Proceedings of The Ahmadu Bello University Postgraduate Students’ Conference 2016

© School of Postgraduate Studies, Ahmadu Bello University Zaria, Nigeria

EFFECTS OF CAPITAL FLIGHT ON EXCHANGE RATE IN NIGERIA

Ebire Kolawole and Bello Sabo
Department of Business Administration, Ahmadu Bello University, Zaria
Corresponding Author: Tel. (+234) 07065681464, email: ebirekolawole@yahoo.com

ABSTRACT
This paper empirically examines the effects of capital flight on exchange rate in Nigeria using time
series data spanning from 1981-2015. The time series data was subjected to stationarity tests using
ADF and PP. Cointegration test was carried and the findings revealed that there exists a long run
relationship between capital flight and exchange rate in Nigeria. The Error correction Mechanism
revealed that capital flight had a short run relationship with exchange rate. The study concludes that
there exist a significant and negative relationship between foreign reserves and exchange rate. This
implies that when the capital flight increases, foreign reserves are reduced. Based on these findings,
the study recommends that measures should be put in place to prevent the depletion of Nigeria foreign
reserves.

Keywords: Capital flight, Exchange rate, Error correction mechanism, Foreign reserves

1.0 Introduction Secondly, capital flight may also intensify

Exchange rate stability is embraced as a
framework of monetary policy in both
industralised and emerging market economies.
This involves maintaining a fixed exchange rate
in relation to another currency or a basket of
currencies. This is necessary to facilitate trade
and investment between the two countries.
Central Bank of Nigeria (CBN, 2011) noted
that this forms a large part of the country’s GDP
as well as a means of controlling inflation. The
objective of the monetary policy in achieving
exchange rate could however, be constrained,
most especially in a country like Nigeria which
have suffered more from capital flight than any
other country in Africa. Capital flight have
however been defined as the movement of cash
and investment out of a country to a place that
is believed to be safe. According to Saheed and
Ayodeji (2012) capital flight takes place
through the transference of domestic private
savings abroad, the persistence of which can
lead to a serious decline in domestic savings.
This implies capital that flight is perpetuated
through foreign currencies. Ndikumana, Boyce
and Ndiaye (2014) reported that a cumulative
amount of capital flight for 39 African countries
between 1970-2010, summed up to US$1.3
trillion out of which Nigeria contributed about
US$311.4 billion. Continuous capital flight
fuels increasing demand for foreign currency,
which according to Fofack and Ndikumana
(2014) affects foreign exchange reserves by
exerting pressure on the exchange rate and
causing a depreciation of local currency.
exchange rate volatility because most countries
are heavily dependent on natural resources and
primary commodities (e.g Nigeria).
Given the negative effect of capital flight on
exchange rate and the continuous depreciation
of the naira against the US dollar, it is against
this background that this study intends to fill
this existing gap by examining the effect of
capital flight on exchange rate using the
determinants of world bank residuals method of
estimating capital flight.
Therefore, the broad objective of this study is to
empirically examine the effect of capital flight
on exchange rate in Nigeria.
1.1 Statement of Hypotheses
The following hypothesis are formulated:
H01: Change in external debt has not
significantly affected exchange rate in Nigeria.
H02: There is no significant effect between
foreign direct investment and exchange
rate in Nigeria.
H03: Current account balance has not
significantly affected exchange rate in
Nigeria.
H04: There is no significant effect between
change in reserves and exchange rate in
Nigeria.
2.0 Literature Review
A lot of controversies surrounds this
phenomenon called capital flight. Reasons
being that there is no universally accepted
definition and also because it means different
things to different people. Cuddington (1986) in

