DETERMINANTS OF EXTERNAL RESERVES IN DEVELOPING

ECONOMIES

(THE NIGERIAN CASE)

BY

ONIKOLA HAMMED OLAWALE

MATRIC NO

0502203

BEING A RESEARCH PROJECT PRESENTED TO THE

DEPARTMENT OF BANKING AND FINANCE,

FACULTY OF MANAGEMENT SCIENCE,

UNIVERSITY OF ADO-EKITI,

EKITI STATE, NIGERIA.

IN PARTIAL FULFILMENT OF THE REQUIREMENTS

FOR THE AWARD OF DEGREE OF BACHELOR OF SCIENCE (B.Sc)

HONOURS IN

BANKING AND FINANCE.

APRIL, 2010.

CERTIFICATION

This is to certify that this research project was researched and carried out by

ONIKOLA HAMMED OLAWALE, which has been read and approved as meeting the

requirements of the Department of Banking and Finance, for the award of a Bachelor

of Science (B.Sc.) Honours Degree in Banking and Finance, University of Ado-Ekiti,

Ekiti State, Nigeria.

……………………………… ..…………

PROF. J.A. OLOYEDE DATE

PROJECT SUPERVISOR

………………………………. …..……..

PROF. J.A. OLOYEDE DATE

HEAD OF DEPARTMENT

DEDICATION

This research work is specifically dedicated to the glory of Almighty Allah,

who sustained me throughout the course, and for transforming my deficiencies into

efficiency through his proficiency and sufficiency.

And to my parents and well-wishers for their love and support, and to all

dedicated scholars and students of banking and finance in the world.

ACKNOWLEDGEMENTS

All praises, adorations, glorifications, exaltations, beautifications and thanks

are solely due to Allah (SW), the Lord of the world, the one who determines what be

and that which will never. No doubt, the success of this project is only by His grace.

Life is actually in stages and we have all come to play our part, here’s my part

on this face of life and I give all glory to God who helped me this far. Life would have

given me its worst blows on this campus but for the ever faithful God that I have. He

has been my love, my life, my source of sustenance, the totality of what I stand for.

Specifically, I just cannot but say thank you Allah, for the good health he gave me,

especially when it is needed most, despite my real strength-consuming ups and downs!

Whaoow!!!, You’ve been so good to me all the time. Thank you Allah, and may the

peace and blessings of Allah be upon the Noble soul of Prophet Muhammad.

(ALIHAMDU LILAHI ROBI’L A’LAMIN, WA SOLATU WASALAMU A’LA

ROSULU LI KAREEM, MUHAMMAD, SOLALAHU ALAHI WASALAM)

My utmost and sincere appreciation with respect to gratitude goes to my

dynamic, brilliant and indefatigable supervisor, Associate Professor John ‘Bayo.

Oloyede (who co-incidentally I had wished to be supervised by, since my BFN 102

days). Thanks very much sir, for painstakingly going through my script, despite your

tight schedule, by making necessary corrections and suggestions in ensuring that the

quality of this work is improved upon. I pray almighty Allah in His mercy continues

to assist and uplift you in your life endeavours (Amin).

At this junction, I want to appreciate my lovely parents, who despite their

meagre resources, squeezed out resources for my educational pursuit. To my dad, MR.

OLALERE IBRAHIM ONIKOLA. I say you are a rear gem. Words cannot express

the extent of my gratitude towards you but I know surely that you know the love I have

for you is far above rubies. Also to my sweet mother MRS. HASANAT ONIKOLA,

you’ve been mother among mothers indeed – thanks for all the encouragement,

confidence and advice, the love, care and mostly for your prayers over me. They done

a great deal, I love you dearly (Iya Hammed). And also to my Step-Mum, MRS.

OLADELE ONIKOLA, thanks very much for your co-operation, understanding,

concern and support. Once again, I really appreciate you all for the training;

understanding, love and concerns, and I pray Almighty Allah will never sweep you off

with any mishaps, illness or death, when the fruits of your labour are edible for

consumption.

The journey through the University of Ado-Ekiti has been very rough and

rugged. Through God’s grace and assistance of some people I was able to weather the

storm.

My sincere appreciation goes to my educational Mum and Dads at the level of banking

and finance department. I really say a very big thank you for squeezing us

(specifically, myself) through rigorous and tasky activities which eventually brings out

the best in me. To my level coordination, Mr. Olugbenga A. Adaramola (I say thank

you for the trust, advice and consistency especially in confiding the tasky departmental

electoral process at my shoulder). I also appreciate the coolness and calmness of my

amiable Ag. H.O.D, Sir Lawrence Boboye Ajayi, (thanks very much sir, for all your

efforts towards ensuring our success, specifically, I also appreciate you for your

fatherly supportive roles). To my departmental mum, Mrs. Bolanle Aminat Azeez

(Ummuh, I really appreciate all your efforts, not only the motherly advice and

supportive roles, but also your consistent constructive and supportive criticisms, really

will I miss you ma). I will everly be ungrateful if I fail to remember the kind gesture

and support of Mr. L.A. Sulaiman (thanks for your support and understanding

especially when they mattered most, I pray Allah continue to strengthen the bond of

our affections). Also, special recognition and appreciation is due to Dr. Stephen O.

