CBN JAS Article: Impact of Interest Rate Differential and Exchange Rate Movement on the Dynamics of Nigeria�s International Private Capital Flows

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

29-63

Impact of Interest Rate Differential and Exchange Rate Movement on the Dynamics of Nigeria's International Private Capital Flows

Tari M. Karimo1

The study examines the impact of interest rate differential and exchange rate movement on the dynamics of Nigeria's international private capital flows from 2010Q1 to 2019Q4. It uses the interest rate parity theory and the Markov Switching Time Varying Transition Probability Modelling approach. Findings show that interest rate differential does not explain the dynamics of aggregate capital and Foreign Direct Investment (FDI) flows, but significantly explains Foreign Portfolio Investment (FPI) flows. Also, Movement in real exchange rate is significant in explaining outflows and inflows in FPI, and inflows in FDI, but neutral to aggregate capital flows. The study concludes that deviations from interest rate parity provides opportunities for interest rate and currency arbitrage in Nigeria but using aggregate capital flows mask this evidence. The study therefore recommends that the CBN should focus on exchange rate stabilization policies, so as not only to discourage FPI reversal but to also enhance FDI inflow. This can be done by putting in place foreign reserve accretion measures to boost the ability of the CBN to defend the Naira. The new policy initiative on remittances is a right step in the right direction as it could boost external reserve.

Keywords: Arbitrage, capital flow, exchange rate, interest rate parity, time varying transition probability

JEL Classification: F31, F41

DOI: 10.33429/Cjas.11220.2/8

1. Introduction

Economists have over the years sought to explain the determinants of capital flows among economies. Consequently, there are two main strands of thought providing explanations of the mechanism governing capital mobility across national boundaries. These are the Resource Gap Theory (RGT) and the Interest Rate Parity Theory (IRPT). The RGT argues that countries that are closed to international capital mobility would have their income equal to expenditure on consumption and investment. Countries that are integrated into the world financial market could finance the discrepancies between income and expenditure through

• Statistics Department, Central Bank of Nigeria.
  The views/opinions expressed in this paper are those of the author and do not in any way represent the views of the Central Bank of Nigeria.

29

Impact of Interest Rate Differential and Exchange Rate Movement
on the Dynamics of Nigeria's International Private Capital Flows	Karimo

international borrowing or lending (Chenery & Stout, 1966; Thirlwall, 1976). The RGT has been supported by findings from Kim, Kim and Wang, (2007) for EU countries, Drakos, et al (2017) for Asian countries and Adegboye, et al. (2020) for sub-Saharan Africa countries.

The IRPT describes the idea of parity between interest rate differentials and forward premium and provides reasons why the Interest Rate Parity (IRP) might not hold (Keynes, 1923). Fur- ther, the main reason for capital mobility is because parity does not always hold between interest rate differential and exchange rate movement. The theory has since developed into becoming an important theory in modern international finance (see Georgoutsos & Kouretas 2016; Lothian, 2016; Ames, Bagnarosa, & Peters, 2017; Park & Park, 2017; Vasilyev, Busy- gin, & Busygin, 2017; Ismailov, & Rossi, 2018; Adewuyi & Ogebe, 2019).

From Chenery and Stout, (1966) and Thirlwall, (1976) a large body of literature has emerged on the use of foreign capital to bridge foreign exchange gap with the benefits of technology spillover and transfer of managerial skills (see Caves 1974; Mansfield & Romeo, 1980; Aitken & Harrison, 1994; Blomstrom,¨ Kokko & Zejan, 1994; Barry & Bradley, 1997; Bosworth, Collins & Reinhart, 1999; Konings, 2001; Buckley, et al., 2002; Schoors & Tol, 2002; Basu, Chakraborty & Reagle, 2003; Kose, Prasad, & Terrones, 2009; Caporale, Don- adelli & Varani, 2015; Djordjevic, Ivanovic & Bogdan, 2015; Okereke & Ebulison, 2016; Nwosa & Adeleke, 2017; Enisan, 2017; Ning & Zhang, 2018;Wang, Su, & Tao, 2019).

