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IMPACT OF EXCHANGE RATE INSTABILITY ON FOREIGN DIRECT INVESTMENT IN NIGERIA (1981-2014)

CHAPTER ONE

INTRODUCTION

Background of the Study

The developing countries of the world face a number of problems. The one of the major problems is scarce financial resources, with the passage of time investment needs to increase along with other things, these needs in the LDCs are fulfilled by the capital inflow from the developed nations either in the form of aid or foreign direct investment (Ellahi and Ahmad, 2011). FDI is therefore, the key determinant of capital inflow that brings technological spill over in the less developed countries (LDCs) by introducing better production methods.

Exchange rates is defined as the domestic currency price of a foreign currency, matter both in terms of their levels and their volatility. Exchange rates can influence both the total amount of foreign direct investment that takes place and the allocation of this investment spending across a range of countries.

Exchange rate instability refers to the erratic fluctuation in exchange rate, which could during periods of domestic currency appreciation or depreciation. Exchange rate changes may lead to a major decline in future output, if they are unpredictable and erratic. The exchange rate is therefore, an important relative price as it has influence on the external competitiveness of the domestic economy. Volatility of exchange rate is a sort of risk challenged to international traders and investors engaged in FDI. So, we may conclude that volatility of exchange rate is a factor that curtails the trade volume and reduces the investment. This volatility when appears in developed nations causes instability all over the world (Chege, 2009). It is a wide recognized fact that exchange rate volatility in LDCs is the key factor to bring economic instability all over the world (Chege, 2009).

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 spill over effects. Such positive spill overs 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).

Justification for a negative impact of exchange rate volatility 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 volatility 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 domestic market 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. It was observed that aggregate investment expenditure as a share of GDP grew from 16.9% in 1970 to a peak of 29.7% in 1976 before declining to an all-time low of 7.7% in 1985. Thereafter, the highest was 11.8% of GDP in 1990, before declining to 9.3% in 1994. Beginning from 1995, investment/GDP ratio declined significantly to 5.8% and increased marginally to 7.0% in 1997 and remained there about till 2004 when 7.1% was recorded. On the average, about four-fifth of Nigeria’s national output was consumed annually. It is against this background that this study aims at investigating the impact of exchange rate instability on foreign direct investment in Nigeria.

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