What’s the fuss about foreign exchange reserves?

Earlier in March 2018, the Central Bank of Nigeria (CBN) announced that the country’s foreign currency reserves were steadily growing and that the reserves stood at $43 billion. This represented almost 100 percent increase from about $23 billion recorded in October 2016 when Nigeria was in a recession. The last time the FX reserves hit the $40 billion mark was in January 2014, five months before global oil prices began to fall in mid-2014. Subsequent to the apex bank’s announcement, the reserves reached $45.3 billion as of 21st March, 2018.

To the current administration of President Muhammadu Buhari and the CBN, the accretion in FX reserves is hardly about economics. They consider it as a tool for wielding political clout. However, many Nigerians have different opinions about the rise in FX reserves. Some people also wonder why the government is accumulating debt at a time its FX reserves are growing. While some of these concerns may have validity, the government needs to educate the citizens on the economic benefits of foreign currency reserves. The man in the street wants to know the importance of foreign currency savings to his wellbeing.

There are even some misconceptions that the Nigerian government’s maintenance of FX reserves is a recent phenomenon. Nigeria has had foreign reserves since the 1960s. According to available data, the country’s foreign exchange reserves averaged $10.9 billion over the last 57 years, reaching an all-time high of $62 billion in September 2008, and a record low of $63.22 million in June 1968.

So, what are foreign currency reserves? Why does Nigeria need them? What’s their impact on the economy? How do they affect the common man? And how much of FX reserves is enough?

In the 5th edition of its Balance of Payments Manual, the International Monetary Fund (IMF) describes foreign reserves as “consisting of official public sector foreign assets that are readily available to, and controlled by the monetary authorities, for direct financing of payment imbalances, and directly regulating the magnitude of such imbalances, through the intervention in the exchange markets to affect the currency exchange rate and /or other purposes.”

Contrary to the misperception that not all reserves are assets, foreign exchange reserves are classified as assets in the balance of payments (BoP) of a country. FX reserves are located in the capital account section of the BoP, which includes foreign direct investment (FDI), portfolio and other investments. These show that reserves are an important element of a country’s international position.

According to some literature, there are seven major reasons a country maintains foreign currency reserves. First, FX reserves are used to maintain a fixed exchange rate for a domestic currency. In a fixed exchange rate regime, the value of the local currency is tied or pegged to some other widely-used commodity or currency. This helps to remove volatile currency movements and provide some level of currency stability. In such a regime, central banks usually commit to buying and selling forex to forestall sudden changes in the exchange rate that might discourage trade and investment.

The second rationale for a country to want to use FX reserves is to keep the value of its currency lower, relative to major trading partners. This is to make its exports relatively cheaper. A third reason is to maintain liquidity in the case of an economic crisis. Foreign exchange reserves enable countries to coordinate trade policy and participate in international trade, which is dominated by the U.S. dollars.

Fourthly, FX reserves provide confidence and assurance to investors, thereby preventing capital flight. Having a currency’s value backed by reserves in stronger currencies shores up confidence in the local currency. A fifth reason for maintaining FX reserves is to meet external obligations such as financing of imports.

A country may use FX reserves to fund critical sectors. China has used this strategy to invest in infrastructure. Finally, a country would want to use its FX reserves to earn returns through diversified portfolios.

While other currencies like the British pound sterling, the Eurozone’s euro, the Chinese yuan and the Japanese yen are common foreign exchange currencies, most global FX assets have been held in U.S. dollars since the collapse of the Bretton Woods system, which lasted between 1944 and 1971, during which time gold was the primary currency reserve for most countries.

To be sure, FX reserves serve different purposes to different countries, depending on the individual nation’s foreign exchange policy as well as other economic factors. Japan purports to have a floating foreign exchange system. However, the country holds the second largest foreign reserves stockpile, after China, the world’s largest holder of FX reserves. China’s reserves (mostly in U.S. dollars) reached $3.16 trillion in January 2018.

