CURRENCY SUBSTITUTION AND THE DEMAND FOR MONEY IN NIGERIA: 1980 - 2014
ABSTRACT
The persistent increase in demand for foreign currency, especially in recent years, exerts pressure on  Nigeria's  foreign  exchange  market.  This  trend  is  often  accentuated  by  economic  agents’ perceived loss of purchasing power and confidence in the domestic currency. Therefore, resort to holding currencies that have a relatively stable value such as the United States dollar (USD) which in turn increases the extent of currency substitution in the economy. This study investigates the existence and extent of currency substitution and how it invariably affects the demand for money in Nigeria using time series data for the 1980-2014 period. A significant contribution of this study is the consideration of the impact of crude oil price as well as the extent to which election periods contribute to currency substitution phenomenon in Nigeria. The study estimated six models that were predicated on Cuddington’s currency substitution framework. The Johansen cointegration test was employed in order to ascertain the existence of a long run relationship among  the  variables,  and  an  error  correction  model  was  used  to  ascertain  the  short  run adjustment dynamics. In addition to the finding   that currency substitution had increased over time, albeit slowly; empirical results reveal that the expected rate of depreciation, inflation rate, election period, and crude oil price as well as foreign rate of interest determine the extent of currency substitution in Nigeria. Therefore, this study recommends that measures should be taken that will encourage and to bring back the confidence of economic agents in the domestic currency by the monetary authorities. Also, the financial system should be further deepened with liquidity to minimize vulnerability and exposure to sudden disturbances that could affect the financial system especially during election period and oil shocks.
CHAPTER ONE
INTRODUCTION
1.1 Overview
Currency substitution is often used interchangeably with dollarization. An economy is said to be dollarized when a foreign currency or foreign currencies serve as the local currency unit in all three functions of money (medium of exchange, store of value and unit of account) in an economy. Dollarization refers to the use of foreign currency as a store of value and unit of account. It refers more to the store of value role of money while currency substitution more narrowly relates to substitution between currencies as means of payment (Heimonen, 2008). Calvo and Vegh (1992) defined currency substitution as a shift away from domestic to foreign currencies and is often viewed as a safety precaution during periods of high and volatile inflation, while dollarization is viewed as one form of currency substitution where the store of value, medium of exchange and unit of account properties of the domestic money are transferred to foreign currencies.
The collapse of the Bretton Woods fixed exchange system and advent of generalized floating of currencies in the early 1970s gave rise to currency substitution. After the Second World War, the Bretton Woods system (also known as the gold exchange standard) was set up. Under this system, member countries defined their currencies relative to gold. Nevertheless, only the US dollar was relied upon for conversion to gold because of its dominant role as the international medium of exchange and store of value at the time. The collapse of the system in the early 1970s  was followed by the adoption of floating exchange rate regime. Since then, the international monetary system  has  been  based  on  fiat  money  rather  than  commodity  standard.  At  the  same  time, international trade was increasing in the global economy and many changes in the financial world were occurring. For example, financial deregulations and new financial instruments which together with the floating system allowed for a reduction in portfolio risk and encouraged diversification (Arce-Catacora, 1997). This phenomenon also included location diversification, because capital movements from one country to another were observed and economic agents started to rely on different currencies to settle business transactions. Therefore, one may conclude that financial globalization  may  have  contributed  to  the  portfolio  diversification  and  currency  substitution phenomena.
Currency  substitution  is  a  prevalent  phenomenon  and  a  major  feature  of  some  developing countries,  especially  the  emerging  market  economies  in  Latin  America,  Asia  and  African countries. Some of these countries are, in fact, fully dollarized while many others are partially dollarized. Some of the fully dollarized countries in Latin America include Ecuador, El Salvador, Panama and the Marshall Islands in which the United States (US) dollar is officially used as legal tender. Partially dollarized economies include Angola, Malawi, Nigeria, Bolivia, Uruguay, Peru, Cambodia and Turkey among others. The pattern of currency substitution in Latin American countries is related to their macroeconomic policies and institutional framework. Furthermore, they are characterized by the absence of restrictions on maintaining foreign currency deposits in their domestic  financial  system.  Notably,  weak  financial  markets  and  unstable  macroeconomic environment in these countries (especially their previous inflationary history) can be attributed to the factors determining the presence of currency substitution (Selcuk, 2003; Calvo and Vegh, 1992).
In Asian countries for example, currency substitution and high dollarization accelerated due to exchange rate fluctuations. The experience of the Asian crisis led to the shift from pegged to floating exchange rate system. Loss of confidence in the domestic currency led to an unstable exchange rate and consequently, agents substitute dollars for domestic currency, thereby depleting foreign reserves and increasing devaluation pressure (Sharma, Kandil and Chiasrisawatsuk, 2005). The implementation of Structural Adjustment Programmes (SAPs) and subsequent liberalization of foreign exchange markets, led to the removal of many foreign exchange restrictions. This has resulted in a number of emerging market economies to move from fixed to flexible exchange rates. In most African countries, the late 1980s and the early 1990s were characterized by massive
depreciation of their currencies as they sought to reduce and /or eliminate the influence of parallel market for foreign exchange that had existed in these countries over the years (Agenor, 2004).
In Nigeria, exchange rate arrangements have transited from a fixed regime in the 1960s to a pegged regime between the 1970s and the mid-1980s and to the floating regime from 1986 with the deregulation and adoption of SAP. This was the period when there was no restriction on holding  of  foreign  currency  by  residents  or  non-residents  in  the  country.  Foreign  currency (especially the US dollar) was used as medium of exchange, store of value as well as for unit of account in the economy (Gabriel 2012; Falana 2015). Foreign currency deposits in the Nigerian banking system as at 1986 was N0.6 billion, N2.3 billion in 1990 and was N9.04 billion in 1994. It fell to N6.1 billion in 1995 and rose to N7.7 billion in 1999. It maintained its upward trend as at 2003 with N122.6 billion, and more than quadrupled to N1, 444.3 billion, N3, 402.2 billion, N3961.8  billion  in  2009,  2013  and  2014,  respectively  (Central  Bank  of  Nigeria  Statistical Bulletin). Thus, currency substitution generally takes place in the context of worsening economic and  financial  conditions  that  unfavorably  affect  the  return  on  holding  of  local  currency  as compared to foreign currency. As such, individuals attempt to protect the value of their income and wealth from being eroded by inflation and/or exchange rate volatility (Meyer, 2000).
Although,  some  studies  have  shown  that  dollarization  in  Latin  America  have  helped  some countries  reduce  their  hitherto  out-of-control  inflation  and  increased  output  growth,  currency substitution can have several adverse spillover effects. These spillover effects include weakening the autonomy of monetary policy, increasing vulnerability to economic shocks arising from the host country, the potential for significant deterioration of the balance of payment account and/or exchange rate volatility (Boamah, Guy, Grosvenor and Lescott, 2012).
* MSC ECONS