Adeusi (Thank you very much sir for your words of constructive criticism, corrections,

also for the honour granted during the BAFINSA Muslim Students’

Seminar/Symposiun), also to Mr. Micheal O. Oke (I really appreciate all your efforts

in increasing my project analytic skills, through rigorous and tasky paper analysis,

thanks for your constant support and understanding). My hall of recognition and

appreciative list is endless if I fail to mention my Boss, Mr. Tajudeen F. Kolapo

(VEGA) (thanks Boss, for the training and understandings, also in believing in my

ability), also to Hon. Dapo Fapetu (sincerely, I really appreciate you sir and thanks for

the training). I also appreciate the words of encouragement of Dr. A.A. Awe (of

Economics department), thanks very much sir, for the fatherly advice and the

handsome reward for my ECO 201 performance.

I also appreciate the effort of all my lecturers and teachers I have passed

through at one point or the other, particularly Mr. Emmanue Mbong (my Primary 6

teacher), who shapened my tooth of mathematical coherence and analytic ability, then

Br Oluwole Olusola Aliu, Pavlov (UI) and Br. Saheed (Darul Huda) who sharpened

the tooth for financial and econometric analysis and then Dr. J.A. Oloyede who taught

me the effective use of the tooth in project interpretation through teaching me (BFN

312, Research Methods) and supervision of my project work. I also appreciate my old

school friends, the likes Onikoyis (OAU and Lautech), Alli Saheed (Sei’du), Bode

Babalola, Adeniyi Yinka (UI), Oyetola (UNAAB), Majekodumi (OSU), Savaoda

Toyin (UNILORIN), Peters Oluwaseun (RUN), Akinlolu Femi, Awosika Lanre,

Ijeoma Nduka, Obinna Cyprian, Ma’aruf Jimoh and others too numerous to outline.

I express my gratitude to ALHAJI AFUNSO ISIAK, MR. ADENIJI and

ALHAJI YUSUF AMUDA and families for their fatherly and motherly intervention

when it mattered most. Also my appreciation goes to Br. Bidemi, Bisi, Tajudeen,

Agba, Ganiyat, Dhkrullah and others at Akure for thier unquantified and untiring

assistance and appreciation. Also, I express my unresearved gratitude to my school

boys (Habeebullah and yakub), my personal assistance on logistic matters (Governor

Dhkrullah) and school daughters (Monsurat, Elizabeth, Osho) and others too many to

mention.

An unalloyed appreciation goes to the ONIKOLAS (Soliu Baba, AbdulAfeez,

Razaq, Lateef, Muhammed, AbduWasiyy, Sis. Khadrot, Hanau, Maryam, Zainab,

Ummu Hannau and little Al-Amin), for their multi-farious support and love. In fact

you are brothers and sisters par excellence.

I also appreciate the trio of Abel Kayode, Ogundola oluseyi and Motinwo

Olumide who gave me all the necessary support while serving as the chairman of the

departmental Academic Committee, also special recognition is due to the quad of

Mogaji Habibat Mojisola (a sister from another mother), Talabi Eunice Titilayo, Adu

Tomilola Adeola and Aruwajoye Kemisola Ovioke for taking me through the

registration process (when I was a JCC) at the beginning and also for being there till

now. I also appreciate the fives of Dada Demola, Ogunkale Tope, Funmilayo, Gloria,

and Akins for their utmost support and assistance delivered while serving as the

Electoral Chairman. I also appreciate all Al-Barka savings Home member (Akanmu

Ibrohim (Chairman), AbdulJeleel, Secretary, Sis. Maryam Afolabi, Lateefah, Aminat,

Kaothar and others) for the support and understanding.

Also, my Adio khadijat (K-Bee), Yosoye Yetunde (Most expensive), Oyebode

Folashade and Olumilua are very much appreciated for their usual constructive

criticism and advice. I really appreciate you all even though you deserve more that a

paper appreciation.

I also use this medium to praise the bold efforts of my dear brother Hamzah

Ahmad Bidemi (my 2nd half), Adegoke Muydeen, Adelowo Azeez (ECO), Wale (Eco

President), Bode (Whitesoul), Law Charlse, President Debo, Mike, 2bossjok and

others at MLK for being there at one point or the other

I appreciate my wonderful friends, who been my companion throughout

school. I cannot but mention your names you are all wonderful, the likes of my close

pals; Ajibaye Abduwasiyy, Lamidi Jimoh, Ademoroti Towo, Governor Ajibade and

Deputy Bunmi, Bailey (Project Rep), Brazillian, Ifejah, Dauud, Fagbemi Peter (Sec.

Gen), BJphobia, Ogunmoroti, Gloria, Tanwa Tinuola, Funmilayo, Ayoade, Bukky and

Olayemisi (of ACMC), Imran Azeez and friends, and others, just too numerous to

mention, thanks for your contribution, love, encouragement and supportive criticism

that makes me conscious at all times.

