Exchange rate and external reserves in Nigeria: A threshold cointegration analysis

This paper models the long-run relationship between the Bureau De Change exchange rate and external reserves in Nigeria in a Threshold Vector Error Correction Model (TVECM) framework using daily data that spans from Jan 1, 2014 to Jul 31, 2015. Modeling BDC exchange rate and external reserves within this context can be motivated by the fact that the transition mechanism between the variables is controlled by the degree of BDC exchange rates premium which is within central bank of Nigeria's policy oversight. The supLM test result indicates that there is a non-linear long-run relationship between the series, providing empirical support in favor of a TVECM specification. Thus, Cointegration occurs when the divergence between the two variables is above the threshold point estimate. Two regimes are implied by the model: the 'usual' regime, which accounts for 93.1per cent of the observations and the 'unusual' one, representing about 6.9 per cent of the observations of the sample. We also find that the error correction coefficients for both the bureau de change exchange rate and external reserves equations were not statistically significant at the 5 per cent significance level. While in the second regime, error correction coefficient for the external reserves equation was found to be statistically significant at 10 per cent. This implies that the adjustment mechanism between the two variables flow from external reserves to BDC exchange rate.