 |
| Professor M.A Iyoha. |
AN ECONOMETRIC ESTIMATE OF THE BENEFITS AND COSTS OF NAIRA CONVERTIBILITY
Milton
A. Iyoha, Ph. D.
Professor
of Economics
Department
of Economics and Statistics
University
of Benin
Benin
City
A previous version of this paper was presented at a Workshop organized
by the Nigerian Economic
Society.
AN
EMPIRICAL ESTIMATION OF THE BENEFITS AND COSTS
OF
NAIRA CONVERTIBILITY
by
Professor
M. A. Iyoha
University
of Benin
I. Introduction
In general, currency
convertibility implies absence of exchange controls on payments and receipts,
hence the ability of non-residents and even residents to exchange domestic
currency for any foreign currency of choice without limit and hindrance. Thus,
according to Gilman (1990, p. 32), currency convertibility essentially means
"the unrestricted use of a country's currency for international
transactions, allowing it to be freely exchanged for foreign currencies - as
part of the process of integration into the world market economy".
Restrictions on the use
of a national currency, i.e., currency inconvertibility, is most often achieved
by the imposition of exchange controls using the instrumentality of multiple
currency practices. Thus, perhaps the most commonly used concept of currency
convertibility is that of the International Monetary Fund (IMF) which
proscribes multiple currency practices and indeed outlaws restrictions on
current international payments. This is contained in Article VIII, Sections 2,
3, and 4 of the IMF Articles of Agreement, Tew (1971), IMF (1997). Consider the
following:
"... no member shall,
without the approval of the Fund, impose restrictions on the making of payments
and transfers for current international transactions".
Note that in this sense, currency convertibility is limited to freedom
of payments and transfers for current international transactions only. In
particular, it excludes freedom of international capital transfers. This is why
countries who notify the IMF that they accept the obligations of Article VIII,
Sections 2, 3, and 4 of the IMF Articles of Agreement are deemed to have
convertible currencies. Formally, they are said to have "assumed Article
VIII status". As at December 1996, a total of 137 member countries of the
IMF had assumed Article VIII status IMF Survey (Feb. 10, 1997, p. 45).
According to the IMF,
By accepting the
obligations of Article VIII, member countries assure the international community that they will pursue
sound economic policies that will obviate the need to use restrictions on
making payments and transfers for current international transactions, and
thereby contribute to a multilateral payments system free of restrictions, IMF
Survey (July 15, 1996, p. 240).
Current account convertibility exposes domestic producers to foreign
competition particularly under conditions of trade liberalization (low tariffs
and quotas). It essentially introduces the structure of world prices into the
domestic economy. According to Hanke and Schuler (1994, p. 21),
World prices are signals
that help people determine which areas of production to specialize in. By
specializing in the goods they produce most efficiently and then trading those
goods for other goods, wealth increases globally.
Thus, undeniably, current account convertibility promotes world trade
and enhances efficiency through the elimination of price distortions.
The main purpose of
this paper is to obtain a quantitative estimate of the benefits and costs of
Naira convertibility. Both econometric and simulation techniques will be
utilized to obtain a quantitative estimate of the net benefit of Naira
convertibility during the 1997-2010 period. In addition to this introductory
section, the current paper has three other sections. In section II, we present
an economic analysis of the benefits and costs of Naira convertibility. Section III presents a quantitative estimate
of the net benefits of Naira convertibility in the years ahead using
econometric and simulation techniques. In particular, we estimate Nigeria's
real GDP for the 1997-2010 period assuming Naira convertibility. This series is
compared with estimates of what the real GDP would be without Naira
convertibility. The difference obviously gives an estimate of the net benefits
of Naira convertibility. The last section contains a summary of the paper and
some concluding remarks.
