FOREIGN EXCHANGE MARKET & THE BALANCE OF PAYMENTS Elements, Policies and Nigerian Experience Mike I. Obadan, ph.d, FNES, FIMC Professor of Economic; University of Benin, Benin City, and former Director-General, NCEMA Ibadan, Nigeria Goldmark Press Limited Abuja and Benin City
Table of Contents Dedication Preface Chapter 1: Basics of the Foreign Exchange Market and International Payments 1.0 Introduction 1 1.1 Key Currencies, Foreign Exchange and International Transactions 2 1.2 Making International Payments 4 1.2.1 Domestic versus International Payments 5 1.2.2 Instruments of International Finance 6 1.2.3 Effects of Making International Payments 15 1.3 Concept of Foreign Exchange Market 18 1.4 Functions of the Foreign Exchange Market 19 1.5 Operators in the Foreign Exchange Market 20 1.6 Spot and Forward Foreign Exchange Markets 21 1.7 The Nominal Exchange Rate 23 1.8 Demand for and Supply of Foreign Exchange 25 1.9 Foreign Exchange Supply and Demand Curves and the Equilibrium Exchange Rate 28 iv
1.10 Stability of Exchange Rate Equilibrium 30 1.11 Rates of Devaluation/Depreciation of acurrency 35 1.12 Aims and Effects of Devaluation 39 1.13 Overvaluation and Undervaluation of a Currency 42 1.14 Nominal Exchange Rate Changes 43 1.14.1 TheoreticalDeterminantsof Nominal Exchange Rates 44 1.14.2 Empirical Findings on Nominal Exchange Rate Determinants 46 1.15 Key Points and Conclusions 47 1.16 Annex 1.1: Relationship between Elasticity of Demand for Dollars and the Elasticity of Supply of Naira 53 Chapter 2: Hedging, Arbitrage and Speculation in the Foreign Exchange Market 2.0 Introduction 57 2.1 Hedging 58 2.2 Foreign Exchange Speculation 60 2.3 Foreign Exchange Arbitrage 63 2.4 InterestArbitrage 64 2.5 InterestParity Condition for Arbitrage 66 2.6 Key Points and Conclusions 68 Chapter 3: Exchange Rate Regimes: Multiple and Fixed Exchange Rates 3.0 Introduction 73 3.1 Concepts of Exchange Rate Policy and Exchange Rate Regime 73 3.2 Unified versus Multiple Exchange Rates 75 3.3 Fixed Exchange Rate Regimes 77 3.3.1 The Gold Standard 79 3.3.2 The Gold Exchange Standard/Bretton Woods System 85 3.3.3 Currency Boards 88 v
3.3.4 Dollarization 90 3.3.5 Monetary Union 90 3.3.6 Currency Peg 91 3.3.7 Crawling Peg/Crawling Band or Target Zone 92 3.4 Prerequisites for Adopting Firmly-fixed Exchange Rate Regimes 93 3.5 Key Points and Conclusions 3.6 Annex 3.1: Balance of Payments Adjustmentunder the Gold Exchange Standard 96 Chapter 4: Flexible Exchange Rate Regimes and Choice of Exchange Rate Regimes 4.0 Introduction 103 4.1 Typesof Flexible Exchange Rate Regimes 103 4.1.1 Clean Float versus Managed Float 104 4.1.2 Interbank and Auction Systems 105 4.2 Floating Exchange Rates and the Balance of Payments 105 4.3 Case for and against Flexible Exchange Rates 106 4.3.1 The Case for Flexible Exchange Rates 106 4.3.2 The Case against Flexible Exchange Rates 108 4.4 Floating Exchange Rates from 1973 Onwards 112 4.5 Prerequisites for Successful Floating Exchange Rate Regimes 115 4.6 Considerations in the Choice of an Exchange Rate Regime 117 4.7 Further Issues in the Choice of an Exchange Rate Regime 120 4.8 Some Lessons and Policy Conclusions on Exchange Rate Regimes 124 4.9 Key Points and Conclusions 127 Chapter 5: Real Exchange Rates 5.0 Introduction 131 5.1 The Bilateral Rea! Exchange Rate 132 vi
