African Development Review, Vol. 28, No.

3, 2016, 247–263

Nigeria: Should the Government Float or Devalue the Naira?

Perekunah Eregha, Arcade Ndoricimpa, Solomon Olakojo, Mamello Nchake, Owen Nyang’oro
and Edith Togba

Abstract: The recent rapid fall in oil prices and its impacts on foreign exchange earnings and reserves in Nigeria has resulted
in a number of internal and external imbalances putting serious threat to the stability of the economy. This study therefore
examines whether devaluation or floating exchange rate regime is an option to consider given the recent challenges in the
nation’s policy space. A behavioural equilibrium exchange rate approach is used to determine the extent of exchange rate
misalignment complemented with a structural vector autoregressive (SVAR) model to examine the impact of currency
devaluation on trade balance, domestic output and inflation. The result reveals the existence of an overvalued currency
misalignment in recent times; while there is weak evidence to support that devaluation will improve the trade balance. Hence,
floating the currency will be an adequate policy option given the current reality. This is expected to boost investors’ confidence,
creates needed automatic adjustment mechanism and makes the tradable goods sector more competitive, resulting in more
favourable external balances. However, this requires a concerted effort at boosting the nation’s supply capacity through
implementation of structural reforms in both oil and the non-energy sector to diversify Nigeria’s production and export base.

1. Introduction
Nigeria is Africa’s largest economy, by the last rebasing exercise in 2014, with real GDP ahead of South Africa but real per capita
GDP is still below that of South Africa (NBS, 2014; UNDP, 2015). Statistics show growth rate averaging 6.3 per cent in 2014
from 5.3 per cent in 2013. Available evidence shows that Nigerian growth is driven by the non-oil sector with the service sector
taking the lead coupled with the contribution from the manufacturing and agricultural sectors (CBN, 2014). On the contrary, the
country still remains the top oil producer and exporter in Africa with approximately 2.2 million barrels of oil produced per day
and crude oil export accounting for 90 per cent of total export, 75 per cent of consolidated budgetary revenue but just 15 per cent
of GDP (MOF, 2015; World Bank, 2016). However, the contribution of the oil and gas sector has declined to approximately 11
per cent which points to an economy in the process of diversification (AfDB et al., 2015).
Over the years, budget preparation has been based on crude oil price per barrel exposing the country to budgetary
uncertainties. For instance, preparation and approval of the 2015 budget became a concern for the country due to the dwindling
price of crude oil.1 Oil prices have declined by more than half from over $100 a barrel in mid-2014 to below $50 at the beginning
of 2015 (AfDB et al., 2015). This has continued in 2016, putting the Nigerian economy into unexpected macroeconomic
imbalances and economic threats ranging from fiscal to external imbalances. About 95 per cent of foreign exchange revenue is
also based on oil revenue, resulting in a significant decline in gross foreign reserves following a fall in oil prices (World Bank,
2016). Increased pressure on foreign reserves due to a decline in foreign exchange earnings has made the exchange rate unstable.
Consequently, the Central Bank of Nigeria (CBN) has continued to defend the naira and has fixed the currency around 197–199

The authors are grateful to the African Economic Research Consortium AERC, the African Development Bank AfDB for the opportunity to be at the
Development Research Department EDRE of the AfDB as Visiting Research Fellows during which this study was carried out. Specifically, useful
comments, directions provided by Professor John Anyanwu, Dr Jacob Oduor of EDRE, AfDB are also acknowledged. The views expressed here are
those of the authors.



Perekunah Eregha, Department of Economics, University of Lagos, Nigeria. Arcade Ndoricimpa, Faculty of Economics and Management,
University of Burundi. Solomon Olakojo, Center for the Study of the Economies of Africa (CSEA), Abuja, Nigeria. Mamello Nchake, School of
Economics, University of Cape Town. Owen Nyang’oro, School of Economics, University of Nairobi. Edith Togba, Department of Economics and
Development, Alassane Ouattara University, Bouake.
© 2016 The Authors. African Development Review © 2016 African Development Bank. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA. 247
248 P. Eregha et al.

per dollar. The foreign reserves have declined by about $5 billion (CBN, 2016b) as demand for foreign exchange from importers
of both consumable and capital goods and payments of external debt obligations has outstripped supply.
The CBN has undertaken some aggressive measures following the recent oil price slump. These include foreign exchange
control that restricts certain items from assessing foreign exchange, fixed exchange rate system and initial suspension deposit of
foreign currencies in order to fight unfavourable movement in exchange rate (partly to protect the value of domestic currency),
check worsening terms-of-trade and minimize foreign reserve depletion (CBN, 2015a,b,c). However, the bank’s foreign
exchange policy stance has generated controversies over the effectiveness of such policies in delivering the desired outcomes.
For instance, as a response to adoption of the Treasury Single Account, the CBN reduced the monetary policy rate from 13 per
cent to 11 per cent and the Cash Reserve ratio from 25 per cent to 20 per cent. These monetary policy adjustments resulted in
inflation increasing from 8.2 per cent to 9.5 per cent due to increased money supply coupled with imported inflation arising from
unavailability of foreign exchange and the recent fuel shortage (CBN, 2015d). Recently, the CBN stopped supplying Bureau de
Change with foreign exchange as an attempt to bring stability to the naira. Importers were greatly affected — unavailability of
foreign exchange resulted in the growth of the parallel market as demand for foreign exchange increased, widening the gap
between the parallel market and official rate at 300 naira against 199 naira per dollar (CBN, 2016a).
The CBN has continued to take its stand not to devalue or allow the forces of demand and supply to determine the price of the
naira against the other currencies. This could have been a way to salvage the declining foreign reserves as its continued decline is
risking the country’s import cover and debt servicing. However, there is so much pressure on the CBN to consider the option of
floating or devaluation of the naira. For instance, recently J.P Morgan delisted the country’s bond from its site after a number of
warnings because of the currency restriction (CBN, 2015d), but the CBN has stood its ground and the situation does not seem to
be better. The question is, should the country float or devalue the currency?
It is against this backdrop that this study empirically provides answers to whether the naira should be floated or devalued. The
study is divided into five sections. Section 2 focuses on the empirical review while Section 3 presents the methodology and data.
Sections 4 and 5 present the discussions of the results and concluding remarks respectively.