II. The Benefits and Costs of Convertibility
2.0 Preface
Countries strive to
have convertible currencies because of the potential gains and benefits of
currency convertibility. However, there are also potential costs and dangers,
particularly for developing countries. Logically, a rational decision can only
be made after weighing the benefits and costs of convertibility. However, what
should be borne in mind right from the beginning is that while the costs are
short-term in nature, the benefits are long-term. Thus, in the long run,
currency convertibility is almost certain to be beneficial to any contemporary
economy -- particularly in this era of economic and financial globalization.
2.1 Benefits of
Convertibility
The major benefits of
currency convertibility arise from the economic effects of removing exchange
restrictions. The greatest benefits no doubt arise from adoption of full
convertibility as the country then reaps the effects of both increased trade
and significant expansion in foreign investment flows. However, even
current-account convertibility confers enough benefits to make the effort
worthwhile. The main benefits of currency convertibility include:
(i)elimination
of distortions associated with foreign exchange rationing;
(ii)promotion
of optimal decision making by consumers and producers whose decisions will now
be based on correct price signals;
(iii)increase
in foreign competition by the removal of protection fostered by exchange
controls, thus increasing domestic productivity;
(iv)promoting
a positive environment for increases in investment by both domestic and foreign
investors, thereby contributing to rapid economic growth;
(v)reduction
of capital flight with benefits for increased capital accumulation and growth;
(vi)rise
in R & D and increased adoption of foreign technology and management
techniques resulting in rising productivity;
(vii)Expansion
of trade leading to growth; and
(viii)improved
international credibility.
Note that the benefits of currency convertibility, which are dynamic and
long-run in nature, arise from greater exploitation of the principle of
comparative advantage. Currency convertibility permits greater integration into
the global economy with consequences for improved competition, increased
investment, greater exploitation of scale economies, and enhanced growth over
time.
2.2 Costs of Convertibility
The costs of
convertibility are adjustment costs and are short run in character. These costs
are greater the more highly protected the economy is before the adoption of
currency convertibility. This is because the more pervasive protectionism is,
the more the distortion of prices and costs. Shifting from a regime of high
protection to a free one inevitably involves significant transitional or
adjustment costs both for individuals and firms and even entire sectors of the
economy.
The main costs of
currency convertibility may therefore be summarized thus:
(i)possible
dislocation of firms, industries and even entire economic sectors resulting in
high social costs including unemployment;
(ii)increases
in foreign competition which could lead to the restructuring of domestic
production and result in a temporary fall in output; and
(iii)adoption of full convertibility could lead to
capital outflows if macroeconomic policies are not perceived as credible,
transparent, and consistent or if the domestic financial environment is
considered unstable.
III. The Net Benefits of
Naira Convertibility: Econometric Estimation
and Simulation Results
3.1 "Openness" and
the Net Benefits of Naira Convertibility
Since convertibility
facilitates the inflow of foreign private capital, it would undoubtedly promote
investment-led growth. However, apart from this, the greatest potential source
of gains from convertibility will probably arise from the dynamic effects of
openness1 on economic growth. The idea is that increased openness in
an economy may release dynamic forces which will accelerate its economic
growth. One channel of transmission is that increased openness will accelerate
growth by making realizable vast internal and external economies of scale.
Increased economic openness implies that the country's potential market is now
the entire world. Thus, by vastly expanding the market size, increased openness
will enhance the chances of reaping these economies of scale. The induced
increase in the market size will widen the scope of gains arising from the
interplay of sectoral developments. Also, the increase in the size of the
market will encourage diversification and creative experimentation. Investment
in Research and Development will increase leading to innovation which is
critical to growth. This is why Ghura (1995, p.763) has asserted that "Outward-oriented
trade strategies promote external competitiveness, which, in turn, is conducive
to export expansion and is beneficial to growth". This conclusion agrees
with the results obtained in the endogenous growth models developed by G.M.
Grossman and E. Helpman (1989), namely, that openness to international trade
accelerates technological advancements and growth because of increased access
to goods and services with embodied technology. A similar conclusion was
reached by Romer (1986), namely, that increased openness is beneficial to
growth because of enlarged availability of technologies and the accompanying
knowledge spillovers.