I also want to use this medium to say a big thank to the Muslim Student

Society of Nigeria (MSSN), the BAFINSA Muslim Students association, Albarka

Savings Home UNAD Branch, the Martin Luther King II Hostel and the entire Darul

Hudaites for the Islamic orientation impacted to me and the oppourtunity to serve at

one point in time. I just cannot, but must names like Amir AbdulHakeem and Talmidh

Adesina, Br. Habeebulah Ameen and Zhulnura’in (former & new Hostel coordinator),

Dilau AbdulKabir, AbduLateef (Mujaheed), Hassan Abubakar (Room Mate), Jayeju

papa, Alfa Esin, ibn Abass, Tao-ventures, Imran, Awoland, PRO Abdallah, Diplomat

Ibahim, Hacker-Habeebullah, Jamiu Lawal, AbdulHameed Tijani (Name-sake),

Kifayahs and Ruqoyahs, Amirat Zhullaikoh, Simbiat, Sidikoh, Abu Hameedah and

family and all other brothers and sisters too many to mention, for the honour and

respect given to me during the short time spent together.

Specifically, my sincere appreciation goes to Sis. Habeebat Damilola Ijitola for

the words of encouragement and concerns especially when it is needed most and most

especially for the release of her laptop in typing this project, so also is Br. Isiak

Olalere, for his painstaking assistance in typing the project at the oddest of students’

hours (Examination period). I say Jazakum llahu Khairan to you all.

In a synopsis, I appreciate everyone that has impacted my life in one way or the

other even if your name is not mention in these project, it is due to restriction of the

project work, you can be sure that I really, really love you all and the place you’re

filled in my life cannot be empty. I feel like staying with all of your for larger time but

the stage of life, as I said earlier, has to continue. I say the memory of all of you

cannot be forgotten and surely will I miss you all. I promise, Insha Allah, to extend my

love whenever I find myself in the next stage of life.

Also, to all I have offended one way or the other, knowingly or unknowingly,

please find a space in your heart to forgive and forget, I pray Almighty Allah forgives

us all, and crown our efforts with success and lots of Barka (Blessings). Thank you

all, SEE YOU AT TOP! And God bless you all.

-ONIKOLA HAMMED OLAWALE

(BFN, UNAD, 2005-

2009)®

TABLES OF CONTENTS

Title page i

Certification ii

Dedication iii

Acknowledgement iv

Tables of contents xi

Abstract xvi

CHAPTER ONE 1-16

INTRODUCTION

1.1 Background of the study 1-6

1.2 Statement of the problem 6-8

1.3 Research questions 9-10

1.4 Objectives of the study 10-11

1.5 Statement of Hypothesis 11-12

1.6 Significance of the study 12-15

1.7 Scope and limitation 15-16

1.8 Outline of the study 16

CHAPTER TWO

LITERATURE REVIEWS AND THEORETICAL FRAMEWORK 17-78

2.1 Introduction 17-19

2.2 Conceptual Issues 19-22

2.2.1 Vulnerability and Characteristics of Developing Economies 22-27

2.3 Historical background of External Reserves 27

2.3.1 Earlier Thinking on Demand for External Reserves 27-32

2.4 Literature Review 32

2.4.1 Reserve-Adequacy – Theoretical and operational issues. 32-37

2.4.2 Indicators for assessing Reserve adequacy for developing economies. 37-

40

2.4.3 Rationale for holding Reserves 40-43

2.4.4. Sources of Nigeria’s external Reserve 43-44

2.4.5 Composition of external Reserve 44-46

2.4.6 The Special Drawing Rights 46-49

2.4.7 The Reserve Currency 49-50

2.4.8 Ownership structure of Nigeria’s external Reserve 50-51

2.4.9 Uses of Foreign Reserves in Nigeria 51-55

2.4.10 Monetization of Reserves. 56

2.4.11 The Nigeria external Reserve position and crude oil prices (2007-2009) 56-

58

2.5 Theoretical Framework 58

2.5.1 The Buffer Stock Model 58-59

2.5.2 Criticism of the Buffer Stock Model 59-60

2.5.3 The Precautionary Adjustment Approach 61-62

2.5.4 The Modern Mercantilism Approach 62

2.5.6 Macroeconomic stabilization Theoretical Model 62-63

2.6 Recent Macroeconomic Perspective on Reserve Accumulation 63-66

2.7 Reserve Buildup in Africa 67

2.7.1 Sources of Reserve: Key Balance of Payment (BOP) Identities. 67-69

2.7.2 Trends and motivation for Reserve buildup in Africa 69-76

2.7.3 Sources and Composition of African Foreign Exchange Reserve 76-78

CHAPTER THREE

RESEARCH METHOD 79-89

3.1 Introduction 79-80

3.2 Model Specification 80-82

3.3 Estimation Techniques 82-83

3.4 Estimation Procedure 83

3.4.1 The Unit Root Test 83-84

3.4.2 The Error Correction Modeling (ECM) 84-86

3.5 Data Sources 86-87

3.6 Data justification and Apriori expectation 87-89

CHAPTER FOUR

DATA PRESENTATION AND RESULT INTERPRETATION 90-110

4.1 Introduction 90

4.2 Data presentation 90-91

4.3 Results interpretation and Discussion 91

4.3.1 Results of Stationarity (Unit Root) Test 91-94

4.3.2 Summary of Order of Integration 94

4.3.3 The ADF Test Equation 95

4.3.4 Co-Integration Test 96-97

4.3.5 The Long Run Model 97

4.3.6 Error Correction Mechanism (ECM) 98-101

4.3.7 The Least Square Estimation Results 101-102

4.3.8 Test for the statistical significance of the parameter (T-Test) 102-104

4.3.9 Test of Overall Significance of the Model (F-Test) 104-105

4.3.10 Test for Serial Correlation 105-106

4.4 Summary of Findings 107-108

4.5 Implications of Findings 108-110

CHAPTER FIVE

SUMMARY, CONCLUSION AND POLICY RECOMMENDATION 111-116

5.1 Summary 111-112

5.2 Conclusion 112-114

5.3 Recommendation 114-116

LIST OF TABLES

TABLE 1: Sources of Reserves Accumulation in Africa (US$million) 71

TABLE 2: Sources of Reserve accumulation in Africa US$ million 74

(Oil Rich countries)

