Evaluating The Adequacy of Nigeria’s External Reserves Level


Monday, October 16, 2017  09.11PM / FDC


Nigeria’s external reserves grew significantly in the last two decades, from $3.4bn in 1996, to an all time high of $62.1bn in 2008. By August 2014, as the oil price shock gained momentum, Nigeria’s gross reserves level dropped to $39.6bn. Increased CBN market interven-tions, lower oil proceeds and capital flight all contributed to the sharp decline in external reserves to a decade low of $23.9bn in October 2016. After lingering between $30-30.9bn in the first half of 2017, the external reserves crossed the $31bn threshold on August 29th, to settle at $32.7bn on October 3rd. The accretion was primarily due to the rise in oil revenues. Additionally, the introduction of the Investor & Exporter Foreign Exchange (IEFX) window helped boost investor confidence and foreign portfolio inflows.


The accretion has some wondering if Nigeria has reached a point of comfort with its reserve levels. When measuring the sufficiency of a nation’s external reserves, it is generally accepted that there are four key considerations: import cover, broad money, current account deficit and the stress test. Of the four, the stress test is con-sidered to be the most important because it determines the country’s vulnerability to possible crisis. A review of the four considerations demonstrates that while Nigeria performs well in the first three, it fails the fourth. There-fore, while the increase is positive, further growth is still needed if the country is to build resilience against exter-nal factors such as another global economic slowdown or oil shock. 


What Are External Reserves?


External reserves are assets stored in foreign cur-rency by a country’s monetary authority. The for-eign currency is viewed as a stable safe haven for capital. More than 60% of all external reserves are held in US dollars, the world’s most traded currency. Other currencies commonly used as reserve currencies include the euro (20.3% of global reserves), the British pound (4.7%), the Japanese yen (4.2%) and the Canadian dollar (2%)1. China has the world’s largest external re-serves, with approximately $3.1trn. Japan comes second, with $1.25trn, followed by Switzerland with 714.3bn Swiss francs ($0.73trn) in external reserves.2


Foreign reserves include foreign bank notes, bank deposits, bonds, treasury bills and other government securities. Nigeria’s external reserves are mainly from the proceeds of crude oil production and gas, which make up at least 91% of the reserves. Other sources include non-oil export revenue, Diaspora remittances, recovered funds, tax and com-missions. 


Why Does A Country Need Robust External Reserves?

There are many reasons why a country may look to build-up its reserves.


A tool for monetary policy

Using external reserves, the CBN can exert some control over exchange rates. If the monetary authority desires to make the national currency cheaper, to promote international trade, it can restrict the supply of forex. Prior to its adoption of a managed float, China’s central bank frequently intervened in the forex market, to weaken the yuan and boost the attractive-ness of its exports. Alternatively, a central bank could increase supply of the foreign currency to the market. This strategy reduces pressure on the local currency, leading to its appreciation. This policy is a favorite of the Central Bank of Nigeria (CBN). The higher the re-serves level, the more the CBN can intervene to influence the exchange rate.


As a buffer against external shock

An external shock is anything that can affect aspects of the domestic economy (consumer prices, government revenue or investment flows) and is outside the control of the government or monetary authority. These can include global economic slowdowns, financial crisis in major trading partners, natural disasters, or commodity price falls. In the event of any of these, external reserves provide an interim cushion, by providing back-up funds; it can support a quick recovery or adjustment. The more robust the external reserves, the more resilient a country is to external shocks.


To maintain investor confidence

In measuring the credit worthiness of a country, investors sometimes consider its external reserves. Robust reserves suggest that, if push comes to shove, the country can utilize part of its reserves to pay its debts and liabilities. The higher the reserves level, the lower the risk of a repayment default.


Government savings

External reserves are a form of government savings that can be used when access to capital markets and borrowing is curtailed. A central bank may also build-up its reserves to accumulate wealth or provide backing for the domestic currency. 


When Do Reserves Become Large Enough?

Compared to its peers, Nigeria lags behind.

 Proshare Nigeria Pvt. Ltd.

Source: IMF


However, comparisons aren’t always the most beneficial way to assess the size of the reserves. When measuring the sufficiency of a nation’s external reserves, the following factors provide some guidance:


Import Cover

The rule of the thumb is that external reserves should be able to cover at least three months’ worth of imports. However, according to a case study research carried out by the International Monetary Fund (IMF)6, countries that exceed the three month advised minimum are less likely to experience a significant slowdown in gross domestic product (GDP), as a result of external shock. At $32.7bn, Nigeria’s external reserves are equal to approximately 9 months of imports and service payment cover. Using this measure, Nigeria’s external reserves are adequate.


