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EXCHANGE RATE PASS-THROUGH TO IMPORT AND CONSUMER PRICES IN NIGERIA: EVIDENCE FROM THRESHOLD REGRESSION MODELS
This study examined the exchange rate pass-through effect at the aggregate level into import and consumer prices in Nigeria between the periods 1986 and 2014. The study used the Threshold Regression statistical technique to ascertain the possibility of the presence of nonlinearity and asymmetry in the behaviour of exchange rate pass-through in Nigeria. It also considered the pass-through from exchange rate to import prices, using import data, and then the pass-through from import prices to consumer prices. The study found that Exchange Rate Pass-Through in Nigeria is incomplete, low, nonlinear, slow in speed and symmetric. The effect was discovered to be higher on import than consumer prices, implying that the pass-through effect declines along the pricing chain. These findings are useful in the design and implementation of monetary and exchange rate policies by the Central Bank of Nigeria.
1.1 BACKGROUND OF THE STUDY
Globalisation has increased the openness of global economies thereby necessitating an increased focus on exchange rate pass-through with the aim of determining an appropriate monetary policy response to exchange rate fluctuations. The incidence of large fluctuations in exchange rates has informed the need for a better understanding of the determinants of transmission of exchange rate variations into import and domestic prices (Aliyu, Sanni and Duke, 2009). The concept of Exchange Rate Pass-Through (ERPT) has been well known to Economists for a long time but significant interest in the concept grew since after the Plaza Accord of 1985. This was an agreement between France, West Germany, Japan, USA and UK to depreciate the US dollar in relation to the Japanese yen and German Deutsche Mark and it was expected that the price of Japanese import in US dollar would be expensive. However, it was later observed that the price of the Japanese imports in US dollar rose only slightly or even remained unchanged and in some cases actually declined (Goldberg and Knetter in Berga, 2012). This prompted Economists‟ increased interest in trying to estimate the extent of speed and magnitude of Exchange Rate Pass-Through (ERPT).
Exchange Rate Pass-Through refers to the change in domestic prices that can be attributed to a prior change in the nominal exchange rate (Aliyu et al., 2009). It is also generally considered as the extent to which changes in exchange rate are reflected in the prices of goods and services (Sanusi, 2010). When there is a proportionate change in domestic prices arising from a change in exchange rate, the pass-through is said to be complete. It is incomplete when the change is less than proportionate and zero pass-through occurs, when a change in exchange rate does not affect domestic prices. ERPT affects consumer prices directly through prices of imported consumer goods and indirectly through the prices of imported intermediate goods. When the currency of the domestic country appreciates, it will lead to lower import prices of finished goods and inputs. Likewise, when the domestic currency depreciates, it will result in higher import prices which are more likely to be passed on to consumer prices. Currency depreciation also causes a rise in the prices of imported inputs which may result in the increase in the marginal cost of producers. Thus, this results to higher prices in domestically produced goods (Mohammed, 2013).
Initially ERPT was perceived to be theoretically one-to-one, i.e, hundred percent change in foreign price is wholly passed unto domestic consumer prices. This is because the Purchasing Power Parity (PPP) was based on the perfect competitive market model. However, later empirical studies have found ERPT to be incomplete (Berga, 2012). This may not be unconnected with the fact that most of the assumptions underlying the theory do not exist in reality thus, leading to contradictory outcomes from empirical studies. Some of the explanations to the incompleteness of pass-through include the exporters‟ Pricing-To-Market (PTM). Krugman (1987) first popularised this idea that, when there is a depreciation in the importers‟ currency, foreign exporters tend to reduce their export prices by reducing the margin of their profits instead of increasing the import prices in order to maintain market share. Similarly, exporters may invoice in the currency of the importer known as Local Currency Pricing (LCP). In such situations, prices do not often fluctuate with the variation in exchange rate (Goldberg and Knetter, 1997). Similarly, some studies on ERPT have found that in some cases, there tend to be higher pass-through during appreciation than during depreciation. In some situations also, there tend to be zero/low pass-through during small changes in exchanges and higher pass-through during higher changes in exchange rate. This brings about the concept Asymmetry in ERPT.
There has been a debate about the major sources of inflation in Nigeria. Exchange rate depreciation is believed to be one of the sources of inflationary trend in Nigeria. This is more
so as empirical evidence shows that there is a stronger positive relationship between autonomous exchange rate and Consumer Price Index (CPI) even though the relationship is weaker between the official rate and CPI (Adekunle, 2010). Other reasons brought forward include the persistent inflationary trend experienced in the country alongside the successive depreciation of the naira following the adoption of the Structural Adjustment Programme (SAP) in 1986.
The Structural Adjustment Programme (SAP) was introduced to among other things, correct the overvaluation of the naira through the setting up of a viable Second-tier Foreign Exchange Market (SFEM). This led to the successive depreciation of the naira from N1.56 /US$1 at the end of September, 1986 to N4.54/US$1 in 1988. It almost double to N8.04 = US$1and N17.30/US$1 in 1990 and 1992 respectively. By 1994, the de-factor pegging of the official exchange rate formalised when the naira was officially pegged at N21.88/US$1 in 1994 Budget and the parallel market was declared illegal (Sanni, 2006). By the year 2000, when the new civilian administration of Olusegun Obasanjo came to power, the exchange rate was liberalised leading to the nose-dive of the naira to N102.1/US$1 in 2000, N120.9/US$1 in 2002 and 133.5/US$1 in 2004 respectively. The naira appreciated against the USD for the first time in 2005 since 1986 to N132.1/US$1 and later N128.7/US$1 and N118.5/US$1 in 2006 and 2008. It, however, skyrocketed to around N157.3/US$1 in 2013 and later N158.6/US$1 in 2014 (CBN statistical Bulletin, 2014).