TABLE 3: Sources of Africa Reserve accumulation in Africa US$

Million(Oil Rich countries) 75

TABLE 4: Sources of Africa Reserve accumulation US$ million 75

(Non-Oil Rich countries)

TABLE 5: Reserves and selected economic indicators for

21 African countries, 1980-2005 (average) 78

Table 4.1: Result of Stationary Test before Differencing 92

Table 4.2: Result of Stationary Test at First Difference 93

Table 4.3: Result of Stationarity Test at Second Difference 93

Table 4.4: Summary of Order of Integration 94

Table 4.5: ADF Test Result Table 95

Table 4.6: Result of Johansen Co-Integration Test 96

Table 4.7: The Over–Parameterized Model 99

Table 4.8: The Parsimonious Model 100

Table 4.9: T-Test Statistics 103

Table 4.10: F- statistics 105

LIST OF FIGURE

Fig. 1 Durbin Watson (Serial Correlation) Test 106

Bibliography 117-121

Appendix

ABSTRACT

The accumulation of external reserve basically is to meet eventualities of Balance of

Payment (BOP) crisis and to enhance stabilizing and favourable level of exchange

rate. Countries are showing interest in accumulating external reserves to ensure

macroeconomic stability. There has been some debate whether to beef up the level of

nations’ foreign reserves or make it lower, especially in developing countries, like

Nigeria. Whereas, some argue that external reserve determines the countries rating in

global market, others hold opposing views, comparing the cost with expected gains for

its accumulation.

In light of this, this paper examined the interactive influence of external reserve (ER)

and some macroeconomic variables, such as economic size (GDP), exchange rate

(EXR), trade position (BOP) and the country’s major export product, crude oil

production (COP). The aforementioned variables were captured as factors driving or

determining the level of external reserve in the country. The econometric analysis was

done, employing secondary data from the Central Bank of Nigeria (CBN) statistical

bulletine. The result obtained from the co-integration test and error correction

mechanism (ECM) reveals the following; (1) existence of a long run relationship

between the variables and two co-integrating equations at 5% and 1% significant

levels; (2) the possibility of convergence of the variables from the short to long run

with slow speed of adjustment of about 44.09%. it is thus the conclusion of this paper

that accumulation of large foreign reserves is not very productive in Nigeria due to

her inability to induce some macroeconomic variables. It is therefore recommended

that, the country should embark on domestic production efficiency rather than

accumulating huge reserve, coupled with ensuring exchange rate stability and

appropriate level of reserve holdings to ensure improved macroeconomic

performance.

CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

The traditional logic behind the holding of reserves is to face an eventuality of

balance of payment (BOP) crisis; hence, ensuring macro-economic stability.

Among the many economic indicators that central bankers, financial market

participants, financial and economic analyst and the financial press perpetually keep

taps on is the size of the country’s international or external reserve holdings. This

fixation with international reserve is to a degree understandable; its ability to boost

investor’s confidence and enhance investment and economic growth.

External Reserves are variously called International Reserves, Foreign

Reserves or Foreign Exchange Reserves. While there are several definitions of

international reserves, the most widely accepted is the one proposed by the IMF in its

Balance of Payments Manual, 5th edition. It defined international reserves as:

consisting of official public sector foreign assets that are readily available to, and

controlled by the monetary authorities, for direct financing of payment imbalances,

and directly regulating the magnitude of such imbalances, through intervention in the

exchange markets to affect the currency exchange rate and/or for other purposes.

Financial reserve is seen as one of the indicators of strength of the economy all

over the world. For instance, countries like China, Japan, and Russia which occupy

top position on world external reserves ranking have strong economies. However, the

term (Reserve) in popular usage commonly consists of gold, foreign exchange

holdings, reserve position in the international monetary fund (IMF) and holdings of

special drawing rights (SDRs). The valuation of reserves is at the end of each year in

SDRs, converted to dollar at the prevailing dollar per SDR rate (i.e. $/SDRs rate). In

addition, various macro-economic variables such as the exchange rate, trade balance

position, the GDP, portfolio investment to reserve holdings etc, which are vulnerable

and varies over time also determines the size, compositions, adequacy and cost of

external reserve holdings.

The buildup of reserves in Africa and developing economies has accelerated

over the last decade with the bulk of the increase occurring in oil-exporting countries.

The accumulation of reserves as occurred at a time of generally stable or slightly

appreciating exchanging rate, particularly against the US dollar. Countries generally

maintain reserves in order to effectively manage their exchange rate and to reduce

adjustment cost associating with fluctuations in international payment. Empirical

research shows that both the variance and level of trade (current account and openness

to trade or the propensity import) are important determinant of demand for reserves

(Mendoza, 2004).

