CBN Releases study on Optimal Foreign Exchange Reserves in Nigeria

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Wednesday, June 10, 2015 5.59PM/CBN

1.0 Introduction
Economies maintain foreign reserves for different reasons which including amongst others to efficiently manage exchange rate volatility and adjustment costs associated with variations in international payments (Elhiraika and Ndikumana, 2007). Recently, there has been a growing trend in reserves accumulation amongst developing countries. The International Monetary Fund (IMF) estimates that the global external reserves holding increased from US$1.57 trillion in 1996 to US$11.69 trillion in 2013, with the share of developing and emerging economies increasing from US$0.55 trillion to US$7.87 trillion. The phenomenal rise in external reserves holding across many emerging markets and oil exporting countries in recent years have been motivated largely by the drive for selfinsurance against adverse external shocks (Adam and Ndikumana, 2007).

Nigeria has witnessed significant rise in external reserves from US$3.40 billion in 1996 to US$28.28 billion in December 2005 peaking at an all-time high of US$62.08 billion in September 2008 before declining to US$ 39.07 billion as at July 2014 (Figure 1). The huge accretion to external reserves between 2000 and 2008, reflected favourable developments in the oil market; including high prices, strong demand and improved domestic production. However, the significant drop in reserves between 2008 and 2010 was attributed to the effects of the 2008/09 Global Financial Crisis (GFC), significant production declines due to insecurity in the oil producing region and high import bills.More recently, the effects of tapering in the US coupled with dwindling fiscal buffers, accentuated the threat of depletion of the country’s external reserves.

Evidence suggests that the depletion in foreign reserves witnessed in Nigeria in recent times could elevate risk concerns among foreign investors. This could have serious implications for risk premium, portfolio flows, short-term external debt position, balance of payment position and economic growth. Also dwindling fiscal buffers tend to increase the country’s reliance on foreign portfolio flows which are known to be volatile and characterized by sudden stop constitute a major risk to exchange rate stability, especially with uncertainties around capital flows and oil price. This suggests that a country’s ability to manage its short-term obligations to the outside world, maintain a disciplined fiscal regime and attract long-term capital is crucial in the determination of its risk premium (Ozyildirim and Yaman, 2005).

The debate on what constitutes an optimum reserve holding remains unsettled in the literature. While some countries have remained aggressive in the accumulation of external reserves, others strive to maintain adequate reserves based on certain international standards. Practical experience suggests at least three import cover2 “rule of thumb” in determining the optimal level of reserves (Mendoza 2004). Import based reserve adequacy criteria suggests that 30 per cent of broad money or 4 months of import covering reserves can be considered as a minimum benchmark for reserve adequacy.

Similarly, Wijnholds and Kapteyn (2001) proposed that countries on managed float or on fixed exchange rate regime could maintain reserves to cover around 10 and 20 per cent of broad money, while the IMF posits 3 months of import cover. The role of reserves in macroeconomic management remains debatable, as both low and high reserves portfolios have their characteristic cost implications. The conventional external reserves adequacy ratios may not represent optimality in external reserves holdings. Therefore, it is important to estimate the optimal external reserve holding, while taking cognizance of adverse external shocks, cost profile of reserve maintenance and sensitivity of international capital to macroeconomic fundamentals. This would facilitate the comparison of the optimal trend with the conventional benchmarks, and help determine if actual reserves are beyond or below the optimal levels in which case, the country could be incurring some costs or benefits.

The knowledge of how a country’s sovereign risk may be impacted by key external and fiscal variables such as portfolio flows, fiscal deficit and short-term external debt in relation to the foreign reserve levels and output is critical for the attainment and sustenance of macroeconomic stability.

More importantly, identifying the external reserves level which is deemed optimal to enable the country adequately absorb the effect of a severe adverse shock is key to effective macroeconomic management. The objective of this paper is to estimate the optimal external reserve level for Nigeria. Following this introduction, Section 2 presents some stylized facts while Section 3 examines related literature including theoretical framework. Section 4 discusses data and methodology. Section 5 interprets the estimation result for the empirical analysis, while section 6 concludes with policy recommendations.

2.0 Stylized Facts
Nigeria’s external reserves derive mainly from the proceeds of crude oil production and sales. The main sources of rising external reserves in Nigeria include inflows of oil revenues complemented by diaspora remittances, growing foreign direct investment (FDI) and portfolio investments, capital inflows, banks’ on-lending activities to foreign financial institutions, growing guarantees and grants, etc. Nigeria’s external reserves rose phenomenally from 2005 and maintained the upward trend until the wake of the global financial crisis when it nose-dived from its peak in 2008. From an average position of $6.32 billion between 1990Q1 and 2004Q4, the external reserves peaked at $62.08billion in 2008Q3. It, however, declined to its 2014Q1 position of $38.33 billion (Chart 1).





Table 1 indicates that between 2000Q1 and 2006Q1, reserves, FPI and interest rate spread averaged US$12.64 billion, US$135.03 million and 3.05 per cent, per quarter. This period was characterized by high levels of short-term debt to reserves ratio, which adversely impacted the inflow of FPI. Between 2006Q2 and 2007Q4, reserves, FPI and interest rate spread averaged US$42.93 billion, US$694.69 million and 1.54 per cent, per quarter. The increase in FPI despite the lower spread could be explained by the significant decline in the ratio of short-term debt to reserves during the period.

Furthermore, it coincided with a period when the economy exited the Paris and London club debt obligations. The significant increase in the stock of reserves was primarily as a result of the steady increase in crude oil prices, during the period.

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