Fountain Journal of Management and Social Sciences: 2014; 3(2) XXX-XXX

A publication of College of Management and Social Sciences, Fountain University, Osogbo.

Journal homepage: www.fountainjournals.com
ISSN: 2315 - 6325

THE IMPACT OF EXCHANGE RATE VOLATILITY ON MANUFACTURING

PERFORMANCE: NEW EVIDENCE FROM NIGERIA

Taofeek Olusola, AYINDE

Department of Economics and Financial Studies, College of Management and Social Sciences, Fountain University, Osogbo

Fountain University, Osogbo, Nigeria.

Abstract
This paper examines the impact of exchange rate fluctuation on the performance of manufacturing sector in Nigeria. Testing
the hypothesis that high frequency data matters for forecasting volatility, we employ the use of generalized autoregressive
conditional heteroscedasticity (GARCH) technique coupled with quarterly time series data spanning the period 1986-2012
to investigate the relationship. In tandem with theoretical exposition, our results show that exchange rate has significantly
negative relationship on manufacturing performance. Also, the result obtained for the ARCH effects indicate high volatility
clustering but too insignificant to alter the performance of the manufacturing sector as the persistence of volatility is found
moderate with 0.482 coefficients. Hence, the hypothesis is accepted. This study, thus, produces new evidence for the study of
exchange rate volatility. We recommend that the government should properly manage exchange rate in Nigeria as it
volatility has the potential to distort other factors (such as the lending rate, labour force and price stability) that matter for
the performance of the manufacturing sector.

Key Words: Exchange Rate, Volatility, Manufacturing, GARCH, Output

Introduction
The interaction between exchange rate volatility and manufacturing sector performance has remains topical among
economists and policy makers, alike; since the period of currency differentials among nations. Many hypothetical scenarios
of over-valuation and under-valuation of currencies and their attendant predictions have resulted in a wide variation of study
to examine and re-examine the nature of the relationship between exchange rate movements and changes in the
manufacturing performance, using different samples, variables, economic and econometric techniques which produce
varying results that, at best, led to ambiguity and inconclusiveness. Although, there are vast of amount of literature
(Carranza, Cayo & Galden-Sanchez, 2007; Oyejide 1985; Olisadebe 1991, David, Umeh & Ameh, 2010) available on this
subject; very little can be reported to have been examined to explain the African situation; and specifically, the Nigerian case
given a high frequency data structure. . According to Hansen and Lunde (2012), high frequency data have help improved
volatility forecasting in six major ways. First, it assists in better understanding the dynamic properties of volatility.
Secondly, it helps improve the evaluation of the volatility forecasts.

*Corresponding author: +234(0)7063357968.

Email address: olusolaat@gmail.com; ayinde.taofeek@fountainuniversity.edu.ng

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Thirdly, it assisted in understanding the impetus that drives the volatility and their relative importance. Fourthly,
the realised measures from high frequency data would yield more valuable predictors in reduced form models. Fifthly,
high frequency data structure for volatility study has enabled the development of new volatility models that provide
more accurate forecasts. Lastly, it assists in obtaining estimates for more complex volatility models. It is within these
overwhelming reflections on the use of high frequency data for volatility effects that we employ quarterly datasets to
investigate the impact of exchange rate volatility on manufacturing performance; being the major gap existing in
empirical researches generally; and Nigeria in particular. Few studies such as Enekwe, Ordu and Nwoha (2013) have
attempted to cover this gap of high frequency data for volatility study of exchange rates. However, their study employed
a firm-level data and as such policy suggestions were firm-bound. But, the role played by the manufacturing sector has
remained the sine qua non for industrial development and the bedrock of economic transformation (see Fakiyesi, 2005;
Ehinomen & Oladipo, 2012; Asher, 2012). Apart from this introductory section, the remaining part of this study is
further divided into four other sections. Section 2 focuses on the review of both theoretical and empirical literature as
section 3 sets the methodological framework for the study while section four focuses on the estimations of model
specified and section 5, being the last, concludes and proffer necessary policy suggestions.

