Gusau Journal of Accounting and Finance, Vol. 2, Issue 1, April, 2021 1 Gusau Journal of Accounting and Finance (GUJAF) Vol. 2 Issue 1, April, 2021 ISSN: 2756-665X A Publication of Department of Accounting and Finance, Faculty of Management and Social Sciences, Federal University Gusau, Zamfara State -Nigeria Gusau Journal of Accounting and Finance, Vol. 2, Issue 1, April, 2021 2 EFFECT OF GLOBAL CRUDE OIL PRICE ON EXCHANGE RATE AND INFLATION RATE IN NIGERIA Abdullahi Masud Putra Business School +2348032170149, talk2masud2008@gmail.com Abstract The aim of this study is to assess the effect of global oil price volatility on exchange rate and the inflation rate on Nigerian economic activities. The study also attempted to explained how naira will gain value as a result of increase in price of global crude oil in the oil market environment and also to highlight how the oil shocks will affect the exchange rate and as well as inflation rate in the Nigerian economy. This study developed a structural VAR model, using quarterly data spanning 2002Q1-2020Q2. The study hypothesized positive relationship between inflation rates and exchange rate with the change in prices of global oil market price downward or upward. The result indicated that: first, positive oil price shocks led to accretion of reserves and the naira appreciation against the US dollar, which come along with the wealth effect channel of oil price transmission techniques for oil-exporting countries; second, oil price shocks resulted in inflationary pressures and decrease in output growth; third, response of monetary policy to oil price shocks was found to be generally restrictive; lastly, treasury-bill rate was found to be the optimal monetary policy tool in stabilizing exchange rate and the macroeconomic, amidst oil price shocks in the country. Keywords: Crude Oil Price, Inflation rate, Exchange rate, Structural VAR and Monetary Policy 1. Introduction The frequent changes in the global oil market prices in the oil market has an impact of the exchange rate and the inflation rate on Nigerian economic activities. This is because, Nigerian firms as it’s directly affects the price level of their domestic activities and profitability of some of the traded goods and services, resource allocation, and as well as financial decisions. The instability of exchange rate and inflation rate today has actually had direct relationship with crude oil price in the oil market. The Nigeria has suffered economically due the changes in price of oil in oil market, this had prompted the government to introduce policies and method of exchange rate regime as a result of shortage of forex in the country. The exchange rate regime in 2016 has led to the introduction of different methods with the aim of finding the most appropriate technique for achieving acceptable exchange rate for the Naira to be stable in the country. Therefore, exchange rate and inflation are two parameters of economic performance which shows demand conditions, production, growth, and the monetary and physical policy was known to be a controversial policy instruments in Nigeria. In the recent time 2020 there where devaluation of currency emerged which led to the inflationary impact in the country. Presently Nigeria is facing such situation that affects the profitability of the companies. Nigeria as an oil producing country heavily depends on crude oil price in the oil market as one the major source of revenue and foreign exchange to the government. The revenue from Crude oil is about 82% of foreign exchange earnings and 70% of government income in the last 40 years. Even though Nigeria is a market follower not a market leader in the oligopolistic market. This is why; Nigeria has little or no control in the global oil market price, like Saudi Arabia and Russia thus becoming highly vulnerable to external shocks. With greater chunk of foreign exchange earnings coming from crude oil export, once there is any changes in the crude oil price would no doubt affect the foreign reserve and the value of naira exchange rate. Therefore, volatility in oil price has implication on external reserve accretion and exchange rate stability. mailto:talk2masud2008@gmail.com Gusau Journal of Accounting and Finance, Vol. 2, Issue 1, April, 2021 3 A depleted external reserve due to fall in oil price could also affect the investment level of the country, as there are four component of investment such as domestic investment, diaspora investment, foreign portfolio investment and foreign direct investment. In short, even if when the confidence of the investors could also add to the problem of the economy thereby leading to capital reversal and exchange rate depreciation due to demand shocks or supply shocks as the case may be. Furthermore, observed that the volume of investment increases or decreases with decreases or increases in interest rates. Sauders and Schumacher (2000) offered that the margin between the bank’s interest rate earnings and expenses as a percentage of interest earnings assets vary widely across banks. The variation is obtainable within and across countries and depicts the spread of the margin. High lending rates, according