Finch and
Michaelopoulos (1988) have provided a useful and important insight into the
nature of the link of external trade to development2. According to them,
It is not solely, or
perhaps even mainly, a demand-driven link, whereby export growth stimulates
incomes and output in the rest of the economy.
Rather, effective participation in international trade permits economies
of scale not open to small protected economies.
By introducing greater market competition, it encourages a more
efficient utilization of resources and greater growth in productivity in the
whole economy. Moreover, open trading
policies permit quicker adaptation to new technologies and greater flexibility
in responding to international economic developments.
3.2 Econometric Estimation of
Net Benefits of Naira Convertibility
In this section, an
attempt is made to estimate the "net benefits", i.e., benefits less
costs, of Naira convertibility. It is assumed that the principal channel
through which convertibility impacts on the economy is through increased
openness. It is further assumed that increased openness affects the economy by
raising aggregate investment. A second channel through which convertibility
affects the economy is through reduction of domestic macroeconomic distortions
which results in enhanced allocative efficiency and improved productivity.
3.2.1 A Model of Openness, Investment and Economic Growth in Nigeria
This section presents a
small macroeconometric model which permits estimation and simulation of the
effects of increased economic openness on economic growth in Nigeria. The
macroeconometric simulation model consists of 2 simultaneous equations
consisting of an investment demand equation incorporating an openness variable
and a parallel market premium variable, and an output equation which depends
critically on investment.
Investment Equation
In Nigeria, real GDP
growth was negative in the early and mid-1980s. This was due to a host of
factors including the collapse of investment. In fact, the investment-income
ratio fell below 10 percent in the mid-1980s. See Table 1. The depressed level
of investment in turn can be ascribed to many factors including falling savings
and income, the escalating external debt, and crippling trade distortions.
TABLE 1: INVESTMENT/GROSS DOMESTIC PRODUCT RATIO
Year Percent
Year Percent Year
Percent
1970 14.84 1980 22.24 1990 16.01
1971 18.68 1981 23.29 1991 17.03
1972 21.12 1982 20.09 1992 17.52
1973 22.44 1983 14.75 1993 15.00
1974 16.98 1984 12.33 1994 10.00
1975 25.20 1985 12.07
1976 31.50 1986 15.07
1977 29.04 1987 13.69
1978 27.56 1988 13.47
1979 21.97 1989 14.42
Source: (i) CBN. Statistical Bulletin, various issues; (ii) World
Bank. World Debt Tables,
various issues; (iii) World Bank.
(1994).
Starting from the early 1980s, the Nigerian economy faced a major
economic crisis largely as a result of falling oil export revenues consequent
on the collapse of world oil prices.
With oil revenues accounting for over 90 percent of total foreign
exchange earnings, the collapse of oil prices had a devastating effect on the
Nigerian economy. Import compression, using restrictions on trade and payments,
was one of the key policy responses to the crisis. In retrospect, it seems
clear that such a strategy could, in the long run, only serve to aggravate the
crisis and exacerbate Nigeria's development problemmatique.
Following Sachs (1988),
Krugman (1988), Borensztein (1991), Chhibber and Pahwa (1994), Ghura (1995),
Iyoha (1997a) and Iyoha (1997b), we specify an investment demand function which
has its roots in neoclassical optimization theory. We also make allowance for a
potential role for trade openness and a method of measuring the impact of
domestic macroeconomic policy distortions on investment. In the final
specification, the investment-income ratio is hypothesized to depend negatively
on domestic interest rate, positively on the marginal product of capital,
negatively on the foreign exchange premium, and positively on trade openness.