In principle, a floating exchange rate regime does not need forex reserves to back the value of the domestic currency’s value. The balance between the supply of and demand for forex should determine the exchange rate. But in practice, countries that claim to allow their currencies to free-float actually don’t. That is why they hold foreign exchange reserves in the event they need to use them to stabilise the exchange rate, apart from using them as savings during potentially future crisis.

In Nigeria’s case, the country moved from a fixed exchange rate system in June 2016, to what is technically referred to as a “managed” or flexible exchange rate regime. This move was expedient in terms of boosting supply of FX in domestic market, stabilising the FX market and gaining the confidence of foreign investors. The Nigerian equities market has since been the darling of global investors. And with the recovery in oil prices, the country’s foreign reserves have had to reverse their depletion course.

So how much reserves are enough? Several years ago, it was enough for a country to have forex reserves enough to cover three to six months of imports. Not anymore. In December 2016, Nigeria’s reserves were enough to cover 12.6 months of imports. For a country like Nigeria, what should be enough is a very subjective question. It would sometimes depend on the policies being pursued by the central bank and also the structure and vibrancy of the economy. Other contingent factors would also include the share in GDP of the traded and non-traded sectors, the level and rate of capital inflows and outflows, as well as commodity prices.

In 2011, the IMF proposed new metrics for assessing reserves adequacy. The metrics involve taking into consideration the probability of tail events, among other factors. Other guidelines involve benchmarks like percentage of reserves to short-term debt, ratio of reserves to GDP. In 2015, Greece did not have enough reserves to cover the country’s debt payments and current account deficits for the next 12 months. It ended up falling into crisis.

There’s no doubt that foreign currency reserves have far-reaching positive implications for the economy. In a paper by Olayinka Akinlo, titled “Impact of Foreign Exchange Reserves on Nigerian Stock Market,” published in the International Journal of Business and Financial Research, it was established that the relationship between foreign reserves and the stock market has significant policy implications. According to the paper, “Foreign reserves have a positive effect on stock market growth.”

It is instructive to note that while FX reserves are very important to the Nigerian economy, as long as poverty and lack of basic infrastructures continue to ravage the country, the debate on the rationale for accumulating foreign reserves will not abate.

Therefore, the government should refrain from seeking to gain political capital from the accretion of Nigeria’s FX reserves. The reserves should continue to be strictly an economic policy tool. As the country continues to grow its reserves, care must be taken to ensure that mistakes of the past – when reserves were frittered away into private pockets – are not repeated. More importantly, information on the deployment of the FX reserves – as well as the general principles used in managing the reserves – should not be shrouded in secrecy.

Finally, the monetary authorities should know when the level of FX reserves is enough. Stockpiling reserves just for the sake of it could be counterproductive to the economy. Keeping reserves in a foreign land helps to develop that country. We cannot continue to beg and borrow funds to develop the country when we have funds stashed away. The CBN and the Ministry of Finance should devise a means of calculating exactly how much reserves we need at every particular period in time. That way, we would not keep stashing away funds needed to develop our own economy.


About Olajide Olutuyi

Entrepreneur Social Entrepreneur. Calgary Flames fan. Calgary Stampeders fan. Supports conscious capitalism.Progressive conservative( supports sin taxes, low taxes and laissez-faire economy). Former rap fan. Now listens to gospel and country. Believes in volunteering and community service as agents of developmental change. A lot of my time goes into community service, reading, encouraging people and most importantly God’s business. Loves culture , business start-ups and politics of both my home and adopted countries. This is my blog. The opinions and thoughts in my article are mine and I make no mistakes for having them. You may also find articles, news or opinions of others that I agree with or love to keep. More information about my professional background and interests available on my LinkedIn page.
This entry was posted in Africa, Finance, Foreign Exchange Reserves, Foreign Reserves, Governance, Nigeria, Politics-. Bookmark the permalink.

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