Effect Of Foreign Reserves On Macroeconomic Variables
The main objective of this study was to determine the effect of foreign reserves on macroeconomic variables in Nigeria. To establish the moderating effect of balance of trade on the relationship between international oil price and foreign reserves. To determine the moderating effect of balance of trade on the relationship between nominal exchange rate and foreign reserves. To establish the moderating effect of balance of trade on the relationship between real interest rate and foreign reserves in Nigeria. In addition, this study covered periods of rising and falling international oil prices and periods before and after the global financial crises. The study adopted the positivism doctrine. The study made use of causal research design. The research primarily relied on secondary data on the research variables ranging from 1986 to 2019 which was sourced from Central Bank of Nigeria, National Bureau of Statistics, Organization of Petroleum Exporting Countries and World Bank. The study carried out diagnostic tests before conducting the analysis. Time series regression analysis model (Autoregressive Distributed Lag approach) was employed in the study. The research findings showed that macroeconomic factors namely international oil price, nominal exchange rate and real interest rate have a significant effect on foreign reserves in Nigeria. The findings showed no evidence of a moderating effect of balance of trade on the relationship between international oil price and foreign reserves. However, there was evidence of a moderating effect of balance of trade on the relationship between nominal exchange rate and foreign reserves. Lastly, the findings of the study showed no evidence of a moderating effect of balance of trade on the relationship between real interest rate and foreign reserves. Furthermore, the study recommends that the Federal Government of Nigeria should put in place measures that will boost exports and discourage imports.
Table of Content
- 1.1 Background to the Study
- 1.2 Statement of the Problem
- 1.3 Objectives of the Study
- 1.4 Research Question
- 1.5 Research Hypothesis
- 1.6 Significance of the Study
- 1.7 Scope of Study
- 1.8 Limitation of the Study
- 1.9 Definition of Terms
- 1.10 Organisation of the Study
2.0 Literature Review
- 2.1 Conceptual Framework
- 2.2 Overview Of Nigeria’s Foreign Reserves Accumulation
- 2.3 Factors Affecting Foreign Reserves
- 2.3.1 Oil Price and Foreign Reserves
- 2.3.2 Exchange Rate and Foreign Reserves
- 2.3.3 Interest Rate and Foreign Reserves
- 2.3.4 Other Macroeconomic Factors
- 2.4 Theoretical Review
- 2.4.1 Liquidity Preference Theory
- 2.4.2 Purchasing Power Parity (PPP)
- 2.4.3 Interest Rate Parity
- 2.4.4 The Theory of Balance of Trade
- 2.5 Empirical Review
3.0 Research Methodology
- 3.1 Research Design
- 3.2 Model Specification
- 3.3 Definition of Variables
- 3.3.1 Insurance Penetration Rate
- 3.3.2 Total Premium Income
- 3.3.3 Gross Domestic Product
- 3.4 Method of Data Analysis
- 3.5 Sources of Data
4.0 Results and Discussion
- 4.1 Result
- 4.2 Discussion of Results
5.0 Summary, Conclusion and Recommendation
- 5.1 Summary
- 5.2 Conclusion
- 5.3 Recommendation
1.1 Background to the Study
Globally, foreign reserves have improved considerably since the 1990’s as most developing economies hold foreign reserves as a preventive measure to curb against the effect of external shocks in their economies. In June 2009, China, Japan, and Saudi Arabia were ranked first, second and third respectively, in foreign reserves holdings (Oputa and Ogunleye, 2010). Similarly, the International Monetary Fund (2014) estimates that the global foreign reserves holding have increased from US$1.57 trillion in 1996 to US$11.69 Trillion in 2013, with the share of developing and emerging economies increasing from US$0.55 Trillion to US$7.87 Trillion. The phenomenal increase in foreign reserves holding across many emerging markets particularly among oil exporting countries in recent years have been motivated largely by the drive for self-insurance against adverse external shocks (Gong, 2012)
However, global foreign reserves decreased to approximatelyUS$11.6 in March, 2015 after reaching a peak of US$12.03 trillion in August, 2015. The decline in global foreign reserves value is as a result of the strengthening of the US dollar, which subsequently led to a fall in value of other foreign reserves currencies such as the pounds (CBN, 2015). China being the world’s largest reserves holder accounts for about 30 percent of total global reserves holdings. China’s foreign reserves declined from its peak ofUS$4 trillion in June, 2014 toUS$3.56 trillion in September, 2015. This has been largely attributed to the devaluation of the Yuan, which made it a less attractive investment option, as more individuals and enterprises prefer to hold US dollars. In addition, Russia’s foreign reserves holdings declined to US$361 billion in 2014, while Saudi Arabia, the third largest reserves holder after China and Japan, also experienced aUS$10 billion decline in its foreign reserves holdings amounting to US$721 billion in September, 2015 (Bloomberg, 2015).