Thus, the basic specification of the investment demand function is given
by
 (1) |
b1 < 0, b2
> 0, b3 < 0, b4 > 0,
where I/GDP is the ratio of investment to GDP, r = interest rate
(commercial lending rate), MPK = marginal product of capital, FXP = foreign exchange premium (measured by
the ratio of parallel market foreign exchange rate) which is designed to
capture the effects of trade distortions on the economy, M/Y is the ratio of
imports to income which is expected to measure the effect of trade openness and
u is a stochastic error term assumed to be Gaussian white noise.
From preliminary
ordinary least squares regression calculations, it was found that the
one-period lagged value of interest rate gave better and more consistent
results than its contemporaneous value. It was therefore decided to use rt-1
in place of rt. The amended equation was then estimated by the OLS
technique and the following results obtained:
 (2) |
R2 = 0.871 
= 0.81 F(4, 9) = 15.2
= 0.81 F(4, 9) = 15.2
see = 1.7
Mean of dependent variable = 14.9
D-W statistic = 2.06
In equation (2), t-values are given in parentheses below each
coefficient. With an R2 of .871, it is clear that we are able to
explain over 87 percent of the systematic variations in Nigeria's
investment-income ratio by the four independent variables. Three of the
independent variables, viz., the interest rate, the foreign exchange premium,
and the openness ratio are correctly signed and significantly different from
zero. The interest rate and the openness ratio pass the two-tailed significance
test at the 1 percent level. However, the parallel market premium only passes
the significance test at the 4 percent level. The fourth variable, MPK, is
incorrectly signed and not significantly different from zero. The Durbin-Watson
statistic used to test the existence of first order serial correlation is
2.06. This suggests the absence of serial correlation.
The F-statistic of 15.2 is significant at the 1 percent level. Thus, the
hypothesis of a significant linear relationship between the investment-income
ratio and the four independent variables is validated.
From the results, it
can be concluded that economic distortions and trade policy inadequacies, as
proxied by the parallel market premium, have had a dampening effect on
investment. The elasticity3 of investment with respect to the
parallel market premium is -.24. Thus, a 10 percent decrease in the ratio of
parallel market exchange rate to official market exchange rate would result in
a 2.4 percent increase in the investment-income ratio. The results also show
that trade openness is a significant determinant of investment in Nigeria. The
trade openness variable, proxied by the ratio of imports to GNP, is positive
and highly significant. The elasticity of investment with respect to the trade
openness variable is .44. Thus, a 10 increase in trade openness would lead to
4.4 percent rise in the investment ratio.
The Output Equation
The inspiration for the
output equation used in this study is neoclassical, tracing its ancestry to
Solow (1957) who hypothesized that output depended on capital and labour inputs
and on disembodied technical change. It also owes much to the modifications
introduced by development economists, particularly Chenery and his associates,
eg. Chenery and Strout (1966), which emphasized the role of investment and the
investment-income ratio. This combination is now becoming standard in the
development literature and variations of the model have been used by Ram Rati
(1985), Ghura (1995), Iyoha (1997a), Iyoha (1997b), Khan and Kumar (1993) and
Pindyck and Solimano (1993). In this study, it is hypothesized that output
depends on the capital-labour ratio, the investment-income ratio and technical
progress (proxied by time). Thus the output function to be estimated
econometrically using time series data is
 (3) |
where et is the random error term assumed to be Gaussian
white noise, a1, a2, a3 > 0, and GDP stands
for Gross Domestic Product, KLR is the capital-labour ratio, I/GDP is the
investment-income ratio, TM is chronological time, and ln stands for natural
logarithms. In equation (1), a3
is a crude measure of the rate of technical progress.
Using the two stage
least squares regression method, the MICROFIT MFIT 386 econometric software for
PCs, and data for 1980-1994, the following estimated output equation was
obtained:
 (4) |
R2 = 0.989 =
0.985 F(3, 10) = 292
=
0.985 F(3, 10) = 292
see = 0.12
Mean of dependent variable = 5.05
D-W statistic = 1.85
where t-values are reported in parentheses below the coefficients. Given
the value of the R2, it can be concluded that the three independent
variables (capital intensity, investment-income ratio and time) together
explain approximately 99 percent of the systematic variations in output during
the period. The F-value of 292 is highly significant, easily passing the
significance test at the 1 percent level. The signs of all the coefficients are
correct and the t-values of the three independent variables are highly
significant, passing the 2-tailed test of significance at the 1 percent level.