Broad Money

Another benchmark for measuring adequacy sug-gests that reserves should be at least 20% of broad money.7 Broad money is the amount of money in circulation plus banks’ short-term de-posits and 24hour money market funds.8 As of July 2017, broad money (M2) stood at N22.2trn. 20% of this is N4.44trn. Using an exchange rate of N305/$, this is equivalent to about $14.21bn. Again, using this measurement, Nigeria’s external reserves prove sufficient.


Current account

It is usually recommended that a country has enough in its reserves to cover its debt payments and current account deficit for 12 months. Nigeria’s current account balance is projected to close 2017 at $7.6bn. Total debt service payments stood at $2.45bn in H1’2017.9 Using this as a proxy, we can estimate that total debt service payments, both domestic and external, for 2017 will reach $4.9bn. This means, using the current ac-count measure, Nigeria’s external reserves would need to be at least $12.5bn. Again, Nigeria passes this yardstick.


Stress testing or worst case scenario analysis

This simulation technique involves evaluating if the external reserves level could provide an adequate buffer in the event of an external or domestic crisis. This method is similar to the banking industry’s stress test. In this instance, a worst case scenario for Nigeria would be an oil price below $40, and/or the resurgence in disruptions, push production below 1.4mbpd. With this method, Nigeria’s reserves are inadequate. 2014, serves as a case in-point for this. Despite an external reserves level of $39bn during that year, when oil lost over 50% of its value, the exchange rate plunged, and Nigeria was thrown into a full blown recession. Although some other factors, such as delayed policy response and oil dependence, exaggerated this, had the reserves been more robust, the impact of the oil price shock would have been less severe.


Should this scenario play out again, Nigeria is likely to face an-other recession. A fall in price to $40pb is a 29.12% loss from the current price of $56pb (Oct.12th). Compared to the price plunge of over 50% in 2014, this doesn’t seem like much. However, with cost per barrel at $22, this represents a 47.1% fall in yield. Additionally, this is below the budget benchmark of $44.5pb. Accompanied with a possible decline in production, this will be pose severe risks to Nigeria’s fiscal earnings. Additionally, the implications for the exchange rate are significant.


This is because oil proceeds are the primary source of funding for the external reserves, which the CBN uses to maintain a stable naira. Any interruption to this inflow could deplete the re-serves level rapidly. Meanwhile, to balance the shortfall in supply, and maintain stability, the CBN is likely to introduce restrictions on dollar demand, like it did in 2015 with the ban on 41 items. A forex liquidity and availability problem will mount pressure on the naira. This implies an inflationary impact on consumer prices and a decline in purchasing power.


According to three out of four measures, Nigeria has an adequate level of reserves.


Yet, it fails to pass the most important one of all: the stress test. This indicates that should there be another oil shock, or global economic slow-down, Nigeria will experience another crisis that will affect every aspect of the economy from consumer prices, to exchange rate, and investments. Fortunately, this impact is expected to be less severe than the 2015-16 crisis; seeing as Nigeria is at a lower economic base than it was in 2014. Also, given OPEC’s aggressive drive to increase prices, and the recent decline in global rig count, the chances of an oil price below $35 is highly unlikely- at least in the short to medium term. How-ever, with the increasing prominence of green energy and electric cars, oil faces an inevitable obsolescence in the long term. This means significantly lower demand will drive global prices down.


To shore up reserves, Nigeria will need to boost inflows and limit outflows. Inflows include export revenue and borrowing funds while outflows are primarily directed to the forex market. Thus, export diversification, improved investor sentiments and reduced forex market interventions, will help boost reserves.




1. Source: Investopedia. Available at : http://www.investopedia.com/terms/m/monetary-reserve.asp

2. Source: Trading Economics. Available at: https://tradingeconomics.com/country-list/foreign-exchange-reserves?continent=america

3.Source: Central Bank of Nigeria. Available at: https://www.cbn.gov.ng/out/2015/ccd/determination%20of%20optimal%20foreign%20exchange%20reserves%20in%20nigeria.pdf

4. Tables in this section present External Reserves data as at August 2017. Expect for Nigeria and where otherwise stated.

5.   Table includes data for countries which recorded a GDP within this range in 2016

6.Source: International Monetary Fund (IMF). Available at: https://www.imf.org/external/pubs/ft/wp/2012/wp1207.pdf

7.  Source: Antilles Economics. Available at: https://www.antilleseconomics.com/reserve-adequacy/

8. Source: The Financial Times. Available at: http://lexicon.ft.com/Term?term=m0,-m1,-m2,-m3,-m4

9. Total debt service includes external and internal debt. Internal debt was converted to dollars using N305.5/$ exchange rate. Source: Debt Management Office (DMO) https://www.dmo.gov.ng/debt-profile/external-debts/debt-service; https://www.dmo.gov.ng/debt-profile/domestic-debts/domestic-debt-service 


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