Literature Review
The relationship between exchange rate fluctuation and the manufacturing sector performance has been the
subject of much debate both at the theoretical and empirical levels. While the literature is replete with many theories on
exchange rate; the most cited are the traditional flow model; the monetary approach; the purchasing power parity and the
uncovered interest rate hypothesis. The traditional flow model is essentially based on the principle of the interplay of
demand and supply. The forces of the market i.e demand and supply determine the rate of exchange. It views exchange
rate as the product of the contact between the demand for and supply of foreign exchange. In this model, the exchange
rate is in equilibrium when supply equals demand for foreign exchange. The exchange rate adjusts to balance the
demand for foreign exchange depends on the demand domestic residents have for domestic goods and assets. The major
limitation of the traditional model or the portfolio balance model include the over-shooting of the exchange rate target
and the fact that substitutability between money and financial asset may not be automatic, this led to the development of
the monetary approach.

The monetary approach is couched in relative hypothesis. The model stipulates that a situation of falling prices
with a given nominal money supply results in exchange rate depreciation, the monetary approach is predicted on the
importance of money. It identifies exchange rate as a function of relative shift in money stock and inflation rate as a
proxy and domestic output between an economy and a trading partner economy. According to the theory, a fixed
exchange rate regime can increase trade and output growth by reducing exchange rate uncertainty and thus the cost of
hedging, and also encourage investment by lowering currency premium from interest rates. However, on the other hand
it can also reduce trade and output growth by stopping, delaying or slowing the necessary relative price adjustment
process. The purchasing power parity (PPP) is also one of the earliest and perhaps, most theory of exchange rate
between two currencies would be equal to the relative national price levels. This is a theory which states that exchange
rates between currencies are in equilibrium when their purchasing power is the same in each of the countries. This means
that the exchange rate between two countries should equal ratio of the countries price level of a fixed basket of goods
and services. it assumes the absence of the trade barriers and transactions cost and existence of the purchasing power
parity (PPP). When a country‟s‟ domestic price level is increasing (i.e. a country experiencing inflation), that country‟s
exchange rate must be depreciated in order to return to PPP. The basis of PPP is „the law of one price‟. In the absence of
transportation and other transactional costs, competitive market will equalize the price of an identical good in two
countries when the prices are expressed in the same currency. In its version the purchasing power parity (PPP) doctrine
equates the equilibrium exchange rate of the ratio of domestic to foreign price level (Lyon, 1992). The PPP is long-term
approach used in the determination of equilibrium exchange rate. It is often applied s a proxy for the monetary model in
exchange rate analysis (CBN, 1998). This theory could be of absolute or relative and could be short-term or long-term
oriented.

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The uncovered interest parity (UIP) is another model of exchange rate determination which appears in
literatures and it can be expressed as the capital account equivalent of the purchasing power parity. This forms the
central assumption of the capital account monetary model of exchange rate determination, which maintains that
exchange rate movement in such a way that the expected rates of return are equalized across countries. This implies that
the spot rate and expected value of future exchange rate, in asset market equilibrium in such a way that investors are
indifferent between the currencies in which they hold assets given the relevant interest rate. The UIP assumes that
capital is perfectly mobile across that is, there are no exchange controls, no transaction cost, and that investors are risk
neutral. This implies that assets denominated in different currencies are regarded by investors as perfect substitutes.
Hence the law of one price will hold for assets returns rather than prices of tradable goods, under this scenario, if the
expected changes in the nominal spot exchange rate reflect that expected inflation rate differential in two countries
which ensure that real exchange rate remains constant, UIP implies that the real exchange rate will be the same in two
countries.