2. Empirical Literature
Studies on the impact of currency devaluation or deprecation can be classified into two main groups; studies that analyse the
impact of devaluation on domestic output (or output growth) and those that analyse the impact of devaluation on the trade
balance. The first group of studies investigates whether currency devaluations are expansionary or contractionary, while the
second group tries to examine whether currency devaluation improves or worsens the trade balance.
Among the first group of studies, some find that currency devaluation (depreciation) is contractionary (see, for instance,
Bahmani-Oskooee and Miteza, 2006; Muhammad et al., 2011; Upadhyaya et al., 2013; Bahmani-Oskooee and Gelan, 2013). For
instance, Bahmani-Oskooee and Miteza (2006) analysed the impact of devaluation on real output for 18 OECD countries and 24
non-OECD countries using panel data. They estimated a model in which real GDP is a function of nominal effective exchange
rate, money stock and government demand for non-tradables. Their findings indicated that in the long run devaluation is
contractionary for non-OECD countries for all the specifications considered; however, for OECD countries, the impact of
depreciation on real GDP is sensitive to model specification. Melander (2009) analysed the effects of real exchange rate
depreciation for the Bolivian economy using a vector autoregressive (VAR) technique and found that a real depreciation has
negligible effects on output. The justification given is that a contractionary balance-sheet effect on investment is counteracted by
the standard expansionary effect on net exports. In addition, the study found that a real depreciation has inflationary effects.
Muhammad et al. (2011) investigated the effect of real devaluation on economic growth in Pakistan using an autoregressive
distributed lag (ARDL) approach and found that real devaluation is contractionary. Upadhyaya et al., (2013) analysed the effect
of devaluation on aggregate output in South-East Asian countries using a panel data model including monetary, fiscal and
exchange rate variables. Results showed that currency devaluations are contractionary in the short run. Bahmani-Oskooee and
Gelan (2013) investigated the impact of devaluation on domestic production using panel data on 22 African countries and found
that in general devaluations are contractionary in Africa. Ayen (2014) assessed the impact of currency devaluation on economic
growth in Ethiopia using a vector error correction model. The findings suggested that currency devaluations are contractionary in
the long run but neutral in the short run. Cantavella-Jord
a and Guti
errez de Pi~neres (2012) examined how devaluation affects
different export sectors and found that devaluation had contractionary effects on real exports in 80 per cent of specific export
sectors.
© 2016 The Authors. African Development Review © 2016 African Development Bank
Should the Government Float or Devalue the Naira? 249

Contrariwise, other studies reported that currency devaluation is expansionary (see for example, Narayan and Narayan, 2007;
Bahmani-Oskooee and Kandil, 2007; Kim and Ying, 2007). For example, Narayan and Narayan (2007) examined the
relationship between currency devaluation and output in Fiji using a model that incorporates monetary and fiscal policy variables
using an ARDL approach. Their findings suggested that devaluation is expansionary. Bahmani-Oskooee and Kandil (2007)
analysed the effect of exchange rate fluctuations on real output in Iran by controlling for monetary and fiscal policy variables.
Contrary to previous studies, using an ARDL model they found that currency depreciation is expansionary. According to the
authors, the expansionary effect of devaluation is due to the emergence of the non-oil export sector. Kim and Ying (2007)
examined the impact of devaluation in seven East Asian countries. Although the results are somewhat sensitive to the definition
of the exchange rate and the period of estimation, apart from Chile and Mexico, currency devaluation is found to be strongly
expansionary.
However, some other studies found devaluation to be contractionary in the short run but expansionary in the long run (see, for
instance, Yiheyis, 2006; Rhodd, 1993; Obonye and Tshimologo, 2011; Datta, 2012). For instance, Yiheyis (2006) examined the
effect of devaluation on aggregate output in 20 African countries using panel data by controlling for the parallel currency
premium, the rate of net capital inflow, the degree of capacity utilization and political instability. The findings indicated that
devaluation is contractionary in the short run but the contractionary effect of devaluation is found to be temporary. Rhodd (1993)
examined the effect of real exchange rate changes on output in Jamaica using a three-market Keynesian model. The results
showed that devaluation is contractionary in the short run and expansionary in the long run.
Obonye and Tshimologo (2011) studied the impact of currency devaluation on output in a small import-dependent economy,
Botswana, using an error correction model. The findings suggested that currency devaluations are expansionary in the short run
but contractionary in the long run. According to the authors, the contractionary effects of devaluation in Botswana are not
surprising for two reasons. First, devaluations are likely to be inflationary in Botswana since most of the goods and services
traded are imported. Second, in Botswana, most of the intermediate inputs are imported, the cost of imported intermediate inputs
increases due to devaluation, causing a decline in aggregate supply. Datta (2012) investigated the effects of currency
depreciation on the growth of output for Pakistan. The findings of the study indicated that currency depreciation has an
expansionary effect on output growth in the short run but contractionary in the long run.
As mentioned earlier, the second group of studies examine whether currency devaluations improve or worsen the trade
balance. Some studies used aggregate data to examine the impact of currency devaluation on the trade balance (see for instance
Yol and Baharumshah, 2007, Ogundipe et al., 2013; Iyoboyi and Muftau, 2014; Niyitegeka and Tewari, 2014; Edoun et al.,
2015) while others use disaggregate data (see Bahmani-Oskooee and Cheema, 2009; Bahmani-Oskooee et al., 2008; Halicioglu,
2008). Among studies that used aggregate data, Yol and Baharumshah (2007) analysed the effect of exchange rate changes on the
bilateral trade balance of 10 African countries. Based on fully modified ordinary least squares estimation, results indicated that
currency depreciation improves trade balance in Botswana, Egypt, Kenya, Nigeria, Tunisia and Uganda, while it worsens trade
balance in Tanzania. For Ghana, Morocco and Senegal, no effect was found.
Niyitegeka and Tewari (2014) investigated whether the devaluation of the rand can improve South African competitiveness
by examining the relationship between the trade balance, domestic income, foreign income and the bilateral real exchange rate
using an autoregressive distributed lag (ARDL) approach. Their findings showed that depreciation of the rand worsens South
African trade balance more than it improves it. Their explanation being that the South Africa economy is characterized by a high
degree of import intensity that places limits on any export-oriented strategy. Edoun et al. (2015) examined the impact of
devaluation on trade balance in Zimbabwe using a vector error correction model and found that devaluation is effective in
improving trade balance in the long run.
Among studies that used disaggregate data, Halicioglu (2008) examined the impact of devaluation on trade balance for Turkey
with her 13 trading partners and found that in the long run, real depreciation improves Turkey’s trade balance with Switzerland,
UK and USA. Bahmani-Oskooee et al. (2008) analysed the impact of currency devaluation on the trade balance of Canada with
her 20 major trading partners using an ARDL approach. The findings indicated that in the long run, devaluation improves
Canada’s trade balance with 10 of her trading partners, namely Australia, Germany, India, Netherlands, South Korea, Spain,
Singapore, Sweden, Switzerland and the USA. Bahmani-Oskooee and Cheema (2009) also examined the effects of currency
depreciation on the bilateral trade balance between Pakistan and her major trading partners. They estimated a model in which the
dependent variable is the trade balance between Pakistan and each trading partner, defined as the ratio of Pakistan’s nominal
imports from the trading partner to her nominal exports to the same trading partner. The explanatory variables include domestic
income, foreign income and bilateral real exchange rate. Using an ARDL model, their findings showed that for six training
partners, currency depreciation improves the trade balance in the long run, however short-run dynamics do not show evidence for
© 2016 The Authors. African Development Review © 2016 African Development Bank
250 P. Eregha et al.

