Understanding FX, external reserves and naira value
In recent months, developments in the Nigerian foreign exchange market have elicited reactions from stakeholders, some of which reflect understanding while others do not. This piece seeks to throw light on the issues relating to foreign exchange, external reserves and naira exchange rate instability.
Foreign exchange is relevant in the context of world trade, payments and capital flows into and out of a country. 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. Foreign exchange forms a major component of a country’s external reserves which according to the International Monetary Fund (IMF) consists of “official public sector foreign assets that are readily available to, and controlled by the monetary authorities, for direct financing of payments imbalances, and directly regulating the magnitude of such imbalances, through intervention in the foreign exchange markets to affect the currency 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 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%). The CBN Act 2007 enjoins the Bank to “use its best endeavour to maintain external reserves at levels considered by the Bank to be appropriate for the economy and the monetary system of Nigeria”.
In light of this, the CBN has strived to carry out this mandate by using supply and demand management strategies, particularly, foreign exchange conservation and control measures as well as measures to ensure adequate supply of foreign exchange. This is particularly so because 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.
It must be 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? 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 then, 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.
And achieving adequate amount of foreign exchange earnings requires developed domestic production structures, diversified economy and export orientation, and a conducive macroeconomic environment, among others. For quite some time now, there have been issues about these which predate the present Administration. The genuine efforts of the Federal Government to achieve a headway on these have tended to be undermined by exogenous shocks in the past five years which pushed the economy into recession in 2016 and 2020. The shocks affected foreign exchange earnings, external reserves accumulation and exchange rate stability.
The first recession which lasted from the first quarter(Q1) of 2017 to the first quarter of 2017, was 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 in 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. 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. This contrasts with US$50.43 per barrel on 4th January, 2021 and a low of US$14.67 per barrel recorded on 27th April 2020. Although the price of the commodity is currently above the pre-pandemic level of US$67.20 per barrel recorded on 1st January, 2020, its impact on government revenue and foreign exchange reserves is further limited by the continued heavy importation of refined petroleum products for nearly all the domestic consumption needs. For example, in in July and August, the inflow of foreign exchange revenue from Crude Oil and Gas was zero.
Thus, the nature of challenges that the authorities currently face in the management of foreign exchange and exchange rate must be understood: net inflow of foreign exchange being negative in Q1 and Q2, 2021; current account balance was negative from Q1 2020 to Q2 2021; overall balance of payments was negative in Q1 and Q2, 2021; external reserves declined from US$ 36.5 billion in Q4 2020 to US$ 32.9 billion in Q2 2021 due to heavy forex demand pressures and weak forex inflow. It however increased to US$ 36.03 billion as at 13th September 2021 due to a lifeline allocation in August of SDR equivalent of US$ 3.35 billion to the country by the IMF. Foreign exchange required for external debt servicing has also increased, rising from US$ 289.45 million in Q4 2020 to US$ 1,003.41 million in Q1 2021.
All the above developments constitute some of the immediate triggers of the observed naira exchange rate depreciation such that the Investors and Exporters exchange rate (I & E rate) (the official exchange rate for investors, exporters and end-users) has, because of the external shocks and other fundamental factors, depreciated from US$ 385.55 in Q1 2020 to US$ 411.5 in August, 2021. In the I & E market, foreign exchange is traded (sold and bought) based on prevailing market conditions. Periodically, the monetary authority intervenes with supply in the market to ensure stability of the exchange rate.
The parallel market rate is determined mostly by speculators and rent seekers in a shallow and illegal market which constitutes a very tiny proportion of the foreign exchange market in Nigeria. Because the quantity of foreign exchange available in that market is very small in relation to the demand of the desperate economic agents that want to buy foreign exchange at any cost, the exchange rate is necessarily high. It cannot serve as reference for the naira exchange rate. If it is so, then it is the case of the tail wagging the dog! The parallel foreign exchange market needs to be avoided by decent economic agents. It will continue to exist as long as the naira is not convertible, the productivity of the economy remains low and the country does not earn enough foreign exchange from export of goods and services and capital inflows.
Now, 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. There is a direct correlation between the oil market and the naira exchange rate. When the oil market is enjoying a boom, other things being equal, the naira exchange rate strengthens/appreciates. But when there is a slump in the market, characterised by low prices, accretion to external reserves drops and the naira exchange rate depreciates.
The industrial and agricultural sectors have also not been helpful in stabilising the exchange rate. The manufacturing sector imports most of its raw materials and equipment but ends up with little value addition to GDP and insignificant export earnings. Although the agricultural sector contributes over 24 percent to the GDP, its contribution to foreign exchange earnings is also very low. The production system is highly import-dependent. As the country’s capital goods industry is comatose, like the petroleum product refineries, nearly all machinery, equipment and spare parts used by the production sectors that are in-ward looking, are imported, thereby putting much pressure on available foreign exchange. Yet, the contribution of the non-oil sector as a whole to the pool of foreign exchange has remained low unlike in some other countries where it contributes the bulk of foreign exchange earnings.
Another fundamental factor is the excessive demand for foreign exchange in relation to supply. Since the introduction of the market-based exchange rate system under the Structural Adjustment Programme (SAP) in 1986, excessive demand for foreign exchange has been one notable factor causing depreciation of the naira exchange rate. The naira has had a respite on the few occasions of boom in the crude oil market. 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. It is true that expansionary fiscal and monetary policies have a role to play in the instability of the exchange rate. Indeed, since SAP, expansionary fiscal and monetary policies have tended to put pressure on the exchange rate. This has intensified in the last two years of covid-19-induced health and economic crisis which necessitated increased spending by both the fiscal and monetary authorities across the world in their bids to counter the severe impacts of covid-19 on their economies. The Federal Government implemented a N2.3 trillion naira economic stimulus package through the Economic Sustainability Plan in response to the covid-19 exigencies while the Central Bank intensified its development finance interventions to boost growth, employment and poverty reduction and aggregate supply of goods to tame inflation from the supply side. It is expected that as the country and the world at large gets a good handle on the covid-19 pandemic, monetary and fiscal policies will chart their normal courses.
In conclusion, it is important to stress that considering that the naira is not a convertible currency, foreign exchange and exchange rate management over the years has been quite challenging and it remains so because foreign exchange earnings from oil have followed the boom and burst cycle of the world oil market and some of the past governments did not have the political will to save. Therefore, there is the strong need to move away from the flawed pattern of economic management of the past by considering the following, some of which are short-term while the others are medium/long-term:
· 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;
· 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;
· During oil booms, save forex and build fiscal buffers;
· Increased sourcing of local raw materials and revival of the capital goods industry;
· Promotion of fiscal and monetary discipline and harmony;
· Creating an enabling environment for productive capital inflows, especially foreign direct investment;
· Actively promote restoration of confidence in the economy to check capital flight. A good handle on the current insecurity challenges along with macroeconomic stability will be very helpful in this regard;
· Rationalise imports structure to manage demand for foreign exchange;
· As may be permitted by supply considerations, use external reserves stock to support the exchange rate through increased funding of the foreign exchange market; and
· Use moral suasion to encourage Nigerians to patronize home-made goods and reduce their high propensity for disruptive trade and commerce. Import only when it is absolutely necessary. They should also eschew unhealthy speculation in foreign exchange as well as rent-seeking behaviour and adopt positive attitudes towards ensuring a stable exchange rate for the naira.
Obadan is a professor of economics and former the DG of the National Centre for Economic Management & Administration, Ibadan