to Obamuyi (2009), are detrimental to productive investment and economic growth. He further observed that high lending rates create a situation of high moral hazard, as firms will only borrow to escape bankruptcy rather than either investing or financing working capital. A low rate is desirable because in a country like Nigeria where the financial sector (banks) serves as the engine of growth and plays an intermediary role of providing finance to both private and real sectors. Economic growth is dependent on the facilitation of capital formation and its consequent interest rates (James et al., 2013). Applying the dealership model to respond to in increasing or decreasing situation, McShane and Sharpe (1985), Allen (1988) and Angbazo (1996) believed a bank is synonymous with a dynamic dealer that sets interest rates on loans and deposits to balance the asymmetric arrival of loan demand and deposit supplies. The rate of inflation to be maintained by any nation and its influence on economic growth and development has been a major issue confronting nation. Debates about inflation rates have arisen amongst scholars and economists and directed policy-makers and central monetary authorities to develop sound macroeconomic policies that are aimed at improving output levels and spur growth while keeping inflation as low as possible (Bawa & Abdullahi, 2012; Chimobi, 2010; Izuchukwu & Patricia, 2015). Sound economic policy fosters helpful strategies and mitigates against factors that threaten economic development and have undesirable effects on the economy. One such factor that threatens economic development is inflation (Bakare, Kareem, & Oyelekan, 2015). Inflation is viewed as the constant rise in the overall price level of a broad spectrum of goods and services in a country over a period of time (Umaru & Zubairu, 2012). Several questions have been advanced about whether inflation is detrimental to growth or enhances growth. Kanchan and Chandan (2011) noted that to determine this someone would be required to know whether inflation affects savings and investments. That is because economic growth is a significant function of the rate of capital formation and economists have shown that capital formation is a direct function of saving and investments. Efforts to understand that the Banks could stabilize exchange rate amidst oil price volatility, it is therefore, necessary to empirically investigate the effectiveness of these efforts in stabilizing the economy. The objective of the study is therefore to empirically investigate the effect of global crude oil price shock on the Nigerian economy and the effectiveness of monetary policy measures practices by the monetary authority in stabilizing prices (exchange rate and inflation) and stimulating economic development and growth in the country. Additionally, this study would Gusau Journal of Accounting and Finance, Vol. 2, Issue 1, April, 2021 4 examine the optimal policy to use that would effectively stabilize exchange rate and the macro economy conditions especially under any circumstances or conditions. 2. Review of Relevant Previous Studies From the empirical review perspective, many studies exist on the effect global oil market price shocks on the economy of different countries in the world. These studies majorly concentrated on the economic stabilization policy established by monetary authorities in the aftermath of oil price shocks. Exchange rates and inflation are fundamental macroeconomic variables that drive economic growth and stability. This is because the strength of every currency and economy is highly dependent on its purchasing power compared to other countries of the same status. Achieving a strong Naira value and low interest rates in Nigeria simultaneously have become a ―life time‖ project for Nigeria and are not likely to be achieved soon. This current study creates a condition of ―fit‖ in which Nigerian firms could operate. This is achieved by making both exchange rates and inflation rates as contingents of the operating environments that they cannot control. This is because the soaring inflation and exchange rate create a ―misfit‖ condition for business firms in Nigeria. According to Umaru and Zubairu (2012), the inflation rate affects the entire economic cycle, that is, both savings and investments, because it is a percentage measurement of changes in general prices, the consumer price index, the wholesale price index, and the producer price index, amongst others. A stable price promotes economic growth and development while high inflation or high prices could have several adverse effects on an economy (Khan & Senhadji, 2001; Ocran, 2007). These effects range from high welfare costs posed on the entire society to a distortion in the resource allocation occasioned by price level changes. This adverse condition makes the poor become poorer while the rich become richer because the income of the poor may not be indexed in the price changes. Inflation passes through real income of an average citizen, and salaries of workers are increased without ensuring that these new salaries are commensurate with productivity and are not undue compensation (Olu & Idih, 