the J-curve phenomenon. Similarly, Bahmani-Oskooee and Harvey (2009) investigated the short-run as well as the long-run
effects of the real bilateral exchange rate on the bilateral trade balance between Indonesia and each of her 13 trading partners. The
results based on an ARDL model showed that in the short run, depreciation of the Indonesian rupiah affects trade with nine
trading partners but J-curve hypothesis is supported only for five of the trading partners. In the long run, results showed that
currency depreciation improves Indonesia’s trade balance with Canada, Japan, Malaysia, Singapore and the UK.
With regard to Nigeria, which is the present case of analysis, a number of studies recently undertaken on the impact of
currency devaluation (depreciation) seem to find mixed results (see, for instance, Ogundipe et al., 2013; Iyoboyi and Muftau,
2014; Igue and Ogunleye, 2014; Aliyu and Tijjani, 2015; Akinlo and Lawal, 2015). Ogundipe et al. (2013), for example,
investigated the effect of Naira devaluation on Nigerian trade balance and found that devaluation deteriorates trade balance in the
long run while in the short run devaluation does not affect trade balance. On the contrary, Igue and Ogunleye (2014) analyse the
effect of exchange rate depreciation on trade balance in Nigeria using a vector error correction modelling approach. Their
findings showed that currency depreciation in Nigeria improves trade balance in the long run since the Marshall–Lerner
condition was satisfied. The study indicates that 1 per cent depreciation in the exchange rate would lead to an improvement in
trade balance by 1.16 percent. However, Iyoboyi and Muftau (2014), and Aliyu and Tijjani (2015) seem to suggest that currency
devaluation (depreciation) is neutral.
Using a multivariate vector error correction framework, Iyoboyi and Muftau (2014) found that changes in Nigeria’s balance of
payment are not due to changes in exchange rate movements. Similarly, Aliyu and Tijjani (2015), using an asymmetric error
correction modelling technique, examined the pass through of the official exchange rates into trade balance in Nigeria. The
findings showed that currency devaluation does not improve trade balance. Akinlo and Lawal (2015) examined the impact of
exchange rate on industrial production in Nigeria using a vector error correction model and found that the depreciation of the
Naira does not affect industrial production in the short run but has a positive impact in the long run. This shows that the evidence
on the impact of currency devaluation is mixed in Nigeria which leads to contradicting policy recommendations. For instance,
Igue and Ogunleye (2014) recommended a gradual depreciation of the exchange rate, while Aliyu and Tijjani (2015)
recommended diversification of the economy away from dependence on crude oil exports into productive manufacturing and
non-oil exports.
In general, the empirical literature provides mixed evidence on the impact of devaluation or depreciation on an economy;
devaluation can be expansionary, contractionary or neutral. Theoretically, the impact of currency devaluation can be positive or
negative depending on whether devaluation stimulates the aggregate demand or whether it raises the cost of imported inputs.
However, the question of whether devaluations are expansionary or contractionary remains empirical.

3. Data and Methodology

To empirically examine whether the Nigerian naira should be floated or devalued, the study sets out to undertake two sets of
closely related modelling sections. The first section presents an empirical model for establishing the extent of misalignment with
regards to the currency. The second section presents an empirical model to examine the effect of devaluation on the economy if
the need for devaluation arises. This is because in case the currency is misaligned, there is need to establish whether it is
overvalued or undervalued before any conclusion can be made on whether to float or devalue and establish the effect of such a
conclusion.