The Durbin-Watson statistic used to test the existence of first order serial
correlation is 1.85. This suggests the absence of serial correlation.
The elasticity of nominal output with respect to the investment ratio is
approximately .1, indicating that a 10 percent rise in the investment ratio
will bring about a 1 percent increase in output.
3.3 Net Benefits of Naira
Convertibility: Simulation Results
The econometric results
already obtained can be used to get coefficients to be used in simulating the
effect of Naira convertibility on real GDP. First consider the investment
demand equation. Recall that currency convertibility normally leads to the
elimination of the parallel market premium. Since the coefficient of the
parallel market premium is negative, the existence of multiple exchange rates
reduces the investment income ratio. Logically, elimination of multiple
exchange rates would increase the investment-income ratio. Given that the
coefficient of the parallel market premium is -1.73 and its mean value during
the 1981 1994 period was 2.07, one can conclude that Naira convertibility would
lead to a 3.6 percentage points increase in the investment-income ratio.
Assuming a 10 % increase in openness in the medium term, the investment income
ratio would rise by 4.4 percent. Thus, the investment-income ratio would rise
from its 1981-1994 mean value of 14.9 percent to approximately 19.5 percent.
Thus the investment-income ratio would rise by about 30 percent. Next, we can
use the output equation to obtain the result that GDP growth rate would rise by
approximately 2.5 percentage points.
In the absence of Naira
convertibility, assume that real GDP growth rate would rise to 4 percent in
1997 and, by stages, to 5 percent in the year 2000 where it would remain until
the year 2010. These assumptions have been used to simulate Nigeria's real GDP
for the 1997-2010 period given the 1996 figure of N106.9 billion. This real GDP
series in the absence of Naira convertibility is regarded as the Control GDP
series.
With Naira
convertibility, real GDP growth is assumed to reach 4.5 percent in 1997 and
rise by stages to 7 percent in the year 2000. GDP growth rate is assumed to
remain at 7 percent until 2005 when it is expected to rise to 7.5 percent which
would be maintained until 2010. Thus, ten years after Naira convertibility, the
Nigerian economy is expected to move to a high-growth trajectory reminiscent of
the high-growth performances of the "East Asian Tigers" -- Hong Kong,
Singapore, Taiwan and South Korea.
These assumptions are then used to simulate a new real GDP series. This
real GDP series resulting from Naira convertibility is dubbed the Simulated GDP
series, or GDPSIM.
TABLE 2: NIGERIA'S REAL GDP, 1996 - 2010
(Naira billion)
Control Simulated
Year Real GDP Real GDP
1996 106.9 106.9
1997 111.2 111.7
1998 116.2 118.4
1999 121.4 126.1
2000 127.5 134.9
2001 133.9 144.4
2002 140.5 154.5
2003 147.6 165.3
2004 154.9 176.9
2005 162.7 190.1
2006 170.8 204.4
2007 179.4 219.7
2008 188.3 236.2
2009 197.8 253.9
2010 207.6 273.0
Source:
Author's simulations, 1997
The Control real GDP series and Simulated
real GDP series are reported in Table 2 and illustrated in Fig 1. An
examination of Table 2 confirms that Control real GDP (i.e., Nigeria's real GDP
in the absence of Naira convertibility) rises from N111.2 billion in 1997 to
N207.6 billion in 2010. This translates to an average annual growth rate of 4.9
percent during the period. On the other hand, GDPSIM (i.e., simulated real GDP
assuming Naira convertibility) rises from N111.7 billion in 1997 to N273
billion in 2010. This is gives an average annual growth rate of 7.1 percent
during the period. The difference between the two growth rates is 2.2. Thus, we
can conclude that Naira convertibility would result in an increase of 2.2
percentage points in the average annual growth rate of Nigeria's real GDP
during the 1997 - 2010 period. A
further analysis of Table 2 demonstrates that in the year 2010, GDPSIM exceeds
Control GDP by N65.3 billion, or by approximately 32 percent. This means that
if Nigeria were to embrace convertibility in 1997, then, by the year 2010, her
real GDP would be approximately one-third higher than it would have been with
an inconvertible currency.