The perceived benefits associated with capital importation presents opportunity for emerging market and developing economies to attract foreign capital but with weak governance struc- tures, poor macroeconomic management, and underdeveloped financial systems, attracting investors could be a herculean task. Consequently, a study of the dynamics of international private capital flows is predicated on the suitability of domestic policy design and investment decisions. From a policy perspective, the determinants of international capital flows, particularly the interest rate parity must be properly understood and effectively managed to attract and keep foreign investors to avoid capital outflows and currency crisis. For economies heavily reliant on international capital, a sudden halt or huge reversals could impose difficulties on domestic macroeconomic stability. Such was the case of the East Asian emerging economies in 1997 when the collapse of the Thai baht triggered a sequence of unprecedented currency crises in East Asia. Earlier, these economies had enjoyed relatively high asset values/yield resulting in massive capital inflows to finance productive investments. The continuous capital

30

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

29-63

inflows resulted in the appreciation of the domestic currencies with a simultaneous decline in asset yields. In Thailand, exchange rate pressures built up, forcing the government to abandon its currency peg in July 1997, leading to the eventual collapse of the Thai baht. Within a space of four months, the currency depreciated by about 60%. Investors reassessed the strength of the currency peg and the financial system in the region, resulting in a wave of currency depreciations and declining assets in the stock market as investors withdrew their investments in favour of foreign markets with better yields. The impact was first felt across the entire South-East Asia due to the similarity of these markets (see Moreno, 1998; Ya- mazawa, 1998).

Various scholars have studied the determinants of international capital flows in different countries, including Nigeria (see Taylor & Sarno, 1997; C¸ulha, 2006; Glauco & Kyaw, 2008a; Glauco & Kyaw, 2008b; Brana & Lahet, 2010; Forster,¨ Jorra, & Tillmann, 2012;

´

Byrne & Fiess, 2015; Bogdan 2016; Grzegorz, Brzozowski & Sliwinski,´ 2017; Maghori, 2014; Obida & Abu, 2010; Ibrahim & Omoniyi, 2011; Essien & Onwioduokit, 1999; Ok- ereke & Ebulison, 2016; Nwosa & Adeleke, 2017; Enisan, 2017; Nwokoye & Oniore 2017; Leonard, 2018). However, the causes of capital reversals in emerging economies, especially the role of interest rate differentials and exchange rate movements, are hardly examined, making it difficult to distinguish between policy actions that reverse or perpetuate outflows and policy actions that sustain or perpetuate inflows. More so, except for Leonard (2018) previous studies either aggregate net capital flows without considerations for the components or focused on one component only, mostly FDI. Except for Enisan (2017), previous studies for Nigeria did not account for capital outflow. Studies in Nigeria including Enisan (2017) were also not carried out within the interest rate parity framework and so did not account for the influence of interest rate differential, and exchange rate movement simultaneously. There is, therefore, no empirical evidence that opportunity for arbitrage exists in the Nigerian econ- omy.

There are two major types of international private capital flows - Foreign Direct Investment (FDI), and Foreign Portfolio Investment (FPI). A third which has become important in recent years is remittances (see World Bank, 2020, 2019a, b & c, 2018a & b, & 2016). This study, however, focuses on FDI and FPI only, because these are the conventional types of foreign private capital flows. Also, the exclusion of remittances is due to its impact on exchange

31

Impact of Interest Rate Differential and Exchange Rate Movement
on the Dynamics of Nigeria's International Private Capital Flows	Karimo

rate, which is well documented in the literature and could lead to problem of endogeneity in a study of the impact of exchange rate on capital flows (Adejumo & Ikhide, 2019; Khurshid, et al., 2017; Lartey, 2017; Amuedo-Dorantes, 2014; Singer, 2010).

