GREENER JOURNAL OF ECONOMICS AND ACCOUNTANCY

ISSN: 2354-2357                 

Submitted: 20/11/2017                 Accepted: 23/11/2017                     Published: 29/11/2017

Research Article (DOI: http://doi.org/10.15580/GJEA.2017.3.112017170)

Exchange Rate Volatility and Fiscal Deficit in Nigeria: Any Causality? (1970-2016)

*¹Nwaeze Nnamdi Chinwendu, ²Kalu Ijeoma Eme,

³Tamuno Steve Otonye

¹Dept. of Economics, University of Port Harcourt.

²Dept. of Economics, University of Port Harcourt.

³Department of Economics, University of Port Harcourt.

                                           jiekal@ yahoo. com; Tel: ²+2348033098733; ³+2348034725830          

*Corresponding Author’s Email: nwaezennamdi @yahoo. com, Tel: +2348093063220

ABSTRACT

This study investigated possible causal relationships between fiscal deficit and exchange rate in Nigeria. The study adopted the vector autoregression (VAR) econometric technique to analyze the time series data obtained from the Central Bank of Nigeria and other sources. The study amongst other findings, found long run relationship between exchange rate and fiscal deficit, irrespective of how the deficit is financed. The study also found joint causality running from fiscal deficit to exchange rate with feedback. Also joint causality was found running from exchange rate to both the size of deficit finance through domestic and external borrowings, but without any feedback. Consequently, the variation in exchange rate are chiefly from both overall fiscal deficit financed through external and domestic borrowings. The study concluded that, fiscal deficit irrespective of how it is financed has significant negative effect on exchange rate in Nigeria and has contributed in worsening exchange rate volatility in Nigeria. The study recommends that the fiscal deficit should be scarcely deployed and moderated as a fiscal policy tool, as this causes shock and instability in price levels in general and exchange rate in particular.

Keywords: Exchange rate, volatility, causation, fiscal deficit and aggregate demand.

1 INTRODUCTION

Exchange rate is one of the cardinal macroeconomic variable, which to a greater extent decides the economic growth and development fate of economies, be it developed or less developed economies. Exchange rate, which is the price of a domestic measured in terms of other currencies of the world. Thus, exchange rate is the amount of other currencies a domestic currency is capable of purchasing in the international exchange market. It is the unifying factor in international trade between a country and the rest of the world. Therefore, the health of a country’s Balance of Payments (whether favourable and unfavourable), to a larger extent, depends on the strength and value of that country’s local currency.

The Naira which is Nigeria’s domestic currency has witnessed tumultuous and unpredictable regimes, which incidentally has coincided with Nigeria’s stagnated economic growth and development trajectory. For instance, the Naira which exchanged at the rate of N0.7k/$1 in 1970, has depreciated colossally to N310/$1 in 2017. This official statistics do not evidently captured the whole story, as the Naira/USD exchange rate has deteriorated to as high as N540/$1 at the parallel market as at March 2017.the monetary managers have adopted several exchange rate management options, ranging from full regulation, partial regulation, full deregulation, partial deregulation, mixed regime as well a multiple exchange rate regimes, aimed at hurting the disgraceful depreciation of the Naira, with little or no success recorded.  These volatility in exchange rates have hampered growth in Nigeria’s foreign reserves, trade balances as well as worsened the Balance of Payments conditions. These conditions have posed serious threats to Nigeria’s economic growth and development aspirations, especially as Nigeria is predominantly an import dependent and mono product (export of crude oil) economy. Whatever instability witnessed in Naira exchange rate has continuously and inadvertently been transmuted to the entire economy.

            Despite the prominent roles it plays in an economy, exchange rates or the external sector of the economy cannot be discussed or managed in isolation, as the economy is the interplay of several sectors and macroeconomic variables. Thus, the macroeconomic variables and their management are, therefore, interwoven and the fiscal and monetary authorities must chat a common course, if an economy must be put on the trajectory of sustainable economic growth and development.