From the empirical standpoints, Oladipo and Adegbite (2012) examined the impact of exchange rate movement
on the growth of the manufacturing sector in Nigeria. Ordinary least square (OLS) multiple regression analysis was
employed. The study covered the periods of 1986-2010 with the use of time series data. The results did shows that
depreciation which forms part of the structural adjustment policy (SAP) 1986, and which dominate the period under
review, has no significant relationship with manufacturing sector productivity. He also found out that exchange rate
appreciation as a significant relationship with domestic output and exchange rate appreciation will promote growth in
the manufacturing sector performance in Nigeria for the periods 1986-2010. Also, Dogruel, Dogruel and Izmen (2011)
investigate the effect of the changes in the exchange rate of domestic prices during the last two decades in Turkey. The
study focused mainly on detecting the present of measuring the degree of exchange rate pass-through. However this
method has a limited explanatory power regarding the interaction between exchange rate and real size of economy. It
also scrutinizes the effect of changes in the exchange rate on the production cost and on the competitiveness of the
manufacturing sectors. The results confirm that the share of imported inputs and the profits gained from Dollar-euro
parity changes are important determinants of the competitiveness of the Turkish manufacturing. Dickson (2012),
employ the generalized autoregressive conditional heteroscedasticity (GARCH) technique to generate exchange rate
volatility. The relationship between exchange rate fluctuation and economic growth were estimated and findings shows
that in a short run, economic growth is positively related to exchange rate volatility, while in the long run, a negative
relationship exist between the two variables. Enekwe, Ordu and Nwoha (2013) employed four variables such as the
manufacturing gross domestic product MGDP, manufacturing foreign private investments MFPI, manufacturing
employment rat MER, and exchange rate ER. In this case, MGDP stands as dependent variable and MFPI, MER, AND
ER as independent variables. Using descriptive statistics and regressions were employed and the result shows that all
independent variables have significant and positive relations with dependent variable.

Opaoluwa et. al., (2005) examines a 20 year period from 1986-2005 used the economic tool of regression. In the
model that was used, manufacturing output, unemployment rate and foreign private investment were used as the
explanatory variables. The result of the regression analysis shows that co efficient carried both negative and positive
signs which also shows adverse effect and is a statistical significant in the final analysis, Copelman and Wermer, (1996)
reported that positive shocks to the rate of exchange rate depreciation, significantly reduced credit availability, with a
negative impact on the output. Surprisingly, they found that shocks to the level of the real exchange rate had no effects
on the output, indicating that the contractionary effects of devaluation are more associated with the rate of change of the
nominal exchange rate than with the level of the change of the real exchange rate. Ehinomen & Oladipo (2012), says
that in Nigeria, exchange rate appreciation has a significant relationship with domestic output and it will promote
growth in the manufacturing sector. It also ascertained that there is a positive relationship between the manufacturing
gross domestic product and inflation. Asher (2012) opines that exchange rate is used to determine the level of output
growth of the country. However, with already existing exchange rate policies, a constant exchange rate has
beenuncertain in the trade transaction.

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This has resulted to declines in standard of living of the population increase in costs of production which resulted in cost-
push inflation.

Methodology
The theoretical framework adopted for this work is the traditional flow model which was further extended by
Campa &Goldberg (1999). The model states that exchange uncertainty affect firm‟s output and investment behavior. The
model is being extended by decomposing firms output. Assuming a representative firm, operating either in the export
sector (tradable) or the non-tradable goods sector; let the real exchange rate be defined as et. The firm‟s production
function is given as:
Qts=A1L1αKt1-α………………………………………………………………………………………..(1)
Qts= QT + QN…………………………………………………………………………………….........(2)
Q represents good produced which can be divided into tradable and non-tradable goods,K and L are capital and labor
input respectively.A is an arbitrary function representing managerial skills. It is further assumed that exchange rate is the
source of uncertainty in the model, Exchange rate affected non tradable goods through the procurement of input from
abroad while its effect on tradable is through import of raw materials and export. In addition, the representative firm
faces product demand curve given as
Qtd =A2(PT/ PN)-N…………………………………………………………………………………....... (3)
Where Q1d denote goods demanded and PI and PN denote the prices of traded and non-traded goods respectively A2 is a
function of internal and external functions (such as firm size, government policy and exchange rate policy). The
parameter ᾐ stands for the price elasticity of demand for traded goods. At equilibrium the quantity supply equals quantity
demand.
QT+QN=Qd=A2 (PT/PN)-n………………………………………………………………………………........(4)
Hence, the Cobb-Douglas production function for both output and export depends on capital,
labor and As ( 1 A and 2 A ) after linearization becomes
lnQ =α1lnL+ α2lnK + α3lnE+ α4lnP………………………………………………………………….. (5)

