Understanding Foreign Exchange, External Reserves and the Naira Exchange Rate -GCFRNG
In recent months, developments in the Nigerian foreign exchange market have prompted reactions from stakeholders, some of which reflect understanding and some of which do not. This article seeks to shed light on issues related to currencies, foreign reserves, and the instability of the naira exchange rate.
The exchange rate is relevant in the context of world trade, payments, and the flow of capital to and from a country. It is the monetary instrument for the settlement of international transactions and for the financing of imbalances in the position of external payments of a country compared to other countries.
The exchange rate constitutes an important component of a country’s foreign reserves, which, according to the International Monetary Fund (IMF), consists of “official external assets of the public sector that are readily available and controlled by the monetary authorities, for direct financing. of payment imbalances, and directly regulate the magnitude of said imbalances, through intervention in exchange markets to affect the exchange rate and / or for other purposes ”.
In light of this, the Nigerian Central Bank Act, 2007, Section 24, obliges the Bank to hold external reserve assets in gold or bullion coins, balances in banks outside of Nigeria, short-term treasury bills and securities. medium term foreigners. IMF Drawing Rights (SDR), etc.
The characteristic of liquidity
These assets have the characteristic of liquidity and are represented by convertible currencies such as the US dollar, the British pound sterling, the Chinese remnibi, the Japanese yen, etc. As of September 8, 2021, US dollar assets accounted for the majority (72.04%) of Nigeria’s external reserve stock of US $ 36.25 billion.
The share of the other components of foreign reserves was as follows: pound sterling (0.75%); Euro (0.33); Chinese remnibi (11.81%); SDR (15.05%); and Japanese Yen (0.02%). The CBN Act of 2007 obliges the Bank to “do everything possible to maintain external reserves at levels that the Bank deems appropriate for the Nigerian economy and monetary system.
In light of this, the CBN has endeavored to carry out this mandate through the use of supply and demand management strategies, in particular currency conservation and control measures, as well as measures to ensure adequate supply. currency. This is particularly true because foreign exchange is a scarce resource that must be managed efficiently for the country to achieve macroeconomic stability and avoid chronic balance of payments and foreign reserves problems.
It should be noted that only foreign exchange, in the form of convertible currencies or internationally acceptable currencies, and not nairas, can be used for international transactions. The main sources of foreign exchange supply to a country include foreign currency earnings from exports of goods and services, monetary donations, and capital inflows from abroad, such as loans and investments.
It is from these earnings that the demand for foreign exchange to be spent on foreign imports of goods and services (including travel abroad, medical educational treatment abroad), monetary gifts to foreigners, and loans and investments abroad is satisfied. What is the implication of this? It is that for Nigeria, whose currency is neither convertible nor serves as an international currency, it must necessarily obtain foreign exchange through high productivity and export of goods and services, the receipt of monetary gifts or the receipt of foreign loans and investments in order to import the necessary goods and services destined to the development of the economy and the improvement of the well-being of the citizens. Furthermore, high levels of foreign exchange earnings and foreign reserves are the backbone of the naira exchange rate. They ensure the stability of the rate while low levels weaken the naira. But then, it should be noted that the CBN does not produce foreign exchange; it is what the country earns that the Bank strives to manage and use to stabilize the exchange rate.
And achieving an adequate amount of foreign exchange earnings requires developed national production structures, a diversified economy and an export orientation, and a conducive macroeconomic environment, among others. For quite some time, there have been problems on these that predate the current Administration. Genuine Federal Government efforts to advance these have tended to be undermined by exogenous shocks in the past five years that led the economy into recession in 2016 and 2020. The shocks affected foreign exchange earnings, the accumulation of foreign reserves and exchange rate stability.
