CBN JAS Article:Currency Substitution and Exchange Rate Volatility in Nigeria: An Autoregressive Distributed Lag Approach

04/08/2021 | 09:40am

CBN Journal of Applied Statistics Vol. 11 No. 2 (December 2020)


Currency Substitution and Exchange Rate Volatility in Nigeria: An Autoregressive Distributed Lag Approach

Isaiah O. Ajibola, Sylvanus U. Udoette, Rabia A. Muhammad, and John O. Anigwe 1

This study investigates the relationship between exchange rate volatility and currency substitution in Nigeria, using Autoregressive Distributed Lag (ARDL) model. After accounting for the presence of structural breaks, evidence from the findings shows that domestic interest rate and expected changes in exchange rate are important determinants of currency substitution. In addition, there is empirical support for a positive relationship between exchange rate volatility and currency substitution both in the short- and long-run. This implies that higher real exchange rate volatility is associated with an increased level of currency substitution. In view of these findings, the paper calls for sustained efforts by the monetary authority in containing exchange rate volatility and inflation as a way of curbing the spate of currency substitution in the country.

Keywords: Autoregressive distributed lag, currency substitution, exchange rate volatility, structural breaks

JEL Classification: C5, F3, F31

DOI: 10.33429/Cjas.11220.1/8

1. Introduction

The traditional role of money as established in the literature shows three distinguished func- tions: as a medium of exchange; store of value; and unit of account. The existence of currency substitution (CS) is an indication of the failure of the national currency to effectively perform these functions due to some underlying macroeconomic conditions such as inflation, persistent depreciation or volatility in the value of the national currency (Agenor & Khan, 1992; Clements & Schwartz 1992; Tanzi & Blejer, 1982; El-Khafif, 2002). Therefore, currency substitution can be described as a phenomenon where a domestic currency is being replaced by foreign currency due to the failure of the domestic currency to perform its roles effectively, as a means of payment and store of value.

1The authors are staff of Statistics Department, Central Bank of Nigeria

The views expressed in this paper are those of the authors and do not represent the views of the Central Bank of Nigeria.


Currency Substitution and Exchange Rate Volatility in Nigeria:

An Autoregressive Distributed Lag Approach.

Ajibola et al.

Girton and Roper (1981), Bahmani-Oskooee and IIker (2003), Yeyati (2004), Boamah et al. (2012), and Laopodis (2011) have argued that the degree of currency substitution, otherwise known as "dollarization", can have significant negative implications for the domestic economy. Such negative effects include undermining the sovereignty of monetary policy, growing susceptibility to monetary tremors arising from the host nation, causing deterioration of the balance of payments account, exchange rate volatility, and contracting overall output (Bawa, Omotosho & Doguwa, 2015).2 Currency substitution has negative economic implications for a country especially with regards to the conduct of monetary policy, as it undermines the transmission mechanism of monetary policy decisions. (See, Miles, 1978, Girton & Roper, 1981; Ho, 2003; Boamah et al. 2012). Mizzen and Pentecost (1996) and Chang (2000) believe that currency substitution undermines the freedom of the exchange rate strategy and obfuscate monetary policy in a sphere where capital controls do not exist or are simply avoided. In other words, instead of permitting a country to regulate her monetary posture under an uncontrolled exchange rate, currency substitution creates undue inter-addiction amongst countries. Batten and Hafer (1984) also argued that currency substitution exposes an economy to external shocks and noted that domestic and foreign currencies should not be considered substitutes. This view is consistent with the monetary independence perspective. According to them, if domestic currency is substituted with the foreign currency, the domestic money demand would easily respond to adverse shocks emanating from both domestic and external sources.

In the context of Nigeria, some of the key works on currency substitution include Akinlo (2003), Yinusa and Akinlo (2008), Lionel and Ubi (2010), Adeniji (2013), Doguwa et al. (2014), Bawa et al. (2015), Huseyin et al. (2015) and Udoh and Udeaja (2019). A review of these studies showed that their findings are mixed. While Akinlo (2003) failed to establish the incidence of currency substitution in the country, the remaining studies provided empirical evidence in support of its existence and drivers. The divergent findings are attributable to issues surrounding difference in sample period, methodology and the measurement of the currency substitution indicator. This lack of definite conclusion necessitates the need for investigation in this area hence the justification for this study. It is believed that a proper understanding of the drivers of currency substitution in Nigeria is of crucial importance to

  • See Cuddington (1983), Mizzen and Pentecost (1996), and Yinusa and Akinlo (2008), and Bawa et al. (2015) for more explanation on currency substitution and exchange rate instability.


CBN Journal of Applied Statistics Vol. 11 No. 2 (December 2020)


monetary authority as well as conduct of monetary policy. Therefore, this study differs from the above studies and contributes to the literature in the following distinct ways: it employs the use of Autoregressive Distributed Lag (ARDL) model with structural breaks; it also controls for the effect of Exchange rate volatility; it has wide data coverage, using quarterly data for the period 1995-2018 that include recent economic episodes, especially the Nigeria's economic recession and exchange rate crisis of 2016.

The objective of this paper is to examine the degree of currency substitution in Nigeria and the effect of exchange rate volatility on currency substitution while accounting for the presence of structural breaks in the time series. To achieve this objective, the study applied the ARDL to quarterly data spanning 1995 - 2018. This methodology is useful in estimating models that may include variables of mixed orders, I(0) or I(1) and different lag-length.