In practice, however, most countries follow the “rule of thumb” in determining the

optimal level of reserves, including maintaining reserves equivalent to at least three

months of imports. (Mendoza, 2004). For developing countries, (i.e. Africa) recent

commodity price hike have allowed reserves accumulation among exporters while

draining reserves among importers. Meanwhile macroeconomic stabilization remains

at the forefront of national economic policymaking and aid conditionality in Africa.

This induces countries to hold reserves to allow monetary authorities to intervene in

markets to influence the exchange rate and inflation. Adequate reserves may also allow

African. Countries to borrow abroad attract foreign capital and promote domestic

private investment as a result of strengthened external position and reduce

vulnerability to external shocks.

Nigeria’s foreign reserve consists of liquid assets held by central Bank in trust of the

Federal Government for use in intervening in the foreign exchange market. The

Nigeria’s external reserve that reached a peak of $63 billion in September 2008, from

$4.98 billion in 1999 has dropped to $52.7 billion as at 2nd January, 2009 and further to

$43.087 billion as at January 2010. The decrease is of no doubt the effect of the twin-

devils of continuous dwindling prices of crude oil in the international market and the

global financial crises that has dried up influx of foreign currency in the financial

market. This has left the Central Bank of Nigeria (CBN) as the sole provider of

international trading currencies out of the available foreign reserve. Furthermore, this

has heightened the recent depreciation of the naira because of CBN inability to meet

the market demand.

In making the case for Nigeria of a robust (though dwindling) level of external reserve

as at 2005, the Central Bank of Nigeria (CBN) argues that China has over one million

dollars in her foreign reserves even though her population is very large (Soludo, 2006).

For instance, China’s foreign reserve position was estimated as US$822 billion in

2004, while the value for Nigeria in the same year was about US$176 billion, which

has increased to about US$51.33 billion in 2007 and to about US$43 billion in 2007.

(Wikipedia-CBN, 2010). One of the major reasons for the external reserve

accumulation put forward by the CBN is the need to make Nigeria more credit worthy;

this is believed to be essential for attracting foreign capital. However, it has been

noted that other issues such as a country’s institutional structure play key roles in

attracting foreign capital (Hassan et al, 2009).

More importantly, reserves accumulation in developing countries is akin to

build- up of deficits in reserves asset countries, especially the U.S. Thus, adjustments

in the US might have important costs for the rest of the world, especially reserves-

accumulating countries. Hence, the benefit (of reserves holdings), should therefore,

carefully weighed against potentially high economic and social costs. The cost of

maintaining reserves comprise the opportunity of forgone domestic consumption and

investment as well as financial costs and the strain on monetary policy arising from

effort to sterilize the effects monetary expansion through higher domestic interest

rates.

In this context, some slowdown in the rate of reserves accumulation is likely to

be justifiable for commodity–rich developing countries that need to finance high–yield

domestic investment instead of locking up the reserves in low-yield foreign assets.

The question of how to manage large foreign exchange reserve effectively also arises

because available reserve assets may not provide an optimal risk-return mix.

Traditionally, two alternative explanations have been offered for the behavior of

international reserve through time. On one hand, the literature on the demand for

international reserve postulates that reserve movements respond to discrepancies

between desired and actual reserves. On the other hand, according to the monetary

approach changes in international reserve will be related to excess demand or excess

supplies for money as reflected by movements in the balance of payment identities.

Conclusively, for a developing country, the use of external reserve in financing

unanticipated balance of payment deficit is not the only one, it is also used in signaling

financial strength in order to build up foreign investor’s confidence in the country and

to attract long term capital inflows aimed at macroeconomic stability. The above,

according to Agarwal J.P, 2008, is a function of the movement or factors that affects

the changes in foreign reserves, which this study is an attempt.

1.2 STATEMENT OF THE PROBLEM

The urge for an effective management of a country’s external reserve by its

central bank authorities is inspired by the need to meet the general macro-economic

activities. In recent years, an important aspect of external transaction is private capital

flow. Specifically, the short-term flows are perilous in the case of outward movement,

it may expose the developing country to a greater risk of liquidity squeeze,

occasionally, leads to a full fledge financial crisis. (Aizenmann and Marion, 2003).

Holding of high level of reserve is a recent phenomenon of developing economies,

though it may be a quick fix solution for this type of situation. When private capital

outflows threaten to weaken the exchange rate stability, the central bank can sell

reserves and buy domestic asset. However, as for developing economies, the problem

lies in a debatable issue that; how long will high reserve holdings prevent the crisis if

the fundamentals and other macro-economic determinants variables are weak?

In addition, after the East Asian crisis after the East Asian crisis a new

phenomenon has been observed, many governments her holding a large pile of

reserves; if they feel popular mood is not with them. And in this type of cases, the

central bank desire to hold reserves even through the return on domestic capital far

exceeds the return on safe asset (Aizemann and Marion 2003). However, high degree

of risk is involved in hoarding large reserves if the domestic currency appreciates

against the dollar, (or against other foreign currency), the country will lose the value of

the assets in the national currency.

Another problem and risk in owing sterilized purchases of reserves; since there is no

clear limit of extent of sterilization; a central bank may go on with issuing new

liabilities and permit domestic asset of the economy to few below zero level.