3.1 Analysing Naira Misalignment

Providing an answer to the question of ‘whether to float or to devalue the naira’ cannot be arrived at without establishing whether
and to what extent the current real exchange rate (RER) deviates from the equilibrium exchange rate of the economy, that is, the
level of exchange rate misalignment, since the effectiveness of the devaluation tool depends on it. Nouira and Sekkat (2015)
opined that to assess the extent of currency misalignment it is necessary to compare the observed exchange rate, in this case the
real effective exchange rate (REER), with its equilibrium value (EREER), which is the value it should have been under the
hypothesis that the macroeconomic equilibrium is maintained. However, the equilibrium exchange rate is not directly observable
and the literature provides three ways, namely the purchasing power parity equilibrium exchange rate approach, the fundamental
equilibrium exchange rate approach and the behavioural equilibrium exchange rate approach (see Nouira and Sekkat, 2015).
This study employed the behavioural equilibrium exchange rate approach to determine the equilibrium real effective exchange
© 2016 The Authors. African Development Review © 2016 African Development Bank
Should the Government Float or Devalue the Naira? 251

rate. The present study follows the procedure of Edwards (1988), which is to estimate the real effective exchange rate2 equation
with its fundamental determinants. These include among others,3 terms of trade (tot), net capital inflows (fdi), foreign reserves
(res), government spending (gspend), debt service (ds), budget deficits (bd) and technological progress or productivity (prod).
Misalignment is then measured as the difference between the REER and the EREER. Following Nouira and Sekkat (2015),
technological progress (productivity) is proxied by the ratio between the country’s real per capita GDP and the geometric mean
of the same variable in ten trading partners.
The empirical model is given by Equation (1):

lnðreert Þ ¼ c þ b1 bd t þ b2 lnðdst Þ þ b3 lnðf dit Þ þ b4 lnðgspend t Þ þ b5 lnðprod t Þ þ b6 lnðrest Þ þ et ð1Þ

where all variables are expressed in logarithm except the ratio of budget deficits (bd). As Nouira and Sekkat (2015) point out, the
signs of the coefficients depend on a number of factors such as the nature and use of the capital flows and whether government
consumption is biased toward tradable or non-tradable goods. However, it can be expected that an increase in productivity,
capital inflows and foreign reserves will lead to currency appreciation; increased debt service and budget deficits will lead to
currency depreciation; while the effect of terms of trade and government spending is ambiguous.

3.2 Modelling the Effect of Devaluation

The major difference between devalued and floating exchange rate regimes is that while the former is a deliberate effort at
reducing the value of a currency against another currency to achieve specific objectives, the latter is market driven. Hence, a
floating exchange rate regime has a bidirectional effect; it leads to either appreciation or depreciation of a currency depending on
the market forces of demand and supply. A floating exchange rate regime reduces market distortions and acts as an automatic
stabilizer. In the event of either a negative demand or supply side shock affecting an economy, the exchange rate falls as currency
traders sell the currency, leading to a fall in export prices in terms of foreign currency and an automatic increase in
competitiveness. Meanwhile, devaluation has a unidirectional effect, misses the potential benefits of currency appreciation and
does not necessarily reduce market distortions, especially in the case of controlled devaluation.
To analyse the impact of exchange rate devaluation in the Nigerian economy, the study first employed the elasticity approach
to ascertain the Marshall–Lerner condition before proceeding to examine the devaluation effect. To do this, the study followed
Yol and Baharumshah’s (2007) specification, which used the trade balance–real exchange rate link approach.4 However, this
trade balance–real exchange rate link equation is estimated with modification to account for trade liberalization and oil price
shocks periods.
We improved on the previous specification on Nigeria by including two dummy variables, DUM1 and DUM2 to capture the
effect of trade liberalization and oil prices shocks. DUM1 takes the value of 1 from 1986 onwards and 0 before 1986. DUM2 takes
the value of 1 for the periods of oil shocks: 1973–1974, 1985–1986, 1997–1998, 2000–2001, and 2008–2009 and 0 otherwise.
In Yol and Baharumshah’s (2007) specification, trade balance (TB) is specified as a function of real exchange rate (RER),
domestic real income (GDP) and foreign real income (GDPf) thus:

LNTBt ¼ b0 þ b1 LNRERt þ b2 LNGDPt þ b3 LNGDPf t þ et ð2Þ

where e is the error term, and all the variables are in logarithm. Devaluation improves trade balance if the coefficient of the real
exchange rate is positive (b1 > 0) and worsens trade balance if it is negative (b1 < 0). Also, the Marshall–Lerner condition holds
if the coefficient of the real exchange rate is (b1 > 1), otherwise it fails to hold, indicating that devaluation will not improve the
balance of payment. However, as Yol and Baharumshah (2007) point out, ‘since asymptotic distribution of the ordinary least
squares (OLS) estimator is based on the unit-root distribution, which is non-standard, any inferences drawn on b using the usual
t-tests in the OLS regression of the above model will be invalid’. Phillips and Hansen (1990) therefore suggested the use of the
fully modified ordinary least squares (FMOLS) technique to remedy that problem. It is an estimation technique used in case of a
system of cointegrated variables. It uses a semi-parametric correction to eliminate the long-run correlation between the
cointegrating equation and the error terms which creates an endogeneity problem. This estimator corrects the standard pooled
OLS for serial correlation and endogeneity of regressors that are normally present in a long-run relationship. According to Yol
and Baharumshah (2007), FMOLS estimation is done in two stages. In the first stage yt is corrected for any potential long-run
© 2016 The Authors. African Development Review © 2016 African Development Bank
252 P. Eregha et al.