5.2 Nominal and Real Effective Exchange Rates 135 5.2.1 Nominal Effective Exchange Rates 135 5.2.2 Real Effective Exchange Rates (RER) 137 5.3 Equilibrium Exchange Rate 143 5.3.1 Equilibrium Exchange Rate for Internal and External Balance 143 5.3.2 Short-run RER versus Long-run Equilibrium RER 144 5.4 The Purchasing Power Parity Doctrine (PPPD) 145 5.4.1 Elements of the PPPD 146 5.4.2 Assessment of the PPPD 149 5.4.3 Empirical Findings on Misalignments of Nigeria's Exchange Rate Using PPPD 151 5.5 Significance of Real Exchange Rates 154 5.6 Factors Affecting RER Movements and Empirical Findings 155 5.7 Key Points and Conclusions 157 Chapter 6: Elements of the Balance of Payments 6.0 Introduction 161 6.1 Meaning of B alance of Payments 163 6.2 Sources of Balance of Payments Data 164 6.3 Changes in Balance of Payments Classification 166 6.4 Significance of the Accounting Balance of Payments 168 6.5 Balance of Payments Accounting 170 6.6 Balance of Payments Accounting and Notions of Balance 175 6.6.1 Current Account 178 6.6.2 Capital and Financial Account 182 6.6.3 Balance on Capital and Financial Account 186 6.7 The Balance of International Indebtedness 186 6.8 Key Points and Conclusions 191 Chapter 7: Measures of Balance of Payments Disequilibrium 7.0 Introduction 195 VII
7.1 MeasuringSurplusorDeficitundertheAccountingBalance 196 7.2 Autonomous and Accommodating Transactions 197 7.3 Overall B alance of Payments in the Context of Autonomous Transactions 198 7.4 Different Defmitions of Overall Balance 199 7.4.1 Basic Balance 199 7.4.2 The British Basic Balance 200 7.4.3 Net Liquidity Balance 200 7.4.4 Ofßcial Settlements Balance 202 7.5 Some Remarks on Overall Accounting Balance of Payments 204 7.6 Overall Balance of Payments and Reserves/DebtAccumulation 205 7.7 Current Account Financing and Relation to thebopidentity 206 7.8 Appraisal of the Accounting Balance 208 7.9 The Market B alance of Payments 209 7.10 The Programme Balance 211 7.11 Balance of Payments Concepts Used by Nigeria 212 7.12 Causal Factors in Balance of Payments Disequilibrium 213 7.13 Key Points and Conclusions 215 Chapter 8: Theories of the Balance of Payments: Elasticities and Income-Absorption Approaches 8.0 Introduction 219 8.1 Key Features of the Elasticities Approach 220 8.2 ADiagrammaticAnalysisof the Elasticities Approach 222 8.2.1 The J-Curve Effect ofdevaluation 223 8.2.2 Impact of Devaluation on Imports and Export Revenue 225 8.3 A Brief Evaluation of the Elasticities Approach 228 8.4 Basic Features ofthe Income-Absorption Approach 230 8.5 The Absorption Approach and Devaluation 232 8.6 Elasticities Approach versus Income-Absorption Approach 235 8.7 A Brief Evaluation ofthe Income-Absorption Approach 236 8.8 Key Points and Conclusions 236 viii
Chapter 9: Payments The Monetary Approach to the Balance of 9.0 Introduction 241 9.1 Development of the Monetary Approach 242 9.2 Features of the General Monetary Approach 243 9.2.1 Assumptions of the Monetary Approach to the Balance of Payments (MAB?) 243 9.2.2 Definition of Payments Imbalance 244 9.2.3 Central Thesis of the MABP 245 9.2.4 B alance of Payments Adjustment Process under Fixed Exchange Rates 245 9.3 Global Monetarism 247 9.4 The Monetary Approach under Flexible Exchange Rates 248 9.4.1 The Balance of Payments Adjustment Process under Flexible Exchange Rates 248 9.4.2 Determination of Flexible Exchange Rates 250 9.5 A Model of the MABP and