Understanding foreign exchange, external reserves and Naira exchange rate

In recent months, developments in the Nigerian foreign exchange market have elicited reactions from stakeholders, some of which reflect understanding while others do not.

Foreign exchange is relevant in the context of world trade, payments and capital flows into and out of a country.

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 It is the monetary instrument for the settlement of international transactions and for financing imbalances in a country’s external payments position vis-à-vis other countries.

The Central Bank of Nigeria Act, 2007, Section 24, mandates the Bank to maintain external reserve assets in gold coin or bullion, balances in banks outside Nigeria, foreign short-term treasury bills and medium-term securities, Special Drawing Rights (SDR) of the IMF, etc.

These assets have the feature of liquidity and are represented by convertible currencies such as the US dollar, British pound sterling, Chinese Remnibi, Japanese Yen, etc.

As at  September 8, 2021, US dollar assets accounted for the lion’s share (72.04%) of Nigeria’s external reserve stock of US$ 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 Remnibi (11.81%); SDR (15.05%); and Japanese Yen (0.02%).

Professor of Economics and Chairman, Goldmark Education Academy, Benin City, Mike Idi Obadan said Foreign exchange is a scarce resource that needs to be efficiently managed if the country is to achieve macroeconomic stability, and avoid chronic balance of payments and external reserve problems.

Obadan stressed that it is only foreign exchange, in the form of convertible currencies or internationally acceptable currencies, and not Naira that can be used for international transactions.

The main sources of foreign exchange supply to a country include foreign currency receipts from exports of goods and services, monetary gifts and inflows of capital from abroad such as loans and investments.

 It is from these earnings that the demand for foreign exchange is met to spend on foreign imports of goods and services (including foreign travel, education, medical treatment abroad), monetary gifts to foreigners, and loans and investments abroad.

What is the implication of this? Obadan said: “It is that for Nigeria whose currency is not convertible or serve as international currency, she must necessarily earn foreign exchange through high productivity and export of goods and services, receipt of monetary gifts or receipt of foreign loans and investments in order to import needed goods and services aimed at the development of the economy and enhancing the welfare of the citizens.”

Also, high levels of foreign exchange earnings and external reserves are the backbone of the Naira exchange rate. They ensure stability of the rate while low levels weaken the Naira.

But, it must be noted that the CBN does not produce foreign exchange; it is what is earned by the country that the Bank strives to manage and use to stabilise the exchange rate.

Obadan  said achieving an adequate amount of foreign exchange earnings requires developed domestic production structures, diversified economy and export orientation, and a conducive macroeconomic environment, among others.

He said: “For quite some time now, there have been issues about these which predate the present Administration.”

Nigeria entered a recession in the first quarter (Q1) of 2017 triggered by the collapse of crude oil prices in the global market. The price of Nigeria’s Bonny Light crude oil declined continuously from US$ 62.22 in quarter 2(Q2) in 2015 to US$ 34.39 per barrel in Q1, 2016.

As at the second quarter, 2017 when the country exited recession, crude oil price per barrel stood at just US$ 50.21 per barrel.

Due to the heavy dependence of the Nigerian economy on the oil sector, the impact of the oil market crash was severe on export earnings, foreign exchange reserves, government revenue and other macroeconomic aggregates including economic growth.

External reserves declined from US$ 28.28.33 billion in Q2, 2015 to US$ 23.8 in Q3, 2016. The other external sector indicators similarly deteriorated: balance of goods and services, balance of current account, financial account, overall balance of payments, and external debt stock and debt servicing.

The net foreign exchange inflow became negative, implying that the country paid out more foreign exchange to the rest of the world for importation of goods and services than it received. This implied that the demand for foreign exchange was higher than receipt of foreign exchange, and the pressure on forex and the naira exchange rate was very high. This accounted for the devaluation/depreciation of the naira in relation to the US dollar at that time.

Secondly, the covid-19 pandemic-induced economic crisis in 2020 resulted in recession in the third and fourth quarters of last year. The pandemic containment measures in the form of economic lockdowns and restrictions on international travels and business resulted in recessions for countries to various degrees.

Again, the external sector aggregates of the Nigerian economy experienced serious deterioration due to the economy’s continued heavy dependence on the oil sector for export earnings and external reserves accumulation.

Crude oil production reduced from 2.07 mbpd in Q1, 2020 to 1.61 mbpd in Q2, 2021. Reports even indicate further decline to 1.27 mbpd in August, lower than the 1.38 mbpd achieved in July 2021 caused by difficulties in some oil terminals.

Obadan  said: “This decline in output partly explains why the observed increase in oil prices to about US$ 70+ per barrel has not impacted much on government revenue or foreign reserves accretion.

“Thus, the nature of challenges that the authorities currently face in the management of foreign exchange and exchange rate must be understood:  net inflow of foreign exchange being negative in Q1 and Q2, 2021; current account balance was negative from Q1: n 2020 to Q2 2021; overall balance of payments was negative in Q1 and Q2, 2021; external reserves declined from US$ 36.5 billion in Q4 2020 to US$ 32.9 billion in Q2 2021 due to heavy forex demand pressures and weak forex inflow.”

He opined that  the nature of the exchange rate and its fundamental determinants also need to be clearly understood, the key among which is the undiversified nature of the economy.

The value of a country’s currency is determined by the strength of the economy in terms of its production capacity and productivity, structure, and diversification of the export production base.

A vibrant and diversified productive real sector of the economy saves a nation the disbursement of scarce foreign exchange for the import of finished goods and production inputs, especially where these could be produced locally, and reduces pressure on foreign exchange demand.

In the same way, an export-oriented production base contributes substantially to foreign exchange supply which in turn strengthens the local currency. But in Nigeria, these desired attributes have not been achieved. Hence, the heavy dependence of the country on the oil sector for foreign exchange and government revenue creates instability in the Naira exchange rate.

Obadan  further argued that another fundamental factor is the excessive demand for foreign exchange in relation to supply.

He said: “The truth about excess demand for foreign exchange is that a sizable part of it is not genuine as it is aimed at transferring funds out of the country to enable the importation of unnecessary finished goods and promote capital flight – illegal financial outflows and money laundering.

Obadan who  was the former Director-General, National Centre for Economic Management and Administration, Ibadan, recommended the strong need to move away from the flawed pattern of economic management of the past by considering the revival and rebuilding of the productive sectors of the economy to achieve higher capacity utilisation and productivity, and competitive manufactured exports.

“Strong government encouragement of local refining of petroleum products for both domestic consumption and exports as well as strong and effective surveillance of the foreign exchange market by the monetary authority to check round-tripping of foreign exchange from the deposit money banks to the parallel market,” he said.