CHAPTER ONE

INTRODUCTION

1.1        Background of the Study

Foreign exchange reserves (also called Forex reserves) in a strict sense are only the foreign currency deposits and bonds held by central banks and monetary authorities. But it is more accurately termed official international reserves or international reserves. These are assets of the central bank held in different reserve currencies, mostly the US dollar, and to a lesser extent the Euro, the UK pound, and the Japanese yen, and used to back its liabilities, e.g. the local currency issued, and the various bank reserves deposited with the central bank, by the government or financial institutions (CBN 2010).

IMF(2003) defined international 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 intervention in the exchange markets to affect the currency exchange rate and/or for other purposes”.

Eichengreen and Adalet(2005), affirmed that in recent decades, currency and/or financial crises accompanied by reversals in capital flows have become more frequent and severe. Therefore, with increased financial integration, countries are more vulnerable to contagion from within and outside their regions. Consequently, central banks in developing countries have accumulated reserves to cushion extreme events, the bunching of external debt maturities, or other shocks that could affect the foreign exchange market and the domestic economy. Central banks also hold reserves to back a peg or managed exchange rate system.

Calvo and Reinhart (2002), Reinhart and Rogoff, (2004) affirmed that countries classified as having a free or a managed float often resemble pegs, a “fear of floating” appears to be pervasive. Choi and Cook (2004) argued that this is true for countries with dollarized liabilities. To soften local currency volatility, central banks use reserves even in the absence of severe shocks. As a result of this, Foreign exchange reserves have clear implications for exchange rate stability, financial markets and hence for overall economic activity.

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Note worthy here is that there have been divergent views about reserves holding. Some economists argue that foreign exchange reserves are useless and unutilized, while others argue that reserve holding is necessary to help smooth balance of payments imbalances (Friedman 1953, Kemal 2002). Friedman(1953) criticized the fixed exchange rate system with the argument that it contains unutilized foreign exchange reserves while, Kemal(2002), argues that foreign exchange reserves should be there to smooth out the imbalances in balance of payments. Therefore, it is believed that the concern of the critics of reserve holdings is about the cost of holding reserves which is the investment that the nations must forego in order to accumulate reserves.

However, the supporters of reserve holdings argue that the cost of reserves holding is small compared to the economic consequences of exchange rate variations. For example, depreciation in the value of the currency, caused by either financial crises or other internal or external shocks, may increase a country’s costs of paying back debt denominated in foreign currency as well as its costs of imported items. Furthermore, it also creates high inflation expectations. Choi and Cook (2004), and Frankel (2005), confirmed that many of the currency and financial crises of the last ten years have been associated with the contractionary effects of currency depreciation, with substantial output losses, especially through balance sheet channels. It is pertinent to put down here that, with adequate amount of reserves, monetary authorities can intervene at the appropriate times to help maintain the value of the domestic currency.

Landell-Mills (1989), suggests that the rationale for holding reserves include the following: Financing external imbalances, intervening in foreign exchange markets, and providing a buffer to cushion the economy against future exigencies or emergencies. However, in the past few years, reserve accumulation has mainly been associated with emerging Asian economies following the Asian financial crisis of the early 1990’s.

Today, it has become a global phenomenon traversing oil exporting nations and other non renewable resource dependent economies. In Nigeria, the period beginning from the later end of 1999 marked a turning point from a hitherto culture of fiscal indiscipline characterized by frivolous spending to a new dawn of prudent consumption and saving. Hence, this can be seen from her extraordinary accumulation in the level of reserves from USD 4.98 billion in May 1999 to USD 59.37 billion and USD40.48 billion as at March, 2007 and 2010 respectively (CBN 2007, 2010).

According to Magnus (2007), these robust domestic economic performances were occasioned by macroeconomic fundamentals like internal reforms, complemented by

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favourable external conditions like the persistent and unprecedented rise in crude oil prices joined with drastic decline in external obligations like debt service.

According to Central Bank of Nigeria, the Sources of Nigeria’s external reserves are derived mainly from the proceeds of crude oil production and sales.

Other sources of external reserves in Nigeria include: income from Investing foreign reserves, repatriation of unutilized Wholesale Dutch Auction System (WDAS), interest on WDAS Accounts held by Deposit Money Banks, WDAS Purchases, Inward Money Transfer, Value Added Tax (VAT), Education Tax, Commission, etc.

These can be shown in the diagram given bellow:

Source: Foreign Operations Department, Central Bank of Nigeria

The data given by CBN (2010) indicates that the trend of foreign reserves in Nigeria has been fluctuating overtime. For instance, foreign reserves in Nigeria averaged USD 756.4 billion between the periods 1970 to 1974. More so, in Nigeria, the foreign reserves between 1975 and 1979 averaged USD 2650.2 billion. This indicates a rise in foreign reserve. But between 1980 and 1984, foreign reserves in Nigeria dropped to USD 2164.48 on the average. Also, the average foreign reserve in Nigeria between 1985 and 1989 is USD 5320.32 billion, indicating a rise in reserve accumulation. Furthermore, from 1990 to 1994, there was a significant rise in foreign reserves on the averaged to about USD 38179.34 billon. Moreover, Nigerian foreign reserves rose to USD 325051.8 billion between 1995 and 1999 on the average, indicating a sharp rise in foreign reserves. The reserve further rose to USD 1805737 on the average between the year 2000 and 2004. The increase in this foreign reserve was due

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to improvements in the overall performance of the economy. Finally, between the year 2005 and 2009, the foreign reserve position of Nigeria averaged USD 6060636 billon.

On the same data by CBN (2010), the trend of real income in Nigeria has also not been steady. Between 1970 and 1974 average level of real income is shown to be USD 7011.4 billion. Between 1975 and 1979, real income in Nigeria averaged USD 29399.84 billion. This shows a rise in real income in Nigeria. But between 1980 and 1984, there was a sharp rise in Nigeria’s real income to about USD 161123.1 billion on the average. It also averaged USD 213683.9 billion between 1985 and 1989, also indicating a sharp increase in accumulation of real income. Further, from 1990 to 1994, it also increased on the averaged to USD 270915.7 billon. Nigeria’s real income rose also to USD 300049.8 billion between 1995 and 1999 on the average. Between the year 2000 and 2004, the real income of Nigeria averaged USD 424897.1 billion. Also, between the year 2005 and 2009, it further rose on the average to USD 636231.3 billon.

On financial openness, CBN (2010) showed that its trend in Nigeria is also not stationary. For example, from 1970 to 1974, financial openness averaged 2.9%. Between 1975 and 1979, it reduces to about 2.3% on the average. Financial openness in Nigeria rose further to about 14% on the average between 1980 and 1984. From 1985 to 1989, it also averaged about 77.6%. More so, from 1990 to 1994, it further increased to about 96.7% on the average but thereafter, it decreased on the average to about 37% between 1995 and 1999. From the year 2000 to 2004, financial openness of Nigeria averaged 57.4%, marking an increase in Nigeria’s financial openness. Finally, between 2005 and 2009, Nigeria’s financial openness decreased a bit and averaged 54.8%.

The trend of trade openness of Nigeria has also not been stable as shown by CBN (2010). From 1970 to 1974, the trade openness of Nigeria averaged 36.2%. Between 1975 and 1979, it increased to about 43.3% on the average. Trade openness in Nigeria decreased to about 38.7% on the average between 1980 and 1984 but, from 1985 to 1989, it also decreased further and averaged 34.7%. However, from 1990 to 1994, it increased to about 57.6% on the average but after this period, it rose on the average to about 70.9% between 1995 and 1999. Trade openness in Nigeria from the