The questions typically centre around why we are keeping so much in reserve when the economy is struggling, and we have poor infrastructure? Why don’t we use the reserves to reduce the poverty that is rampant? The question typically betrays a little bit of misunderstanding over what the foreign reserves are and how the entire thing works.
Hopefully, after reading this we will have a better understanding of what it is and what it can and can’t be used for.
First, what is the “Foreign Reserves?” It is the amount of foreign exchange that the central bank has at its disposal at any point in time. Some of this is in cash and some in other liquid assets, that is assets that can quickly be turned to cash.
Some of this is in US dollars but sometimes it’s in other currencies too. Some of this is physically in a vault at the CBN but most of it is managed by partner banks abroad.
How does the CBN get foreign reserves? By buying it of course, given that it cannot print foreign currency.
Central banks typically buy and sell foreign exchange sometimes as part of their mandate of price stability. In a scenario where a central bank buys more foreign exchange than it sells, then its reserves increase.
In a scenario where a central bank sells more foreign exchange than it buys then its reserves decrease. In the Nigerian scenario, the central bank typically buys foreign exchange from the federal government and sells to importers and travellers via banks.
Think about a simple example mechanically as the NNPC exporting crude oil on behalf of Nigeria, remitting the FX earned to the federal government who sells it to the CBN for naira. The CBN then takes that FX and sells on the FX market to BDCs, or banks, or importers, or whoever wants dollars.
If the CBN does not sell all the foreign exchange it buys from the federal government then its foreign reserves increase. If the CBN sells more foreign exchange than it bought from the federal government then its foreign reserves decrease because it must dip into its savings.
Of course, in the real world it is a lot more complex. Central banks are not the only ones who have foreign reserves in an economy. Banks also have foreign reserves and sometimes people too have foreign reserves. Think of the FX cash a bank has in its vaults and the small FX you hide under your mattress (note: I don’t).
All those are reserves but they do not count as part of the central bank’s foreign reserves. Also, in the real world, crude oil is not the only source of foreign exchange inflows.
Foreign investors who invest in Nigeria come with FX. Travellers who visit come with FX. Family members abroad send FX to Nigeria too. The mechanics with respect to the CBN foreign reserves are however the same. If FX inflows are more than outflows, then reserves increase. If outflows are more than inflows, then the reserves decrease.
A side effect of the CBN buying and selling FX is that it influences the exchange rate. If the CBN sells a lot more FX than is wanted, then the exchange rate goes down; and if the CBN sells a lot less FX, then the exchange rate goes up.
The change in foreign reserves therefore serves as a signal for what may happen to the exchange rate going forward. That’s why economists care about it.
So, why can’t the CBN give some of the reserves to the government to spend? Well, because it has already given the FG the naira equivalent. Imagine you took your $100 to the BDC to exchange for naira and then went back again to demand for the $100 back.
Of course, if you force the BDC to give you the $100, then the next time you, or other buyers, want to buy FX then there will be none to buy. And I’ll leave it up to you to determine what happens to the exchange rate if people want to buy FX but there is no FX to buy.
Central banks are typically advised to have enough reserves to cover six months’ worth of imports in the event something unexpected happens.
If the CBN blows those reserves for whatever reason, then the likely outcome is that people will get spooked and once the reserves disappear and the CBN can no longer meet FX demand, the currency will collapse. And, as we have learned over the last three years, currency problems, collapsing economies, and increasing poverty attend the same school.
Nonso Obikili is an economist currently roaming somewhere between Nigeria and South Africa. The opinions expressed in this article are the author’s and do not reflect the views of his employers.
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