The foregoing is in line with the Nigeria economy, which is perceived and

recognized as the commercial backhaul of Africa due to the endowments in natural

resources, crude oil and bitumen, and other revenue which depends largely on an

internationally determined price. The country, since the 1970’s, had been persistently

dependent on oil, which made her vulnerable to fluctuations in the export prices of the

resources and direct impact on the level of the accumulation of external reserve. The

Nigerian economy tends towards being a “Mono-cultural Economy” since the 1970’s

as a result of its over-dependence and reliance on the resources and neglects of other

productive sector especially the agricultural sector that has once been the mainstay of

the economy prior the discovery of oil in the country.

In contrast of aiding the economy development, the booms period of 1974,

1981, and 1990 as a result of hike in crude oil process were wasted, which had a reflect

on the country’s external reserve; the aftermath effect made the burst period to bit

harder than they should ordinarily have been.

With respect to the above, a country’s external reserve has been tagged as a function of

several variables, which are vulnerable to the real sector shocks and causes the

instability and variability of the country’s reserve. Therefore, the bane of the problem

which this research work tend to investigate is to examine the core, and long run

macroeconomic determinants of external reserve, with respect to its cost, benefits and

adequacy in developing economies, taking the Nigerian “monoculture state” as a case.

1.3 OBJECTIVES OF THE STUDY

The main focus of this study is to identify the salient factors that determine external

reserve in developing economies (focusing on the Nigeria economy) with a view to

suggesting policy measures to enhance output expansion in the country.

The specific objectives of this study include:

i. To revisit the issue of indicators/determinants used to assess the

adequacy and cost of external reserve in the context of developing

countries, taking the Nigeria case.

ii. To estimate the short and long run effects, and relative importance of

the variables in (i) above on the Nigerian economy.

iii. To examine the basic components of external reserve.

iv. To highlight the critical factors that affects the variability of external

reserve in developing economies taking the Nigeria case.

v. To provide policy recommendation aimed at enhancing the

management of foreign reserve in the country.

1.4 RESEARCH QUESTIONS

Several variables, as discussed earlier, determine the vulnerability, cost,

adequacy, level and instability of a country’s reserve. In which, to effectively manage

it, it is a requisite to understand its major determinants in a globalized economy.

According to Gosselin and Parent (2005), there is a relative stable long run demand

function that depends on five categories of explanatory variables, which are; economic

size, current account vulnerability, capital account vulnerability, exchange rate

flexibility, and the oppourtunity cost. Reserve holding is expected to increase with

economic size and the volume of international transactions.

Therefore, the bane of the problem which this study tends to investigate is to examine

these determinants, taking the Nigerian case as a study. In furtherance of this, attempt

will be made to provide answers to the following pertinent questions:

i. What are the core compositions of a country’s external reserve?

ii. What are the factors responsible for the behaviour of external reserves?

iii. To what extent is the external reserve variability related to the

movements in other macro-economic variables?

iv. To what extent as the crude oil prices, as a major trade determinants of

Nigeria external reserve impacted on the economy?

1.5 STATEMENT OF HYPOTHESIS

Oloyede (2002) explains a hypothesis to be a tentative but testable or verifiable

statement about the relationship between two or more variables. It states the

expectation of the researcher with respect to the relationship among the variables

implied in the stated research problem. That is, it states what the researcher expects

the outcome of the study to be.

For the purpose of this research, the hypothesis will be formulated in two forms,

namely; the Null hypothesis, which is a negative statement and will be denoted by

(H0), and the Alternative hypothesis will be represented by (H1).

Hence, the hypothesis to be tested in this study includes the following as stated in

the nulls:

1. Exchange rate fluctuation do no affects the level of external reserve in the short

and long run.

2. External reserve does not vary proportionately to a favourable balance of

payment (BOP) position in the long run.

3. The Nigerian crude oil production is not positively related to external reserve

4. The economic performance indicator (GDP) does not affect the level of

external reserve in both short and long run.

5. Interest rate does not affect the level of external reserve in the short and long

run.

From the above, the hypothesis can be formulated thus;

H0: Macroeconomic factors do not determine External reserve movement in

developing countries

H1: Macroeconomic factors determine External reserve movement in

developing countries

1.6 SIGNIFICANCE OF THE STUDY

Most research work has investigated the management, cost, adequacy and

hoarding of external reserve in the context of developing economies; but the

management will be more worth studied if the major determinants or factors are

considered and understood especially in the Nigerian economy, whose mono-cultural

state as resulted in variability of its reserve position.

Developing economies are induced to hold reserves to allow monetary authorities to

intervene in market to control exchange rate and inflation. Adequate reserves also

allow the country to borrow from abroad and to hedge against instability and

uncertainty of external capital flows. However, reserve accumulation can have high

economic and social costs, including a high opportunity cost emanating from low

returns on reserve assets, losses due to reserve currency depreciation, forgone gains

from investment and social expenditures that could be finance by these reserves.

It is therefore pertinent to note that developing need to have a better

understanding of the determinants and economic costs of reserve accumulation, which

could aid in designing optimal reserve management strategies to minimize these costs

and maximize the expected gains from resources inflow; which the study is of a

significance importance.

Accumulation of foreign exchange reserve by developing countries may best be

understood in the context of reserve behaviour in developing regions in general.

