The impact of real exchange rate on economic growth: Additional evidence from

Nigeria

Isah Mudi Malumeashi PhD

Department of Business Administration, Faculty of Social and Management Sciences,

Bayero University Kano (BUK)

Abstract

This study is designed to investigate the impact of real foreign exchange rate on economic
growth in Nigeria. The study is organized to avoid the pitfalls of existing studies in this area
especially in Nigeria as these studies did not include all the variables such as international
finance and trade openness. This study takes these variables into account, in addition to
applying more robust parameters estimating methods using co-integration regression models,
the dynamic OLS and the fully modified OLS. The findings in this study establishes that real
foreign exchange rate significantly stimulated economic growth in Nigeria. This finding,
differs significantly from most existing empirical findings in Nigeria which show that real
exchange rate do not stimulate economic growth in Nigeria.

Key words: Real foreign exchange rate, developing countries, economic growth, dynamic
ordinary least squares.

1. Introduction

This study is designed to investigate the impact of foreign exchange rate on economic growth
in Nigeria. The study has observed that theoretically, foreign exchange rate theory does not
provide a clear line of causality between economic growth and foreign exchange rate. It is
argued that fixed exchange rate has the capacity to ensure that there is stability in the
domestic economy and this assists in planning productive activities. It also gives the investors
the assurance that the economy is stable for them to operate. It is argued, on the other hand
that fixed foreign exchange policy has the disadvantage of not having the ability to absorb
sudden shock in an economy. A shock in the economy causes severe distortions in the
allocation of resources and this affects the productivity of production inputs. Thus, there is no
generally accepted theoretical links between foreign exchange rate policy and economic
growth.
However, Rodrik (2007), Eichengreen (2008) and Rapetti, Skott and Rasmi (2011) have
hypothesized that foreign exchange undervaluation in a developing country has the tendency
to stimulate economic growth by lowering the production cost of tradable goods. This makes
the cost of non-tradable goods higher than tradable goods. There is no theoretical basis for
this conclusion. Several studies have been carried out to investigate the validity of this
hypothesis. Some of these studies are Eichengreen (2008), Rapetti, Skott and Rasmi (2011),
Uddin, Rahman and Quaosar (2014), and Adeniran, Yusuf and Adeyemi (2014). Others are
Basirat, Nasirpour and Jorjorzadeh (2014), Akpan and Atan (2012), Schnabl (2007), Petreski
(2009), and so on.

This study is also designed to investigate the validity of this hypothesis in the context of
Nigeria. But unlike other studies that investigated this hypothesis in Nigeria, this study is
unique in the sense that it corrects the deficiencies in the methodologies. As Petreski (2009)
notes, deficiencies are non-inclusions of trade openness and international finance as
mediating variables through which foreign exchange rates affect economic growth of
developing countries. Another shortcoming which this study is designed to correct is
endogenity problems which exists in the literature studying the impact of foreign exchange
rate on economic growth in Nigeria. These defects are made-up by including the control
variables of trade openness and international financial and applying more robust regression
models based on dynamic ordinary least squares (DOLS) and fully modified ordinary least
squares (FMOLS).

In order to carry out this study, it is hypothesized that real foreign exchange rate has not
stimulated economic growth in Nigeria. The study also hypothesizes that the other control
variables such as trade openness, international finance and stock of private capital do not
stimulate economic growth in Nigeria. The rest of this study is organised as shown in this
section of the study. Section two reviews existing related literature which examines the
impact of real exchange rate on economic growth. Section three reviews the research methods
by examining the effect of foreign exchange rate on economic growth that is applied in the
current study and it also reviews the diagnostic tests used. Section four presents the results of
analysed data and interprets the results. The section also presents the results of diagnostic test
carried and states the implication of the second order test that investigates the reliability of
the statistical tool of regression method adopted. Section five states the findings, the
conclusions and policy implication based on the results of finding of the study.
2. Literature review