The first recession that 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 Nigerian Bonny Light crude oil fell continuously from US $ 62.22 in the second quarter (second quarter) of 2015 to US $ 34.39 per barrel in the first quarter of 2016. As in the second quarter of In 2017, when the country emerged from recession, the price of crude oil per barrel stood at just US $ 50.21 per barrel. Due to the strong dependence of the Nigerian economy on the oil sector, the impact of the oil market downturn was severe on export earnings, foreign exchange reserves, government revenue, and other macroeconomic aggregates, including economic growth. Foreign reserves decreased 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 deteriorated in a similar way: balance of goods and services , current account balance, financial account, general balance of payments and balance of external debt and debt service.
The net inflow of foreign exchange turned negative, which implies that the country paid more foreign currency to the rest of the world for the import of goods and services than it received.
This implied that the demand for foreign exchange was higher than the receipt of foreign currency, and the pressure on the currency and the exchange rate of the naira was very high. This explains the devaluation / depreciation of the naira relative to the US dollar at that time.
Second, the economic crisis induced by the covid-19 pandemic in 2020 resulted in a recession in the third and fourth quarters of last year.
Containment measures for the pandemic in the form of economic lockdowns and restrictions on international travel and business resulted in recessions for countries to varying degrees. Once again, the external sector aggregates of the Nigerian economy seriously deteriorated due to the continued heavy dependence of the oil sector economy 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 indicate a further drop to 1.27 mbpd in August, down from 1.38 mbpd reached in July 2021 due to difficulties in some oil terminals.
This decline in production partly explains why the observed rise in oil prices to around US $ 70 + per barrel has not had much impact on government revenues or the accumulation of foreign reserves.
This contrasts with US $ 50.43 per barrel on January 4, 2021 and a low of US $ 14.67 per barrel recorded on April 27, 2020. Although the price of the product 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 heavy import of refined petroleum products for almost all domestic consumption needs . For example, in July and August, the inflow of foreign exchange from oil and gas was zero.
Therefore, the nature of the challenges that authorities currently face in exchange and exchange rate management must be understood: the net inflow of foreign currency is negative in the first and second quarters of 2021; the current account balance was negative from the first quarter of 2020 to the second quarter of 2021; the general balance of payments was negative in the first and second quarters of 2021; Foreign reserves decreased from US $ 36.5 billion in the fourth quarter of 2020 to US $ 32.9 billion in the second quarter of 2021 due to strong currency demand pressures and weak foreign exchange inflows.
However, it rose to US $ 36.03 billion as of September 13, 2021 due to a vital allocation in August of the SDR equivalent of US $ 3.35 billion to the country by the IMF. The exchange rate required to service the external debt has also increased, from US $ 289.45 million in the fourth quarter of 2020 to US $ 1,003.41 million in the first quarter of 2021.
All of the above developments constitute some of the immediate triggers for the observed depreciation of the naira exchange rate, such that the exchange rate for investors and exporters (I & E rate) (the official exchange rate for investors, exporters and users end) has external shocks and other fundamental factors, depreciated from US $ 385.55 in the first quarter of 2020 to US $ 411.5 in August 2021. In the I&E market, currencies are traded (bought and sold) depending on the prevailing market conditions. Periodically, the monetary authority intervenes with the supply in the market to ensure the stability of the exchange rate.
The parallel market rate is determined primarily by speculators and rent seekers in a shallow and illegal market that constitutes a very small proportion of the foreign exchange market in Nigeria. Because the amount of currency available in that market is very small in relation to the demand of desperate economic agents who want to buy currency at any price, the exchange rate is necessarily high. It cannot serve as a reference for the naira exchange rate. If so, then it is the case with the tail wagging dog! The parallel foreign exchange market should be avoided by decent traders. 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 obtain enough foreign exchange from the export of goods and services and capital inflows.
Now, the nature of the exchange rate and its fundamental determinants must also be clearly understood, the key of 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 outlay of scarce foreign exchange for the import of finished goods and production inputs, especially when these could be produced locally, and reduces pressure on the demand for foreign exchange. In the same way, an export-oriented productive base contributes substantially to the supply of foreign exchange, which in turn strengthens the local currency. But in Nigeria, these desired attributes have not been achieved. Therefore, the country’s heavy dependence 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, all other things being equal, the naira exchange rate strengthens / appreciates. But when there is a recession in the market, characterized by low prices, the accumulation of foreign reserves falls and the exchange rate of the naira depreciates.
