Capital Inflows and Exchange Rates in Nigeria : A Vector Autoregressive (VAR) Approach

The study examines the relationship between capital inflows and exchange rate for the Nigerian economy between the periods of 1986-2014. A monetary policy indicator such as M2GDP is also introduced in the model. Estimated results show that capital inflows granger cause exchange rate suggesting that capital flows into Nigeria play a significant role in determining real exchange rate. Also, the Granger-causality outcomes have also shown that capital inflows play significant role in determining the extent of financial deepening in the country. Using the vector autoregressive (VAR) approach, findings from the impulse response functions (IRFs) show that capital inflows respond negatively to a shock in real exchange rate. The IRF also reveals that real exchange rate responds positively to an innovation in capital inflows suggesting that when exchange rate rises, the rate of capital inflows to Nigeria also increases. In addition, the outcome from the IRF reveals that capital inflows respond positively to an innovation in M2GDP and also M2GDP responds positively to capital inflows suggesting that the more the financial deepening, the higher the rate of capital inflows. The variance decomposition shows that the determinants of capital inflows in descending order of importance include real exchange rate followed by M2GDP. Also, the variance decomposition reveals that the determinant of real exchange rate in descending order of importance is capital inflows, followed by M2GDP. The study suggests that for Nigeria to experience an improvement in the value of its currency as well as the extent of its financial deepening, conscious efforts should be made to woo capital inflows and one of the ways of attracting foreign capital is to create a favourable economic and social environment