The fiscal authorities, especially in the less developed countries and modern development theorists especially the Keynesian and Neo- Keynesian theorists, favour the unbalancing of government fiscal budget owing to its acclaimed expansionary effects on economic growth and development. To the proponents, for economic growth and development to be achieved, a country especially the less developed nations who most a times lack adequate savings and capital formation; high poverty and unemployment level, dearth of critical infrastructures; as well as the private sector’s lack of desired capacity to drive growth and industrialization, needs  government intervention in the form of expansionary fiscal policy to raise savings and capital formation, improve critical infrastructures, develop the productive capacity of the economy; invest in functional education, research and development and healthcare to improve human capital development while maintaining macroeconomic stability in price level and exchange rates in the economy.

Consequently, despite the expansionary objectives of targeting expansion in growth and employment, fiscal deficits have some macroeconomic undesirables it could produce in an economy, which may negate the expansionary objectives, especially in the long run. Thus, fiscal deficit may be counterproductive to the macroeconomic objectives expansion in output and employment. Some of such macroeconomic undesirables include, price instability, exchange rate instability or volatility, accumulation of debt burden in both principal and interest and “crowding out” of private investment spending and interest sensitive consumer spending. Therefore, the efficacy of fiscal deficits are objectively measured in terms of the macroeconomic performance of the economy vis-a-viz price and exchange rate stability, employment generation and economic growth. This is because, stimulating employment and economic growth through sustained fiscal deficits, may lead to an inflation induced growth as well as exchange rate volatility, which negates the primary objectives fiscal deficits intended to achieve.

It is evidently established, therefore, that the external sector of the Nigerian economy cannot be said to be immune from deterioration and volatility as a result of sustained fiscal deficits. With Nigeria’s deteriorating external reserve position, exchange rate volatility, rising external borrowing and/or debt and its attendant adverse pressure on the Balance of Payments conditions, may not be unconnected with fiscal deficits over the years. Exchange rates are an important index for measuring economic performance, predominantly, the impact on price signals, international trade and foreign direct investment. The preservation of low inflation rate encompasses higher interest rates, and this leads to the appreciation of the country’s exchange rate (Agu and Evoh, 2011). 

Generally, economists believe that excessive and prolonged fiscal deficits usually contribute to macroeconomic instability. In the case of Nigeria, high and sustained fiscal deficits over the years is believed to have fuelled inflationary pressures, exchange rate volatility and decreased the amount of loanable funds available for private investment through increases in interest rate. According to Obi and Nurudeen (2008) Nigeria’s fiscal deficits have been blamed for much of the economic crisis that beset it resulting in over indebtedness in both external and domestic borrowing, high inflation, poor private investment performance and economic growth.  This position is corroborated by Oluba (2008) who noted fiscal deficit in Nigeria as one of the reasons for the continued pressure on the price level. To him, the financing of fiscal deficits is the major source of inflation irrespective of how it is financed. All options of financing fiscal deficit has poisonous effects on the economy. He further argued that fiscal deficits substantially reduces national saving and consequently domestic investment (crowding out effect); there are obvious macroeconomic imbalance which includes serious debt burden, inflation, foreign exchange scarcity and high interest rate. These macroeconomic imbalances if inherent in an economy, could obviously be inimical to the originally intended economic growth/output expansion and employment objectives of undertaken fiscal deficits.

The aim of this study, therefore, is to investigate possible causality between exchange rate volatility and fiscal deficits in Nigeria. The specific objective is to determine the effect of fiscal deficit and the disaggregated effects of domestic and external borrowing financed fiscal deficit on exchange rate in Nigeria

2.0 LITERATURE REVIEW

2.1 Review of Theoretical Literature

The theoretical framework of this research work therefore, is based on Keynes theory of employment which gave utmost relevance to fiscal policy and government consumption. The objections as put up by the classical and the neoclassical economists as well as the Ricardian equivalence shall also be highlighted.