Global official foreign exchange reserves rose from US$1.3 trillion in January 1995 to

Us$5.04 trillion in December 2006, and the share of developing countries in world

reserves increases from 50 to 72 percent over the same period. This large share needs

explanation especially in view of the fact that developing countries accounted for only

41 per cent of world trade in 2005.

For a developing country, the use of international reserve, however important is

not the only one; developing countries also use reserves to signal financial strength in

order to build up foreign investor’s confidence in the country and to attract long term

capital inflows. The recent accumulation of reserves in developing countries has been

largely interpreted as a form of self-insurance precipitated by the high level of global

economic and financial instability and the absence of an adequate international system

for crisis management, the current global financial crisis is a good example in this

regard (Stiglitz, 2008).

Moreover, many countries see reserve accumulation not only as a means for

effective exchange rate management, but also as a tool for maintaining low exchange

rates in order to promote trade and international competitiveness. Stiglitz further

expatiated that, regional breakdown of reserves buildups suggests a positive

correlation between reserves buildup on the one hand and trade and output on the

other.

The significance of this study can be justified from the forgoing, which ranges

from the virtual absence of a study examining the long run determinants of external

reserves’ in developing economy with a special reference to the Nigeria economy;

which poses a great challenge for research purpose of which this research is an

attempt. The study will also after considering the above, make recommendation that

will be useful for policy makers and also for further work, to aid future researchers on

related issues.

In furtherance to the above, international finance researchers and practitioners are

always seeking methods and approaches for understanding what constitutes and

determines the optimal international reserve level. The analysis and findings from this

paper will provide practitioners and academicians with appropriate benchmarks for the

case of Africa emerging market economies, taking the Nigerian case.

1.7 SCOPE AND LIMITATION

The focal point of the study is to examine the determinants of external reserves

in developing economies with a special inference on the Nigerian economy. Hence,

the study will be limited to the developing African countries only in terms of model

application, review of past studies etc, while only the Nigeria data will be used to test

and analyse the result.

The study will cover a period of thirty (30) years, that is, the period between

1982 and 2011. This period covers the period of loose management of external reserve,

the period of proper management (of conserving it), and the period of the global

financial meltdown which causes the dwindling of the country’s conserved reserve is

also intended to be captured.

The major constrained and limitation is that of data updating, as a result of day to day

variability of most variables. Also, the collection of data from different sources,

publications, personal interaction, financial institutions, electronic materials, and

governmental agencies pose different challenges.

In addition, time constraint and finance among other factors constitutes other

limitation.

1.8 ORGANISATION OF THE STUDY

The research work shall be stratified into five (5) chapters. Chapter one entails

the background of the study, also, the statement of the problem, purpose, objectives,

scope and limitation, the research questions and hypothesis, and finally the outline of

the study.

The reviews of literature of past studies, conceptual issues, theoretical and

empirical frame works is provided in chapter two (2) with respect to the current issues

in related studies. Chapter three (3) basically examines the research methodology,

where the model specification, and analysis procedure is stated. While chapter four (4)

provides the analysis and interpretation of results, chapter five (5) provides the

summary, conclusion and recommendation of the study with respect to the policy

suggestions in the Nigerian context.

CHAPTER TWO

LITERATURE REVIEWS AND THEORETICAL FRAMEWORK

2.1 INTRODUCTION

Developing countries, particularly East Asia and Africa, accounts for most of

the large increase in international Reserve-GDP rations in recent decades. Possible

explanations include self-insurance against the output cost of sudden stops;

precautionary fiscal outlays, sovereign risks, volatile and limited tax capacity, and a

modern incarnation of mercantilism.

Empirical studies reveal that the 1997-8 East Asian financial crisis triggered in sharp

increase in hoarding international reserve. They suggest prominent roles for the

precautionary demand and self insurance motives and conclude that the financial

integration of developing countries is associated with greater hoarding of international

reserve. Moreover, many countries see reserve accumulation not only as a means for

effective exchange rate management, but also as a tool for maintaining low exchange

rates in order to promote trade and international competitiveness. This motive for

holding reserves is referred to as the mercantilist motive of holding reserves

(Aizenmann and Lee, 2005).

In contrast to the impressive pace of global reserve growth as a result of the

recent global financial crisis and economic meltdown recorded in 2006, world external

reserve rose from US$1.20 trillion in January, 1995 to above US$4.00 trillion, growing

rapidly since 2002, developing economies experience a dwindle in its reserve position.

(ECB, 2006). This has become an important issue and subject of controversy on the

international policy agenda.

Different schools of thought have emerged in recent years explaining the accumulation

of reserve with respect to developing economies. The first school of thought points

out that holding a lot of reserve is costly and that the yield on reserve is much lower

than the potential returns that be could earned by issuing them to make real investment

in the economy. According to this school, countries, especially developing could

progressively lessen their need for reserve accumulation by developing policies such as

structural and macroeconomic measures to foster domestic demand financial system

reforms both at domestic and regional levels.

The second school supports holding large reserve balances on the ground that

cost of doing so is small compared to the economic consequences of a sharp

depreciation in the value of currency that is often associated with financial crisis in

emerging markets. They believe that a devaluation of currency raises a country’s cost

of paying back debt denominated in foreign currency as well as its cost of imported

goods and it also raises the spectra of inflation. By having its own ammunition to

defend its currency crisis, a country with large reserve holdings avoid being shut out of

the international capital markets due to concerns that the government or the private

sector will default on foreign debt payments.