2015). Fischer (1993) stated that inflation also causes budget deficits and reduces growth by its effects on investment and productivity. He concluded that a stable macroeconomic environment is conducive to sustaining a country’s economic growth. High inflation reduces a country’s competitiveness internationally through the expensive nature of export activities. The interruption that results from high inflation through the expensive nature of imports poses a significant and negative impact on the balance of payments and distorts the economic growth of a nation in the long term. Consequently, a country faces the choice of maintaining an inflation rate below zero or aiming at a higher rate (Bawa & Abdullahi, 2012). However, inflation rates below zero lead to deflation and the costs of deflation are also challenging to an economy (Billi & Khan, 2008). In addition, Fischer (1993) further explained that inflation serves directly as an indicator of uncertainty in a macroeconomic environment specifically in the Nigerian environment. The classical economic theory hypothesized that inflation rate and exchange rate could intermingle if the economic growth is linear. In the oriental models of (Dornbusch and Fisher, Gusau Journal of Accounting and Finance, Vol. 2, Issue 1, April, 2021 5 1980). The seminal work of Fischer (1993) concluded that inflation reduces the economic growth of any nation. Fischer (1993) studied the role that macroeconomic variables played in enhancing the growth of 93 countries. Cross-Sectional data between 1960 and 1989 were used, and the study considered samples of both industrialized and developed countries. The results revealed a negative relationship between inflation and economic growth. With an estimation of breaks of 15% and 40%, Fischer noted that a percent above 40 would show not only the non-linearity of the relationship but also weaken the relationship. Khan and Senhadji’s (2007) findings of thresholds of 1-3% for industrial countries and 11-12% for developing countries confirmed Ghosh and Phillips’s (1998) earlier findings. Mlambo, Maredza and Sibanda (2013) assessed the effects of currency volatility on the Johannesburg Stock Exchange. An evaluation of literature on exchange rate volatility and stock markets was conducted resulting into specification of an empirical model. The Generalized Autoregressive Conditional Heteroskedascity (1.1) (GARCH) model was used in establishing the relationship between exchange rate volatility and stock market performance. The study employed monthly South African data for the period 2000–2010. The data frequency selected ensured an adequate number of observations. A very weak relationship between currency volatility and the stock market was confirmed. The research finding is supported by previous studies. Prime overdraft rate and total mining production were found to have a negative impact on Market capitalization. Surprisingly, US interest rates were found to have a positive impact on Market capitalization. The study recommended that, since the South African stock market is not really exposed to the negative effects of currency volatility, government could use exchange rate as a policy tool to attract foreign portfolio investment. Jordan, Sweidan (2004) advanced a question about whether inflation was harmful to economic growth and considered the period between 1970 and 2000. The study found a threshold of 2% to be significant. A percentage below 2% would be positive while a shift above 2% would be negative. Hence, Sweidan (2004) recommended that monetary policy be designed to take effective care of inflation, as inflation is considered harmful to the economy. In Pakistan, Mubarik (2005) estimated the threshold of inflation and growth between 1973 and 2000 and found a 9% threshold level to be significant. The results suggested that a threshold of 9% could be used as a policy formulation tool. Nasir and Nawaz (2010) evaluated investments and inflation and their effects on economic growth from 1961 to 2008 in Pakistan. They found a threshold of 6% and 11% for Pakistan economy. They emphasized the influence of investment on economic growth and found a threshold of 7% for investment and inflation. The two studies from Pakistan had different results. Mubarik’s (2005) findings were open for clarification while Nasir and Nawaz’s (2010) findings correlated with the findings of Fabayo and Ajilore (2006). Nasir and Nawaz (2010) concluded that inflation should be kept below 6% for achieving the desired economic growth and levels of investment. Salami and Kelikume (2010) considered data from 1970 to 2008 and from 1980 to 2008 in Nigeria. Adopting Khan and Senhadji’s (2001) model, the findings revealed a threshold of 8% for the sample from 1970 to 2008 for Nigeria. A threshold of 7% was estimated for the 1980 to 2008 period, though the results failed the significance test. Like Muritala (2011) and Fabayo and Ajilore (2006) and others, Salami and Gusau Journal of Accounting and Finance, Vol. 2, Issue 1, April, 2021 6 Kelikume (2010) recommended single digit inflation as a target for Nigeria and encouraged the government, CBN, and other concerned regulatory bodies