interdependence of mt and nt, and in the second stage, FMOLS estimator of b is computed. Therefore, the FMOLS method is
applied to the above equation.
To complement the above specification also as a way of robustness check and to further examine the impact of currency
devaluation on other macroeconomic indicators through a channel of transmission based on the theoretical consideration
discussed above, the study uses the multivariate approach5 that analyses the effect from both supply (output) and demand (trade
balance) sides. Following the specifications by Akinlo and Odusola (2003), Yol and Baharamshah (2007), Bahmani-Oskooee
and Miteza (2006) and recently by Igue and Ogunleye (2014), the model used in this study is presented hereafter with some
modifications to account for trade liberalization and oil price shocks periods.
Consequently, the structural VAR (SVAR) specification is used. This will allow the study to analyse the effect of devaluation
(based on theory by imposition restrictions) on a number of macroeconomic variables such as the trade balance, domestic output
and inflation. One problem in which the VAR framework has received criticism is because it is atheoric, hence the SVAR is an
extension which provides theoretical justification for the use of the VAR framework and this is done by imposing restrictions on
the VAR framework.
Following Blanchard and Watson (1986) and recently Cheng’s (2006) exposition, the study presents the set-up of the SVAR
model which is an extension of the VAR framework to impose restrictions based on economic theory. The VAR model used in
this study assumes that the economy can be described with the following structural form equation:

GðLÞZ t ¼ CðLÞX t þ et ð3Þ

where, G(L) is an n  n matrix polynomial in the lag operator; C(L) is a n  k matrix polynomial in the lag operator; Zt is a n  1
vector of endogenous macroeconomic variables; Xt is a k  1 vector of exogenous variables which in this case are dummies
capturing periods of trade liberalization and oil price falls respectively; et is a n  1 vector of structural disturbances with var
(et) ¼ ^, where ^ is a diagonal matrix.
Corresponding with this structural model is a reduced-form VAR:

Z t ¼ AðLÞZ t þ BðLÞX t þ mt ð4Þ

where A(L) and B(L) are matrices polynomial; mt is a vector of reduced-form disturbances, with var (mt)¼S.
Let M be the contemporaneous coefficient matrix in the structural form, and let H(L) be the coefficient matrix in G(L) without
the contemporaneous coefficient. That is,

GðLÞ ¼ M þ HðLÞ ð5Þ

Therefore, the structural and reduced-form equations can be related thus:

AðLÞ ¼ M 1 HðLÞ and BðLÞ ¼ M 1 CðLÞ ð6Þ

Invariably, the error terms are related thus:

X 0
mt ¼ M 1 et which implies ¼ M 1 ^ M 1 ð7Þ

Estimates of M and ^ that are consistent are inferred by the estimates of S, which are obtained with the Maximum Likelihood
Estimation technique. The right-hand side has n  ðn þ 1Þ=2 free parameters to be estimated and the left-hand side has
n  ðn þ 1Þ=2 parameters. Consequently, there is a need for n  ðn þ 1Þ=2 restrictions to achieve identification. Normalizing
the diagonal elements of M to be unity results in n  ðn þ 1Þ=2 additional restrictions, that is based on economic theory. The
exogenous vector Xt 2 [DUM1 DUM2] are dummies that capture periods of trade liberalization and oil price falls respectively.
The endogenous variables are trade balance (TB), real exchange rate (RER), real foreign income (RGDPf) which is proxied by the
US real GDP, real domestic income (RGDP) and CPI inflation rate (INF) thus:

Z 0t ¼ ½RGDPf t RERt INF t RGDPt TBt  ð8Þ

© 2016 The Authors. African Development Review © 2016 African Development Bank
Should the Government Float or Devalue the Naira? 253

The study employed the standard identification approach which imposes a recursive structure of the VAR, with the
ordering of the variables given in Equation (9). The implication of the ordering in Equation (9) is that real exchange rate
(RER) is assumed to have no immediate effect on real foreign income (RGDPf), CPI inflation rate (INF) is assumed not to
have immediate effect on real exchange rate (RER), real domestic income (RGDP) is assumed not to have immediate effect
on inflation rate (INF), and trade balance (TB) is also assumed not to have immediate effect on real domestic income
(RGDP). Consequently, this leads to estimating the reduced form, then computing the Cholesky factorization of the reduced
form VAR covariance matrix. Thus, the link between the reduced-form errors and the structural disturbance is given below
with the imposed restrictions:
2 3 2 3 2 3
ergdpf
t 1 0 0 0 0 mrgdpf
t
6 7 6 7 6 7
6 erer 7 6f 7 6 mrer 7
6 t 7 6 21 1 0 0 0 7 6 t 7
6 7 6 7 6 7
6 inf 7 6 7 6 inf 7
6 et 7 ¼ 6 f f 32 1 0 0 7 6 mt 7 ð9Þ
6 7 6 31 7 6 7
6 7 6 7 6 7
6 ergdp 7 6 f 41 f 42 f 43 1 0 7 6 mrgdp 7
6 t 7 6 7 6 t 7
4 5 4 5 4 5
eTB
t
f 51 f 52 f 53 f 54 1 mTB
t

The first equation suggests that real foreign income does not respond to any other variable, the second equation shows that real
exchange rate responds to real foreign income, the third equation implies that inflation rate responds to real exchange rate and
real foreign income, the fourth indicates that real domestic output responds to real foreign income, real exchange rate and
inflation and finally, the last equation shows that trade balance responds to all the other variables.
The standard optimal lag length tests of Akaike Information Criterion, Schwarz Information Criterion, Hannan–Quinn
Information Criterion and the Final Predictor Error are used to determine the lag of the VAR.

3.3 Data Requirements and Sources

The study uses annual data covering 1970–2014 and the FMOLS estimation for the misalignment and Marshal–Lerner condition
equations. However, the estimation for the misalignment equation is based on data from 1980–2014 as some of the variables in
that equation only had data from 1980. For the SVAR estimation, quarterly series from 1985–2014 is used. The data was
obtained from the International Monetary Fund’s International Financial Statistics (IFS), the World Bank and the CBN
Statistical Bulletin.