Keynes (1936) came up with his famous theory of employment, output and income to counter the classical economists who have hitherto held sway with their theory of free market system, which they believed has an inbuilt automatic mechanism to adjust itself, especially in the long run. The classical theory,  however ,  failed  to  ameliorate the Great depression in America. Keynes theory, therefore, was postulated following the classical theorists failures in reversing the American depression of the 1930s. John Maynard Keynes attributed the prevailing depression and unemployment to the problem of under-spending or under-consumption. In the Keynesian theory of employment, public spending therefore, can contribute positively to stimulating economic growth. An increase in government consumption is likely to lead to an increase in employment, profitability and investment through the multiplier effects on aggregate consumption. As a result government spending augments the aggregate demand, which triggers an increased output depending on expenditure multipliers. Keynes, therefore, encouraged the running of budget deficits by increasing government spending and/or reducing taxes, and by so doing cited that the market solution would be ineffective because the price mechanism and wages that have to respond to the existence of unemployment do not adjust with sufficient speed (Oluba, 2008). To Keynes, the economy is inherently unstable and needs to be steadied through vigorous government intervention and/or appropriate policies of government.  Deficit financing to the Keynesians is as an important tool to achieve a desired level of aggregate demand consistent with full employment. The major assumption of this theory is that the economy is working at less than full employment level of national income. Given the existence of output gap in the economy, increase in debt financed government expenditure will bring expansion in output and income. Thus, they argue that an escalation in government spending through the use of borrowed money cause an upward shift on the aggregate demand curve.  By implication therefore, deficit financing according to the Keynesian theory can be used to create additional employment when the economy is suffering from a deficiency of effective demand. As an instrument of recovery after recession, deficit financing can be used to mitigate against severe cyclical fluctuations (Dewett, 2009).

Keynesian postulation on the efficacy of fiscal deficit being able to stimulate employment and economic growth is premised on his multiplier concept.  If the assumption of the existence of unutilized human and material resources in terms of economic recessions holds therefore, an increase in government spending (or tax reduction) over its revenue will increase both investment and consumption hence leading to expansion of output in multiples of the government expenditure, which Keynes christened the government expenditure multiplier. However, the magnitude of the output expansion is a function of the marginal propensity to consume (MPC) in the economy. Summarily therefore, government spending increases total output more rapidly in an economy with high MPC than country with low MPC (Ali and Ahmad 2014).

The above theory however was strongly opposed by the classical and neoclassical schools. The classical school criticism postulate that fiscal deficits incessantly financed by domestic debt crowds out investment and by extension lower the level of economic growth. In sum, they postulate that excessive fiscal deficits lead to poor economic performance. Thus, fiscal deficits financed by public debts are principally counterbalance by the crowding out effect of deficit financing on private sector investment, and this by extension lowers the level of economic growth. The implication of such policy does not stop at the crowding out effect on private investment, also the society will have to bear the burden of increased public debts as a result of debt financed expansion in government expenditure. This overriding objection of Keynes employment theory as well as the efficacy of fiscal deficit in stimulating economic growth by the classical economists was premised on their assumption that the economy always operates at full employment.  If an economy is already operating at full employment, any extra expenditure financed by debt or by money creation is bound to create inflationary rise in prices (Anyanwu, 1995; Dewett, 2009).

On their part, the neo-classical economists collaborated the position of the classical economists that fiscal deficit would have adverse effect on economic growth. Their argument is that fiscal deficit is an obvious weakening of government savings. If government savings are weakened, it will put pressure on rate of interest except if it is fully offset by private savings. Therefore, a decline in national savings will exert pressure on cost of credit (interest rate) which crowds out private investment and a resultant fall in general level of output in the long-run. The neoclassical economists further argued that the manner in which the deficit is financed is capable of influencing the level of consumption and investment and by extension economic growth (Omitogun and Tajudeen, 2007; (Mohanty, 2012).

2.1.2 The Balance of Payment Constrained Growth Model.

Thirlwall’s Balance of Payments constrained growth model is another relevant contemporary growth theory of interest to this study. This theory opines that the rate of growth of an individual country is restrained by the balance of Payments as the economy cannot grow faster than what is consistent with the Balance of Payments equilibrium or at least consistent with a sustainable deficit in the Balance of Payments.  To Thirlwall (1979) no country can grow faster than the rate consistent with the Balance of Payments equilibrium on current account unless, it can finance ever-growing deficits, which is generally believed to be overwhelming.  Specifically, therefore, the basic idea of the model is that export performance and import behavior determines the rate of economic growth in the long run. Increasing revenue of foreign exchange from exports of goods and services make up the only sustainable means of financing increasing imports caused by the expansion in domestic activity or aggregate demand. One major assumption Thirlwall premised this theory on is its assumption that trade balance equilibrium and imports are related to domestic income only. Ferreira and Canuto (2003) collaborated Thirlwall’s position with their elucidation that only export growth and the growth of investment in import substitution are the components of aggregate demand that has the capacity to increase the growth of GDP, as well as to relax foreign constraints and Balance of Payments constriction. Conclusively, therefore, favorable Balance of Payments enhances the capacity of an economy to expand while at the same time maintaining an equilibrated current account.