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Proceedings of The Ahmadu Bello University Postgraduate Students’ Conference 2016
© School of Postgraduate Studies, Ahmadu Bello University Zaria, Nigeria
his study quoted a Sao Paulo economist Kanitz
(1984) who asked a question: Why is it that
when an American puts money abroad it is
called "Foreign Investment" and when an
Argentinian does the same it is called "Capital
Flight"? Why is it that when an American
company puts 30 percent of its equity abroad it
is called "Strategic Diversification" and when a
Bolivian businessman puts only 4 percent
abroad it is called "Lack of Confidence"?
Lawanson (2007) noted that the major
constraint to a consensus on the definition of
capital flight can also be traced to the
difficulties involved in distinguishing between
those flows that can be considered ‘normal’ and
those that fall into the category of ‘flight’
capital. The question of definition still remains
unsolved, while developed world sees outflows
as Foreign Direct Investment (FDI), developing
economies see same activity as capital flight.
According to Morgan Guaranty Trust Company
(1986) capital flight can be defined as the
reported and unreported acquisition of foreign
assets by the non bank private sector and
elements of the public sector. This definition
views capital flight as the counterpart of the
sum of net direct investment inflows, change in
gross external debt, current account balance and
change in selected gross foreign assets. World
Bank (1985) on the other hand defined capital
flight as, the sum of gross capital outflows and
the current account deficit less increases in
official foreign reserves. This definition sees
capital flight as a change in debt plus net
foreign and direct investment minus current
account deficit plus change in reserves. Several
different capital flight measures are available in
the existing literature. Inevitably, these
measures lead to differences in capital flight
estimates.
2.1 Measurement of Capital Flight
As earlier mentioned, there are several
definitions of capital flight which has resulted
to different measurements. There are generally
two approaches to measuring capital flight:
direct and indirect approach. According to
Olawale and Ifedayo (2015) the direct approach
variables that constitutes capital flight comes
from the balance of payment statistics and trade
misinvoicing. The emphasis here is on the
identified nature of the capital flows. They
include: hot money and trade misinvoicing
methods.
49
The indirect measures however view capital
flight as a residual of four balance of payments
components. They include: increase in debt
owed to foreign residents, net foreign direct
investment, increase in foreign exchange
reserves and the current account deficit.
Lawanson (2007) identified five measures of
capital flight which can be found in literatures
and they include:
Residual Method
According to Lawanson (2007), the residual
method appears to give a rather straight forward
calculation of capital flight, which may be
responsible for being the most widely accepted
and applied method. This method used by
World Bank, (1986) and Morgan Guaranty
Trust, (1986) are often referred to as the
‘sources and uses’ of fund approach, the broad
measure or indirect approach to measuring
capital flight. The residual method according to
Lawanson, (2007), not only considers all
private capital outflows as capital flight, it also
compares the sources and uses of such capital
flows. This method suggest that for the
nonexistence of capital flight, the sources must
be equal to the uses of capital inflows. The
components of capital flight in this method
include: the net increase in External Debt
(EXD) and the net inflow of Direct Foreign
Investment (DFI) as sources which are
compared with the Current Account deficits
(CA) and addition to foreign reserve (RES) as
uses. Thus, the residual method in a simple
equation form measures the magnitude of
capital flight as
CFt = ΔDEBTt + FDIt - (CAt - ΔRESt)
Dooley Method
The Dooley method sees capital flight as the
total amount of externally held assets of the
private sector that do not generate income
recorded in the balance of payments statistics of
a country. In other words, capital flight is all
capital outflows based on the desire to place
wealth beyond the control of domestic
authorities. According to Cervena (2006),
measuring capital flight according to the
Dooley’s method, the total amount of capital
outflows has to be calculated first:
TCO = FB + FDI + CAS + FR − EO −ΔED,
Proceedings of The Ahmadu Bello University Postgraduate Students’ Conference 2016
© School of Postgraduate Studies, Ahmadu Bello University Zaria, Nigeria
Where FDI, CAS, FR, FB and EO denote
foreign direct investment, current account
surplus, change in foreign reserves, change in
external debt (World Bank data) and errors and
omissions respectively. TCO stands for the total
amount of capital outflows and ED is foreign
borrowing as reported in balance of payments
statistics. Second, we calculate the stock of
external assets corresponding to reported
interest earnings:
ES = IE/rus,
Where ES, IE and rus denote external assets,
reported interest earnings and US deposit rate
respectively. Capital flight is then estimated as:
CF = TCO −ΔES
Hot Money Method
Another name for this method is the
Cuddington (1986) approach. According to
Lawanson, (2007), the hot money measure
views capital flight as the capital outflows
responding to short term variations in the
various domestic and international financial
market conditions. In other words, the hot
money shows capital that react quickly to short
term risk. In order to account for the non-
registered short term capital flows, the net
errors and omissions are included. Therefore,
the hot money measure of capital flight can be
stated as:
CFt = STCt + NEOt
where CF represents hot money capital flight,
STC is short term capital flows and NEO is net
error and omission.
Mirror Stock Statistics
According to Ajayi (1995) the mirror stock
statistics measures capital flight as the record
cross border bank deposits of non-banks by
residence of depositors. The total figures
represents the amount of money owned by the
citizens of a country in foreign banks. The
yearly changes in this stock are referred to as
capital flight. The statistics for calculating
capital flight under this approach are available
from the International Monetary Fund (IMF)
and International Financial Statistics (IFS)
publication.
Trade Misinvoicing
According to Okoli, (2008), capital flight is
measured taking account of trade-faking
activity (over and under invoicing of both
50
export and imports, or the traditional under
invoicing of export and over invoicing
imports). The trade faking from both exports
and imports are calculated and added together.
The results are then added on to previously
derived measures of capital flight to generate
new estimates of capital flight. He further
explained that the usual method of calculating
trade faking is through partner country
comparisons. The trade partner is referred here
to as world.
The above measures of capital flight are subject
to various criticisms by different researchers.
The conflict here arise as a result of which
variable to include in estimating capital flight.
However, given the straight forward calculation
of capital flight associated with the residual
method and also, because of its wide
acceptance and usage in literatures such as
Lawanson, (2007); Okoli, (2008); Al-Fayoumi,
Alzoubi and Abuzayed, (2012); Olugbenga &
Alamu, (2013) and Ebire (2016). This study
therefore, adopts the residual method in
estimating capital flight in Nigeria.
2.2 Empirical Studies
Capital flight is detrimental to any nation’s
economy, yet less attention has been paid to the
effect of capital flight on macroeconomic
variables such as exchange rate. Fofack and
Ndikumana (2014) opined that capital flight
drains foreign exchange reserves, thereby
exerting pressure on the exchange and causing
a depreciation of the national currency. More
so, capital flight may also intensify exchange
rate volatility in countries that are heavily
dependent on natural resources and primary
commodities (e.g Nigeria). They further argued
that the reduction of foreign reserves as a result
of capital flight may undermine the policy
objective of stabilizing the exchange rate,
which is dependent on the size of foreign
exchange reserves available in the central bank.
Egbe (2015) examined the dynamic effect of
capital flight on the real exchange rate of the
naira covering a period between 1981-2009.
Findings revealed that capital flight from
Nigeria does not have a dynamic impact on the
real exchange rate, rather the exchange rate
responds to the domestic price level. On the
contrary, Uguru, Ozor and Nkwagu (2015)
found out that exchange rate is influenced by
the volume of capital flight in Nigeria. This
Proceedings of The Ahmadu Bello University Postgraduate Students’ Conference 2016
© School of Postgraduate Studies, Ahmadu Bello University Zaria, Nigeria

