Impact of Monetary Policy on Financial Openness in Nigeria

Tajudeen Egbetunde and Sandra Oluwabunmi Obikoya Department of Securities and Investments Management Technology, Federal University of Technology, Akure, Nigeria

Corresponding Author: tegbetunde@futa.edu.ng

Abstract

This study examines the impact of monetary policy on financial openness as well as direction of causality between monetary policy and financial openness in Nigeria covering the period 1980 to 2019. The econometric techniques of analysis that the study used were Autoregressive Distributed Lag (ARDL) bounds test and Granger causality to address objectives of the study. The results reveal that monetary policy had short run and long run positive and significant effect on financial openness in Nigeria. The result of the ARDL bounds test shows that monetary policy and financial openness had long run relationship, and short run deviation from long run equilibrium in the relationship between monetary policy and financial openness is corrected annually at an adjustment speed of 84 per cent. The result of Granger causality shows that there exists uni-directional causality between monetary policy and financial openness in Nigeria, that is, direction of causality runs from monetary policy to financial openness in the economy. The study concludes that monetary policy plays a pivotal role in the determination and attraction of foreign capital flows within and outside the economy. The empirical findings recommend that monetary authority should ensure efficiency of monetary policy in deriving the benefits of financial openness and protect the economy against the adverse effects of financial openness.

Keywords: Monetary policy; financial openness; causality; Nigeria Jel Classification: E52; F36; C59; 055

1.0 Introduction

The part that capital flows play has become more important with the globalization of the financial market. Despite the benefits of capital flows such as enhancing investment activities, it poses significant challenges to an economy with weak macroeconomic stability and thereby hinders policymakers in the country. Financial openness is defined as the opening of a country's financial market to other countries of the world in a broad sense. Financial market openness and financial transactions enable individuals to conduct a variety of financial transactions in their home market while also allowing residents and domestic institutions to transact in international financial markets.

Nigeria has benefited immensely from capital flows due to different incentives and policy actions that were taken to attract these inflows. The surge of capital flows in developing countries such as Nigeria weaken the strength of central banks to affect national liquidity, such as domestic money supply, and consequently a country's economic performance. Nonetheless, Nigeria's share of global capital flows is insignificant compared to 2005 net private capital flows worth US$ 491.0 billion for developing countries (WDI, 2006). Foreign capital flows, on the other hand, are influenced by the prevailing monetary factors. This position is supported by Kouri and Porter (1974) that monetary policy is an important source of capital flows.

Over the years there have been one main reason that complicate empirical research on financial openness which has always produced mixed results is the proxies of financial openness which are de jure and de facto. In the literature, these measurements were used as a proxy for financial openness. Majority of scholars (such as Kose, Prasad, Rogoff & Wei, 2006; Orji, Anthony-Orji & Ogbuabor, 2016; Arimurti & Morley, 2020; Nwokoye & Oniore, 2017, Nihat, Mustafa & Bayram, 2005) argued that de facto is the best measurement of financial openness. Hence, this study used de facto as a measurement of financial openness.

Empirically, de Mendonca and Nascimento (2020) examine the influence of financial openness and economic globalization on monetary policy inefficiency and macroeconomic instability and find that financial openness and economic globalization are key to enhance monetary policy efficiency and macroeconomic stability. Guru and Yadav (2021) show that financial openness significantly enhances productivity and capital accumulation in developing countries but only boosts productivity in less developed countries. Egbetunde and Abayomi (2020) concludes that deepening of the financial sector attracts more FDI inflow to the Nigerian economy and thereby promoting sustainable development.

Fasanya and Olayemi (2020) show that financial openness largely erodes the growth-promoting role of financial development and argue that financial system's performance needs to be stabilized in Nigeria. Arimurti and Morley (2020) show that capital inflows and outflows are key determinant of nominal interest rates in an economy. BIS (2021) posits that a change in the exchange rate typically helps reduce current account imbalances and stabilize output.

The nexus between monetary policy and financial openness has not extensively addressed in the literature, particularly in Nigeria. Therefore, this study examines the effect of monetary policy on financial openness in Nigeria as well as direction of causality between monetary policy and financial openness for effective policy making in the country.

Following the introductory section, the rest of the paper is structured as follows: section two focused on the review of literature, section three described the data and empirical method, the empirical results were reported in section four while section five concluded the paper.

2.0 Literature Review

Financial openness refers to the free cross-boundary of capital flows resulting from less capital restrictions imposed by government and more free market role in capital market. Bennett (2005) views financial openness as a group of operational reforms and policy agenda aimed to deregulate and transform a country's financial mechanism with the view to achieving a liberalized market-oriented system within an appropriate regulatory framework. In operational terms, this study adopts financial openness as the extent to which Nigeria's financial markets are integrated with global financial systems, measured through de facto indicators of capital flows.

