Exchange Rate Volatility and the extent of Currency Substitution in Nigeria

This study tests for the existence of currency substitution and attempts to gauge its magnitude in Nigeria. The analysis was based on a multi-perspective unrestricted portfolio balance model. The stock of foreign currency deposits in Nigeria and the ratio of deposits denominated in foreign currency in the domestic banking system to deposits denominated in the domestic currency were modelled. First, the study revealed the presence of currency substitution in the domestic banking system in Nigeria. A major factor driving this process was exchange rate volatility especially real parallel market exchange rate volatility. Also, the study demonstrates that currency substitution in Nigeria was low during the period under review and as such classified Nigeria as moderately dollarized economy. Subsequently, alternative policy options for curtailing currency substitution in Nigeria were explored. The study concludes that currency substitution is an element of Nigerians’ behaviour concerning wealth allocation and as such macroeconomic policies that ensure long periods of low inflation and exchange rate stability become the most powerful policy option that could help stabilize or reduce currency substitution. Also very paramount are the development of domestic financial markets with relevant infrastructural facilities and the development of new financial instruments, which will serve as alternatives to holding money in the domestic economy.