findings was corroborated by Ebire (2016) who is widely used method and also gives a straight
found out that, as capital flight increases, the forward estimation of capital flight Lawanson
exchange rate between the domestic currency (2007). Multiple regression was used in
and foreign currency increases. estimating the model of the study which is
3.0 Methodology stated below:
This study is adopts ex-post facto research EXr = 0 + 1LnΔEXDEBT + 2LnFDI +
design. Secondary data which are time series 3LnCAB + 4LnΔRES +
were sourced from CBN data base spanning the where,
period between 1981-2015. The data were first Exr – Naira to US dollar exchange rate
subjected to staionarity test in order to avoid ΔEXDEBT – Change in External Debt
spurious regression. The hypotheses were FDI – Foreign Direct Investment
tested using Ordinary Least Square (OLS), CAB – Current Account Balance
cointegration and Error Correction Mechanism ΔRES – Change in foreign reserves
(ECM). 1- 4 – coefficient of the explanatory variables
The model for this study is based on the World Ln – Natural Logarithm
Bank residual method (1985). This is because it
4.0 Result and Discussion
4.1 Unit Root Test Results
Table 4.1: Augmented Dickey-Fuller and Phillips-Perron Unit Root Tests
Variable ADF t-statistics Order PP t-statistic Order
EXr -3.828444*** 1 -3.815964*** 1
LNΔEXDEBT -7.510665*** 1 -7.347518*** 1
LNFDI -8.449010*** 1 -8.205289*** 1
LNCAB -7.297957*** 1 -7.848672*** 1
LNΔRES -4.524595*** 0 -4.570477*** 0
Note: *** represents significant level at 1% Mackinnon critical values
Source: Authors’ computation (2016)
ADF and PP were used in testing for the presence of unit root and the results shows that all variables
are stationary at first difference except foreign reserves.

