THE EFFECT OF EXCHANGE RATE AND INFLATION ON FOREIGN DIRECT INVESTMENT AND ITS RELATIONSHIP WITH ECONOMIC GROWTH IN NIGERIA

ABSTRACT

This study is on the effect of exchange rate and inflation on foreign direct investment and its relationship with economic growth. Its main objective is to find the effect of inflation and exchange rate and the bidirectional influences between FDI and economic growth in Nigeria. A twenty one year period was studied. A linear regression analysis was used on the twenty one year data to determine the relationship between inflation, exchange rate, FDI inflows and economic growth. The study reveals that FDI follow economic growth occasioned by trade openness which saw the entry of some major companies especially the telecommunication companies, while Inflation has positive effect on FDI. However exchange rate has effect on FDI.

CHAPTER ONE

INTRODUCTION

1.1    BACKGROUND OF THE STUDY.

In most developing countries there is the dearth of capital for investment which has affected the economic situation of these nations. In other to ameliorate the situation various governments of these nations has now focused much attention on investment especially foreign direct investment which will not only guarantee employment but will also impact positively on economic growth and development. FDI is needed to reduce the difference between the desired gross domestic investment and domestic savings. Jenkin and Thomas (2002) assert that FDI is expected to contribute to economic growth not only by providing foreign capital but also by crowding in additional domestic investment. By promoting both forward and backward linkages with the domestic economy, additional employment is indirectly created and further economic activity stimulated.

According to Adegbite and Ayadi (2010) FDI helps fill the domestic revenue-generation gap in a developing economy, given that most developing countries’ governments do not seem to be able to generate sufficient revenue to meet their expenditure needs. Other benefits are in the form of externalities and the adoption of foreign technology. Externalities here can be in the form of licensing, imitation, employee training and the introduction of new processes by the foreign firms (Alfaro, Chanda, Kalemli- Ozean and Sayek 2006).

Foreign direct investment consists of external resources including technology, managerial and marketing expertise and capital. All these generate a considerable impact on host nation’s productive capabilities. The success of government policies of stimulating the productive base of the economy depend largely on her ability to control adequate amount of FDI comprising of managerial, capital and technological resources to boast the existing production capacity. Although the Nigerian government has being trying to provide conducive investment climate for foreign investment, the inflow of foreign investments into the country have not been encouraging. Given the Nigerian economy resource base, the country’s foreign investment policy should move towards attracting and encouraging more inflow of foreign capital. The need for foreign direct investment (FDI) is born out of the under developed nature of the country’s economy that essentially hindered the pace of her economic development. Generally, policy strategies of the Nigerian government towards foreign investments are shaped by two principal objectives of the desire for economic independence and the demand for economic development.

1.2    STATEMENT OF THE PROBLEM

An analysis of foreign flow into the country so far have revealed that only a limited number of multinationals or their subsidiaries have made Foreign Direct Investment in the country. Added to this problem of insufficient inflow of FDI is the inability to retain the Foreign Direct Investment which has already come into the country. Also what effect have foreign direct investment have on such variables as- Gross Domestic Product (GDP) and Balance of Payment (BOP).  Moreover, what effect does inflation and exchange rate have on Foreign Direct Investment. However the focus of this paper is on the effect of inflation and exchange rate and the bidirectional influences between FDI and economic growth in Nigeria. According to Ayanwale (2007). The relationship between FDI and economic growth in Nigeria is yet unclear, and that recent evidence shows that the relationship may be country and period specific. Therefore there is the need to carry out more study on their relationship. Developing countries economic difficulties do not originate in their isolation from advance countries. The most powerful obstacle to their development comes from the way they are joined to the international system. Also an economic policy that can provide a conducive economic environment that will help to attract FDI inflows into the country is desired. However the characteristics of monetary policy according to Kiat (2008) present the impossible trinity that is a dilemma problem where trade-offs must be done in order to maintain economic stability. Two of these anchors are inflation autonomy and exchange rate variability. These trade-offs can impact on the on FDI inflow (Lahreche-Revil and Benassy-Quere, 2002; Gelb, 2005; Umezaki, 2006) as cited by Kiat (2008). Foreign direct investment (FDI) is a major component of capital flow for developing countries, its contribution towards economic growth is widely argued, but most researchers concur that the benefits outweigh its cost on the economy. (Musila and Sigue, 2006). Me Aleese (2004) states that “FDI embodies a package of potential growth enhancing attributes such as technology and access to international market” but the host country must satisfy certain preconditions in order to absorb and retain these benefits and not all emerging markets possess such qualities. (Boransztain De Gregorio and Lee 1998, and Collier and Dollar, 2001).