to formulate policies that would reduce inflation to the barest minimum because inflation directly affects the performance and growth of the economy. Obansa et al. (2013), Obamuyi (2009), James et al. (2013) and Udoka and Anyingang (2012) observed that, before the Keynesian era, developed nations drew upon the benefits of low interest rates to develop their industries, and industrialization is driven by heavy investment finance through capital accumulation. Udoka and Anyingang (2012) pointed out that minimal lending rates and inflation rates are sine-qua-non for propelling rapid investment and industrialization. Obamuyi (2009) affirmed that high interest rates or lending rates are detrimental to productive investment. Thus, the Keynesian and neoclassical theories noted that low interest rates should promote investment, increase spending and bring economic development (Odhiambo, 2008). McKinnon (1973) and Shaw (1973) opined that, by liberalizing the interest rates, economic development and investment would increase. The increase would be occasioned by the fact that savers would switch from unproductive sectors (real sector) to financial sectors, which will ultimately increase the supply of credit to the entire economy through advancement in lending. This position brought a disagreement between the proponents of the Keynesian school of thought who believe in prior investment and the proponents of the McKinnon-Shaw school of thought who believe in prior savings (Obansa et al., 2013). The hypothesis of the McKinnon-Shaw (1973) is premised on the fact that, in developing countries, the demand for loanable funds exceeds supply. The increase is because the financial system is repressed. Rather than high demand, interest rates should be increased to attract deposits. This will spur investment and economic growth will pick up. Empirical evidence supports the assertion that economic growth is dependent on moderate interest rates. The studies of Obamuyi (2009), Chete (2006), Nicholas (2010), Adeyeye and Fajembola (2006), and Ogede (2013) found the relationship between interest rates and economic growth to be significant. Obanso et al. (2013) also found a significant relationship between interest rates and economic growth and concluded that interest rates should be regulated to bring fair rates so that firms can borrow to finance their operations. The CBN introduced the Monetary Policy Rate (MPR) to regulate the official interest rates. CBN (2011) said that, in the absence of efficient policy coordination, financial instability could ensue as high interest rates, exchange pressure and high inflation have negative impacts on economic growth. The findings of Muhammed et al. (2013) confirmed Obansa et al.’s (2013) results. They revealed that high interest rates significantly lower investments because of the expensiveness of acquiring loans to finance business activities in the country. 3. Methodology and Model Specification From the Sims (1980)’s seminal paper, VAR models have become a noticeable powerful macroeconomic tool that gauge the dynamic response of a set of variables to exogenous shocks, and identify the magnitude of shocks on the endogenous variables. Specifically, Structural Vector Autoregressive (SVAR) models have become popular for structural and policy analysis. The idea behind these models is that structural economic shocks could be found as linear combinations of residuals of linear projection of a vector of variables with their past values. Gusau Journal of Accounting and Finance, Vol. 2, Issue 1, April, 2021 7 This method of technique is to estimate the reduced form of Equation (3), and recover the structural parameters, using the estimated coefficients and residuals obtained from the reduced form VAR. In general, Equation (4) is not identified unless restrictions are imposed on either A0 or B. The study utilized a 6-variable SVAR system similar to that of Kim and Roubini (2000). While Kim and Roubini (2000) applied this model to investigate the impact of monetary policy shocks on other macroeconomic variables, their model can be used to examine the effect of oil price shocks on exchange rate and analyze its implications for monetary policy. This is because, major macroeconomic variables, as well as variables relevant to oil price and monetary policy, are included in the VAR system utilized. The VAR system is divided into several blocks as in Kim and Roubini (2000). For instance, the domestic real sector, two variables are included to represent aggregate output and general prices while external reserves and exchange rate are incorporated to represent the external sector. For the monetary sector, the monetary policy rate is initially applied, thereafter, other monetary policy indicators such as cash reserve ratio, sales of OMO bills, 3-month treasury bill rate and supply of forex to the foreign exchange rate market, are used in place of the policy rate, so as to investigate the effectiveness of these instruments individually. Finally, a measure of an exogenous oil price series has been added to represent the oil price shock. However, the form error et are linear combinations of the structural errors as