IV. Summary and Concluding Remarks
In this paper, an attempt has been
made to empirically estimate the benefits and costs of Naira convertibility
using econometric and simulation techniques. Operationally, it was found
convenient to estimate the net benefits (i.e., benefits less costs) of
Naira convertibility. The net benefits of Naira convertibility are expected to
increase over time as the costs are largely of a short-term nature while the
benefits are dynamic and of a long-term nature. The net benefits of Naira
convertibility presumably arise mainly from: (i) increased gains from trade;
(ii) expansion of output arising from augmented investment triggered by
increased openness; and (iii) expanded output arising from productivity gains
resulting from elimination of trade distortions.
The basic approach involved the
estimation of a small macroeconometric model of the Nigerian economy. The key
relations were: (i) an investment demand function incorporating openness and
the parallel market premium (a measure of domestic macroeconomic distortions
caused by trade restrictions); and (ii) an output function depending critically
on investment. Thus, the channel of transmission of the effect of Naira
convertibility on real GDP is through investment.
The estimated empirical equations
showed that openness, as measured by the import-income ratio, and the parallel
market premium are key determinants of investment. Increased openness has a
strong positive effect on investment; also, the elimination of multiple
currency practices greatly spurs investment. On its part, increase in
investment triggers output expansion. Using the coefficients obtained from the
econometric model and plausible assumptions about the phasing of the effects of
Naira convertibility on output growth, we utilized simulation techniques to
obtain a real GDP series from 1997 to 2010 on the assumption of immediate
embrace of convertibility. This series, called GDPSIM, was compared with a
counter factual, called Control GDP, under which the Naira remains
inconvertible. It was found that, by the year 2010, GDPSIM would exceed Control
GDP by one-third. Viewed another way, the average annual growth rate of GDPSIM
(Nigeria's real output under the assumption of Naira convertibility) would be 7.1
percent during the 1997-2010 period compared with 4.9 percent in the absence of
convertibility.
It should be pointed out
that Naira convertibility is not a panacea for all of Nigeria's economic ills.
In order to harvest the gains of Naira convertibility, it seems apparent that
the implementation of macroeconomic policies which are transparent, consistent,
and market friendly is not just desirable but in fact imperative. Thus, so long
as an appropriate enabling environment is provided, our results demonstrate and
confirm that Naira convertibility would be immensely beneficial to the Nigerian
economy.
Footnotes
1. "Openness"
refers to the degree of dependence of an economy on international trade and
financial flows. Thus, we may talk of trade openness and financial openness,
Iyoha (1973). In this paper, the primary interest is on trade openness which
may be measured by: (i) the import-income ratio, (ii) the export-income ratio,
or (iii) the ratio of the sum of imports and exports to income. In the
econometric estimations that follow, the three different measures were utilized
but the import-income ratio performed best.
2. The mechanism through
which external trade affects economic development and growth may be briefly
described thus: external trade leads to an increase in income, in the level of
investment and on the state of technical knowledge in the country. The increase in investment and improvements
in innovations and technological progress then lead to increased productivity
and competitiveness, and trigger a further increase in trade and in
income. This positive feedback continues
and brings about a "virtuous circle" of increased trade and economic
development.
3. Since this is a linear
equation, the elasticity-at-the-mean of a given independent variable is
obtained as the coefficient of that variable multiplied by its mean value and
divided by the mean of the dependent variable.
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