Rapetti, Skott and Rasmi (2011) investigate the impact of foreign exchange under-valuation
on economic growth using the theoretical framework of studies earlier developed by Rodrik
(2008) and Eichengreen (2007). In Rodrik (2008) and Eichengreen (2007) studies, it is
hypothesized that foreign exchange undervaluation promotes economic growth in developing
countries. Rapetti, Skott and Rasmi (2011) use data for the period of 1950-2004 to estimate
the impact of undervaluation of foreign exchange using growth rate as the endogenous
variable while applying the real exchange rate and a combinations of standard controlled
exogenous variables like government expenditure, inflation, and degree of trade openness,
human capital and gross domestic savings. The study of Rapetti, Skott and Rasmi (2011)
establish that foreign exchange undervaluation stimulates economic growth in developing
countries more than developed countries. The study also establishes that as per capita of
developing a country increases, the impact of foreign exchange under-valuation tends to
decline.

Uddin, Rahman and Quaosar (2014) investigate the influence of real exchange rate on
economic growth of Pakistan for the period of 1973 to 2013. The data used for the study were
extracted from Bangladesh Bank (BB), Bangladesh Bureau of Statistic (BBS), World Bank
Development Indictors (WDI), Asian Development Bank (ADB), etc. The study hypothesizes
that real exchange rate does not cause RGDP and vice versa. The empirical evidence from
Granger causality regression shows a bi-directional causality from real exchange rate to
RGDP and vice versa.

Adeniran, Yusuf and Adeyemi (2014) examine the impact of foreign exchange rate on
Nigeria economic growth. The data used for their study were collected from the Central Bank
of Nigeria Statistical Bulletin (various editions). Their study employed ordinary least squares
(OLS) regression. The finding of the study shows that real exchange rate has no significant
impact on economic growth in Nigeria.

Basirat, Nasirpour and Jorjorzadeh (2014) examine the impact of real exchange rate in a
panel of developing countries. The data used covered the period of 1986 -2010. The study
employed pool regression method based on OLS regression. The results of panel regression
show that financial development, real foreign exchange rate and trade openness have
significant positive effect on economic growth. The data used in the study were collected
from WDI. However, the interaction of foreign exchange rate with the financial development
has no significant impact on economic growth in the developing countries studied.

Harberger (2003) investigates the impact of economic growth on real foreign exchange,
taking into account the Balassa-Samuelson effect. The Balassa-Samuelson hypothesis states
that as a developing country develops, the prices of tradable goods will tend to fall faster than
the prices of non-tradable goods. By extension, this means that the value of dollar will fall
against the domestic currency. Harberger’s (2003) study was designed to investigate this
hypothesis. In the study, Harberger (2003) selected scenarios in which developing countries
have significant increase in real GDP growth of more than 5% for 10 years and above and
regressed them on the real exchange rate to test the theory. The results were mixed. The
reason he gave was because of complex causal relationships among economic variables that
cannot be separated.

Akpan and Atan (2012) investigate the effect of real foreign exchange rate on economic
growth in Nigeria. The study employed data covering the period of 1986 to 2010. The
regression methods applied are the simultaneous equation method and the generalised
methods of moments (GMM). The results of the regression methods show that real exchange
rate has no significant impact on economic growth in Nigeria.

Schnabl (2007) investigates the impact of foreign exchange stability on economic growth of
countries at the periphery (developing countries). The study employed panel data approach
involving 41 countries. The study selects international trade, international capital movements,
and macroeconomic stability as the channels through which exchange rate affect economic
activities. The time-series data collected covers the period of 1994 to 2005 and the regression
method used is the genelalised least squares (GLS). The study establishes that flexible foreign
exchange rate depressed economic growth of the peripheral countries while fixed exchange
rate is more convenient for economic growth of developing countries.

Petreski (2009) analyses empirical evidences and theoretical arguments relating exchange
rate and economic growth. The study argues that the theoretical arguments used to justify
exchange rate effects on economic growth are ambiguous. The study opines that exchange
rate affects economic growth through trade, investment and productivity of factor inputs. It
also argues that flexible exchange rate reduces economic growth through uncertainties it
causes in the economy. Fixed exchange rate reduces uncertainty and promotes growths. The
major disadvantage of fixed exchange rate is that it has no provision to absolve shock in
economic system. It therefore leads to price distortions. It causes misallocation of resources.
Thus, there is no theoretical reason to suggest that exchange regime can stimulate economic
growth.

