CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

Nigeria, like many other countries hold Foreign Exchange Reserve at what is perceived a favourable level, the reason for this is not farfetched. Foreign Exchange Reserve plays a critical role in the stability of any given economy on the whole and this is a major reason why its dynamics creates worrisome riddles to policy makers. Foreign Exchange Reserve otherwise called External Reserve, as defined by the International Monetary Fund (IMF, 1993), Central Bank of Nigeria (CBN, 2007a), “consists of official public sector foreign assets that are readily available to, and controlled by the monetary authorities for direct financing of payment imbalances, through intervention in the exchange markets to affect the currency exchange rate and or for other purposes”. This definition as implied by the IMF explains that the quantum of Foreign Exchange Reserve held in any given economy depends to an extent on the monetary policy implementation of the said economy. According to Mbeng, Cédric and Duru (2013:1), “they are the result of the operations of the economic policy. They constitute a key indicator that estimates a country’s external economic relationships in terms of exports and capital inflow. In other words, they reflect the country’s international trade surpluses, foreign debt balance and foreign direct investment balance”.

Nigeria operated the Bretton Woods exchange rate system as did most other world economies, and switched over to the free-floating exchange rate when in 1973 (Obadan; 2009), the United States single-handedly terminated convertibility of the US dollar to gold, automatically bringing the Bretton Woods system to an end and making the dollar a fiat currency. Nigeria’s choice of exchange rate regime today, just like every other country’s as outlined by the IMF (1997) is informed by the size of the economy, openness, diversified production structure, geographical concentration of trade and divergence of domestic inflation from World inflation and more (see Appendix A1 for tabular outline).

Before independence, Nigeria had been identified by the ascendancy of exports and commercial activities as the economy lacked an industrial sector at the time. Much of the exportable goods up to about 70% came from agriculture which was the mainstay of the economy, and despite fluctuations in world prices, it contributed about 65% to the Gross Domestic Product (GDP) (Sanni, 2010). Though agriculture in Nigeria started from peasantry

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and subsistence, it was enough to feed the populace, but on a commercial scale, owing to exportation, agriculture soon provided the foreign exchange needed for importation of capital goods as well as raw materials. This in turn enabled the various marketing boards accrue much revenue for which the surplus generated was used by government to develop the infrastructure that were prerequisites for long term development as a means to maximizing export-led development strategy.

In the words of Sanni (2010), “in 1971, the share of agriculture to GDP stood at 48.23 per cent. By 1977, it had declined to almost 21 per cent. Agricultural exports, as a percentage of total exports, which was 20.7 per cent in 1971, reduced to 5.71 percent in 1977. The discovery of oil in commercial quantity in the mid-1950s, coupled with the oil-boom resulting from the Arab oil embargo on the USA in 1973 affected the agricultural sector adversely”. The foregoing made sure Nigeria was heavily dependent on oil for which oil constituted about 90 per cent of Foreign Exchange Reserves and about 85 per cent of total exports. So, as Sanni (2010) commented, while the boom afforded the government the much needed revenue, it came with attendant adverse structural problems.

Within the context of Reserves management, consideration should be given as a priority, to settling the optimality issues of liquidity and Returns on Investment. An approach to this could be a more strategic targeting of reserve portfolio in a bid to spontaneously meet the demands of both the liquidity portfolio and the investment portfolio respectively. Accordingly, Blackman’s seminal work in 1982 explains that foreign exchange reserves management is an instrument of exchange rate policy in developed countries while it is a major national asset of economic development in developing countries. In establishing a Foreign Exchange Reserve management system, cognisance must be taken of the aphorism that external obligations have to be settled in foreign exchange, and this explains that the stock of reserves is an indispensable spring of funding external imbalances. Typically, the purpose of holding Reserves is to allow the central bank an additional means to stabilize the issued currencies from shocks. In addition to meeting the transaction needs of countries, reserves are used for the precautionary purpose of providing cushion to absorb unexpected shocks or a sharp deterioration in their terms of trade or to meet unexpected capital outflows, as witnessed in the case of the negotiated exit payment of the Paris Club Debt by Nigeria. Reserves are also used to manage the exchange rate through intervention in the foreign exchange market. Thus, the motives for holding adequate level of external reserves can

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therefore analogously be summarized as the reasons why individuals hold money (CBN, 2007b).