This theory however, has been criticized for excluding the savings-investment gap, fiscal gap and monetary implication of the Balance of Payments.  It also does not show the foreign exchange requirement relating to the maintenance of level of reserves (Darku, 2013). The reason for this theory is that it observed Balance of Payments as an important variable of the external sector. Also, the model is relevant to this study because export performance and import behavior determines the Balance of Payments and exchange rates which has significant impact on rate of economic growth and/or development, as well as macroeconomic stability.

2.2 Review of Empirical Literature

Indication on the relationship between fiscal deficit and external sector is also split. For instance, the study of Piersanti (2000) deployed the Granger-Sims causality technique to study the relationship between the current account deficits and budget deficits for seventeen OECD countries over the period 1970-1997. The findings reveal that external sector performance is negatively correlated with budget deficits.  Other studies that fall under this findings include that of Al-Khedair (1996), Islam (1998), Volker (1984), Bundt and Solocha (1988), Zaidi (1985) and Laney (1986). On the flip side, the study of Khalid and Guan (1999) using the sample of developed countries in their study, with data from 1950 to 1994, found out that there is no relationship between fiscal deficit and external sector performance, as measured by the current account deficit. Other studies that support this findings include Bachman (1992), Zaidi (1985), and Evans (1988), in the case of Brazil.

Rahnaddi and Ichhashi (2011) developed a multivariate Error Correction model and found a significant relationship between export and growth in Indonesian but found no supportive evidence of positive causality from intermediate imports to GDP per capital. Usman, et al (2012) in an attempt to understand the causality between export and economic growth, investigated the impact of export on economic growth in Pakistan using ordinary least square. The findings reveal a strong positive and significant effect of export on economic growth. The work of Korsu (2007) studied the effect of fiscal deficit on external sector performance in Sierra-Leone. His study used three stage least square (3 SLS) and simulation techniques on time series data. His findings showed that fiscal deficit has negative implication for external sector performance in Sierra-Leone.

Ngerebo-a and Ibe (2013) investigated the causal relationship between exchange rate, balance of payment, external debt, external reserves, gross domestic product growth rate and inflation rate in Nigeria post Structural Adjustment Programme (SAP). The Johansen co-integration test, equation estimation and Granger causality tests were applied on annual time series data 1987-2011. Johansen co-integration result confirms the existence of a long-run equilibrium relationship among the indicators. Their study concluded by affirming the existence of a causal relationship between exchange rate, balance of payment, external debt, external reserves, gross domestic product growth rate and inflation in Nigeria post-SAP. These indicators somehow impact exchange rate determination in Nigeria post-SAP. Fasoranti and Amasoma (2013) the study examined the relationship between fiscal deficits and the external sector performance of Nigeria between 1961 and 2011, using a bi-variate Granger causality technique and the error correlation modeling techniques to analyze the time series data. There also existed a bi-directional causality between budget deficit and external sector performance in the long run while a one – way causation existed from external sector performance to budget deficit in the short run with no feedback from fiscal deficit. Findings also showed that fiscal deficit did not significantly affect external sector performance in the short run. The study concluded that result of the cross correlation coefficient showed that fiscal deficits would lead to long run deterioration in external reserves accumulation and exchange rate.

Udeh et al (2016) studied the impact of external debt on economic growth in Nigeria for the period 1980-2013. The study adopted the Ordinary Least Squares, co-integration and Error Correction techniques. The findings showed that external debt had a positive relationship with Gross Domestic Product in the short run, but a negative relationship at the long run. Also, while external debt Service payment had negative relationship with Gross Domestic Product, exchange rate had a positive relationship with it. The work of Ifionu and Ogbuagu (2007) was an econometric evaluation of exchange rate and external sector performance in Nigeria under the regulation and deregulation era. Their study tested Balance of Payments on exchange rate, external debt burden, external debt service, external reserve and exchange rate regime using the Ordinary Least Squares technique. They found that external sector performance was better under a deregulation regime than during a regulated regime. Their main recommendation is that the government should adopt a mixed exchange rate policy and diversify the productive base of the economy.