Correspondingly, monetary policy is defined by Anyanwu (1993) as the instrument used by monetary authorities to regulate and control the volume, cost, and direction of money and credit in the economy to attain macroeconomic stability. Understanding the interaction between these two variables – financial openness and monetary policy – is key for developing economies such as Nigeria, where liberalization has altered the policy environment.

From a theoretical viewpoint, greater financial openness is argued to strengthen the domestic financial system by enhancing capital allocation efficiency and boosting investment (Levine, 2001). Nevertheless, critics caution that financial openness may not always expand welfare, particularly in the existence of institutional weaknesses, trade distortions, or macroeconomic instability (Bhagwati, 1998; Rodrik, 1998; Rodrik & Subramanian, 2009; Stiglitz, 2000). The Capital Flow Theory, which underpins this study, posits that foreign capital movements are influenced by domestic monetary conditions. Specifically, a contraction in net domestic assets through open market operations raises domestic interest rates, thereby enticing foreign capital (Nwokoye & Oniore, 2017). This theoretical link, first advanced by Kouri and Porter (1974), suggests that monetary policy can serve as an important source of capital flows.

According to Kose et al. (2006), financial openness can be measured through de jure and de facto indicators. The de jure measure focuses on the legal or regulatory removal of capital flow restrictions, while the de facto measure captures actual financial integration based on observed cross-border transactions. Orji et al. (2016) examined the impact of both measures on output volatility in Nigeria using a GARCH model and found that neither contributed significantly to volatility. In contrast, Guru and Yadav (2021) reported that de jure openness significantly affects capital stock, output, and productivity, whereas de facto openness shows mixed effects.

Several empirical studies have discovered the interaction between financial openness and monetary policy. Karras (2001) found a negative relationship between financial openness and the effectiveness of monetary policy on output growth but a positive relationship with inflation across different country groups. Equally, Berument et al. (2007), using quarterly data from 1957–2003 for 29 countries, detected that the effect of financial openness on policy outcomes varies by country characteristics such as exchange rate regime, central bank independence, exposure to crises, and capital control policies. In Africa, Ekpo and Effiong (2017) examined 37 countries from 1990–2015 and found a strong link between financial openness and monetary policy effectiveness, showing that greater openness tends to lower inflation by improving money supply discipline.

Other scholars have studied the effect of monetary conditions on capital flows. Bacchetta et al. (2013) observed that favourable monetary policy enhances the stabilizing role of capital flows, while contractionary policy weakens economic resilience. Nwokoye and Oniore (2017) established, using the ARDL framework, that both short-run and long-run variations in capital inflows are significantly driven by monetary policy instruments. Clark, Converse, Coulibaly, and Kamin (2020) further noted that capital flows to emerging economies were sensitive to shifts in U.S. monetary policy, particularly during the post-2008 period. Similarly, Dua and Sen (2006) found a long-run relationship among capital flows, exchange rates, fiscal and monetary policy indicators, and current account balances in India, suggesting that policy dynamics influence external financial integration.

The institutional dimension of financial openness has also drawn attention. Okada (2013) found that while the direct relationship between financial openness and capital flows was statistically weak across 112 countries, the interaction with institutional quality was significant, implying that governance intermediates the effectiveness of openness. Likewise, Santana et al. (2013) investigated the effect of financial openness on capital flows in a sample of 51 countries (developed and developing) during the period of 1970-2010 using OLS techniques and found that financial openness enhanced the flow of total capital, FDI and other form of capital in both developed and developing countries.

Recent studies further highlight the macroeconomic implications of capital mobility. Safwat, Salah and El Sherif (2021) revealed that foreign debt can either support or hamper growth in Egypt depending on how borrowed funds are utilized. Brkić (2021) also detected that external borrowing relieves domestic financing constraints, thereby supporting investment. In related contexts, Tiberto and de Mendonça (2023) noted increasing FDI inflows to developing economies, while Oanh, Van, and Dinh (2023) found that financial stability positively influences money supply and inclusion in advanced economies but has weaker effects in developing ones. Similarly, Bencharles and Kokumo-Oyakhire (2022) showed that while financial openness and portfolio investment drive growth in developed countries, their effects are insignificant in developing countries. Bila et al. (2023) further showed that economic prosperity strengthens cross-border aid flows in Africa, illustrating the interconnectedness of openness, growth, and regional interdependence.

