDP FDI FDI GDP of No of lags F. Values Decision Accept H 0 Reject H 0 ED GDP GDP ED Reject H 0 Accept H 0 ED FDI FDI ED Accept H 0 Reject H 0 Source: Authors computation 2012 The result from the granger causality test presented above shows that, there is a unidirectional causality between GDP and FDI. The results suggest that the direction of causality is from FDI to GDP since the estimated F is significant at the 1 percent level; the critical F value is On the other hand, there is no reverse causation from GDP to FDI, since the F value is statistically insignificant. For External debt (ED), the results also suggest that the direction of causality is from ED to GDP since the estimated F is significant at the 1 percent level; the critical F value is On the other hand, there is no reverse causation from GDP to ED, since the F value is statistically insignificant. This shows that external debt can lead to economic growth but when an economy is growing it cannot encourage more external debt in the economy. The result for External debt (ED) and Foreign Direct Investment (FDI) also shows a unidirectional relationship. The results also suggest that the direction of causality is from FDI to ED since the estimated F is significant at the 10 percent level; the critical F value is On the other hand, there is no reverse causation from ED to FDI, since the F value is statistically insignificant. 5.0 Conclusion and Recommendations This study investigates the impact of financial crisis and external debt management on economic development in Nigeria. The findings from the study revealed that financial crisis and external debt management have not really impacted positively on the Nigerian 26

12 economic development during the period covered. It was also seen that FDI engender GDP in the country and hence will help to build the economy to a greater extent and external debt is what engender economic development and not a reverse causation. Hence, it cannot be generally concluded that external debt impact negatively on the economic development. From the findings and conclusion of the study, it is recommended that: a) The overreliance of the economy on the external sector should be reduced so as to ensure that any shock that affected on country should not automatically affects the country without any way out. b) The Nigerian government should investigate the reasons behind the noncontribution of external debt to the GDP per capita of the country with a view to unveiling the bottlenecks and correct them. The bottlenecks could be as a result of mismanagement or higher cost of borrowing. c) Now that the external debt stock of the country has declined significantly due to cancellation and relief, the modalities of borrowing external debt and their application should be technically and tactically analyzed prior to accessing the debt. d) External debts are meant to boost the economic growth and development of the debtor country and improve the standard of living of the citizenry. Therefore, the Nigerian government should always consider the debts as means to long run development not just for solving short run problems. e) Foreign Investment stand as a positive variable that engender economic growth in the country, hence government should provides means in which the free inflow of investment can enter the country and hence help to engender economic growth. References Abubakar, M. (2008) The Implication of Global Financial Crisis on International Marketing Unpublished M.Sc. Assignment on International Marketing Bayero University, Kano. Ajayi, S.I.(1995). Capital flight and external debt in Nigeria. AERC Research paper no.35. Nairobi: AERC. Ajayi, S.I.( 2002). Macroeconomic Approach to External Debt: The case of Nigeria. AERC Research paper no.8. Nairobi: AERC. Aluko, F and Arowolo, D (2010), Foreign aid, the Third World s Debt crisis and the implication for Economic Development: The Nigerian experience, African Journal of Political Science and International Relations, Vol. 4(4), pp , April Development of Nigeria. International Journal of Business and Social Science Vol. 3, No. 12 Dickey, D.A., and Fuller, W.A. (1979). Distribution of the Estimators for Autoregressive Time Series with a Unit Root. Journal of the American Statistical Association, 74, Engle, R. F., and Granger, C. W. J. (1987). Co-integration and Error Correction: Representation, Estimation, and Testing. Econometrica, 55, Josten, S. D. (2000, March). Public debt in an endogenous growth model of perpetual youth. FinanzArchiv: Public Finance Analysis, 57 (2), Kindleberger, C.P. and Aliber, R. (2005) Manias, Panics, and Crashes: A History of 27

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