1.3    RESEARCH OBJECTIVES

The general of objective of this study is to determine the exchange rate and inflation of on foreign direct investment and its relationship with Economic growth in Nigeria,

The specific objectives are:

i.        To examine the effect of exchange rate and inflation on Foreign Direct Investment

ii        To determine the extent to which foreign direct investment affect Gross Domestic product in Nigeria.

1.4    RESEARCH QUESTIONS

Based on the research problems and objectives mentioned above, the following research questions were formed.

i.        what is exchange rate and inflation?

ii.       What are the relationship between exchange rate and inflation?

iii.      How does exchange rate and inflation affect Foreign Direct Investment in Nigeria?

iv.      What is the impact of Foreign Direct investment on Gross Domestic Product in Nigeria?

1.5    RESEARCH HYPOTHESIS

The following were formulated to test the impact of exchange rate and inflation on Foreign Direct investment and its relationship with economic growth in Nigeria.

HYPOTHESIS ONE

Ho:   There is no significant effect of foreign exchange rate and inflation on FDI.

Hi:    There is significant effect of foreign exchange rate and inflation on FDI.

HYPOTHESIS TWO

Ho:   There is no significant relationship between GDP and FDI

Hi:    There is significant relationship between GDP and FDI

1.6    MODEL SPECIFICATION

This study is based on the assumption that the inflow of FDI affects economic growth in Nigeria (GDP).

And again, that inflation and exchange rate in turn affect the inflow of Foreign Direct Investment (FDI). Hence the model:

MODEL 1

FDI = f (INFL., EXR.) ……… (2)

Where:

FDI = inflow of Foreign Direct Investment

INFL = Inflation rate

EXR. = Exchange rate

FDI = βo +βI  INFL +β2 EXR +u —– Equation 1

Where:

α0 = the intercept for equations (1)

β0 = the intercept for equation (2)

αI= the parameter estimate of FDI.

βI = the parameter estimate of INFL.

β2 = the parameter estimate of EXR.

u = the random variable or error term.

MODEL 2

GDP = f (FDI) ……….  (1)

GDP = bo+ bi FDI +U

Where:

Bo= constant, bi = coefficient of FDI and u = Error term.

1.7    SIGNIFICANCE OF STUDY

The significance of this study is to add to the general body of knowledge, enlighten the general public on the impact of exchange rate and inflation on Foreign Direct investment and its relationship to economic growth in Nigeria. It will also help the government to map out strategies that encourage foreign direct investment in Nigeria.

1.8     SCOPE OF STDUY AND LIMITATION

This study covering thirty year period 1990-2010 are used in this study for estimation of functions. Foreign Direct Investment inflow (FDI), Gross Domestic Product (GDP), Exchange rate (EXR) and inflation (INL) from Central Bank of Nigeria Statistic Bulletin and National Bureau Statistic.

Due to the financial constraint coupled with available, the research will make use of available materials in the Central Bank of Nigeria (CBN), National Bureau statistic and library where books relevant to the research topic will be consulted and the internet.

1.9    METHOD OF DATA COLLECTION

Annual time-series data on the variables under study covering thirty year period 1980-2010 are used in this study for estimation of functions.

Foreign Direct Investment inflow (FDI), inflation rate and exchange rate are the relevant explanatory variables. Equally, the Gross Domestic Product. The Gross Domestic Product is the quantitative variable that measures economic performance of a country. Data were collected from various editions of the various issues of Central Bank of Nigeria Economic and financial Review; and Central bank of Nigeria Statistical bulletin.

1.10 ORGANIZATION OF THE STUDY

This study is divided into five parts. Part one above is the introduction which is background of the study, research problem, objective of the study, research questions, research hypothesis, model specification, significance of the study, Scope and limitation of the study and organization of the study .Part two reviews the relevant literature, part three discusses the methodology employed in this study, and part four is data presentation and analysis while part five focus on summary, conclusion and recommendation.