The paper is organized into five sections. Following the introduction, Section 2 presents a review of relevant literature. Section 3 discusses the methodology while the results are presented in Section 4. The last section contains conclusion and policy recommendations.

2. Literature Review

This section provides a summary of theoretical and empirical literature on the degree of currency substitution and exchange rate volatility as well as some stylized facts on Currency Substitution in Nigeria.

2.1 Theoretical Literature

The concept of currency substitution has been hypothesized severally in literature with variant classifications and with no consensus theory on its definition3. Currency substitution can be described as a phenomenon where a domestic currency is being swapped for foreign currency due to the failure of the domestic currency to perform its roles effectively, as a means of payment and store of value. It is a measure of the degree that currencies are substitutes in the portfolio of wealth holders, Girton and Roper (1976). Traditionally, each country has its own currency use as means of exchange therefore, when there are multiple currencies used for the same purpose, a stronger foreign currency competing with or substituting the domestic currency, then currency substitution is said to occur. Currency substitution is often caused by persistent macroeconomic instability in a country. During high inflation periods,

  • See Giton and Roper (1976), Ho (2003), Calvo and Vegh (1992), and De Nicolo et al. (2005).


Currency Substitution and Exchange Rate Volatility in Nigeria:

An Autoregressive Distributed Lag Approach.

Ajibola et al.

economic agents hold diversified portfolios of foreign currencies as a result of depreciation of the local currency with the intention of reaping profit in the future. The presence of ratchet effect makes economic agents to continue using foreign money in the financial system even after the high inflation periods and the expected differential in return leads to instability in the domestic money demand function making monetary policy management ineffective, Calvo and Vegh (1992). Residents tend to adjust their portfolio holdings to more stable foreign currencies in anticipation of further devaluation of the domestic currency to safeguard against high risk of the exchange rate, which consequently leads to decline in domestic currency demand function (Yeyati, 2004; Yinusa & Akinlo, 2008). The eroded confidence in the domestic currency among other factors, culminate into currency substitution as well as currency crisis and exchange rate instability. The effects of dollarization culminated from persistent macroeconomic instability is evidenced in developing countries like Zimbabwe, Panama and Ecuador. These countries experienced severe hyperinflation with no choice but to dollarize.

Currency substitution also known as dollarization is categorized as "partial" or "full". According to Andrew et al. (2000), full dollarization means taking the next step, from informal, limited dollarization to full, official use of a foreign currency in all transactions, as a medium of exchange, unit of account and as a store of value within an economy. Whereas partial dollarization connotes a limited, unofficial form of dollarization mostly common in high in- flation countries, which to a greater or lesser degree, is indicated by residents' preference to hold more of foreign currency and foreign currency-denominated deposits at the domestic banks, only as a store of value and portfolio diversification against macroeconomic instability and risk of exchange rate depreciation, and less of the riskier and unstable domestic currency.

However, apart from the negative implications of currency substitution or dollarization, there are some benefits that come with it. According to Schuler (2002),4 dollarization causes the following:

  1. An officially dollarized country enjoys the reduction of inflation rate from double digit to a single digit inflation of the foreign or issuing country.
  2. Reduction of the transaction cost of currency exchange. That is, the cost of converting domestic currency to foreign currency is low.

4The benefits of currency substitution or dollarization are well discussed in Schuler (2002)


CBN Journal of Applied Statistics Vol. 11 No. 2 (December 2020)


  1. High level of domestic investment and future economic growth as a result of reduced and stable interest rates for local borrowers.
  2. Assists financial institutions to develop, improve efficiency and quality of services. It also fosters financial integration with the issuing country as well as builds credibility with the government by adopting issuing country's policies.
  3. Fosters high levels of economic openness and transparency on the part of the govern- ment and eliminates balance of payments crisis.

Several approaches are found in theoretical literature for modelling the process of currency substitution with a large portion adopting the portfolio balance model approach of the money demand function. (see, Thomas, 1985; Yinusa & Akinlo, 2008; Doguwa, 2014). The cash- in-advance model based on the use of money as a medium of exchange (Clower, 1967; Lucal

  • Stoky, 1987) and the transactional model which hinges on the store of value function of money (Baumol, 1952; Tobin, 1956) formalized the macroeconomic foundation of the money demand function.5 The main theoretical basis of these models lies in the belief that demand for foreign currency largely depends on the interest rate differentials and the associated exchange rate risks. Baumol (1952) in his portfolio balance model, shows that transaction demand for money is interest inelastic whereas Keynes expresses that it is mostly interest inelastic and income elastic. The portfolio balance model is based on an ideal holding of money for transaction purposes. Economic agents hold money in the form of cash and assets to bridge the differences between income and expenditure, or for its return as an asset in a portfolio (Thomas, 1985). In both cases, the demand for money may rest on a scale of variables, such as wealth, real income or on the returns to money and other assets, which is the opportunity cost variable or the substitution effect. This substitution effect is captured by the interest rate on the assets invested in by the economic agents. The Maintenance of minimum transaction balances allows firms to maximize returns from assets. According to De Nicola et al. (2003), the portfolio balance model follows the assumption that money demand functions positively depends on scale variables such as wealth or income and negatively on the return of each substitute asset. However, other studies (Calvo & Vegh, 1992; Cuddington, 1989)
  • Clower (1967), Lucal and Stoky (1987), Baumol (1952), and Tobin (1956) for more discussions on the evolution and macro-foundation of the money demand function.


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