THE IMPACT OF EXCHANGE RATE ON FOREIGN DIRECT INVESTMENT (FDI) IN NIGERIA

CHAPTER ONE

INTRODUCTION

1.1 Background of the Study

The power of the exchange rate policy under the structural Adjustment programme are to discourage imports and   promote agricultural production, encourage local sourcing of raw materials something they had considered impossible before the introduction of structural adjustment programme. One cannot fail to notice that importation has decreased, exports other than crude oil has increase over the months.

Problems crisis in international transactions is because of the inefficiency in our financial system, which introduce “lag” between the time the importer and the time of the fund are actually remitted to the exporter. The remittance lag as we call it, introduces exchange rates risk into the transaction. For example the rate prevailing at the time of payment by imports may differ from the rate of which the commercial banks will use in remitting the funds.

The 1980s witnessed increased flows of investment around the world. Total world outflows of capital in that decade grew at an average rate of almost 30%, more than three times the rate of world exports at the time, with further growth experienced in the 1990s (Kosteletou and Liargovas, 2000). Despite the increased flow of investment, especially, to developing countries, Sub-Saharan Africa

(SSA) countries still lag behind other regions in attracting foreign direct investment. The uneven dispersion of FDI is a cause of concern since FDI is an important source of growth for developing countries. Not only can FDI add to investment resources and capital formation, it can also serve as an engine of technological development with much of the benefits arising from positive spillover effects. Such positive spillovers include transfers of production technology, skills, innovative capacity, and organizational and managerial practices.

Given these significant roles of FDI in developing economies there have been several studies that tried to determine the factors that influence FDI inflows into these economies. One of such factors that recently have been a source of debate is exchange rate and its volatility. The existing literature has been split on this issue, with some studies finding a positive effect of exchange rate volatility on FDI, and others finding a negative effect. A positive effect can be justified with the view that FDI is export substituting. Increases in exchange rate volatility between the headquarters and the host country induce a multinational to serve the host country via a local production facility rather than exports, thereby insulating against currency risk (Foad 2005).

In economic analysis, Foreign Direct Investment (FDI) is a direct investment by a corporation in a commercial venture in another country. Mallampally and Sauvant (2009) define FDI as an investment by multinational corporations in foreign countries in order to control assets and manage production activities in those countries. It plays an extraordinary and growing role in global business by providing a firm with new markets and marketing channels for their products. For a host country or the foreign firm which receives the investment, it provides a source of new technologies, capital, process, products, organizational technologies and modern management practices.

Foreign direct investment (FDI) not only provides developing countries (including Nigeria) with the much needed capital for investment, it also enhances job creation, managerial skills as well as transfer of technology. All of these contribute to economic growth and development. To this end, Nigerian authorities have been trying to attract FDI via various reforms. The reforms included the deregulation of the economy, the new industrial policy of 1989, the establishment of the Nigeria Investment Promotion Commission (NIPC) in early 1990s, and the signing of Bilateral Investment Treaties (BITs) in the late 1990s. Others were the establishment of the Economic and Financial Crime Commission (EFCC) and the Independent Corrupt Practices Commission (ICPC). However, FDI inflows to Nigeria have remained low compared to other developing countries (CBN, 2010).

Nigeria has over the years been a beneficiary of Foreign Direct Investment (FDI) inflow. For instance, FDI inflows increased from N786.40 million in 1980 to N2193.40 million in 1982, but soon dropped to N1,423.50 million in 1985. The value of FDI rose from N6,236.70 million in 1988 to N10,450.0 million and N55, 999.30 million in 1990 and 1995, respectively. However, the value of FDI fell drastically to N5,672.90 million in 1996 and further to N4,035.50million in 1999. The inflows of FDI has continued to rise since the year 2001, moving fromN4937.0 million to N13531.2 million in 2003 and N20,064.40 million in 2004. The FDI inflows stood at N41734.0 million in 2006 (CBN, 2006). In terms of growth rate, FDI inflows increased by 182.68 percent in 1986, the value soon fell by -24.76 percent in 1989 and further to -89.87 percent in 1996. Since the year 2000 the growth of FDI has remained positive except in 2001 when the value was -70.00 percent but since recently, 2010, 2011, 2012, 2013, and 2014 the values have been 1.09552, 2.236095, 0.668744, 7.953192 and 2.261765 respectively and they are all positive. The recent surge in FDI inflows to the country is attributable to the reduction in the nation’s debt profile (through debt arrangements with London club and Paris club) and the renewed confidence of foreign investors in the Nigerian economy (CBN, 2006).

1.2 Statement of the Problem

Justification for a negative impact of exchange rate on FDI can be found in the irreversibility literature pioneered by Dixit and Pindyck (1994). A direct investment in a country with a high degree of exchange rate will have a more risky stream of profits. As long as this investment is partially irreversible, there is some positive value to holding off on this investment to acquire more information. Given that there are a finite number of potential direct investments, countries with a high degree of currency risk will lose out on FDI to countries with more stable currencies (Foad 2005).

One of the countries that fall into this category (countries with a high degree of currency risk) is Nigeria. With a population of about 130 million people, vast mineral resources, and favourable climatic and vegetation features, Nigeria has the largest domesticmarket in Sub-Saharan Africa. The domestic market is large and potentially attractive to domestic and foreign investment, as attested to by portfolio investment inflow of over N1.0 trillion into Nigeria through the Nigerian Stock Exchange (NSE) in 2003 (Central Bank of Nigeria, 2004). Investment income, however, has not been encouraging, which was a reflection of the sub-optimal operating environment largely resulting from inappropriate policy initiatives.

Except for some years prior to the introduction of the Structural Adjustment Programme (SAP) in 1986, gross capital formation as a proportion of the GDP was dismally low on annual basis.