Understanding the Importance of External Reserves in Nigeria

By

Chimere Iheonu

Date Published

April 25, 2024

Category

Finance

Introduction

Nigeria’s external reserve averaged $33.45 billion between January 2nd, 2024, and April 18th, 2024. Currently, external reserves stand at $32.1 billion and have recorded a daily decline over the past three weeks.

The decline in external reserves has raised concerns among stakeholders due to its implications for the Nigerian economy. So, why do stakeholders and economists care so much about external reserves, and how can depleting external reserves affect the domestic economy?

It is important to highlight that in macroeconomic management, external reserves are key factors that determine the stability of an economy because they serve several purposes. They can act as a financial cushion in times when an economy is under financial stress or faces unexpected external shocks. With rising global tensions, particularly in the Middle East, the need for Nigeria to have a robust external reserve cannot be overstated. 

In this article, I highlight the essentiality of external reserves to the Nigerian economy and their key role in maintaining domestic economic stability.

What are External Reserves?

In the context of Nigeria, external reserves refer to assets held by the Central Bank of Nigeria (CBN) in foreign currencies, comprising banknotes such as the United States dollar, bonds, Treasury bills, foreign government securities, and commodities such as gold. These reserves serve multiple functions, including influencing monetary policy and supporting the country's currency. They act as a safeguard to meet external obligations, manage exchange rates, and foster confidence in the Nigerian economy. Additionally, external reserves play a crucial role in facilitating international trade and ensuring stability in the economic landscape.

How do External Reserves work?

Stabilizing the Exchange Rate: The naira has witnessed remarkable volatility in the parallel market in 2024. It moved from about ₦1200 to a dollar in January 2024 to ₦1900 to a dollar in February 2024. Currently, the parallel market exchange rate is about ₦1250 to a dollar.

This has resulted in economic uncertainty and has also raised prices. The CBN can, however, use its external reserves to cushion the high rate of volatility by buying naira in the foreign exchange market. The increase in demand for the naira can help stabilise the exchange rate by raising the value of the naira against the dollar.

The CBN can also use its external dollar reserves to increase the supply of the dollar in the foreign exchange market by selling the dollar. The increase in the circulation of dollars leads to a reduction in the value of the dollar relative to the naira. The current appreciation of the naira has been attributed to the CBN directly selling the dollar.

Mitigate External Shocks: When a country faces an external shock, external reserves can be used to mitigate such shocks. For example, the beginning of the Russia-Ukraine war saw a sharp increase in the price of wheat. A country with large external reserves can use some of its reserves to purchase wheat, thereby mitigating the effect of such an increase on the currency or the domestic economy.

Build Confidence: Aside from influencing the naira-dollar dynamics, a robust external reserve signals to potential investors and foreign governments that the country is financially stable and has the ability to meet its external financial obligations. This can attract foreign investment and prop up domestic economic activities. However, the decline in Nigeria’s external reserve can create pessimism about the economy, which can deter foreign investors from investing. When investors know that a country has sufficient reserves to support its currency, the likelihood of holding onto the currency increases, which can help provide stability to the exchange rate.

Influence Market Sentiments: The level of a country’s external reserve can influence investors’ confidence. A robust external reserve signals a healthy economy, while a weak or declining external reserve can signal a weak economy, leading to negative market sentiment. Negative market sentiments can reduce investment and cause the depreciation of a country’s currency. On the other hand, positive market sentiment can enhance foreign investment.

International Trade and Debt Repayment: External reserves are also used to facilitate international trade. It allows a country to pay for imports efficiently without influencing the dynamics of the internal economy. It also provides the funds needed to repay debts without straining the domestic currency. 

Nigeria’s External Reserve Statistics

Over the last few days, Nigeria’s external reserves have declined. While some analysts attribute the decline in external reserves to the CBN’s effort in defending the naira, the CBN has revealed that the fall in the external reserve is due to its effort in meeting short-term debt obligations. Irrespective of the reason behind the decline in Nigeria’s foreign reserves, maintaining a health reserve has its underlying benefits.

Figure 1: Gross External Reserves, January-April 2024, $billion.

Source: CBN

Low external reserves make a country susceptible to external shocks. It should also be highlighted that one of the reasons Nigeria was able to navigate through the 2007-2008 global financial crises was due to its external reserves, which were also backed by the excess crude oil account (ECA). With inadequate external reserves, Nigeria will find it difficult to defend the naira in the event of an external shock.

Conclusions

In the last couple of days, Nigeria has witnessed a decline in its external reserves. While several stakeholders have linked the decline to the appreciation of the naira in the foreign exchange market, the CBN has noted that the decline is due to debt repayment. Irrespective of the reason behind the decline, Nigeria must maintain adequate external reserves to ensure the long-term stability of the Nigerian economy.

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Disclaimer: This information in this article is NOT investment advice. It is intended for information and entertainment purposes only.

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