In view of the above assertions, most of the studies are not strictly focused on the nexus between monetary policy and financial openness, particularly Nigeria. Hence, this study.

3.0 Methodology

The study examines the effect of monetary policy on financial openness in Nigeria. This study rests on the framework of the Capital Flow Model (see Nwokoye and Oniore, 2017). In this framework, financial openness is a function of monetary policy instruments. Thus, we have the model below

FOP = f(MP) (1)

Where FOP = financial openness indicators; MP = monetary policy instruments This study used two de facto financial openness indicators, namely: net foreign asset (NFA) and capital flow (CF). The monetary policy instruments used are money supply (MS), exchange rate (EXR) and interest rate (INR). Therefore, the instruments of monetary policy are stated below

MP = f (MS, EXR, INR) (2)

Substituting the monetary policy instruments into Model 1 yields the following explicit model

FOP = a + a₁MS₄ +a2EXR₄ +a3INR₄ +&₁ (3)

Where a = intercept term and ɛ₁ = error term In the literature, inflation rate is also among the determinant of financial openness and it is incorporated into Equation (3), yielding the re-specified model:

FOP = a + a₁MS, +a2EXR₄ +a3INR₄ +a₁INF₁ +ε, (4)

Where INF = inflation rate The indicators of financial openness used in this paper are estimated in different model.

The study used secondary data and covered a period of 1980 to 2019. The data for the variables were sourced from the Central Bank of Nigeria Statistical Bulletin (CBN), 2020 and World Development Indicators (WDI) 2020. Specifically, broad money supply sourced from CBN statistical bulletin (2020) and other variables sourced from WDI (2020).

The econometric techniques of analysis that the study used to capture objective of the study is Autoregressive Distributed Lag (ARDL). The study conducts robustness checks by determining the direction of causality using Granger causality test. The ARDL model that capture objective of the study is specified below

nAFOP, = B + BAFOP + BAMS + BAEXR+BAINR+BAINF i=0 t-1 i=0 i=0 AEXR4-1 4AINR-1 i=0 i=0 +δ₁MS4_1+δ2EXR4_1 + δ3INR4_1 + δ4INF₁-1 + AECM₁-1 + E₁ (5)

Where ECM = error correction term representing the speed of adjustment toward long-run equilibrium While the Granger causality model is stated as follow

FOP = Σᵢ₌₁ᵏαFOPₜ₋ᵢ + Σᵢ₌₁ᵏβMPₜ₋ᵢ + vₜ (6)

MPₜ = Σᵢ₌₁ᵏλMPₜ₋ᵢ + Σᵢ₌₁ᵏδFOPₜ₋ᵢ + vₜ (7)

Where rejection of the null hypothesis that βᵢ = 0 (or δᵢ = 0) implies the existence of Granger causality in the respective direction.

Prior to estimation, the study performs unit root tests for all variables to determine their order of integration. If the series are integrated at order one – I(1), the equation is modeled at first difference to achieve stationarity, as expressed below:

Δyₜ = ρyₜ₋₁ + εₜ (8)

A time series is stationary if it does not change overtime, which implies that its values have constant variability. This enables us to avoid the problems of spurious regressions that are associated with non-stationary time series models.

4.0 Results and Discussion

The unit root test was conducted for all the variables in the study and the results are presented in Table 1 below.

Table 1: Unit Root Test

Variables	ADF UNIT ROOT TEST Level t-stat	Critical Values	First Difference t-stat	Critical Values	ORDER OF INTEGRATION
CF	-4.731583	-2.938987**	-6.114488	-2.945842	I(0)
NFA	-0.378607	-2.943427	-4.619139	-2.948404**	I(1)
INR	-4.569301	-2.938987**	-12.68686	-2.9411445	I(0)
INF	-3.003137	-2.938987**	-5.834835	-2.941145	I(0)
EXR	-1.918866	-2.938987	-4.299008	-2.941145**	I(1)
MS	-1.072075	-2.943427	-5.643062	2.945842**	I(1)
Note: CF = capital flow; NFA = net foreign asset

The results reveal that money supply, exchange rate and net foreign asset are stationary at first difference because at first difference t-statistic was greater than the MacKinnon critical value at 5 per cent significance level but at level the t-statistic was less than the MacKinnon Critical Values at 5 per cent significance level. The other variables such as capital flow, interest rate and inflation were stationary at level. The results of the unit root tests indicate that there is mixture of stationarity i.e. I(0) and I(1). With the results of the unit root, we used ARDL in order to capture dynamic relationship among the variables. Firstly, we examine the ARDL bound test approach to cointegration proposed by Pesaran et al. (2001) and the calculated F-statistic is compared to the tabulated critical value in Pesaran (2001). The result of the bound test is presented in Table 2 below:

