By Gifted Hands Research Team: Image Credit: Gifted Hands
External reserve of a country refers to the foreign exchange account of the country which is managed by the apex monetary authority on behalf of the country. In Nigeria, the apex bank is the CBN. It is from the external reserve that the country is able to pay for importation of goods and services. Once the country exports (or individuals export to other countries), the foreign currencies are exchanged for local currencies. The CBN is the overall holder and manager of the country’s account that comprises other currencies of the world. Because the US dollars is the worlds traded currency, it is therefore imperative for the external reserve of different countries of the world to be quoted in US dollars. Hence, the Nigerian external reserve is in US dollars.
That said, exchange rate can be defined as the rate at which a country’s currency can be exchanged for another country’s currency. For instance, to import goods from the United States does not require the use of Naira but the dollars. Hence, an importer will have to go to the bank to exchange the naira for the dollar at the day’s exchange rate figure. This exchange is made possible through the availability of external reserve of the country.
Therefore, there tend to be negative relationship between exchange rate and external reserve. That is, the higher external reserve, the lower the exchange rate and vice versa. This is because when the external reserve is high, there would not
be pressure on the CBN to ration foreign exchange (dollars) among importers, hence importers get dollars at their will. However, when the external reserve is falling, the CBN sees the need to come up with measures to halt this fall so that dollars can be allocated to more productive uses. As a result, not all importers will get dollars, thereby making them patronize the Bureau De Change. This therefore will increase the amount of naira needed to obtain a dollar, hence a high exchange rate.
In this study, we shall be providing empirical analysis to this relationship using the CBN data on external reserves and exchange rate from 2005 to 2018.
Fig. 1: Nigeria’s Exchange Rate Vs External Reserve
From 2005 to 2018, the average rate of exchange has increased by 132% while the external reserve increased by 51% from $28.3bn in 2005 to N42.6bn in 2018. This shows that the change in both exchange rate and external reserve is not proportional and whenever there is a decline in external reserve, the CBN tends to devalue the naira much more than the decline in external reserve.
In 2008 when the external reserve was at its highest at $53bn, average exchange rate was lowest at N118.57. Also, before the CBN partially devalued the Naira in late 2016, external reserve hits its lowest point in 2016 at $27bn and that was when the average exchange rate was also the highest at N253.19. It was as a result of the partial devaluation that the average exchange rate figure has moved around N305 in 2007 and 2008, thereby improving the external reserve to $39.4bn and 442.6bn in 2017 and 2018 respectively.
Note that devaluation of the currency is the lowering of a country’s currency in relation to another country’s currency. When a currency is devalued, then more of that currency will be needed to exchange for another currency. As a result, import becomes costly while export becomes cheap. Take for instance, A is into importing of Textiles and he imports 1000 yards of textiles at the exchange rate of N300/dollar for N300,000. B on the other hand, exports 1000 yards of textiles to the US at the same exchange rate for N300,000. A pays the dollar equivalent of N300,000 ($1000) while B recieves the dollar equivalent of N300,000 ($1000). Assume the naira was then devalued to N400 naira, it means A will now require N400,000 to import the same 1000 yards of textiles while B will receive the same N400,000 by exporting the 1000 yards of textiles. This makes sense for B but does not make sense for A. Therefore, A will not be motivated to import (thereby preserving external reserve because he will not go to the bank to exchange his naira to get dollar) but B will be motivated to export (thereby increasing the external reserve because he will have to change the dollars he recieves, into naira).
Table 1: Correlation Coefficient
Average Exchange Rate
Average Exchange Rate
Source: Gifted Hands (Using Eviews 9.0)
From the correlation table above, it can be seen that the correlations in the main diagonals are all equal to 1. This is because a variable is always perfectly correlated with itself. When correlated with each other, the result however showed that though there is a negative correlation between the average exchange rate and external reserve, this relationship is a weak one. This is further confirmed by our OLS regression analysis which showed that if the external reserve increases by $1bn, exchange rate will reduce by 1.51%, but this relation is not statistically significant at 5% level of significance. This could mean that the data is not much enough to provide strong evidence that the negative relationship between exchange rate and external reserve is a significant one.
Table 2: Nigeria’s Average Exchange Rate and External Reserve (2007-2018)
For further clarifications, enquires and questions, please provide your feedback in the comment section or send us a mail at firstname.lastname@example.org
About Gifted Hands Associate
Gifted Hands is an independent economic think tank that carries out independent research on data as released by the relevant government agencies (NBS and CBN). It also assists and provide tips to undergraduates and Postgraduate students carrying out economic research work. Gifted Hands also write business plans/proposals, project financials of start-ups into the future, write CVs and cover letters, as well as Train students on the use of Economic Analysis software such as Eviews, STATA and SPSS.