Understanding Foreign Exchange, External Reserves and the Naira

On Oct 4, 2021

By Mike Idi Obadan

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 flow 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.

The feature of liquidity

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…