In the empirical literature, the workhorse model to investigate the volatility and/or fluctuations of economic
phenomenon has been done through the use of Autoregressive Conditional Heteroscedasticity (ARCH) and its further
extensions as these techniques provide a more real world prediction than other form of techniques. Since the introduction
of ARCH by Engle (1982) and its further extension into the GARCH models by Bollerslev (1986), there has been an
explosion of research looking for the dynamics of volatility clustering. The specification procedure for GARCH models
includes determining time-varying volatility behavior as well as searching for the asymmetric effects of shocks on
volatility. Also, the traditional measures of volatility as represented by variance or standard deviation are unconditional
and does not recognize that there are interesting patterns in volatility study; e.g., time-varying and clustering properties.
The lend credence to the choice in Generalised Autoregressive Conditional Heteroscedasticity adopted for this study. The
models for this study are thus specified in linear form below;

Mean equation;
logMGDP= 𝑏0 +𝑏1 logEXR+𝑏2 INF+𝑏3 logLF+b4LR+𝑈𝑡
Variance equation:
𝛼 𝜀 𝑡−1 𝑌 𝜀 𝑡−1
𝛿 2 = w+ + 𝛽1 𝛿 2 +
𝛼 𝑡−1 𝛿 𝑡−1
Where; w= Constant Coefficient of Variance equation;
𝛼= Determinant of EGARCH Effects; depicting the Volatility Clustering of stock returns;
𝛽 = Determinant of the degree of volatility persistence;
The scope of this study shall be restricted only to exchange rate fluctuation and Manufacturing sector performance in
Nigeria. Data would be sourced from the CBN statistical Bulletin, Nigerian development indicators, relevant journals,
textbooks on financial development in Nigeria and abstract from the internet to cover the study.

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Data used would be quarterly data from 1986-2012. Quarterly data are employed in order to avoid loss of degree of
freedom during estimations and improve the volatility forecast.

Empirical estimations

Descriptive Statistics and Trend Analyses

Table 1: Descriptive statistics
EXR INF LF LR M_GDP
Mean 71.35193 39.97844 9573376. 19.52877 19.19950
Median 86.32197 29.55996 9496625. 19.21000 18.46000
Maximum 157.9475 132.6000 13134484 34.86667 25.90000
Minimum 1.000267 0.879121 6593008. 8.833333 13.06000
Std. Dev. 58.56854 37.15740 1842994. 4.362517 3.621090
Skewness 0.089631 0.790441 0.161066 0.623497 0.151671
Kurtosis 1.207722 2.534903 1.982486 4.878384 1.805882
Jarque-Bera 14.19423 11.88032 4.983580 22.23953 6.640958
Probability 0.000827 0.002632 0.082762 0.000015 0.036136
Sum 7491.953 4197.736 1.01E+09 2050.521 2015.948
Sum Sq. Dev. 356748.4 143590.0 3.53E+14 1979.282 1363.678
Observations 105 105 105 105 105
Source: Author

The summary of the statistics used in this empirical study is presented in Table 1. As observed from the table, the labor
force (proxied as LF) has the highest mean value of 9573376, and the dependent variable; which is the manufacturing
contributions to the GDP (proxied as M_GDP), has the mean value of 19.19950 whereas the mean value for exchange
rate (EXR), inflation (INF), and lending rate (LR), are 71.35193, 39.97844 and 19.52877 respectively. The analysis was
also fortified by the value of the skewness and kurtosis of all the variables involved in the model. The skewness is a
measure of dispersion away from the mean value while the kurtosis is a measure of the symmetry of the histogram. The
bench mark for symmetrical distribution i.e. for the skewness is how close the variable is to zero while in the case of
kurtosis, when it is 3.0; is called mesokurtic, when it is higher than 3.0; is called leptokurtic and values lower than 3.0
are described as being platykurtic. EXR, INF, M_GDP with the values of 1.2077, 1.98248 and 1.8058 respectively are
platykurtic as their values are less than 3.0 while LR is leptokurtic with the value of 4.8783 which is greater than 3.0; that
is leptokurtic in nature. The Jarque-Bera statistics is used to measure the normality of the variable used in estimation, it is
used to verify whether the error term is normally distributed. In the estimation above the Jarque-bera probability for
EXR, INF, LF, LR, M_GDP as the probability values of 0.00427, 0.002632, 0.008276, 0.00015 and 0.03613 which
invariable means that the error terms are normally distributed.