4. Empirical Results

4.1 Unit Root and Cointegration Tests Results

Unit root test results in Table 1 show that all the annual series are non-stationary processes integrated of order one, denoted I(1).
For the quarterly series, RGDPf which is foreign income variable is not stationary at level except at first difference while others
are stationary at levels. Though, they all became stationary with the condition of a drift and trend. This invariably implies that
RGDPf is an I(1) variable while others are I(0) variables in the quarterly series.
Cointegration is then tested to see whether there exists a long-run relationship between the annual series using the Johansen
and Juselius (1990) test. The cointegration test result in Table 2 suggests the presence of a long-run relationship with one
cointegrating equation for the Marshall-Lerner equation and three cointegrating equations for the misalignment equation. When
variables are cointegrated, Phillips and Hansen (1990) recommend therefore applying the FMOLS estimation approach to avoid
spurious regression. However, for the quarterly series, since only RGDPf is an I(1) there is not much concern for the time series
property of the variables and further need for cointegration test. Cheng (2006) opined that by estimating the VAR in levels,
implicit cointegration relationships are allowed in the data already.

© 2016 The Authors. African Development Review © 2016 African Development Bank
254 P. Eregha et al.

Table 1: Unit root test resultsa

Annual series
(Marshall–Lerner) Quarterly series (SVAR) Annual series (Misalignment equation)
Variables Level 1st diff. Level 1st diff. Variables Level 1st diff.

TB 0.378 0.000 5.12


– BD 0.176 0.000

RGDP 0.998 0.000 2.73

– REER 0.327 0.001
RGDPf 0.430 0.000 0.67 11.67


DS 0.933 0.000
RER 0.337 0.000 FDI 0.071 0.000
INF – – 3.72

– GSPEND 0.161 0.000
NER – – 0.40 9.80


PROD 0.109 0.001
RES 0.146 0.000
Notes:
a
What is reported are the probabilities for the annual Marshall–Lerner and misalignment equations.




and

indicate 1% and 5 % significance levels respectively. For the annual series, the Mackinnon one sided p-values reported.
Source: Authors’ estimations from EViews.

4.2 Misalignment and Marshal–Lerner Condition Results

Based on the confirmation of cointegration among the annual series, the results of the FMOLS specifications are presented in
Table 3. Results for the REER model shows that apart from the coefficients of the ratio of government spending and productivity,
the rest of the coefficients are significant and are correctly signed. Hence, Figure 1 presents the actual (REER) and equilibrium
real effective exchange rate (EREER) while Figure 2 highlights the naira misalignment from the estimated model.
These figures seem to indicate that the naira was overvalued during the periods 1988–1993, 1999–2000, 2006, 2009–2010 and
2012–2014, while it was undervalued for the rest of the periods. This implies that there is need to devalue the currency as the
current exchange rate will make the tradable goods sector uncompetitive, resulting in more external balances. Consequently, the
study proceeds to present the results on the effect of devaluation.
Estimation results of the trade balance equation indicate that the coefficient of the real exchange rate is negative but only
statistically significant at the 10 per cent level when dummy variables are not included in the equation. This suggests that
devaluation would not have significant improvement on trade balance in Nigeria.
However, when the dummies are included in the estimation, the coefficient becomes insignificant. From the two results, it is
evident that the Marshall–Lerner condition is not satisfied. Estimation results indicate further that the coefficients of real
domestic income and real foreign income are positive and statistically significant for both estimations considered. This suggests
that an increase in both domestic and foreign income improves the trade balance in Nigeria. To support this result and analyse the
effect beyond trade balance, presented below are the SVAR results.

Table 2: Johansen cointegration test among the annual series

Model without dummy Model with dummy REER
variables variables model
H0 Trace statistic Prob. Trace statistic Prob. Trace statistics Prob

r¼0 56.72


0.006 68.22


0.000 187.0


0.000

r1 24.73 0.171 29.13
0.059 121.8


0.000
r2 7.87 0.478 3.47 0.941 77.4


0.010
r3 3.31
0.068 1.45 0.228 40.7 0.19
Notes:
and


denote significance at 10% and 1% level respectively.
Source: Authors’ estimation.

© 2016 The Authors. African Development Review © 2016 African Development Bank
Should the Government Float or Devalue the Naira? 255

Table 3: FMOLS estimation results without and with dummy variables

Marshall-Lerner REER
condition model model
(1) (2) (3)

Intercept 28.5


27.3


4.13

(0.000) (0.006) (0.02)
BD 0.03

(0.06)
LNRER 0.31 0.36
(0.85) (0.105)
LNDS 0.28



(0.00)
LNGDP 1.23


1.23



(0.001) (0.007)
LNFDI 0.45


(0.04)
LNGDPf 1.59


1.59

(0.001) (0.075)
LNGSPEND 0.84
(0.15)
DUM1 0.09
(0.854)
LNPROD 1.40
(0.10)
DUM2 0.09
(0.883)
LNRES 0.60

(0.03)
Notes:
and


denote significance at the 10% and 1% level respectively. p-values are in parentheses. (1) ¼ model without dummy variable; (2) ¼ model with
dummy variable; (3) ¼ REER equation result.

4.3 Estimation Results for Structural VAR Model

Since the SVAR modelling approach is an extension of the VAR approach which requires the need to determine the optimal lag
length, the standard information criteria for lag selection which are the AIC, SC and the HQ are first presented in Table 4. From
the results, the optimal lag length of three is selected for the analysis as supported by most of the criterion.

Figure 1: Actual (REER) and equilibrium (EREER) real effective exchange rates
7
6
5 REER
4
EREER
3
2
1
0
1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

Source: Authors’ estimation.

© 2016 The Authors. African Development Review © 2016 African Development Bank
256 P. Eregha et al.