Table 2: ADRL Bounds Test

	F-statistic	Optimal lag	Significant level	I(0) bound at (per cent)	I(1) bound at (per cent)
Model 1 (CF)	5.452995	3	5 per cent	2.56	3.49
Model 2 (NFA)	3.912185	2	5 per cent	2.56	3.49

For both models, the F-statistics exceed the upper bound critical value at 5 per cent and this implies that the null hypothesis of the test is rejected. Therefore, the study concluded that the variables are cointegrated, that is, there is long run relationship between monetary policy and financial openness. Thereafter, the study examines the long run and short run relationship between financial openness and monetary policy in Nigeria. Table 3 below shows the results of the long run and short run relationship.

Table 3: The Estimates for the ARDL Model

Model 1 (CF) Variable	Coefficient	t-stat	Model 2 (NFA) Variable	Coefficient	t-stat
D(CF(-1))	-0.769076**	-3.968822	D(NFA(-1))	0.230096	1.177597
D(MS)	0.630766***	2.892078	D(EXR)	-0.001078**	-2.099918
D(INF(-1))	0.132411***	5.189324	D(INR(-1))	0.003830	1.270236
D(EXR)	-0.009332*	-1.855506	D(INF)	-0.007909**	-2.282020
D(INR(-1))	0.071434	1.481446	NFA(-1)	1.065325***	14.44806
CF(-1)	-0.008713	-0.057265	EXR(-2)	0.001312*	1.926795
EXR(-3)	-0.012428**	-2.321894	INF(-1)	0.018115***	4.194052
INR(-1)	0.114012**	2.625342	INF(-2)	-0.007479**	-2.415632
INF(-1)	0.126695***	3.853339	MS(-1)	-0.093386***	-2.875263
MS	0.474294**	2.433077	EXR(-2)	0.001312*	1.926795
ECM(-1)	-0.842086***	-6.395112	ECM(-1)	-0.948817***	-5.390913
Adjusted R-squared	0.781063		Adjusted R-squared	0.679594
Durbin-Watson stat	2.33329		Durbin-Watson stat	2.102444
*****, * indicate significance level at 1 per cent, 5 per cent and 10 per cent respectively.

The ARDL estimates show that monetary policy significantly affects financial openness in Nigeria, but the direction and magnitude differ depending on the proxy used. In Model 1 (capital flow), money supply has a positive and significant effect both in the short and long run. This suggests that an expansionary monetary policy – through increased liquidity stimulates economic activity and attracts foreign capital inflows. Conversely, in Model 2 (net foreign assets), money supply exerts a negative long-run effect, implying that expansionary monetary conditions may encourage capital outflows or reduce external asset holdings by residents. This contrast highlights the dual effect of liquidity expansion: while it promotes short-term inflows, it may weaken the long-term accumulation of foreign assets.

Interest rate exerts a positive and significant effect on financial openness in Model 1 but is insignificant in Model 2. This indicates that higher domestic interest rates attract short-term capital inflows seeking returns, but they do not significantly influence Nigeria's long-term external asset position.

Exchange rate movements have negative short-run effects on capital flows (Model 1) but positive long-run effects on net foreign assets (Model 2). This suggests that short-term currency depreciation discourages inflows due to volatility, while in the long run, an improved exchange rate may strengthen Nigeria's external investment position.

Inflation rate shows a positive and significant short-run effect on capital flows, implying that inflationary expansion may initially increase nominal asset returns and stimulate temporary inflows. However, the negative short-run effect in Model 2 reveals that sustained inflation can erode the real value of foreign asset holdings.

Collectively, these results indicate that financial openness responds differently to monetary policy channels depending on the dimension captured – either through inflows (capital flow) or asset holdings (net foreign assets). The contrasting signs emphasize the need for balanced monetary management to attract stable capital while maintaining sustainable external positions.

The negative and significant ECM coefficients (-0.842 and -0.949) confirm a high speed of adjustment - 84% and 95% respectively – towards long-run equilibrium after short-run shocks. This reinforces the evidence of cointegration and suggests a strong self-correcting mechanism in the financial openness-monetary policy relationship.