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Table 2: Real and Nominal Exchange Rate in Nigeria (1986-2012)

Average period Nominal exchange rate Real exchange rate

1986-1990 19.236 -1.314

1991-1995 3.35 -45.586

1996-2000 47.685 34.138

2001-2005 96.906 106.512

2006-2010 96.874 117.76

2011-2012 100.055 85.205

Source: Author

Exchange rates can be used to describe a country‟s currency .i.e. its checks if the currency is appreciated or
depreciated. A drastic fall appeared in the nominal exchange rate from 1990 -1995 this implies that the value of Nigeria
currency appreciated. Sudden continuous increase in the nominal exchange rate occurred from 1996 – 2012 which
implies depreciation in the value currency for this period. Real exchange rate on the other hand can be described as the
relative of foreign goods in term of domestic goods by implication, the real exchange rate appreciated within the period
of 1986-1995 and a sudden fall occurred in 1996-2012.

Figure 1: Trend of Real and Nominal Exchange Rate in Nigeria (1986-2012)

200

150

100

50

-50

-100
86 88 90 92 94 96 98 00 02 04 06 08 10 12

REAL NO MI NAL

Source: Author

Real exchange rate can be derived from the removal of inflation from the nominal exchange rate. The graph
illustrates that from 1987-1990 there was an increase in the inflation rate which led to a fall in the real exchange rate
within this period. Persistent increase in inflation led to the fall in real exchange rate from 1991-1995. In 2003-2008,
there was an increase in real exchange rate which was as a result of decrease in inflation with the implications that within
these periods changes occurred the relative price of goods in 2009 the nominal and real exchange rate meets meaning
there was little or no experience of inflation in this period. Inflation increased in 2010-2012 which made the real
exchange rate to reduce.

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Table 3: Manufacturing Sector Performance in Nigeria (1986-2012)

Average period %M_CGDP MU
1986-1990 4.7446 41.106
1991-1995 4.448 35.398
1996-2000 3.594 33.192
2001-2005 3.648 48.92
2006-2012 4.076 54.376
2011-2012 4.17 56.575
Source: Author
Manufacturing utilization is described as the relationship between actual output and the technology which could be
produced if the capacity was fully used. Within the period of 1991-1995, it was 33.192 which was minimal to the
previous year. This implies that technological advancement within this period was little. There was an increase in
technological advance in 2006-2012 leading the manufacturing sector to contribute more to the GDP than other years.

Figure 2: Trend of the Manufacturing Sector Performance in Nigeria (1986-2012)

60 5. 5

5. 0
50

4. 5
40
4. 0

30
3. 5

20 3. 0
86 88 90 92 94 96 98 00 02 04 06 08 10 12

MU M C_G DP

Source: Author
The graph interprets from 1986-1997 the manufacturing sector was able to utilize available technology to contribute
more to the GDP which implies that the capacity was fully used as to enable the manufacturing sector to be geared to
produce more. From 1998-2012, the manufacturing sector were not successful enough in maximizing the available
technological capacity available. This implies that output will be on a minimal level within this period.
Unit-Root and Stationarity Tests
The ADF and PP tests are used to determine the order of integration. That is, the number of times a variable has to be
differenced before it become stationary. In this analysis, the model with constant is considered. The Null hypothesis in
both the ADF and PP test is that there is presence of unit root. Table 3 and 4 below reports the results of ADF and PP
respectively.

Table 4: Augmented- Dickey Fuller (ADF) and Phillip Peron Test

Variables ADF (At First Difference Order of Phillip Peron First Order of
Levels) integration Difference integration
M_GDP -1.22663 -4.5247* 1[1] -2.6661*** - 1[0]
EXR -0.29544 -9.1908* 1[1] -0.335432 -9.1910* 1[1]
INF -3.1799* - 1[0] -7.4454* 1[0]
LR -2.9888** - 1[0] -3.0982** 1[0]
LF 1.54213 -2.641317* 1[1] -3.0822 1[0]
Source: Author. NOTE: *, **, *** denote significance at 1%, 5%, and 10% respectively based on McKinnon
values.