The accumulation of Foreign Exchange Reserve over time has also been used to depict robust economic performances, as evidenced in Nigeria between May 1999 and March 2007 for which the CBN (2007b) reported increase in Foreign Exchange Reserve from US$ 4.98 billion to US$ 59.37 billion in the aforementioned periods and then more recently, a fall to USD31.89 billion as at July 7, 2015 as observed by Chima (2015). However, as pointed out by Gosselin and Parent (2005:1), no country’s monetary authority accumulates reserves indefinitely as excessive reserve hoarding comes with significant sterilization costs. They went on to state that the negative spread between the interest earned on Reserves and the interest paid on the country’s public debt increases with reserve accumulation which to an extent might not be desirable. This is as a result of the changing levels of reserve holdings for the given economy. Varying levels of Foreign Exchange Reserve as endeared by the nation’s exchange rate system is considered for various purposes chief amongst which as suggested by Ajibola, Udoette, Omotosho and Muhammad (2015: 112) are to preserve the value of the domestic currency, maintain a favourable external reserves position and ensure external balance without compromising the need for internal balance and the overall goal of macroeconomic stability. Other uses as put forward by Osuji and Ebiringa (2012:647) to which external reserves can be put are to intervene in the foreign exchange market, guide against unforeseen volatility and maintain natural wealth for future generations.

1.2 STATEMENT OF THE PROBLEM

Foreign Exchange Reserves just like every other macroeconomic variable experiences fluctuation over time in Nigeria and its fluctuations causes co-movements in other macro variables. Crests and troughs have been attained, and its value averages US$ 183,082.2706 million between the periods of 1981 and 2014 for annual data sourced from the CBN (2014). Arguments have been raised in favour and against the accumulation of Foreign Exchange Reserve with debate on issues of the adequacy of reserves, its alternative uses on one hand and building a reserve base in the face of dwindling domestic economic activities, inadequacy of infrastructure as well as high incidence of poverty respectively but to mention a few on the other hand, and as such, the decision to hold more or less has implications on the viability of the economy.

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Osabuohien and Egwakhe (2008: 31) are of the view that external reserves are generally held in the form of high quality marketable securities issue, however, such holdings are not without cost. The costs usually include, among others; financing cost, personnel, and overhead expenses, which fluctuate periodically such that holding External Reserves has both variable and ongoing costs especially when it exceeds the benchmark of the three months import equivalent. With Foreign Exchange Reserves climbing steadily from 2001 till it attained its peak in 2008 to the tune of $701.675 billion for data sourced from the World Development Indicators (WDI, 2014), similar movements were seen in the nation’s economic size as measured by her GDP adjusted for inflation rising to N24.3 billion from N6.9billion in 2001, and the Nominal Exchange Rate at N118.57k/$ from N111.94k/$ all in same year (CBN, 2014). Excess Reserve holdings if existent, thus implies attendant consequences whose impact the various sectors of the economy must feel.

Reserves of Foreign Exchange and Gold compares the dollar value for the stock of all financial assets that are available to the Central Monetary Authority for use in meeting a country’s Balance of Payment (BoP) needs as of the end date of the period specified. For this measure of economic power, the CIA WorldFact Book (2015) ranks Nigeria 48th with an estimated $37.44 billion for the year 2015, while China and Japan with a whooping accumulated Reserves holding of $3.98 trillion and $1.267 trillion, ranks 1st and 2nd respectively. In Africa, Nigeria ranks 4th in Reserves holding, while Algeria, Libya, and South Africa holds $193.6 billion, $105 billion and $50.55 billion respectively, making them the 1st three countries in Africa with regards Foreign Exchange Reserve Holdings. These huge amounts of reserves as held by Nigeria has in the last two years, through to the past few months before the May 29th, 2015 handover, been depleted due to its use to defend the Naira which had been under pressure from market speculation, pre-election spending and fall in crude oil prices giving rise to criticisms from various quarters - Pressure groups, Civil Society groups, Human Rights Proponents and of course, the then opposition party.

In political views, as a criticism, a former president – Chief Olusegun Obasanjo, accused the then ruling party (PDP)-led government, under the watch of President Goodluck Jonathan, of dwindling the nation’s Reserves (Onuba and Fabiyi, 2015), and blamed the government’s (in)actions for the myriads of problems the economy faced which included exchange rate instability and Nigeria’s relative inability to attract investment both domestically and from abroad. This actually might not be a problem if the economic state of

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the country is improved upon and made investor-friendly, with better standard of living. But then, without substantive reasoning, built on economic theory, and garnished by empirical and stylized analysis, one would not be able to tell if the depletion of the Reserves as purported by Obasanjo’s criticism which though could possibly imply lesser (opportunity) costs of holding Reserves, was favourable, or if the accumulation of Reserves were a better option as a shock absorber to international financial and related shocks.

The research work thus is focused on studying the implications of the movement of Foreign Exchange Reserve on the Macroeconomic stability of Nigeria in tandem with the desirability or otherwise of holding Reserves.

1.3 RESEARCH QUESTIONS