Similarly, in 1986, the rate of inflation was 6.25%. The figure more than quadrupled in 1988 to 34.2%. There was sharp decline to 7.9% in 1990 but climbed to 44.57% in 1992.It remained around the same figure until 2002. Ascendancy in the inflation rate began afterwards from 2009. However, the rate continued to rise from 6.94% in 2000 to 12.89% in 2002, 15% in 2004. A drop was experienced in 2006 to 8.22% but rose to 11.58% and 13.72% in 2008 and 2010 respectively (IMF World Economic Outlook, 2011 and International Financial Statistics, 2012). It declines to 12.2% in 2012 and then to 8.0% in 2014 (CBN Statistical Bulletin, 2015).
A closer look at the relationship between the exchange rate and inflation in Nigeria within the period 1986 to 2014 shows a somewhat positive relationship. There were sharp falls in the inflation rate in 2006. The fall in 2006 could be linked to the Central Bank of Nigeria‟s financial sector reforms during the period that led to the consolidation of banks‟ capital base, accumulation of sizeable external reserve and appreciation of the naira against US Dollar. This signifies that there is high level of possibility that exchange rate variability may affect inflation in Nigeria. This study investigates the magnitude and speed of exchange rate pass-through to import and consumer prices in Nigeria using the Threshold Regression Model.
1.2 STATEMENT OF THE RESEARCH PROBLEM
Nigeria is an import dependent and a mono-cultural economy with oil constituting about 90% of its revenue. The country heavily depends on imports from many countries as many industries in Nigeria import their raw materials as well as massive importation of finished goods from foreign countries (Adedayo, 2012). This has renders the nation vulnerable to possible foreign inflation transmission.
Developments in the external sector of the Nigerian economy have led to the continued dwindling of crude oil receipts due to both demand and supply factors which led to the deterioration of the foreign exchange status of the naira. Concerns are on the implications of these developments on inflation or the extent of exchange rate pass-through of foreign prices to domestic and import prices. Thus, the need to empirically unravel the consequences of these developments and provide policy recommendations for monetary policy authorities in Nigeria cannot be overemphasised.
Although studies were conducted on ERPT in Nigeria, they rely heavily on linear models while empirical evidences on some economies have found that ERPT could nonlinear. Again, most of the above studies did not consider the first stage in the pass-through which is to import prices but chose to jump to consumer prices. This has eluded a fundamental aspect of the pass-through mechanism that could give more comprehensive information about ERPT in Nigeria. In addition, the previous studies have not considered the possibility of the presence of Asymmetry in ERPT in Nigeria.
1.3 RESEARCH QUESTIONS
- What is the degree of ERPT to import and consumer prices in Nigeria?
- What is the speed of ERPT to import and consumer prices in Nigeria?
- Is there evidence of nonlinearity in ERPT to import and consumer prices in Nigeria?
- Is there presence of asymmetry in ERPT to import prices in Nigeria?
1.4 RESEARCH HYPOTHESES
- There is low ERPT to import and consumer prices in Nigeria.
- There is low speed of ERPT to import and consumer prices in Nigeria.
- There is evidence of nonlinearity in ERPT to imports and consumer prices in Nigeria
- There is the presence of asymmetry in ERPT to import prices in Nigeria.
1.5 OBJECTIVES OF THE STUDY
The specific objective of this study is to examine exchange rate pass-through to import and
consumer prices in Nigeria.
Broadly, this study intends to:
- Estimate the degree of ERPT to import and consumer prices in Nigeria
- Estimate the speed of ERPT to import and consumer prices in Nigeria
- Examine if there is evidence of nonlinearity in ERPT to import and consumer prices in Nigeria
- Examine if there is the presence of asymmetry ERPT to import prices in Nigeria
1.6 SIGNIFICANCE OF THE STUDY
Exchange rate movements are indeed crucial to the stability of the economy and monetary policy decisions. In a developing country like Nigeria with persistent trade deficits arising from its dependence on imports of intermediate and consumer goods, the knowledge of ERPT is important in appropriately adjusting its exchange rates to ensure competitiveness in the international market and prepare an effective expenditure switching strategy. Similarly, knowledge of Pass-through to import prices in Nigeria is very useful to monetary authorities and the use of import data in this study has given a clearer picture of the pass-through to import in Nigeria.
Knowledge of the linearity status of ERPT is of importance to monetary authorities in designing a more effective monetary policy. In addition, knowledge about the presence or otherwise of asymmetry in ERPT in Nigeria will help the monetary authorities in making an informed policy decisions, most especially as the country is faced with foreign exchange problems.
1.7 SCOPE OF THE STUDY
This study intends to study the exchange rate pass-through to import and consumer prices in Nigeria from 1986 to 2014. It intends to consider the transmission of the ERPT to import prices and also find out whether ERPT in Nigeria is symmetric or asymmetric.
1.8 ORGANISATION OF THE STUDY
This work is organised into five chapters. Chapter one consists of the general introduction, statement of the research problem, research questions, objectives of the study, significance of the study, scope and organisation of the study. Chapter two comprises the conceptual, theoretical and empirical literatures related to ERPT. Chapter three is the methodology while chapter four contains the analyses and interpretation of results. Chapter five provides the summary, conclusion and recommendations. Thereafter, the references and appendices are attached.