3.0 METHODOLOGY

The vector autoregression (VAR) econometric technique was used in estimating and analyzing the time series data, obtained from the CBN, statistical bulletin (various), NBS, DMO and IMF. Econometric view (E-View) software package was used to obtain the estimates for our econometric model. A VAR is system in which every equation has the same right hand variable, and those variables include lagged values of all of the endogenous variables. VARs are useful for forecasting systems of interrelated time series variables. VARs are also used for analyzing the dynamic impact of different types of random disturbances on systems of variables. Green (2000) and Gujarati (2009). The VAR approach sidesteps the need for structural modeling by treating every endogenous variable in the system as a function of the lagged values of all the endogenous variables in the system. The vector autoregressive (VAR) model is a theoretical modeling technique used in economic analysis. It is one of the most successful, flexible, and easy to use models for the analysis of multivariate time series. This study adapted the model specified by Sims (1980). The impulse response function and the forecast error variance decomposition was used to analyze the estimations.

Impulse Response Function: A shock to a particular variable may not only directly affect the variable but is also transmitted to all of the other endogenous variables. An impulse-response function traces the impact of a one-time shock to one of the innovations on the current and future values of the endogenous variables. In order words, an impulse-response was applied to trace the reactions of the variables used in this study.

Forecast Error Variance Decomposition (FEVD): While impulse-response functions trace the effects of a shock to one endogenous variable onto the other variables in the VAR, the Variance Decomposition provides information about the relative importance of each random innovation in affecting the random variables in the VAR (Hamilton, 1994). Therefore, Variance Decompositions show the magnitude of the variations in the endogenous variables.

3.1 Model Specification

This model is built to estimate the dynamic effects and relationship of overall fiscal deficits; domestic and external borrowing financed deficit shocks on exchange rate in Nigeria. The endogenous variables included in the model are specified thus:

(EXCR, OFDE, DBFD, EBFD, EXTR, FDI)                                              (3.1)

The Vector Autoregressive (VAR) transformation of model five (equation 3.1) is stated as:

EXCR_t = ω₁₁EXCR_t-1 + ω₁₂OFDE_t-1 + ω₁₃DBFD_t-1 + ω₁₄EBFD_t-1 + ω₁₅EXTR_t-1 + ω₁₆FDI_t-1 + e_1t          (3.1a)

OFDE_t = ω₂₁EXCR_t-1 + ω₂₂OFDE_t-1 + ω₂₃DBFD_t-1 + ω₂₄EBFD_t-1 + ω₂₅EXTR_t-1 + ω₂₆FDI_t-1 + e_2t          (3.1b)

DBFD_t = ω₃₁EXCR_t-1 + ω₃₂OFDE_t-1 + ω₃₃DBFD_t-1 + ω₃₄EBFD_t-1 + ω₃₅EXTR_t-1 + ω₃₆FDI_t-1 + e_3t          (3.1c)

EBFD_t = ω₄₁EXCR_t-1 + ω₄₂OFDE_t-1 + ω₄₃DBFD_t-1 + ω₄₄EBFD_t-1 + ω₄₅EXTR_t-1 + ω₄₆FDI_t-1 + e_4t          (3.1d)

EXTR_t = ω₅₁EXCR_t-1 + ω₅₂OFDE_t-1 + ω₅₃DBFD_t-1 + ω₅₄EBFD_t-1 + ω₅₅EXTR_t-1 + ω₅₆FDI_t-1 + e_5t          (3.1e)

FDI_t = ω₆₁EXCR_t-1 + ω₆₂OFDE_t-1 + ω₆₃DBFD_t-1 + ω₆₄EBFD_t-1 + ω₆₅EXTR_t-1 + ω₆₆FDI_t-1 + e_5t  (3.1f)

Where;

EXCR = Exchange rate

OFDE=    Overall fiscal deficits

DBDS=   Domestic borrowing debt stock

EBDS=    External borrowing debt stock

FDI=     Foreign direct investment

EXTR= external reserve balance

e_it....e_ij =   the error terms

4.0 RESULTS AND DISCUSSIONS

4.1 Descriptive Statistics

Tables 1 below presents the result of the descriptive statistics of the variables employed in the estimations in this study.

