# Balance of Payments Constrained Economic Growth in Nigeria

Essay 2014 13 Pages

## Excerpt

## Abstract

This paper applies the adjusted balance of payment(BOP) constrained growth framework mod- i ed by Thirwall and Hussain (1982) on Nigeria's economic growth to estimate the determinants of the long run rate of growth in Nigeria. With Nigeria adopting the import substitution indus- trialization policy in 1960, we apply cointegration test on time series data to estimate the long run relationship between Nigeria's real GDP(output) and it's real export. Results signify cointe- gration between our variables, lending support to Thirwall's BOP constrained model as a suitable framework to explain Nigeria's long term growth and reinforces the opinion that external factors constrains Nigeria's economic growth.

keywords: Convergence, Economic Growth, Panel Data , GLMM Model, West Africa JEL Classi cation: C21, C22, C23, O11, O41

## 1 Introduction

This paper assesses the Thirwall's balance of payment(BOP) constrained model by applying it on the Nigerian economy and employing cointegration method to observe the relationship between economic growth and current account balance equilibrium. While extensive research study on economic growth concentrate on the neoclassical supply-oriented approach based on the production function and full employment, Harrod(1939) emphasized that demand generated growth determine long run economic growth and Thirwall developed a Keynesian perspective of the determinants of growth embedded on a dynamic version of the Harrod's foreign trade multiplier. Thirwall pinpoints the incapability of eco- nomic agents to increase aggregate demand inde nitely in open economies as justi cation for income growth di erences across nations.

The balance of payment constrained growth model states that a country's economic growth rate is constrained by the desire to generate foreign exchange and reiterate the function of demand as the motivation for domestic growth. This arises because growth in export and investment growth in import substitution are the only aspect of aggregate demand that can increase GDP growth and reduce foreign constraints. This implies that growth rate is constrained by the balance of payment as the economy cannot grow faster than what is consistent with the balance of payment equilibrium.

The principle of this Keynesian demand side growth theory is that export capability and import attitude establish long run economic growth. Income derived from external trade constitute the principal medium to nance growing import due to a rise in domestic activities.

This model di er from the supply induced growth models which evaluate economic growth by using factor inputs such as savings, human and physical capital, population growth and initial per capital GDP on economic growth. Reservations about the traditional growth models stem from the fact that the factor inputs have inconclusive roles in the growth process in developing countries. Also a lot of the neoclassical assumptions have been observed to be unapplicable in developing or transition economies. The balance of payment constrained model infer that economic growth are stimulated by demand factors and the main constraint on demand is the balance of payment. Trade has been observed to be an important restraint to economic growth when there are BOP constraints. Thirwall BOPC model is a modi ed Kaldor's four-equation regional growth model with import incorporated as a balance of payment constraint.

The economic growth of a country is said to be balance of payment constrained if the growth rate consistent with a current account equilibrium is below the maximum growth of the economy, often determined by the maximum growth of the supply side factors. The rationale is that Nigeria is an ideal economy where economic growth is constrained by external factors since more than 90% of revenue is derived from export of oil, therefore Thirwall's model is a capable medium to test Nigeria's economic growth pattern constrained by unfavourable balance of payments.

### A review of the Nigerian economy

Nigeria's economic growth has been driven by both domestic production and consumption components together with external engagement in goods and services, with the external engagement component widely accepted as a key determinant of it's economic growth and development. Until the advent of petroleum in the late 1950's, the government implemented investment ventures with the assistance of overseas aid, local savings and revenue from agricultural export. Nonetheless, the extent to which the economy could acquire local savings to bankroll investment was restricted and the government was unable to raise adequate foreign exchange because of constant balance of payment issues stemming from dependence on agricultural exports which were uncompetitive in the world market. Resultantly, there was an unfavorable balance of trade and current account de cits which acted as hindrances on import demand and as obstacles to e cient execution of the country's development plans. Upon exploration and exportation of crude oil in the 1960's, expectation of increased foreign revenue to embark on feasible developmental ventures that will lay a foundation for sustainable growth was rife. From 1971-1978, the economy was nancially solvent as savings-GDP ratio ranked between 16.5 and 35 percent and investment-GDP ratio ranked between 16.7 and 25 percent . The spike in crude prices led to substantial foreign exchange earnings and a positive saving/investment-GDP ratio. This facilitated growth in real GDP at an average rate of 8.3% from 1971-1978. Despite a surplus in BOP,income per capita was 2.7%. This was due to policies implemented which were geared towards public sector expansion at the expense of the private sector as well as a skewed income distribution strategy that was undertaken such as the Udoji awards. Nigeria's trade strategy during this period encouraged importation, while the current account balance and balance of payment ratio was neglected. With the oil boom turning to the oil doom following shocks in crude oil prices in the 1980's, there was a signi cant drop in revenue from oil exploration leading to massive recurring balance of payment de cits and unattainable public sector expenditure . E orts to stem the macroeconomic problem was undertaken culminating in the enactment of demand management policies. These include di erent measures aimed at stabilization such as tari s implementation and contractionary scal and monetary policies. These policies were aimed at reducing aggregate demand level and attaining BOP equilibrium. These policies improved the debt-GDP ratio and led to a positive BOP in the mid 80's, but with constraints on local nance and the inability of the private sector to stimulate economic growth and development, per capita income fell despite a BOP surplus. This led to the implementation of the structural Adjustment Programme (SAP), an economic remedy suggested by the Bretton Woods institutions with the stated objective of restructuring and diversifying the productive base of the economy, achieve scal stability and a positive BOP, set the basis for minimal in ationary growth and reduce the dominance of unproductive investments in the public sector. Instruments to achieve the stated objectives include the straightening of demand management policies, deregulation of the foreign exchange market (FEM), privatization of the public sector enterprise and the adoption of appropriate pricing policies for public enterprises. From the late 80's to the mid 90's, investment to GDP ratio was between 11 and 19% while saving to GDP ratio was between 10 and 25%. Subsequently, there was a change in the saving/investment gap-GDP ratio with the ratio switching from negative to positive. This imply low level absorptive capacity in the economy during the SAP era . However with uctuations in international trade during this era, de cits were recorded in the current account and capital account likewise the balance of payment accounts. Evidently, the weak performance of economic variables has an e ect on the economic growth with a decline in GDP growth rate from 8% to 3% between 1990-1993. Fiscal de cit to GDP de cit rose to 12% between 1994-1995 with growth rate of real GDP growing at less than 5% from 1994 to 1999. After 1999, with the advent of democracy, privatization and commercialization programme has been pursued with emphasis on trade openness. This has led to increase in trade and huge current account de cits.

