The Effect of Foreign Exchange Reforms on Financial Deepening: Evidence from Nigeria

Abstract

The peculiarity of the Nigerian economy makes exchange rate management critical to the overall wellbeing of the economy. In particular, Nigeria’s mono-economy with its very high dependence on commodities export and high penchant for imported goods exposes the economy to the vagaries of the international foreign exchange market. Nigeria has witnessed about fifteen distinct foreign exchange reform episodes from 1962 to date with mixed outcomes on the economy of the nation in general and financial depth in particular. This paper therefore evaluates the overall effect of foreign exchange reforms on the financial depth of the Nigerian economy over a twenty –nine year period. The explanatory variables were developed and selected in line with theoretical framework. Having certified that the time series are free of unit root, OLS regressions were applied to the data to determine the overall effect of foreign exchange reforms on the financial depth of the economy. Findings of the resulting times series analysis shed considerable light on the degree, dimension and direction of the determinants of financial depth. First the ratio of FDI to GDP, ratio of market capitalization of listed equities to GDP and real interest rate have positive relationship with financial deepening while exchange rate has a negative relationship with financial deepening. Secondly, among the determinants of financial depth only the ratio of GDP to real interest rates posted a significant relationship with foreign exchange. Overall, the evidence from the non-spurious regression results suggest that foreign exchange reforms in Nigeria have not had the desired positive effect on the depth of the Nigerian financial sector. The paper therefore recommends strong diversification of the Nigerian economy away from the mono-economy and its peculiarities into other non-oil sectors so as to enhance commodities export and reap the benefits of stable exchange rate.