The industrial and agricultural sectors have not contributed to stabilizing the exchange rate either. The manufacturing sector imports most of its raw materials and equipment, but ends up with little value added to GDP and negligible export earnings. Although the agricultural sector contributes more than 24% of GDP, its contribution to foreign exchange earnings is also very low. The production system is highly dependent on imports. As the country’s capital goods industry is in a coma, like the refineries of petroleum products, almost all machinery, equipment and spare parts used by the inward-looking productive sectors are imported, which puts a lot of pressure on foreign exchange. available. However, the contribution of the non-oil sector as a whole to the set of currencies has remained low, in contrast to other countries, where it contributes most of the income in foreign exchange.
Another key factor is the excessive demand for foreign exchange relative to supply. Since the introduction of the market-based exchange rate system under the Structural Adjustment Program (SAP) in 1986, excessive demand for foreign exchange has been a notable factor causing the depreciation of the naira exchange rate. The naira has taken a breather on the few occasions of the oil market boom.
The truth about excessive demand for foreign exchange is that a considerable part of it is not genuine, as it is intended to transfer funds out of the country to allow the importation of unnecessary finished products and promote capital flight: illegal financial outflows and laundering. of money.
It is true that expansionary fiscal and monetary policies have a role to play in exchange rate instability. In fact, since the SAP, expansionary fiscal and monetary policies have tended to put pressure on the exchange rate.
This has intensified in the last two years of the COVID-19-induced economic and health crisis that required increased spending by fiscal and monetary authorities around the world in their offers to counter the severe impacts of COVID-19. 19 in their economies.
The Federal Government implemented an economic stimulus package of 2.3 trillion naira through the Economic Sustainability Plan in response to the demands of COVID-19, while the Central Bank intensified its development financing interventions to boost growth, employment and poverty reduction and the aggregate supply of goods for domestication. inflation from the supply side. It is expected that as the country and the world in general get a good grip on the covid-19 pandemic, monetary and fiscal policies will continue their normal course.
In conclusion, it is important to emphasize that considering that the naira is not a convertible currency, exchange rate and exchange rate management over the years has been quite challenging and continues to be so because foreign exchange earnings from oil have followed the cycle of the rise and fall of the world oil market and some of the previous governments did not have the political will to save.
Therefore, there is a great need to move away from the faulty pattern of economic management of the past by considering the following, some of which are short term while others are medium / long term:
Short and medium / long term
• Reactivation and reconstruction of the productive sectors of the economy to achieve greater utilization of capacity and productivity, and competitive manufacturing exports;
• Strong government encouragement to local refining of petroleum products both for domestic consumption and for export;
• Strong and effective surveillance of the foreign exchange market by the monetary authority to control the exchange of foreign exchange from deposit banks to the parallel market;
• During oil booms, save foreign exchange and build fiscal reserves;
• Greater supply of local raw materials and reactivation of the capital goods industry;
• Promotion of fiscal and monetary discipline and harmony;
• Create an environment conducive to productive capital inflows, especially foreign direct investment;
• Actively promote the restoration of confidence in the economy to curb capital flight. A good management of the current challenges of insecurity together with macroeconomic stability will be very useful in this regard;
• Rationalize the structure of imports to manage the demand for foreign exchange;
• As supply considerations allow, use foreign reserves to support the exchange rate through increased financing of the foreign exchange market; and
• Use moral suasion to encourage Nigerians to patronize homemade products and reduce their high propensity for disruptive commerce. Import only when absolutely necessary. They should also avoid unhealthy currency speculation as well as rent-seeking behavior, and adopt positive attitudes to ensure a stable exchange rate for the naira.
Mike Idi Obadan is Professor of Economics and President of the Goldmark Academy of Education, Benin City. He previously he was Director General of the National Center for Economic Management and Administration, Ibadan, Nigeria.