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The above results .i.e. ADF test shows that INF and LR are stationary at levels; M_GDP and EXR are also stationary at the first
difference while LF was also significant at first difference after the lag was increased. Also, the above results .i.e. Philip Peron test
shows that all variables are stationary at level with the exception of EXR. Therefore, the PP method is adopted for the research
work where the results show that all most all the variables are found to be stationary. Therefore, all variables are non-stationary
and integrated of level order and first level.

Model Estimations
Table 6: Summary of the GARCH analysis
Mean Coefficient Z-statistic Prob. Variance Co efficient Z-statistic Prob.
equation Values Values

b0 17.17644 4.1845 0.000 ∞ 0.00533 0.01883 0.9850

L(EXR) -0.0659 -2.4773 0.0132 α -0.16677 -0.3459 0.7286
INF 0.0031 3.2440 0.0012 Β 0.4825 1.5178 0.1290
L(LF) 0.09256 3.5304 0.0004 L(EXR) -0.0013 -0.5212 0.6022
L(LR) 0.2477 5.6180 0.0000 INF 0.00017 1.0660 0.2868
AIC -2.0411 L(LF) -0.00022 -0.0127 0.9898
SC -1.7378 L(LR) 0.00080 0.1693 0.8656
N 105
Source: E-views Output.

The results of the mean equation for the GARCH model shown in table 6 reveals that exchange rate is negatively related to
manufacturing contribution to the GDP which is the dependent variable with the coefficient of 0.0659 and Z-statistics of -2.4773
coupled with the probability values of 0.0132.This follows that as it is expected that a devaluation of exchange rate will improve
the level of manufacturing contribution to Nigeria. The results show that inflation (proxied as INF) is positively related to
manufacturing sector performance with the co efficient of 0.0031, Z-statistics of 3.2440 and the probability values of 0.0012. The
theory of supply states that increase in price will cause an increase in quantity supplied. In this case, the manufacturing sector
plays the role of the seller and will utilize the positive relationship in increasing productivity which implies more contribution to
the GDP. Both LR and the labour force (proxied as LF) are positively related to the dependent variable. The lending rate (proxied
as LR) has the coefficient, z-stat and probability values of 0.2477, 5.6180, 0.000 respectively while the labour force (proxied as
LF) coefficient, z-stat and probability values of 0.09256, 3.5304¸0.0004 respectively. For the variance equation, the presence of
the ARCH effect (denoted as ∞) is the prevalence of volatility clustering of the foreign exchange series. The positive value of
0.00533 shows a high volatility clustering while its probability value of 0.985 indicates its insignificance to alter manufacturing
sector performance. It is obvious that the persistence as well as degree of volatility (as depicted by β) is averagely 0.483; which is
quiet revealing that the Nigerian foreign exchange market has been moderately volatile for the period under review and could have
also moderately affect the performance of the manufacturing sector. The hypothesis for the presence of asymmetric and leverage
effect (as denoted by α) is rejected for foreign exchanges in Nigeria; indicating that individual investors cannot obtain abnormal or
excess profit through arbitrage activities. Empirically, this is a clear departure from other existing studies (see Enekwe et. al.,
2013; Asher, 2012; Carranza et. al., 2007) which show a high negatively significant effect of exchange rate volatility on
manufacturing performance in Nigeria.

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Diagnostic Tests and Robustness Checks

Table 7: ARCH LM TEST
F-statistics 1.0311 Prob. F(1, 102) 0.3123
2
NR 1.0408 Prob. Chi-Square 0.3076
Source: E-views Output. Null hypothesis: the hypothesis states that there is no ARCH.

The probability values of F (1,102) and Chi-Square are not significant as their values are more than 0.05. This simply denotes
that the hypothesis that there is no heteroscedasticity in the result is accepted. Hence, the robustness of the results employed
for empirical analysis is considered reliable.

Conclusion and Recommendation

In this study, we have empirically verified and discussed impact of exchange rate fluctuations on manufacturing sector
performance; using quarterly data for the period 1986-2012. The high volatility clustering of exchange rate in Nigeria with
moderate persistence effect suggests labour force now have negative relationship with manufacturing performance while both
lending rate and inflation are still positively related to the performance of the manufacturing sector; albeit negligibly. This
implies that government should not underplay exchange rate volatility in Nigeria as it affects other important factors for
manufacturing sector performance.

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