From table 1 above, the standard deviation showed that EBFD (2713923) was the most volatile variable in the series followed by DBFD (1318736), while EXCR (70.74818) was the least volatile variable. The skewness statistic showed that EXCR, DBFD, EBFD, FDI AND EXTR were positively skewed while OFDE variable was negatively skewed. The kurtosis statistic showed that EXCR and EXTR were platykurtic, suggesting that their distributions were flat relative normal distribution while OFDE, DBFD, EBFD and FDI was leptokurtic, suggesting that its distribution was peaked relative normal distribution. Based on these observations, it indicates that the series are non-stationary. However, this indication is not surprising since it involves time series data. In sum, there is unit root (non-stationarity) in the series. In such a case, the presence of unit root in the model is further supported by the values of the Jarque-Bera statistic of most of the variables (OFDE, DBFD, EBFD, FDI and EXTR) in table 1 which are above 5.99 (that is, the Jarque-Bera statistic rejects the null hypothesis of normal distribution for all the variables at 5 percent critical value) depicting the presence of unit root.

Based on these observations it is therefore necessary to test for the long run relationship of the series. This we begin by testing for unit root of the series. The unit root test is conducted so as to make the variables stationary. The study adopts the Dickey and Fuller (1979) method called Augmented Dickey Fuller (ADF) unit root tests procedures.

4.2 Unit Root Test

Tables 2 and 3 below present the results of the stationarity test for each of the variables used in this study. The Augmented Dickey Fuller (ADF) test was tested with intercept but no trend.

The results of the unit root test in table 3 revealed that only DBFD variables was stationary at level while all the other variables were non stationary at level. We therefore accept the unit root null hypothesis indicating the presence of a unit root at levels and then proceed to employ first differentiation approach to establish the order of integration of the variables using the Augmented Dickey Fuller tests unit root test as presented in the table 3 below.

Table 3 revealed that EXCR, OFDE, EBFD, FDI and EXTR were stationary in their first difference. Hence, the study then concluded that the variables of the model are integrated of order one. Having stabilized and stationarized the data, we now conduct the co-integration test.

4.3 Co-integration Test Results

Since all the variables were integrated of order 1, we turned to determine the existence of long run equilibrium relationship between the variables. Separate co-integration tests were carried out on fiscal deficits; financing options vis-a-viz domestic and external borrowing with respect to their relationship with Exchange rate (EXCR). Non-stationary time-series can be co-integrated if there are linear combinations of them that are stationary, that is, the combination does not have a stochastic trend. In other words, if two or more I(1) variables are co-integrated, they must obey an equilibrium relationship in the long-run, although they may diverge substantially from that equilibrium in the short run.

            The co-integration tests are based on the Johansen and Juselius (1989) test. Table 4 present the co-integration test results.

The co-integration results in table 4 for model five (EXCR, OFDE, DBFD, EBFD, EXTR and FDI) reveals that both the trace test and the Max-eigenvalue test also indicate 6 co-integrating equation(s) at the 5 percent level of significance. This suggests that there is a long-run relationship between the variables. We therefore reject the null hypothesis of no co-integration amongst the variables but we do not reject the alternative hypothesis.

Having established that the variables in all of our five models above are co-integrated (Co-integrating Vector) at 5% level of significance in each case, we therefore proceed to estimate our Vector Auto Regression (VAR) model.

4.4 VAR Lag Order Selection

The first step in model building, impulse response analysis and decomposition of the forecast error variance is the selection of the lag order. In this study we use some commonly used lag-order selection criteria to choose the lag order, such as the "Akaike information criterion (AIC)", "Schwartz criterion (SC)", "Hannam-Quinn criterion (HQC)"  and  "final prediction error (FPE)" to determine the optimum lag and then analyze the residuals.

Table 5 shows that lag 2 is chosen as the optimum lag in the specification of VAR model on the relationship between fiscal deficit and macroeconomic performance in Nigeria between 1970 and 2016. Thus, we now estimate and analyze the VAR, impulse response and decomposition of the forecast error variance.