Analyses of existing empirical studies show no distinct pattern. There were diverse findings.
The study notes that few study paid due attention to the financial variable and monetary
variable through which exchange rate impact on the economy. The review also observes that
the existing studies paid no attention to the endogeneity problem, where foreign exchange
influence GDP and GDP influence the foreign exchange too. The review notes that a robust
study must take all these factors into account.

Khondker, Bidisha and Razzaque (2012) investigate the impact of exchange rate on economic
growth of Bangladesh. The study notes that the Rodrik view that foreign exchange
undervaluation stimulates economic growth was confirmed by Gulzmann, Levy-Yeyati and
Sturzenegger (2012), Mario, Sebastian and Gabriel (2011), Mbaye (2012) and Rapetti , Skott
and Rasmi (2011). However, Rodrik view could not be supported by empirical studies of
Magud and Sosa (2010). Using data from 1980 -2012, the study applies time-series method of
vector error correction model. The study also employes Keynesian analytical technique. The
overall empirical results show that foreign exchange devaluation enhances the competiveness
of Bangladesh. It also increases the GDP growth rate in Bangladesh.-

3 Methodologies applied

This study applied time-series methods of analysis. The time-series applied methods are the unit
root test, the co-integration test and fully modified ordinary least squares regression and
dynamic ordinary least squares regression methods. The time series methods applied are the
Augmented Dickey-Fuller (ADF) and Phillips and Perron (PP) unit roots methods. The reason for
applying more than one method is that unit root methods have low power. The use of two
different methods can minimise the possibility of having a misleading result. The co-integration
test that is applied to establish the existence of long-run relationship among the variables is the
Johansen Co-integration Test while the Stock and Watson DOLS and the FMOLS are applied to
estimate the parameters of the regression model applied.
In order to establish the reliability of the regression methods used in estimating the variables of
the population studied, the study applied variance inflation (VIF) test and coefficients variance
decomposition test to test for the existence of co-linearities among explanatory variables in the
DOLS and FMOLS regression models. The study also applied auto-correlation (AC), partial auto-
correlation (PAC) and Q-statistic to establish the existence of serial correlation and
heteroscedasticity among the residuals of the regression. If the second-order tests establish that
there are no co-linearities among the variables and that heteroscedasticity and autocorrelation
(serial correlation) do not exist in the residuals in any of the models, the regression model so
estimated parameters can be assumed to be not only consistent but efficient and therefore a
robust estimated regression in line with Petreski (2009).

The data applied in this study are collected from the United Nations’ Conference on Trade and
Development (UNCTAD) database. The data are data on real GDP, trade openness, international
finance, and real foreign exchange rate. The data covered the period of 1970 to 2014. The data
on GDP and trade openness are stated in US Dollars at their 2005 constant prices. The data on
trade openness are measured on percentage basis. The data on foreign exchange rate are
measured on a number of Nigerian Naira per US Dollar.

4. Results and analysis

The results of empirical data are reported in this section of the paper. The report is made up of
unit root test, which investigates the time-series properties of the data; the co-integration test
which investigates the long-run relationship among the variables modelled in this study. The
other aspects of the report are regression models and their diagnostic test to ascertain their
reliability. Unit root tests are reported in Table 1. Table 2 reports co-integration test; while Table
3 reports the results of regression models. Tables 4, 5 and 6 report the results of diagnostic tests
using variance inflation factors (VIF), coefficient of variance decomposition and auto-correlation,
partial auto-correlation Q- statistic, respectively.