This study therefore examines the impact of interest rate differential and movements in real exchange rate on FDI, FPI and aggregate international capital inflows and outflows in an IRP framework. The study contributes to the body of literature by unveiling the relevance of interest rate differential and movements in exchange rates as determinants of the component of private capital inflows and outflows from 2010Q1 to 2019Q4. It thus highlights that when capital flows are aggregated, the impact of important determinants could be masked since the same factors could have differential impact on different types of capital flows, and the perpetuation of inflows and outflows, respectively.

The rest of the study is set out as follows: Section 2 is literature review; Section 3 is the data and methodology; Section 4 is the results and discussion; and Section 5 provides the conclusion and policy recommendation.

2. Literature Review

2.1 Theoretical Literature

There are two main strands of thought that provide explanations on the mechanism governing capital mobility across national boundaries. These are summed in the Resource Gap Theory (RGT) and the Interest Rate Parity Theory (IRPT). Whereas the RGT argued that it is the deficits in domestic resources in meeting investment and consumption needs that drive economies to seek capital elsewhere, the IRPT maintained that it is the difference between asset yields (interest differential) and exchange rate forward premium that determines the direction of international capital flow.

The RGT is attributed to Chenery and Stout (1966) and expanded by Thirlwall (1976). Ch- enery and Stout (1966) argued that domestic savings do not always equal investment. When savings fall short of investment, a savings-investment gap emerges. To bridge this gap, the government would either borrow from the home economy or from overseas thereby creating a foreign exchange gap. This is the amount by which the investment requirement falls short of the foreign exchange earnings. The difference between these two gaps determines the source of funding the deficit. The gap may be financed through domestic sources if the

32

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

29-63

saving-investment gap is larger relative to the foreign exchange gap otherwise financing will be from international sources. A key assumption of the RGT is that, in a world where there are no barriers to capital mobility there would be zero correlation between changes in domestic investment and national savings (Feldstein & Horioka, 1980; Feldstein, 1983; Obstfeld, 1981). The RGT is not explicit about the role of interest rate differential and exchange rate movement, which this study examines.

This study is anchored on the Interest Rate Parity Theory (IRPT). The IRPT was formalized and popularized by Keynes (1923). In his "A tract on monetary reform" Keynes (1923) described the idea of parity between interest rate differentials and forward premium and provides reasons why the IRP might not hold (see Georgoutsos & Kouretas 2016; Lothian, 2016; Ames, Bagnarosa, & Peters, 2017; Park & Park, 2017; Vasilyev, Busygin, & Busygin, 2017; Ismailov, & Rossi, 2018; Adewuyi & Ogebe, 2019).

The IRPT assumes identical yields on assets, for instance, treasury bills of different countries with similar quality (in terms of maturity, liquidity, and other macroeconomic conditions like capital control exposure and default risk) but differ only in the underlying currency. In its simplest form the IRPT holds when the interest rate differential between any two countries equals the difference between the exchange rate futures and spot rate. In which case there is no arbitrage for investors to take advantage of and the yield from investing in any of the country's assets is equal. Therefore, there is no economic incentive to seek investment outside one's domestic economy. Any deviation from parity creates arbitrage opportunities. To take advantage of the opportunity, international investors borrow from countries with lower interest rate and invest in countries with higher rates (Teall, 2018). The result is capital outflow for the lower interest rate economy and inflow for the higher interest rate economy. Thus, interest rate differentials and movements in exchange rates are thought of as the main drivers of international private capital flows (Keynes, 1923 and Levich, 2011).

2.2 Empirical Literature

The literature provides evidence on important global and country-specific factors determining capital flows in developing economies (see Taylor & Sarno, 1997; C¸ulha, 2006; Glauco & Kyaw, 2008a; Glauco & Kyaw, 2008b; Brana & Lahet, 2010; Forster¨ et al., 2012; Byrne

• Fiess, 2015; Bogdan 2016; Grzegorz et al., 2017) including those relating to the interest rate parity theory (see Dooley, 1988; Wang & He, 2007; Su & Zhang, 2010; Fang, Pei, &

33