4.5 Impulse Response Function (IRF) Analysis

The impulse response analysis is presented in table below. It presents a fraction of the impulse response analysis for each variable in the five models that is attributed to its own innovations and to innovations in other

Table 6 (Exchange Rate (EXCR) model) present the results of the impulse response function for exchange rate. From table 6 above, the response of Exchange Rate (EXCR) to one standard innovation in the overall fiscal deficit (OFDE) is all negative at each time responsive period in the long–run except in the 3^rd period. This implies that OFDE has a negative relationship with EXCR in the long-run as shown in figure 1 below.

Figure 1: Response of EXCR to OFDE

The response of Exchange Rate (EXCR) to one standard innovation in the size of fiscal deficit financed by domestic borrowing (DBFD) is all positive at each time responsive period in the long–run except in the 2^nd period while that of the size of fiscal deficit financed by external borrowing (EBFD) is all positive at each time responsive period in the long–run. This implies that EXCR has a positive relationship with DBFD and EBFD in the long-run as shown in the table above.

Figure 2: Response of EXCR to DBFD

The response of Exchange Rate (EXCR) to one standard innovation in the size of fiscal deficit financed by domestic borrowing (DBFD) is all positive at each time responsive period in the long–run except in the 2^nd period. This implies that EXCR has a positive relationship with DBFD in the long-run as shown in figure 3 below.

Figure 3: Response of EXCR to EBFD

The response of Exchange Rate (EXCR) to one standard innovation in External Reserve Balance (EXTR) is all negative at each time responsive period in the long–run. This implies that EXTR have a negative relationship with EXCR in the long-run as shown in figure 4 below.

Figure 4: Response of EXCR to EXTR

The response of Exchange Rate (EXCR) to one standard innovation in Foreign Direct Investment (FDI) is all negative at each time responsive period in the long–run except in the 2^nd period. This implies that FDI have a negative relationship with EXCR in the long-run as shown in figure 5 below.

Figure 5: Response of EXCR to FDI

4.6 Forecast Error Variance Decomposition (FEVD) Analysis

The forecast error variance decomposition analysis is presented in table 7 below. It presents a fraction of the forecast error variance decomposition for each variable in the exchange rate model that is attributed to its own innovations and to innovations in other variables. The variance decomposition was estimated so as to see the forecast error components of each of the variables originating from shocks in the system. The ordering of the variables in the variance decomposition is vital and this is stated in table below over the same forecasting horizon for a period of ten (10) years.

Table 7 (EXCR model) present the results of the variance decomposition for model five. It shows that 100 percent of variance in Exchange Rate (EXCR) in period 1 is explained by the shock from the variable itself. This implies that there was no shock from other variables. In period 2, 95 percent of the variance in Exchange Rate (EXCR) was explained by the shock from the variable itself; 0.0004 percent from fiscal deficit (OFDE); 0.63 percent from the size of fiscal deficit financed by domestic borrowing (DBFD); 1.02 percent from the size of fiscal deficit financed by external borrowing (EBFD); 2.83 percent from External Reserve balance (EXTR) and 0.03 percent from foreign direct investment (FDI).

Inferences from period 2 to 10 shows that apart from the variance due to the shock from the variance of Exchange Rate (EXCR) itself, the size of fiscal deficit financed by external borrowing (EBFD) is the variable with the highest percentage of induced variance on Exchange Rate (EXCR) of about 19 percent followed by the size of fiscal deficit financed by domestic borrowing (DBFD) while OFDE, EXTR, and FDI induce 14 percent, 1 percent, and 0.93 percent respectively.

4.7 VAR Granger Causality Results

The results of the VAR granger causality tests of the variables in the model is presented in Tables below.

Table 8 above present the VAR granger causality tests result for model five, that is, external sector model. From the result, we found that there is a joint granger causality running from OFDE, DBFD, EBFD, EXTR and FDI to EXCR; there is a joint granger causality running from EXCR, DBFD, EBFD, EXTR and FDI to OFDE and there is also a joint granger causality running from EXCR, OFDE, EBFD, EXTR and FDI to DBFD. Furthermore, the study found that there is a joint granger causality running from EXCR, OFDE, DBFD, EXTR and FDI to EBFD; there is a joint granger causality running from EXCR, OFDE, DBFD, EBFD, and FDI to EXTR and there is also a joint granger causality running from EXCR, OFDE, DBFD, EBFD, and EXTR to FDI.