Table 1: Unit root tests using Augmented Dickey-Fuller (ADF) and Phillips and Perron (PP) tests

Variable NO. of Diff ADF Stat Prob. PP Stat Prob. Remark

CAPPC A-t lvel -1.15 0.91 -1.48 0.82 1(1)
1st Diff. 4.69 0.00 4.42 0.00 1(0)
FER At lvel -1.69 0.74 -1.72 0.73 1(1)
1st Diff. -5.95 0.00 5.95 0.00 1(0)
INTFIN At lvel -1.55 0.79 -2.99 0.15 1(1)
1st Diff. -10.86 0.00 -10.94 0.00 1(0)
RGDPPC At level  1.159 1.00 -0.31 0.99 1(1)
1St Diff -4.75 0.00 -4.72 0.00 1(0)

Table 1 shows that all the variables are not stationary. However, after the first differencing all
the variables become stationary. This may be interpreted to mean that all variables are
integrated in order one, 1(1). Since all the variables are integrated of order one, it is important
to investigate if there is a long-run relationship among the variables. This is done by carrying-out
co-integration test.

Table 2: Co-integration Test (using Johansen Co-integration Test)

Hypothesized Trace Stat. Prob. Max-Eigen Stat. Prob.

No. of CE(s)
None *  83.08012  0.0030  46.06830  0.0011
At most 1  37.01182  0.3470  22.74537  0.1846
At most 2  14.26646  0.8253  10.64120  0.6830
At most 3  3.625254  0.9314  3.366239  0.9194
At most 4  0.259015  0.6108  0.259015  0.6108

Table 2 indicates that this study cannot accept the null hypothesis of none co-integrating
relationship. This means that there is one co-integrating relationship among the variables. The
null hypotheses of having 1, 2, 3 and 4 co-integrating equation cannot be rejected, using but
trace statistic and maximum eigen values. Having established that the variables are co-
integrated, is it important to adopt regression method that is robust to non-stationary data to
avoid spurious regression and to solve endogeneity problem, as Petreski (2011) had
recommended. The essence of this is to avoid the pitfalls of existing empirical works in this area.
These methods are also robust to serial or autocorrelations of not only the first-order but of
higher orders. After estimation, this study test for the existence of multicolinearity,
autocorrelation and heteroscedasticity.

Table 3: Regression models using FMOLS and DOLS (RGDPPC is the dependent variable)

Variable FMOLS DOLS

CCOEFF Prob. COEFF. Prob.
Constant 3074.4 0.000 4422.4 0.000
FER 12.644 0.000 15.849 0.000
CAPPC 3.0194 0.000 4.0428 0.000
INTFIN 38.952 0.498 50.464 0.452
TROPN -8.4331 0.003 -16.976 0.000
Adjusted R2 0.856 0.964

The two co-integrating equations had roughly similar results. All the variables, except trade
openness exhibit the expected signs. The coefficients are not similar but exhibit same signs.
The problem that has to be solved is to find which of the two regression models is more
reliable. The explanatory powers of the models are all high. This was determined through
diagnostic tests.

Diagnostic tests

The diagnostic tests investigated in this section are VIF, the coefficient variance
decomposition test and AC PAC and Q-statistic tests. The first two tests are aimed at
establishing the existence of multicolinearity, while the last test is jointly for auto-correlation
and heteroscedasticity.

Table 4: variance inflation factor (VIF) test

Variable FMOLS DOLS

Coeff. Var. Uncentered VIF Coff. Var. uncentered VIF
FER
 0.849183  1.979797  5.597385  18.78295
CAPPC
 0.291859  13.01404  0.475990  46.21499
INTFIN
 3242.301  4.246603  4358.577  7.874315
TROPN
 7.018859  71.90350  16.99366  330.1772
Constant
 135134.2  46.90754  401259.8  237.6746

Table 4 shows that the coefficient variances and uncentered VIFs are generally low, except
for trade openness under DOLS. However, the existence of multicolinearity must involve two
variables, other than a constant. Thus, there is no evidence of multicoliearity from the two
regression models as shown in the above table.