follows: ᶓ mp a11 0 ᶓ 11 0 am a 22 ᶓ o ᶓ 33 0 ᶓ a 41ᶓ42 a 53 a 54 ℰ mp a 61 a 62 a 63 From the equation oil prices are modelled exogenous, that is, oil prices do not respond at the same time with other macroeconomic variables. Following a wealth effect specification, the second equation assumed that external reserve was influenced by only oil price by itself. Exchange rate is assumed to be influenced by oil price. Therefore, to go along with peculiarities of the Nigerian economy, this is assumed that real output is only influenced by exchange rate, foreign reserves and oil price. Inflation was also assumed to follow Philips curve ideology where it is influenced by oil price, foreign reserves, exchange rate and real output. Therefore, the monetary policy reaction function where monetary policy rate and other variables (as mentioned earlier) are influenced by oil price, external reserves, inflation, exchange rate and real output of production. However, Quarterly data spanning 2000: Q1 to 2018: Q2, consisting 96 observations are used in the analysis of the impact of global oil price on exchange rate and the effectiveness of monetary policy in Nigeria. The oil price series is sourced from the Reuters Eikon IV terminal. All macroeconomic data for the Nigerian economy were extracted from the CBN Statistical Database. The price, output and external reserves are seasonally-adjusted. The oil price and external reserves are deflated, using the US CPI. The choice of scope of data stems from the fact that democratic era started in 1999, thus, reflecting the emergence of monetary policy independence. Gusau Journal of Accounting and Finance, Vol. 2, Issue 1, April, 2021 8 4. Result Analysis Table 1 Showing the Summary of Descriptive Statistics Oil Price Exchange Rate Inflation Rates MPR SFX T. Bill Mean 0.087 0.172 0.131 -0.012 0.002 -0.160 Maximum 0.731 1.213 0.251 5.851 2.642 8.821 Minimum -O.514 -0.314 0.044 -6.001 -35.40 -10.82 Std. Dev. 0.321 0.382 0.051 2.561 0.871 4.345 Jarque Bera 1.241 13.55 3.390 0.913 62.38 0.390 Source: Source: E-views output, 2020 Table 1 shows the correlation coefficients, which states that in general, the chosen series reveals linear associations, consistent with economic theory. The relationships between oil price and the following variables (Exchange rate, Inflation rate, monetary policy rate, SFX and T. Bill) were found to be positive, while that between oil price and the following variables (, Exchange rate monetary policy rate SFX, and T. Bill) were found to be negative from the above analysis. Table 2: Correlation Matrix Variables Oil Price Exchange Rate Inflation Rate MPR SFX T. Bill Oil Price 1 Exchange rate 0.52 1 Inflation 0.00 0.21 1 MPR -0.12 -0.24 -0.11 1 SFX 0.00 0.25 0.13 0.41 1 T. Bill 0.10 -0.20 0.12 -0.31 1 SOURCE: Source: E-views output, 2020 Table 3: Relative Volatilities under Model-Specific Policy Indicators σZ σY  L Oil Price 0.0123 0.0013 0.0070 0.0009 Exchange Rate 00521 0.0040 0.0057 0.0710 Inflation Rate 0.0810 0.0010 0.0321 0.0051 MPR 0.0072 0.0084 0.0012 0.00961 SFX 0.0078 0.0071 0.0012 0.00978 TB 0.0678 0.0080 0.0120 0.0085 Minimum 0.0070 0.0061 0.0070 0.00861 SOURCE: Source: E-views output, 2020 5. Conclusion This paper developed a structural VAR model to study the effect of global oil price shocks on exchange rate and inflation ration in Nigeria, using quarterly data spanning 2002Q1 to 2020Q2. The study identified assumptions that were consistent with Nigeria’s economic structure and confirmed by the estimated dynamic responses to mimic movements of macroeconomic variables in the country. The relationship among oil price shocks, external reserves, exchange rate, output, price, and monetary policy indicators (policy rate, cash reserve ratio, open market Gusau Journal of Accounting and Finance, Vol. 2, Issue 1, April, 2021 9 operations and supply of foreign exchange) were examined and the empirical results revealed that, oil price shocks are associated with rise in external reserves and appreciation in the naira. This outcome conformed to theory regarding oil-exporting countries, like Nigeria. This is also in line with findings of Adeniyi et al, (2012). The oil price shocks generally result to inflationary pressures and reduction in output growth. The inflationary effect may be ascribed to the wealth effect, and effect of fiscal injections. The decline in output may not be unconnected to the marginal contribution of oil to total output, which on average is about 10 per cent relative to that of non-oil output which accounts for about 85 per cent of the economy. Gusau Journal of Accounting and Finance, Vol. 2, Issue 1, April, 2021 10 References Adeniyi O. A., A. Oyinlola, O. A. Omisakin and J. Yaqub (2012). ―Oil Price-Exchange Rate Nexus in Nigeria: Further Evidence from an Oil Exporting Economy‖. International Journal of Humanities and Social Science. Vol 2. No. 8. Adeyeye, P.O. & Fajembola O.D. (2006). An empirical study of the impact of interest rate policy on economic growth in Nigeria (1970-2003). Business & Finance Herald, 2(1), 148-159. Allen, L. (1988). The determinants of bank interest margins: a note. 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