In Africa, commodity price such as international oil price hikes have allowed foreign reserves accumulation among exporting countries, while on the other hand draining the foreign reserves among importing countries. However, the recent fall in international oil price has led to the depletion of reserves for oil exporting countries. Evidently, Egypt devalued its national currency three times in 2015 as a result of the dwindling reserves. Egypt’s reserves depleted by 10 percent in September, 2015, which is the highest since January, 2012 (Namatalla, 2015). Similarly, Libya spent more than 25 percent of its foreign reserves in 2014 to offset the sharp decrease in oil revenues and keep the country running. This sharp decrease in oil revenue is attributed to the fall in international oil price. Libya’s reserves totaled US$76.6 billion at the end of 2014, a decrease from the US$105.9 billion in the previous year (Bloomberg, 2015). The rationale for holding reserves varies from one country to another; however, the most common reason for holding reserves is to back monetary policy (Sajal, 2012).
Nigeria like other developing countries relies on foreign reserves for import cover, and also for exchange rate stability (CBN, 2015). Total foreign reserves for Nigeria was used in this study. Total foreign reserves constitute monetary gold holdings, Special Drawing Rights, holdings of foreign exchange, and foreign reserves of IMF member countries, under the management of Central Banks, which are expressed in US dollars (World Bank, 2014).
Nigeria’s foreign reserves have been on an increasing trend over the past two decades (CBN, 2015). In 2005, the country’s foreign reserves holdings amounted to US$28.63 billion; this is a significant increase from the US$4.33billion reported in 1996. In 2008, the foreign reserves increased to US$53.60 billion (World Bank, 2014). However, in 2014, the foreign reserves declined to US$37.50 billion and this decline has been continuous (CBN, 2014). The Central Bank of Nigeria uses the foreign reserves to meet the country’s transactionary needs. Equally, the regulator uses the foreign reserves for precautionary purposes in order to provide a framework necessary to absorb unexpected fiscal shocks in terms of trade and capital outflows (Gong, 2012).
Charles (2012) reports that the factors that influence foreign reserves level in Nigeria are exchange rate, GDP, inflation and trade openness. Determination of optimal foreign reserves levels has gone through a number of approaches, some of these approaches employed earlier to estimate the optimal foreign reserves level in emerging economies are reserves to external debts, reserves to imports, and reserves to money aggregates. However, reserves to import ratio which makes import cover of three months adequate, appears to be favoured by most developing countries including Nigeria (Oputa and Ogunleye, 2010).
Similarly, the IMF (2014) posits three months of import cover as adequate level of reserves. The Fund noted that low foreign reserves level in a country, leads to loss of investor confidence, thereby generating risk of capital flight in that country. In addition, lack of foreign reserves brings worry to the nation; this is because it limits the ability of a country to make foreign currency denominated payments, and also limits the spending of such a country abroad (Adetiloye and Oyerinde, 2010).