Figure 2: Naira misalignment

1

0.5

0
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
-0.5

-1

-1.5

Source: Authors’ estimation.

However, the establishment of the identification of the SVAR is necessary to its estimation and the recursive approach is
used by applying identification restrictions that are consistent with economic theory and are based on the expected
interactions among the variables as deduced from the theory and the reality at hand. This study uses the SVAR studies of
Akinlo and Odusola (2003) and Cheng (2006) of advanced small open economies as a guide in obtaining the appropriate
restrictions to be imposed on the contemporaneous and the lag structure of the SVAR model to analyse the impact of
exchange rate devaluation on Nigeria’s macroeconomic performance. The study examines the effect on trade balance, output
and inflation as indicators to capture the macroeconomic performance based on the restrictions imposed. Table 5 presents the
restrictions imposed as shown in Equation 9.
Without imposing a number of restrictions, the SVAR cannot be identified. Therefore, to identify the underlying structural
model, restrictions are made based on economic theory and the expected interactions. From Table 5, foreign real income is
restricted not to be affected by any variable in the model, while exchange rate is restricted to be affected by foreign real income.
Inflation in this structure is restricted to be explained by both foreign real income and exchange rate, while domestic income
which is a measure of output is restricted to be explained by foreign income, exchange rate and inflation. Finally, the last
restriction imposed is on the trade balance which is restricted to be affected by all the other variables in the structure. However,
the interest of this study is mainly on what happens to inflation, output and trade balance as exchange rate increases. Table 6
presents the SVAR estimates based on these restrictions.
The SVAR model based on the restriction is estimated without the dummy variables as the baseline model and with the
dummy variables for the purpose of robustness check. The two results are presented in Table 6. The contemporaneous
relationships modelled in Equation (9) are estimated. One common feature of the SVAR models is that most of the coefficients
always appear not to be precisely estimated as confirmed by previous studies including Bernanke (1986), Kiguel et al. (1997) and
Akinlo and Odusola (2003). This is attributed to the technique of constructing the standard errors, which is basically the problem
with VAR methodology as a whole.
However, the estimation generates some interesting results in confirming the FMOLS estimation. For instance, within a
quarter, foreign income innovations are inversely related with inflation innovations though not significant but are positively

Table 4: Optimal lag length criteria

Lag logL LR FPE AIC SC HQ

0 4089.8 Na 2.05eþ24 70.16 70.5 70.3

1 3492.3 1113.4 1.15eþ20 60.38 61.3
60.7
2 3442.4 88.6 7.55eþ19 59.95 61.49 60.6

3 3412.6 50.4
7.02eþ19
59.87
61.9 60.7
Note:
indicates lag length selected.
Source: Authors’ estimation in Eviews.

© 2016 The Authors. African Development Review © 2016 African Development Bank
Should the Government Float or Devalue the Naira? 257

Table 5: Contemporaneous restrictions

RGDPF RER INF RGDP TB

RGDPF 1 0 0 0 0
RER C(2) 1 0 0 0
INF C(4) C(5) 1 0 0
RGDP C(7) C(8) C(9) 1 0
TB C(11) C(12) C(13) C(14) 1
Source: Authors’ imposed restrictions.

related with domestic output and trade balance innovations. This is expected as export depends so much on foreign output which
invariably spurs domestic production and thereby improves the trade balance. However, exchange rate innovations were found
to impact on inflation innovations positively, indicating that devaluation will spur inflation. This is not surprising as Nigeria is an
import dependent economy. This might have an effect on domestic production through input prices, wage indexation and interest
rate channels. As an import dependent economy for both consumables and capital goods, this will increase input prices, making
cost of production increase and invariably discourage output.
Alternatively, capital will become costly as real money balance declines. If devaluation increases demand for money, the
interest rate will increase making working capital unbearable and thus discouraging production. This channel is confirmed in the
result through the negative effect of inflation on both output and trade balance. The results show that within a quarter inflation

Table 6: Structural VAR estimatesa

(1) (2)
Parameters Coefficients z-statistics Coefficients z-statistics

C(1) 0.18


15.30 0.18


15.29

C(2) 0.63


13.80 0.62


13.30
C(3) 0.09


15.29 0.09


15.30
C(4) 0.65 1.19 5.74 1.03
C(5) 7.56 1.12 6.53 0.94
C(6) 6.92


15.30 6.96


15.29
C(7) 0.05 0.73 0.06 0.89
C(8) 0.04 0.62 0.07 0.92
C(9) 0.001 0.51 0.001 0.57
C(10) 0.08


15.30 0.07 15.29
C(11) 3.93 0.02 2.58 0.01
C(12) 10.80 0.04 40.50 0.13
C(13) 1.09 0.27 1.08 0.26
C(14) 74.90 0.21 92.02 0.26
C(15) 304.20


15.29 306.90


15.30

Serial Correlation LM Test 22.83 (0.58) 22.27 (0.62)

LR 952.7 951.6
Notes:
a
The SVAR model is estimated with the maximum likelihood approach given the longer sample period and high frequency data. And because the variables
became stationary either in level or first difference for only one variable with a drift and trend, the model is estimated with the inclusion of trend. All variables
except inflation and trade balance are logged.
(1) represents SVAR estimates without dummies; (2) represents SVAR estimates with dummies. p-values are in parentheses.
Source: Authors’ estimates from SVAR in Eviews.