4.4 Summary and Discussion of Findings

The major findings of this study on the basis of which appropriate policy recommendations were proffered can be summarized as follows:

1.  The study found a cointegrating (long run) relationships between fiscal deficits; financing options vis-a-viz domestic and external borrowing and exchange rate performance in Nigeria. 

2.  The exchange rate was found to have had negative relationship with overall fiscal deficit (OFDE), but were positively related to the size of fiscal deficits financed by domestic borrowing (DBFD) and the size of fiscal deficits financed by external borrowing (EBFD) respectively, in the long–run, in Nigeria.

3. Our study also found out that the size of fiscal deficits financed by public borrowing (domestic (DBFD) and external borrowing (EBFD)) and overall fiscal deficits (OFDE) were the main shocks causing the variation in exchange rate (EXCR) in Nigeria within the period of study.

4. There are bidirectional joint granger causality running from OFDE, DBFD, EBFD, EXTR and FDI to EXCR and joint granger causality running from EXCR, DBFD, EBFD, EXTR and FDI to OFDE. Thus, there exists causation with feedback between overall fiscal deficits and exchange rate performance in Nigeria.

5. Existence of joint granger causality running from EXCR, OFDE, EBFD, EXTR and FDI to DBFD without feedback. Thus one directional causality running from exchange rate and the other endogenous variables to size of fiscal deficits financed through domestic borrowing.

6. Existence of joint granger causality running from EXCR, OFDE, DBFD, EXTR and FDI to EBFD without feedback. Thus one directional causality running from exchange rate and the other endogenous variables to size of fiscal deficits financed through external borrowing.

In sum, the study reveals that among the endogenous variables, the shocks due to the size of fiscal deficits financed by external borrowing (EBFD) contributes more to variance in exchange rate (EXCR) with an average of about 19 percent followed by the size of fiscal deficits financed by domestic borrowing (DBFD) with an average of about 18 percent and then overall fiscal deficits (OFDE) with an average of about 15 percent within the period under review. This implies that the size of fiscal deficits financed by public borrowing, that is, both domestic (DBFD) and external borrowing (EBFD) and overall fiscal deficits (OFDE) are the main shocks causing the variation in exchange rate (EXCR) in Nigeria within the period of study. This finding confirms with the works of previous studies such as Awan, Asghar and Rehman (2011), Hassan, Abubakar and Abu (2015), Udeh, Ike and Onuka (2016). These scholars have found that increased public borrowing both domestic and external borrowings to finance fiscal deficit has cause the instability of exchange rate in Nigeria.

5.0 SUMMARY, CONCLUSION AND RECOMMENDATIONS

This study examined the causal relationships between fiscal deficits; financing options vis-a-viz domestic and external borrowing and exchange rate in Nigeria from 1970 to 2016. The study adopted a four-stage methodology to investigate these relationships as well as the magnitude influences on unemployment. First the stationary status of the data series was examined using Augmented Dickey Fuller unit root test. This was followed by Johansen cointegration test. The third stage was the VAR method and the fourth stage was VAR granger causality test.

Consequent upon the findings of this study, we, therefore, conclude that there exists causation between fiscal deficits and exchange rate in Nigeria. Thus, fiscal deficits have contributed in the worsening exchange rate problem in Nigeria, irrespective of how the deficits are financed. The study recommends that fiscal managers in Nigeria should moderate fiscal deficits. The negative macroeconomic effects of unrestricted fiscal deficits, especially on exchange rate as in the case of Nigeria, far outweigh any gain these deficits can produce. Whatever gains recorded by fiscal deficits in terms of output growth would be eroded by exchange rate volatility, which happens to be a prime determinant of macroeconomic performance of any economy, especially an import dependent country like Nigeria. Secondly, Nigeria need holistic reforms in her budgetary processes. The reforms should cover areas of budget preparation, execution and monitoring mechanisms. Budget preparations and executions must be timely given the inherent impact lags of fiscal budgets. Effective monitoring mechanism must be set in motion to ensure that funds are utilized for purposes for which they were acquired.

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Cite this Article: Nwaeze NC, Kalu IE, Tamuno SO (2017). Exchange Rate Volatility and Fiscal Deficit in Nigeria: Any Causality? (1970-2016). Greener Journal of Economics and Accountancy, 6(3): 082-095, http://doi.org/10.15580/GJEA.2017.3.112017170