Johansen Cointegration Rank Test Result

Having established the stationarity of the
variables, we determined the long run
relationship among the variables using
Johansen test of cointegration technique. Prior
then, we established the lag criteria and 1 lag
was found to be more appropriate.
The result of the Johansen cointegration test
presented above indicates at least 1
cointegration equation. The result therefore,
confirms the existence of cointegration among
the variables. Hence, we can conclude that there
exists a long run relationship between capital
flight and exchange rate in Nigeria.
The ECM is in line with our a priori
expectation. The negative sign of the ECM
implies that the speed of adjustment between
the short run dynamics to its long run
equilibrium is 13.7%. Hence, as a result of its
insignificance, there exists a short run
relationship between the variables. That is,
continuous capital flight increases the exchange
rate between Nigeria naira and US dollar. All
variables were found to be insignificant except
foreign reserves which was negative and
significant at 5%. This implies that a unit
increase in foreign reserve helps in reducing the
exchange rate by 2.63% in the short run. This is
in line with our a priori expectation.
The coefficient of determination denoted as R2,
shows that 43.1% of the variations in exchange
rate can be explained by the independent
variables. Also, the fitness of the model which
is measure by the F-statistics shows that the
model is fit as indicated by the significance
level.
The residuals of our analysis were subjected to
various diagnostics test. Specifically, the
Jarque-Bera test which measures the normality
of the residuals showed that the variables were
normally distributed. The residuals were tested
for serial correlation using Breush-Godfrey
serial correlation LM test. Findings indicated
that there was no serial correlation. Lastly, the
study tested for Heteroskedasticity using

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Proceedings of The Ahmadu Bello University Postgraduate Students’ Conference 2016
© School of Postgraduate Studies, Ahmadu Bello University Zaria, Nigeria

Autoregressive conditional heteroskedasticity residuals were not heteroskedastic (i.e there

(ARCH) test and findings indicated that the were homoskedastic).

Table 3.2: Johansen Cointegration Rank Test Result

Rank Trace statistics 5% Critical value
0 75.24872 69.81889*
Trace test indicates 1 cointegrating eqn(s) at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values

Error Correction Mechanism

Variable Coefficient Std. Error t-statistics
D(LNΔEXDEBT-1) -3.397098 5.267782 -0.644882
D(LNFDI-1) -6.441217 14.24027 -0.452324
D(LNCAB-1) -4.628232 5.115031 -0.904830
LNΔRES -2.630414 1.071629 -2.454594**
ECM(-1) -0.1375540 0.111631 -1.232092
R2 = 43.1%, Adj. R2 = 11.9% F-statistics = 23.00607***
Note: *** and ** represents significant level at 1% and 5% respectively

5.0 Conclusion www.google.com/capitalflightandlongt

The study concludes that there exist a short run
relationship between capital flight and
exchange rate in Nigeria. On the other hand,
there exist a significant and negative
relationship between foreign reserves and
exchange rate. This implies that when the
capital flight increases, foreign reserves is
reduced. Based on this findings, the study
recommends that measures should be put in
place to prevent the depletion of Nigeria foreign
reserves.
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© School of Postgraduate Studies, Ahmadu Bello University Zaria, Nigeria
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