Macroeconomic stability continues to be at the center of economic policy making. According to Agade (2014) macroeconomic factors affect the economy as a whole, rather than just a single unit. Crude oil is a key source of energy in the world as nearly everything we consume is directly or indirectly dependent on oil (Tertzakian, 2007). Oil is an integral part of the Nigerian economy, as it plays an important function in determining the political and economic fate of the country. Annually, the Nigerian government sets oil price benchmark for its revenue budget (Osigwe and Okechukwu, 2015). The value of Nigeria’s overall revenue from export, in 2010 was US$70,579 million and the revenue generated from oil exports amounted to US$61,804 million which is 87.6% of the overall, thus confirming Nigeria to be highly dependent on oil (CBN, 2015). Tule (2015) opined that foreign reserves in Nigeria have become a seasonal commodity. Seasonal in the sense that foreign reserves depend on international oil price movements. The accumulation of foreign reserves has been attributed to its enormous importance to an economy. Foreign reserves contribute to the GDP of a country thereby creating jobs and enhancing the well-being of its citizens (Charles, 2012). In addition, foreign reserves are employed by monetary authorities of countries to curb exchange rate fluctuations (Fang and Lili, 2011). It boosts the confidence of foreign investors, which in turn boosts foreign direct investment (FDI) into the country.
Adequate foreign reserves enhance the value of a country’s currency thereby encouraging traders to embark on imports and exports transactions as they find it profitable to do so, thus boosting the economy (Romero, 2005). Also, the monetary authorities use foreign reserves as a store of value to build up additional wealth which can be consumed in the future. This is done by segregating the foreign reserves into a wealth tranche and liquidity tranche for speculative purposes. The wealth tranche includes long term securities such as bonds and equities, which are controlled alongside a special benchmark that lays emphasis on return maximization (CBN, 2015).
Tule (2015) opines that use of foreign reserves provide monetary authorities means of controlling the money supply in an economy and also to strike equilibrium for foreign exchange demand and supply through policy intervention that is, offering to trade foreign currency to commercial banks in the foreign exchange markets. When commercial banks buy foreign exchange from monetary authorities, the monetary authorities’ level of foreign reserves drops by that amount of sale (CBN, 2015). This in turn, results to a decrease in domestic supply of money by the equivalent of local currency of the sale. On the contrary, when the Central Bank buys foreign currency from commercial banks, its reserves level rises and at the same time an equivalent value of the local currency is credited into the accounts of commercial banks, thus, increasing the level of domestic money supply in an economy. Increase in domestic money supply has a positive impact on the degree of economic activities in a country. This is because; productive activities are enhanced by the availability of more capital. This in turn, generates employment, increases output and boosts consumption in an economy (Akram & Mortazavi, 2015).
Adequate foreign reserves serve as a boost for a nation’s international raking and credit worthiness by enhancing regular servicing of external debt thus avoiding additional penalties (Charles, 2012). Moreover, a country’s foreign reserves is a vital factor in a country’s risk models that are employed by the international financial institutions and credit rating agencies. Foreign reserves serves as a cover for the “Rainy Day”, particularly when nations experience a fall in revenue. A sound reserves level readily provides cushion against such back drop in revenue and facilitates the recovery of such economies (CBN, 2015).
Foreign reserves provide an economy with a buffer against external shocks. When a country’s external trade position is suddenly thrown into disequilibrium, adequate foreign reserves position usually helps an economy to absorb and quickly adjust to such shocks without resorting to any costly financing options (Tule, 2015).
1.2 Statement Of the Problem
Macroeconomic stability is essential for the accumulation of foreign reserves and growth of the economy at large. Adequate foreign reserves enhance the growth and development of an economy. The fall in Nigeria’s foreign reserves has been of great concern and this has caused panic in both the economic and political environment (Sajal, 2012). This is because Nigeria greatly depends on its foreign reserves for import cover, exchange rate stability and for international ranking. In 2014, foreign reserves for Nigeria went below three months import cover which is the IMF stipulated optimum reserves level (CBN, 2015). The main source of foreign reserves in Nigeria is revenue from crude oil exports which are susceptible to the vagaries of international oil shocks.
The falling international oil prices pose great concerns as it forced the Federal Government of Nigeria to review its budgeted crude oil benchmark of US$75 and US$73 per barrel as proposed in its 2014 and 2015 budgets respectively (CBN, 2015). Similarly, the exchange value of the Nigerian currency has experience a continuous downfall thereby discouraging traders from engaging in imports and exports activities as their rate of return is threatened.
