Understanding Forex, External Reserves, and the Naira Exchange Rate (1)

Over the past few months, developments in the Nigerian forex market have elicited reactions from stakeholders, some of which reflect an understanding while others do not. This article seeks to shed light on issues relating to foreign exchange, external reserves and the volatility of the exchange rate of the naira.

Currencies are relevant in the context of global trade, payments, and capital flows in and out of a country. It is the monetary instrument for the settlement of international transactions and for the financing of imbalances in the external payment position of a country vis-à-vis other countries. Foreign currencies are a major component of a country’s external reserves which, according to the International Monetary Fund, consist of “foreign public sector assets that are readily available and controlled by monetary authorities, for the direct financing of payment imbalances. and the direct regulation of the magnitude of these imbalances, by intervening in the foreign exchange markets to affect the exchange rate and / or for other purposes ”. In light of this, the Central Bank of Nigeria Act, 2007 Section 24 mandates the Bank to maintain external reserve holdings of gold coins or bullion, balances in banks outside of Nigeria. , short-term foreign treasury bills and medium-term securities, IMF Drawing Rights (SDRs), etc.

These assets have the character of liquidity and are represented by convertible currencies such as US dollar, British pound, Chinese remnibi, Japanese yen, etc. As of September 8, 2021, US dollar assets account for the lion’s share (72.04%) of Nigeria’s foreign reserve stock of $ 36.25 billion. The shares of the other components of the external reserves were as follows: British pound sterling (0.75%); Euro (0.33); Chinese rmnibi (11.81%); SDR (15.05%); and the Japanese yen (0.02%). The CBN Act of 2007 directs the Bank to “do its best to maintain external reserves at levels considered by the Bank to be appropriate for the economy and monetary system of Nigeria”. In light of this, the CBN has strived to fulfill this mandate using supply and demand management strategies, in particular currency conservation and control measures as well as measures to ensure supply. adequate in foreign currency. This is especially true because currencies are a scarce resource that must be managed effectively if the country is to achieve macroeconomic stability and avoid chronic balance of payments and external reserve problems.

It should be noted that only foreign currencies, in the form of convertible currencies or internationally acceptable currencies, and not the naira, can be used for international transactions. The main sources of a country’s foreign exchange supply include foreign exchange earnings from exports of goods and services, monetary donations, and foreign capital inflows such as loans and investments. It is from these incomes that the demand for foreign exchange is satisfied to spend on foreign imports of goods and services (including travel abroad, education, medical treatment abroad), gifts. to foreigners and loans and investments abroad. What is the implication of this? This is because for Nigeria whose currency is not convertible or serves as international currency, it must necessarily earn foreign exchange through high productivity and the export of goods and services, receipt of monetary gifts or receiving foreign loans and investments in order to import the necessary goods and services. services aimed at developing the economy and improving the well-being of citizens. In addition, high levels of foreign exchange earnings and foreign reserves form the backbone of the naira exchange rate. They keep the rate stable while low levels weaken the naira. But then, it is clear that the CBN does not produce foreign currency; it is what the country gains that the Bank strives to manage and use to stabilize the exchange rate.

And achieving an adequate amount of foreign exchange earnings requires developed domestic production structures, a diversified economy and export orientation, and an enabling macroeconomic environment, among others. For some time now, there have been problems with this that predate the current regime. The real efforts of the federal government to make progress in these areas have tended to be undermined by exogenous shocks over the past five years that pushed the economy into recession in 2016 and 2020. The shocks affected foreign exchange earnings, the accumulation of external reserves and the stability of exchange rates. .

The first recession, which lasted from the first quarter of 2017 to the first quarter of 2017, was triggered by the collapse of crude oil prices on the world market. Nigeria’s Bonny Light crude oil price has fallen steadily from $ 62.22 in the second quarter of 2015 to $ 34.39 per barrel in the first quarter of 2016. In the second quarter of 2017, when the country exited In the recession, the price of crude oil per barrel was only US $ 50.21 per barrel. Due to the heavy dependence of the Nigerian economy on the oil sector, the impact of the oil crash has been severe on export earnings, foreign exchange reserves, government revenues and other macroeconomic aggregates. , especially economic growth. External reserves fell from US $ 28.28.33 billion in the second quarter of 2015 to US $ 23.8 in the third quarter of 2016. The other indicators of the external sector also deteriorated: balance of goods and services, current account, financial account, overall balance of payments, and external debt stock and debt service. Net foreign exchange inflows turned negative, meaning that the country paid more foreign exchange to the rest of the world for the import of goods and services than it received. This implied that the demand for foreign currency was greater than the receipt of foreign currency and the pressure on the forex and the exchange rate of the naira was very high. This explained the devaluation / depreciation of the naira against the US dollar at that time.

Second, the economic crisis induced by the COVID-19 pandemic in 2020 led to a recession in the third and fourth quarters of last year. Pandemic containment measures in the form of economic lockdowns and restrictions on international travel and business have resulted in recessions for countries to varying degrees. Again, the external sector aggregates of the Nigerian economy have suffered a serious deterioration due to the economy’s continued heavy dependence on the petroleum sector for export earnings and the accumulation of external reserves. . Crude oil production fell from 2.07 mbpd in the first quarter of 2020 to 1.61 mbpd in the second quarter of 2021. Reports even point to a further drop to 1.27 mbpd in August, below the 1.38 mbpd reached in July. 2021 due to difficulties in some oil terminals. This drop in production is part of the reason why the observed increase in oil prices to around US $ 70+ per barrel has not had much impact on government revenues or the increase in foreign exchange reserves. This contrasts with US $ 50.43 per barrel on January 4, 2021 and a low of US $ 14.67 per barrel on April 27, 2020. Although the commodity price is currently above the pre-pandemic level of US $ 67.20 per barrel recorded on January 1, 2020, its impact on government revenues and foreign exchange reserves is further limited by the continued massive importation of refined petroleum products for almost all of the country’s needs. domestic consumption. For example, in July and August, the inflow of foreign exchange earnings from crude oil and gas was zero.

Thus, it is necessary to understand the nature of the challenges that the authorities are currently facing in the management of the exchange rate and the exchange rate: negative net inflows of currencies in Q1 and Q2 2021; the current account balance was negative from Q1 2020 to Q2 2021; the overall balance of payments was negative in the first and second quarters of 2021; external reserves increased from $ 36.5 billion in the fourth quarter of 2020 to $ 32.9 billion in the second quarter of 2021 due to strong pressure from foreign exchange demand and weak foreign currency inflows. However, it rose to US $ 36.03 billion as of September 13, 2021 due to a vital August allocation of the SDR equivalent of US $ 3.35 billion to the country by the IMF. Foreign exchange required to service external debt also increased, from $ 289.45 million in the fourth quarter of 2020 to $ 1,003.41 million in the first quarter of 2021.

To conclude

  • Obadan, Professor of Economics, is a former Director General, National Center for Economic Management and Administration, Ibadan Tel. : 08023250853; E-mail: [email protected]

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