With these precedents, there is a need to analyze the degree to which balance of payments hamper Nigeria from achieving its growth potential. The purpose of this paper is to test Thirwall balance of payment constrained growth model on Nigerian economy by applying cointegration techniques. 1960 was selected as our initial year because import substitution industrialization has been the hallmark of successive government policies from that year. Thirwall modeled an e ective method of assessing growth patterns constrained by economic growth and Nigeria is a prime example of an economy in which external factors constrain growth. His model provides us with an insight into Nigeria's growth structure during this time span as his demand-pull method indicate that increasing returns are an important component of economic growth and development.

## 2 The Balance of Payments Constrained Growth model

Thirwall's balance of payment constrained growth model is based on the notion that no country can grow faster than the rate consistent with its balance of payment equilibrum on current account, un- less it can nance ever growing de cit, which in general it cannot . This insinuates limitations to the de cit/GDP ratio and international debt/GDP ratio, beyond which nancial markets get nervous. Thirwall BOPC model asserts that long run growth is founded by the dynamic Harrod foreign multi- plier, which states that the pace of industrial growth can be explained by the principles of the foreign trade multiplier. The balance of payments equilibrium growth model can be stated as:

illustration not visible in this excerpt

Here, Pd and Pz are the domestic price and foreign price, E is the exchange rate, X and M represents exports and imports,F denotes capital in ows. From eq(1), the share of export as a ratio of total earnings can be stated as:

illustration not visible in this excerpt

Also, applying standard demand theory, the traditional export function can be stated as:

illustration not visible in this excerpt

With φ, Z &ϵ as the price elasticity of exports, world income and the income elasticity of demand for exports. The import function can also be stated as:

illustration not visible in this excerpt

With τ, Y & π as the price elasticity of demand for imports, GDP and income elasticity of demand for imports. Di erentiating eq(3) and (4):

illustration not visible in this excerpt

Eq (5) implies that export growth is determined by the rate of change of relative prices and world income while eq (6) implies import growth is determined by the rate of change of relative prices plus income elasticity of demand for imports. Eq (7) is the current account equation Substituting eq(5) and (6) into eq(7) and solving for growth:

illustration not visible in this excerpt

However, changes in relative prices has minimal e ect on growth rates of x and m because(1) MarshallLerner condition holds (2) oligopolistic competition (3) national wage bargaining. Thus: (φ+1+τ )(Pd− Pz − e) = 0 and since growth of z determines growth of x

illustration not visible in this excerpt

Equation (13)is known as the balance of payments constrained growth model or Thirwall's law and it asserts that the higher the π, the lower the balance of equilibrium growth rate. This means that a country's economic growth (y) is determined by it's export growth rate in the long run. Using the above framework, our study aims to analyze the relationship between export and growth in Nigeria.

## 3 Empirical Analysis and Findings

Data applied on the empirical analysis are from the period 1960-2012 obtained from theGlobalEcon- omy.com because of its large span of data on GDP and export in dollars using purchasing power parity. Much of "classical" economic theory is based on the assumption that the observed data is derived from a stationary process, implying a process with constant mean and variance over time Clements and Henry (1998). However, a peek at most economic time series graph disclose the invalidity of such an assumption since economies evolve, grow and change over time in both real and nominal terms. Still economic forecasts and predictions are better made when the variables are stationary thus necessitat- ing the need for stationarity test. Cointegration is an equilibrium relationship between time series that individually are not in equilibrium Hendry and Juselius (2000). Cointegration is the foundation upon which statistical arbitrage is built, however cointegration does not say anything about the direction of causality Johansen (1998). We apply cointegration method^{1} because of the inability of least squares

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^{*} PhD Candidate, School of Economics, University of Rome Tor Vergata, Italy.

^{1} (Gotce and Cankal, 2013; Gonzaga, 2003; Abaidoo, 2011; Hansen and Kvedaras, 2004) and other authors allege validity of Thirwall's law if GDP and export is observed to cointegrate in the long run. This study nonetheless undertake an error correction technique to con rm this assertion and check causality direction