The fall in the value of the Nigerian currency which has made it a less attractive investment and store of value option is largely attributed to low level of reserves, as there are inadequate reserves to ensure its stability. This is further linked to the surplus demand of foreign currencies for international transactions as this has continued to mount pressure on the Nigerian currency (Tule, 2015). In response to this excess demand, the CBN has authorized commercial banks in Nigeria to ban the use of ATM cards overseas. The ban, which was announced to take effect from January 1, 2016, is as a result of the dwindling foreign reserves and the inability of banks to settle transactions involving dollars and other foreign currencies arising from the use of Nigerian ATM cards overseas (CBN, 2015). This has however raised concerns in the society especially from traders in the foreign exchange market and Nigerians in Diaspora.
Various studies have been done on the effect of macroeconomic factors on foreign reserves. These studies include that of Parish and Rusell (2007); Lin and Wang (2010); Fang and Lili (2011); Akhtar et al (2011) and Gokhale and Raju (2013); for China, Japan, China, Pakistan and India respectively. However, these studies were conducted for countries outside Africa and the studies obtained varying results. In the case of Nigeria, studies conducted on macroeconomic factors and foreign reserves include Heller and Klan (1978), Jayaraman and Lau (2011) Olayungbo and Akinbola (2011), Charles (2012). However, these studies did not consider the effect of moderating characteristics on the relationship between macroeconomic factors and foreign reserves. Furthermore, previous studies did not consider the use of time lags. Also, these studies did not capture the periods before and after the global financial crises and also the periods of rising and falling international oil prices.This study sought to address the gap in literature by focusing on the effect of foreign reserves on macroeconomic variables in Nigeria.
1.3 Objectives of the Study
The aim of this study is to examine the effect of foreign reserves on macroeconomic variablesin Nigeria. Specifically, the objectives of the study include to;
- To determine the effect of international oil price on foreign reserves in Nigeria.
- To establish the effect of nominal exchange rate on foreign reserves in Nigeria.
- To determine the effect of real interest rate on foreign reserves in Nigeria.
1.4 Research Question
The following research questions are formulated to guide this research:
- What is the effect of international oil price on foreign reserves in Nigeria?
- What is the effect of nominal exchange rate on foreign reserves in Nigeria?
- What is the effect of real interest rate on foreign reserves in Nigeria?
1.5 Research Hypothesis
- HO1: There is no significant effect of foreign reserves on macroeconomic variables in Nigeria.
- HA1: There is a significant effect of foreign reserves on macroeconomic variables in Nigeria.
1.6 Significance of the Study
The results of this study will be of value in many ways. In the first case, the findings will be useful to the Federal Government of Nigeria as it will influence effective formulation of policies by the government of Nigeria. Secondly, the study will be of great importance to stakeholders and the society at large, it educates them on macroeconomic factors such as international oil price, nominal exchange rate and real interest rate and their effect on external reserves. Lastly, the findings of this study address the knowledge gap in literature on effect of macroeconomic factors on external reserves and the moderating effect of balance of trade on the relationship between macroeconomic factors and foreign reserves in Nigeria. In addition, the study lays foundation for future researchers, as it provides recommendations, which other researchers across the globe interested in similar research study may pursue in future.
1.7 Scope of Study
This study focused on the effect of foreign reserves on macroeconomic variables in Nigeria. The macroeconomic variables include international oil price, nominal exchange rate and real interest rate and the moderating effect of balance of trade on the relationship between macroeconomic factors and foreign reserves in Nigeria. The study made use of time series data while employing time series regression (Autoregressive Distributed Lag Approach) in the study. Yearly data was collected on the research variables ranging from the period 1986 to 2019, this period was sufficient to capture the dynamics of the study as it covers both periods of rising and falling international oil prices. In addition, it covers the periods before and after the global financial crises.
1.8 Limitation of the Study
In the course of this study, the researcher encountered some limitations. There was paucity of data relevant to the completion of this work, hence, the researcher had to make use of secondary data sources that were verified and approved for use such as the National Bulleting of Statistics, the Central Bank of Nigeria and the selected insurance companies. Also, the researcher faced time constraints and had to combine the research with other academic activities and coursework. Also, the study considered four independent variables without considering other proxies that determine macroeconomic variables and foreign reserves, hence, the result may be different if other variables were to be added.