Implications under Different Exchange Rate Regimes 251 9.5.1 The Model 252 9.5.2 The Model and MABP under Fixed Exchange Rates 256 9.5.3 The Model and MABP under Flexible Exchange Rates 256 9.5.4 The Model and MABP under ManagedFloat Exchange Rate System 257 9.6 Implications of the MABP 257 9.7 Issue of Sterilization 260 9.8 Empirical Aspects of the Monetary Approach 260 9.8.1 Approaches to the Tests 261 9.8.2 The IMF and the Monetary Approach 261 9.8.3 Review of Empirical Findings 262 9.9 Evaluation of the Monetary Approach 265 9.10 Key Points and Conclusions 267 ix
Chapter 10: Keynesian Theory of Balance of Payments Adjustment: The Income Adjustment Mechanism 10.0 Introduction 271 10.1 The Basic Keynesian Open-economy Model 272 10.2 National Income Multipliers 274 10.3 Balance of Payments Multipliers 276 10.4 Foreign Sector Di sturbances 278 10.5 Domestic Sector Disturbances 282 10.6 Income Adjustment with Foreign Repercussions 284 10.6.1 Foreign Repercussions 284 10.6.2 A Model of Income Adjustment with Foreign Repercussions 285 10.7 Disadvantages ofthe Income Adjustment Mechanism 288 10.8 Key Points and Conclusions 289 Chapter 11: Balance of Payments Adjustment and Policies 11.0 Introduction 291 11.1 Benefits and Costs of International Economic Policies 292 11.2 Financing of Payments Imbalance 294 11.3 Suppression of Imbalance by Quasi-adjustment Policies 295 11.4 Concept and Natureof Adjustment 299 11.4.1 Automatic Adjustment Mechanisms 299 11.4.2 Adjustment Policies 301 11.5 Typesof Adjustment Policies/Measures 302 11.5.1 Direct Reductions in Income and Expenditure 302 11.5.2 Monetary Policies 303 11.5.3 Fiscal Policies 306 11.5.4 Exchange Rate Changes 308 11.6 Key Points and Conclusions 314 11.7 Annex 11.1: Balance of Payments Adjustment under Flexible Exchange Rates 317 x
Chapter 12: Policies for Internal and External Balance 12.0 Introduction 323 12.1 Macroeconomic Policy Objecti ves and Instruments 324 12.2 Internal Balance with Expenditure-changing Policies and Implications 326 12.3 Monetary and Fiscal Policies for Internal and External Balance and the "Assignment Problem" 330 12.4 Internal and External Balance with Alternative Fiscal and Monetary Policy Instruments 332 12.5 External Balance with Expenditure-switching Policies 336 12.6 Internal and External Balance with Expenditure-changing and Switching Policies 337 12.7 Direct Controls 340 12.8 Key Points and Conclusions 345 Chapter 13: Linkage of the Balance of Payments to the Foreign Exchange Market and the Economy 13.0 Introduction 349 13.1 Linkage of the Foreign Exchange Market to the Balance of Payments 350 13.2 Equilibrium in the Foreign Exchange Market and the Balance of Payments 351 13.3 Implications of Shifts in Foreign Exchange Demand and Supply Curves 353 13.4 National Income Accounts and the Balance of Payments 355 13.5 Link between the Balance of Payments and the Public Finance Sector 359 13.6 Linkage ofthe Balance of Payments to the Monetary Sector 361 13.7 Key Points and Conclusions 362 xi