Table5: Coefficient variance decomposition

Variable FMOLS DOLS
Condition No. Asso. Eigenvale Contion No. Asso. Eigenvalue
FER
 1.36E-07  2.06E-05  2.15E-08  0.482791
CAPPC
 6.85E-06  0.153938  1.95E-06  0.414159
INTFIN
 0.012988  0.172917  0.000153  0.000643
TROPN
 0.041417  0.761220  0.007589  0.867437
Constant
1.000  0.999918  0.027217  1.000000

Table 5 shows that the values of condition numbers are in the two regression models are
generally less than 0.001 indicating high to severe multi-colinearity. However, the associated
eigenvalues are significantly less than 0.60. In both models, only one variable had value that
is greater than 0.06, apart from the constant. Therefore, there is no evidence of high multi-
colinearity from the results of VIF table.

Table 6: Auto-regressive heteroscedasticit (ARH)) test

FMOLS DOLS
Lag AC PAC Q-Stat Prob AC PAC Q-Stat. Prob
1 0.50 0.50 11.5 0.00 0.22 0.21 2.04 0.15
2 0.13 -0.2 12.3 0.00 -0.16 -0.21 3.13 0.21
3 -0.11 -0.14 12.9 0.01 0.10 0.20 3.55 0.31
4 0.07 0.29 13.1 0.01 -0.02 -0.16 3.58 0.47
5 0.14 -0.03 14.0 0.02 -0.14 -0.03 4.47 0.48

Table 6 shows that the fully modified ordinary least squares (FMOLS) regression model has
significant auto-regressive heteroscedasticity (ARH) problems. This is demonstrated by high
values of AC, PAC and Q-statistics as confirmed by significant values of Q-statistic
probabilities. The dynamic ordinary lest squares regression, on the other hand, has no
problems of auto-regressive heteroscedasticity as shown by low values of AC, PAC and Q-
statistics and its associated probability values.

The diagnostic test has shown that the estimated coefficients of DOLS are not only consistent
but efficient. The results show that the foreign exchange rate and private capital stock per
capita have stimulated economic growth in Nigeria during the period under consideration.
The results also show that international capital flows have no significant impact on economic
growth in Nigeria. The results also demonstrated that trade openness has significantly
depressed economic growth in Nigeria.

5. Concluding Remarks and policy implications

This study has empirically investigated foreign exchange devaluation policy in Nigeria and
has established that foreign exchange devaluation has stimulated per capita economic growth
in Nigeria. This finding has supports Rodrik (2011) hypothesis that undervaluation of a
developing economy’s domestic currency can stimulate productivity increase in the country.
The reason is that it brings about an increase in the demand for exports of the country and
therefore increases output. If the country is exporting manufactured products, there is the
possibility of realising economies of scales and also diffusing technological imitation across
other sectors of the economy. This may further enhance the catching up of the country with
the more advanced countries of the world.

The study also established that capital stock per capita stimulated economic growth in
Nigeria. This finding suggests that more available capital stock in the hands of Nigerian
workers can stimulate per worker output in Nigeria. This implies that capital stock in Nigeria
has not yet reached the marginal diminishing returns yet. As such, increase in public and
private capital stock can increase workers productivity and stimulate economic growth.
Therefore, government should provide more infrastructural facilities. This will encourage
more productive investments in Nigeria and raise the level of output and stimulate more
economic growth.

Trade openness has depressing effect on economic growth. This means that Nigerian tradable
goods are not so much competitive. As a result, opening the Nigerian economy to trade tends
to create more productive activities to foreign countries at the expense of local economy.
Nigeria has to restructure its economy and improve its manufacturing base. This will turn
trade openness in favour of Nigeria.

International financial flows have not stimulated economic growth in Nigeria. This means
that foreign investments in Nigeria have not promoted economic growth in Nigeria. The
possible reason is that the interests of foreign investors and the Nigeria interest in promoting
economic growth have not been harmonized or integrated. There is the need for the Nigerian
government to re-organise the country’s growth need and the needs of foreign investors to be
integrated so that foreign investors pursuing their self –interests will automatically lead to
promoting economic growth in Nigeria.

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