1.9 Definition of Terms
Foreign exchange reserves (also called forex reserves or FX reserves) are cash and other reserve assets such as gold held by a central bank or other monetary authority that are primarily available to balance payments of the country, influence the foreign exchange rate of its currency, and to maintain confidence in financial markets.
Macroeconomic variables are indicators or main signposts signaling the current trends in the economy. Like all experts, the government, in order to do a good job of macro-managing the economy, must study, analyze, and understand the major variables that determine the current behavior of the macro-economy.
1.10 Organisation of the Study
This study is organized into five chapters. Chapter one included the background of the study, research problem, research objectives and questions as well as limitation of the study. Chapter two contains the literature review. Chapter three includes the methodology. Chapter Four contains the results and discussion of key findings of the study. Chapter Five finally looks at the summary, conclusions, and recommendations based on the findings.
5.0 Summary, Conclusion and Recommendation
The study sought to determine the effect of foreign reserves on macroeconomic variables in Nigeria. The findings of the study were based on the research objectives and hypotheses of the study. The findings of the study show that international oil price has a significant positive effect on foreign reserves in Nigeria. Therefore, the null hypothesis was rejected. Similarly, nominal exchange rate is shown to have a significant positive effect on foreign reserves in Nigeria. Therefore, the null hypothesis was rejected. Also, real interest rate is shown to have a significant but negetive effect on foreign reserves in Nigeria. Therefore, the null hypothesis was rejected. Furthermore, there was no evidence of a moderating effect of balance of trade on the relationship between international oil price and foreign reserves in Nigeria. Thus, the null hypothesis was accepted. However, there was evidence of a moderating effect of balance of trade on the relationship between nominal exchange rate and foreign reserves in Nigeria. Therefore, the null hypothesis was rejected. Lastly, the study showed no evidence of a moderating effect of balance of trade on the relationship between real interest rate nad foreign reserves in Nigeria. Therefore, the null hypothesis was accepted.
The accumulation of foreign reserves is beneficial to an economy in many folds. They are used by monetary authorities to stabilize monetary policies. Foreign reserves are used in Nigeria to guard against terms of trade shocks and also, unforeseen emergencies. Thus, supporting the liquidity preference theory of money which attributes the demand for money for transactionary, precautionary and speculative motives. The findings of the study show that international oil price, nominal exchange rate and real interest rate are significant in determining foreign reserves. Foreign reserves in Nigeria is sensitive to shocks in the international oil market. The fall in foreign reserves in Nigeria as a result of the fallen international oil prices confirms Nigeria to be suffering from the Dutch disease. Global demand and supply of oil determine international oil prices. Strengthening of monetary policies should be the focus of the Central Bank as it plays a major role in the accumulation of foreign reserves.
Based on the findings of this study, the following are recommended;
- The study concludes that international oil price has a significant positive effect on foreign reserves in Nigeria. This implies that periods of high international oil prices mean periods of higher revenue for Nigeria. Therefore, the Federal government should ensure that such revenue generated from high international oil price is used to increase foreign reserves position.
- Secondly, the study concludes that nominal exchange rate has a positive effect of foreign reserves. Therefore, the CBN should put in place sound monetary policy measures to attain stability in the exchange rate. There is also a need to ensure effective foreign exchange management measures particularly in terms of meeting the high demands for foreign currency for international transactions. Also, the Federal Government of Nigeria should put in place measures that will boost exports and discourage imports especially imports of luxury goods.
- Thirdly, the study concludes that real interest rate has a negative effect on foreign reserves in Nigeria particular negative real interest rate that is, periods of high inflation. Therefore, the Government of Nigeria should employ measures that will ensure moderate inflation that is price stability. Fourth, the evidence of a moderating effect of balance of trade on the relationship between exchange rate and foreign reserves implies that policies aimed at managing the exchange rate should incorporate the dynamics in the balance of trade in Nigeria.
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