International Oil Prices and Exchange Rate in Nigeria: A Causality Analysis

Abstract

This study examined the effect of oil price movements on USD-Naira exchange rate pair using 420 observations from monthly time series data for the period January 2008 to December 2014. An ordinary least squares (OLS) model and a vector autoregression (VAR) model were estimated for analyzing respectively, the impact of oil price movements on exchange rate and the nature of causal link between them. Empirical results show that oil prices on a relative basis significantly affect exchange rate compared to imports. Also, there is evidence of unidirectional Granger causality from oil prices to exchange rate and from oil prices to foreign reserves. Based on the findings, policy recommendations were made in favour of a change in the current structure of our international trade to reduce and gradually eliminate import dependence in order to enhance the ability of the monetary authorities to manage both exchange rate and foreign reserves. Introduction: It is widely known among economists that international oil prices saw a sharp fall during the global economic crisis of 2008. This led to a fall in oil revenues and unfavorable exchange rate movements for major oil-exporting economies especially those that were not well-diversified. The situation was worse for some OPEC economies with low levels of accumulated foreign reserves. The motivation for this paper is drawn from the author's observation that the plunge in international crude prices experienced in late 2014 affected the USD/Naira exchange rate to the extent that according to media reports, the monetary authorities had to devalue the Naira twice between September 2014 and June 2015 after it was no longer sustainable to continue the defense of the local currency using the nation's foreign reserves. In addition, exchange rate volatility occasioned by unfavorable oil price movements not only contributes to increasing the foreign exchange risk of businesses but also leads to higher cost of living when an economy is import dependent. The complex chain of macroeconomic linkages creates a situation where cost-push inflation could lead to fall in real incomes and hence, standard of living. These economic realities show that a study of this nature is worthwhile. Our study examines the effect of oil price movements on exchange rate and attempts to highlight how import dependence exposes the Nigerian economy to huge exchange rate problems especially when oil