The ECM results corroborate the results of the ARDL bound test. The ECM coefficient is negative and significant, indicating that there exists a long run relationship between monetary policy and financial openness in Nigeria. The value of -0.843 and -0.948 for the error correction coefficient show that the speed of adjustment for any past variation in the equilibrium is approximately 84.3 per cent and 94.8 per cent in model 1 and 2 respectively. By implication, shock that distort long run relationship between monetary policy and financial openness will be restored back to equilibrium at the speed of 84.3 per cent and 94.8 per cent if and only if stable macroeconomic policy is put in place. This suggests that the monetary authority should stimulate efficient monetary policies and stable macroeconomic policies in order to protect the economy from adverse effect of financial openness.

The stability tests of the models were conducted using cumulative sum of square (CUSUMSQ) plots. The results indicate that the ARDL estimation models are stable because the plot lines fall within 5 per cent significance level.

[Image with CUSUMSQ plots]

Figure 1: Stability test

The study also conducted serial correlation, heteroscedasticity, and Ramsey reset test; and the results for the tests are presented in Table 4 below

Table 4: Diagnostic Test Results

TEST	Model 1 RESULT	PROB.	Model 2 RESULT	PROB.
Serial Correlation	0.401	0.753	0.752	0.484
Heteroscedasticity	0.751	0.710	1.418	0.239
Ramsey Reset Test	4.146	0.055	0.377	0.546

From Table 4 above, the tests affirm that the estimated model is free of serial correlation, heteroscedasticity and the model is well specified.

The study also examined the direction of causality between monetary policy and financial openness in Nigeria. The VEC Granger causality / block exogeneity wald tests were conducted to determine the direction of causality and the result is presented in Table 5 below.

Table 5: Granger Causality Test

Direction of Causality: MP → FOP	F-stat	Prob.	Direction of Causality: FOP → MP	F-stat	Prob.
	2.65388 *	0.0696		1.54906	0.2256

• indicates 10 per cent significance level; MP = monetary policy and FOP = financial openness

The Granger causality test reveals a unidirectional causality from monetary policy to financial openness, suggesting that monetary policy drives movements in financial openness rather than the reverse. This aligns with the theoretical proposition that effective monetary policy frameworks foster integration with global financial markets.

5.0 Conclusion

The study investigates the impact of monetary policy on financial openness for the periods 1980 to 2019, using ARDL and Granger causality techniques. The results show that monetary policy instruments – particularly money supply, interest rate and exchange rate – significantly influence financial openness in Nigeria. Moreover, the causality test indicates a unidirectional relationship running from monetary policy to financial openness, underscoring the pivotal role of monetary policy in driving external financial integration. The findings carry several policy implications that are vital to the design of Nigeria's macroeconomic and financial sector policies. First, the positive and significant effect of money supply on financial openness suggests that liquidity expansion facilitates cross-border financial transactions and enhances investor confidence. However, in the Nigerian context – where inflationary pressures and fiscal dominance are recurrent – expansionary monetary policies must be implemented with caution. The Central Bank of Nigeria (CBN) should therefore balance liquidity growth with inflation control by strengthening monetary transmission mechanisms and coordinating fiscal policies. This would help ensure that increased money supply translates into productive investment rather than speculative capital inflows that could destabilize the financial system. Second, the study's finding that interest rate exerts a positive and significant effect on financial openness implies that higher interest rates attract short-term capital inflows. While this may temporarily boost foreign reserves, persistent reliance on high interest rates could crowd out domestic investment and raise the cost of borrowing for local businesses. The monetary authority should thus pursue an interest rate policy that maintains Nigeria's attractiveness to foreign investors while sustaining domestic productive capacity. This calls for targeted credit interventions in productive sectors such as manufacturing and agriculture – to offset potential adverse effects of tight monetary conditions. Third, the result showing that exchange rate movements significantly influence financial openness highlights the importance of exchange rate stability in managing capital flows. A competitive exchange rate can promote exports and attract foreign investment; however, persistent depreciation without corresponding growth in domestic output may worsen external imbalances. Hence, policies that enhance local production, diversify exports, and reduce dependence on imported goods are essential to ensure that exchange rate adjustments yield sustainable benefits from financial openness. Lastly, the unidirectional causality from monetary policy to financial openness reinforces the need for credible and transparent monetary management. Stable macroeconomic conditions – characterized by low inflation rate, predictable exchange rate movements, and efficient liquidity management are prerequisites for sustained capital inflows and long-term financial integration. The CBN should therefore strengthen policy credibility through consistent communication, data transparency, and effective coordination with fiscal authorities. In summary, monetary policy in Nigeria must not only aim at attracting foreign capital but also ensure that such inflows are stable, productive, and growth-enhancing. A coherent mix of liquidity management, interest rate alignment, and exchange rate stabilization anchored on improved domestic production capacity – will enable Nigeria to harness the benefits of financial openness while mitigating its potential risks.

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