© 2016 The Authors. African Development Review © 2016 African Development Bank
258 P. Eregha et al.

innovation is inversely related with both output and trade balance innovations. Though exchange rate innovations in the
estimation is found to be positively related with domestic output and trade balance innovations, this is not significant providing
support for the FMOLS result. This further supports the inflation channel that was found to have a negative impact on trade
balance and output. To crown it all, devaluation will have a positive impact on output and trade balance, though not significantly,
but its positive effect on inflation which passes through the inflation channel has a negative impact on output and trade balance.
This is even the case with the model with dummies as the estimates are the same, pointing to the robustness of the result. The only
variance in these two results is that when trade liberalization and oil price shocks are controlled for, foreign income innovation
impacts negatively on trade balance. The SVAR serial correlation test is conducted and as shown in the table 6, the values are
insignificant at lag 3, indicating that the null hypothesis of no serial correlation cannot be rejected. The values of the log
likelihood ratio as shown in the table also provide support for the validity of the restrictions imposed.

4.4 Impulse Response Analysis for Selected Indicators

A selection of key impulse response functions6 of the variables which centre on the shocks (one standard deviation) is discussed
here. The estimated structural shocks are assumed to have unit root variances in the structural VAR, hence their sizes and
adjustment speed can be inferred by analysing the impulse response functions. Here, the sizes of the shocks are measured by the
standard deviations of the corresponding orthogonal errors obtained from the SVAR model. The impulse response function is,
however, used to examine the dynamic responses of the variables to various shocks within the SVAR system. The impulse
response is based on a 95 per cent confidence interval and all the impulse responses fall within this band, though only the impulse
responses are reported. This implies that all the reported impulse responses are significant, suggesting that there are significant
effects on the response variables.
Figure A1 (see appendix) depicts the response of inflation to a positive shock from exchange rate, that is, one standard
deviation in exchange rate has a positive and significant effect on inflation throughout the period. Inflation fell a bit in the first
three periods but increased significantly after the third period and reduced again after the sixth period. However, it was positive
all through. Figure A2 depicts the response of output to shocks in inflation. The figure shows that a positive one standard
deviation from inflation affects output negatively and this confirms the results from SVAR estimates. This effect is negative all
throughout the period. Similarly, Figure A3 shows the response of trade balance to one standard deviation from inflation and it
shows that a positive shock in inflation affects trade balance negatively and this also confirms the SVAR estimate that inflation as
triggered by devaluation impacts negatively on trade balance.
Figure A4 depicts the impulse response of trade balance to positive exchange rate shock. The figure shows that positive
exchange rate shock spurs trade balance in the first four periods and, thereafter, trade balance responds negatively throughout to
positive exchange rate shocks. This confirms the earlier SVAR and FMOLS estimates that devaluation has an insignificant effect
on trade balance and by this impulse response function; the positive effect will die out and become negative later. However,
Figure A5 which depicts the impulse response of output to one standard deviation in the exchange rate shows that output will
respond negatively, which is contrary to the SVAR estimates that showed a positive but not significant effect on output. The
implication is that output will finally respond negatively to any positive shock from the exchange rate. This confirms that the
input price and real money balance is a channel through which devaluation impacts on production negatively that has been
discussed in the SVAR estimates through inflation as an import dependent economy.

5. Concluding Remarks
In recent times, Nigeria, as a primary commodities exporter, has been experiencing budget deficit, external imbalance, sharp falls
in government revenue, and depleting external reserve, emanating from a fall in the prices of crude oil. This has motivated
several policy measures including foreign exchange control and other austerity measures to ease the impact of falling oil prices
on the Nigeria economy. Consequently, this study empirically provides answers to whether the naira should be floated or
devalued. First, the study sets out to establish misalignment of the currency using the behavioural equilibrium exchange rate
approach and then tests the Marshall–Lerner condition, the effect that an exchange rate devaluation will have on the trade
balance, using fully modified OLS with annual data covering 1970 to 2014; second, it traces transmission channels of exchange
rate shocks to other macroeconomic variables through the inflation channel to real gross domestic product and trade balance
using the SVAR approach with quarterly data covering 1985 and 2014. The empirical results confirm the existence of currency
© 2016 The Authors. African Development Review © 2016 African Development Bank
Should the Government Float or Devalue the Naira? 259

misalignment, especially overvaluation, in recent periods. In fact, the results indicate that the currency was overvalued in the
periods 1988–1993, 1999–2000, 2006, 2009–2010, and 2012–2014.Given the results for the identified periods, there is a need to
float the currency given the current reality in the nation’s policy space and to minimize market distortions associated with
controlled devaluation. This is expected to boost investors’ confidence, create needed automatic adjustment mechanism in the
balance of payments and make the tradable goods sector more competitive, resulting in more favourable external balances. The
effectiveness of a floated exchange rate regime will also require a concerted effort at boosting the nation’s supply capacity
through implementation of structural reforms in both the oil and the non-energy sector to diversify Nigeria’s production and
export base.

Notes
1. The first budget submission was based on $77 per barrel and this was later changed to $73 and $65 per barrel of crude oil in
two consecutive periods. Finally the budget was approved at $52 per barrel (MOF, 2015, 2016).
2. Real effective exchange rate (REER) can be measure by internal (non-tradable–tradable prices) or external (trade-weighted
PPP) approaches. The latter is used as already computed by IMF.
3. Terms of trade (tot) was dropped because of a measurement problem while openness was found to be I(0) so it was also not
included in the estimation.
4. For details of this approach to establishing the Marshall–Lerner condition see Yol and Baharumshah (2007).
5. Akinlo and Odusola (2003); Melander (2009); Igue and Ogunleye (2014); Ayen (2014); Edoun et al. (2015) and Akinlo and
Lawal (2015) also used the multivariate approach.
6. See all the Impulse response figures in the Appendix.

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Appendix: Impulse Response Functions

Figure A1: Response of inflation to one standard deviation in exchange rate

Figure A2: Response of output to one standard deviation in inflation

Figure A3: Response of trade balance to one standard deviation in inflation

© 2016 The Authors. African Development Review © 2016 African Development Bank
Should the Government Float or Devalue the Naira? 263

Figure A4: Response of trade balance to one standard deviation in exchange rate

Figure A5: Response of RGDP to one standard deviation in exchange rate

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