Chapter 14: Nigeria's Balance of Payments and Investment FIows 14.0 Introduction 367 14.1 The International Environment of Trade Transactions 368 14.2 Export Trade 371 14.2.1 Importance of Foreign Trade 371 14.2.2 Export Performance 372 14.3 Import Trends and Structure 379 14.4 Direction of Trade 384 14.5 Balance of Payments and External Reserves before SAP 385 14.6 Balance of Payments and External Reserves in the SAP and Post-SAP Period, 1986-2008 390 14.7 Balance of Payments Policies 395 14.8 Foreign Private Investment Flows 397 14.8.1 Portfolio Investment 398 14.8.2 Foreign Direct Investment 400 14.8.3 Direct Investment Income Remittances from Nigeria 407 14.9 Nigeria's Investment Climate 409 14.10 Sources of External Sector Problems: A Summaiy 410 14.11 Key Points and Conclusions 413 Chapter 15: The Nigerian Foreign Exchange Market Pre SAP: Structure and Developments 15.0 Introduction 417 15.1 Institutions and Participants in the Foreign Exchange Market 418 15.1.1 Deposit Money Banks andbureaux de Change 418 15.1.2 Central Bank of Nigeria 418 15.1.3 Public Sector Participants and Retail Customers 420 15.2 Segments of the Foreign Exchange Market 420 15.2.1 Official Foreign Exchange Market 420 xii
15.2.2 AFEM,IFEMandBureaux dechange 423 15.2.3 Informal Foreign Exchange Market 427 15.3 Objectives of Exchange Rate Policy before SAP 429 15.4 Exchange Rate Regime before SAP 430 15.5 Foreign Exchange Management before SAP 436 15.5.1 Modalities and Procedures 436 15.5.2 Policy Instruments 437 15.6 Key Points and Conclusions 439 Chapter 16: The Nigerian Foreign Exchange Market in the SAP and Post-SAP Era 16.0 Introduction 443 16.1 Exchange Rate Policy Objectives under SAP 444 16.2 Flexible Exchange Rate Regimes and Strategies under the SFEM Framework 445 16.2.1 The Dual Foreign Exchange Market and the Dual Exchange Rate System 445 16.2.2 Deregulated Exchange Rate System 448 16.2.3 GuidedDeregulated Exchange System 448 16.2.4 Interbank Foreign Exchange Market System 449 16.2.5 Dutch Auction System 449 16.3 Outcomes of the Foreign Exchange Market Management Strategies 452 16.3.1 Foreign Exchange Market Performance and Exchange Rate Instability 452 16.3.2 Macroeconomic Outcomes and Implications of Exchange Rate Instability 456 16.4 Factors in the Depreciation of the Naira 461 16.5 Foreign Exchange Flows,Demand and Supply 466 16.6 Foreign Exchange Management and the Real Sector 470 16.7 Foreign Exchange Management Strategies under SAP 472 xiii
16.8 Towards Having a Stable Exchange Rate 16.9 Key Points and Conclusions 476 479 Chapter 17: The Transfer Problem 17.0 Introduction 485 17.1 HistoricalSignificance ofthe Transfer Problem 486 17.2 Real and Financial Transfers and the Transfer Problem 487 17.2.1 Real versus Financial Transfer 487 17.2.2 Balance of Payments Entries of a Real and Financial Transfer 489 17.2.3 ADiagrammatic Illustration ofthe Transfer Problem 491 17.3 The Transfer Problem in the Context of Classical and Keynesian Theories 492 17.3.1 The Classical Transfer Theory 493 17.3.2 The Modern Keynesian Transfer Theory 495 17.4 Effects of a Transfer on the Terms of Trade 499 17.5 The Transfer Problem under Flexible Exchange Rates 502 17.6 The Transfer Problem under ConditionsofPriceFlexibility 503 17.7 Key Points and Conclusions 505 References 509 List of Tables 1.1 Effects of Making Domestic Payments 5 1.2 Effects of Making International Payments 16 4.1 Considerations in the Choice of Exchange Rate Regimes 117 5.1 Bilateral Real Exchange Rate Indices for Nigeria, 1970-1990 133 5.2 (a) Average Nominal Effective Exchange Rate Indices for Nigeria, 1970-2000 138 5.2 (b) Nominal Effective Exchange Rate Indices for Nigeria, 2001-2008 139 5.3 Real Effective Exchange Rate Indices for Nigeria 141 XIV