Therefore, large reserve stockpile is a prudent policy for the occasions when

defending the value of the currency becomes expedient. In spite of different

arguments by different authorities on reserve accumulation of developing economy,

aside from being signal of financial strength, the international reserve of developing

economies are an important antecedent of a country’s ability to avoid economic crisis

in times of globalization and capital mobility.

2.2 CONCEPTUAL ISSUES

External Reserves are variously called International Reserves, Foreign

Reserves or Foreign Exchange Reserves (CBN, 2002). In a strict sense, external

reserves are “only the foreign currency deposits and bonds held by central banks and

monetary authorities”. However, the term in popular usage commonly includes

foreign exchange and gold, SDRs and IMF reserve positions. This broader figure is

more readily available, but it is more accurately termed “official international

reserves” or “international reserves”.

The Wikipedia online dictionary in addition to the above also define external

reserve as assets of the central bank held on different reserve currencies, such as the

dollar, euro and yen, and used to back its liabilities i.e. the local currency issued, and

the various bank reserves deposited with the central bank, by the government or

financial institutions.

Foreign exchange reserves as defined by John Black, in Oxford Dictionary of

Economics, refer to liquid assets held by a country’s government or central bank for

the purpose of intervening in the foreign exchange market. The Longman Dictionary

of English Language attempted among other definitions to define reserve as “money or

its equivalent kept in hand or set aside usually meet liabilities and explained external

reserve as liquid resources (assets readily converted into cash) of a nation for meeting

international payments”.

In examining the definitions above, the traditional essence of holding external

reserve has to be understood. The traditional logic by explanation behind holding

reserve is to face an eventuality of balance of payment (BOP) crises (Sharma and

Sehgal, 2008). The definition from the three (3) dictionaries approach differs on the

purpose and holding external reserve. Though, the Oxford dictionary is more

embracing than the duo; but the use of external reserve is captured thus in the

definition of Rasheed (1995): The external reserves of a country are the financial

assets available to government to meet temporarily imbalance in the external

payments, to intervene in its foreign exchange exchange market in defence of its

exchange rate, and to settle obligations arising from international trade, financing

contracts, and diplomatic relations.

Aizenmann, (2005) was of the view that external reserves are liquid external assets

under the control of the central bank. In another words, they are stock of savings from

foreign exchange transactions between the residents of an economy and the rest of the

world during a given period of time that are held and controlled by the monetary

authorities (Obaseki, 2005). While there are several definitions of international

reserves, the most widely accepted is the one proposed by the IMF in its Balance of

Payments Manual, 5th edition. It defined international reserves as:

Consisting of official public sector foreign assets that are readily available to, and

controlled by the monetary authorities, for direct financing of payment imbalances,

and directly regulating the magnitude of such imbalances, through intervention in the

exchange markets to affect the currency exchange rate and/or for other purposes.

From the above definition, it can be said that any asset available to the

monetary authorities held either for mercantile or precautionary motives against

payment imbalance and which is readily acceptable by her potential creditors in the

international market and diplomatic relations qualifies as external reserve assets.

Developing economies as a concept is a term generally said to describe a nation with a

low level of material well being. There is no single internationally recognized

definition of developing economy, and the level of development may vary widely

within so called developing countries with some developing countries having high

average standards of living.

2.2.1 Vulnerability and Characteristics of Developing Economies

There is no single definition of a small economy, but size of population and

level of GDP generally underlie almost all definitions. It is generally recognized that

small developing economies (SDEs), (other terms commonly used includes “less

developed Countries” (LDCs), “under-developed” or “developing” economies, “third

world nations”, and “non-industralized nations” etc, suffer specific handicaps arising

from the interplay of several factors related to their size. They have in common a

number of structural problems: their populations, and therefore their markets, are

small; their resource base is narrow, fragile and prone to disruption by natural

disasters; they typically depend for foreign exchange on a small range of primary

product exports; and they generally have limited local capital for productive

investment. In short, their base for revenue generation is narrow.

Other characteristics include:

1 Small domestic market - Because of the small population and GDP the domestic

market is also small, suggesting limited supply of labour, few firms and thus low

domestic competition. The GDP level for all of the 36 countries for which data was

available was, with four exceptions, below US$700 million. It is worth noting that

the importance of agriculture is very much related to the level of GDP. In the few

countries with GDP above US$1 000 million (e.g. Bahrain, Barbados) the

agricultural sector (including fisheries and forestry) typically plays a relatively

small role in the economy, supplying less than 10 percent of GDP in most cases. At

the opposite end of the scale, countries with GDP levels below US$200 million

(e.g. Sao Tome and Principe, Kiribati, Tonga, Samoa, Comoros) rely on agriculture

for as much as 20-40 percent of GDP.

2 Limited natural resources - The land area available for productive purposes is

limited. All except two of the 36 SDEs have a land area of less than 30 000 square

km (the largest of the group are Guyana and Suriname - above 150 000 square km).

In addition, water resources are generally scarce, often limited to thin sheets of

freshwater floating on seawater, recharged by rainfall. Climate variability and

change, sea level rise and vulnerability to natural disasters are of particular

concern.

3 High degree of openness to agricultural trade - SDEs are highly dependent on

the international trading system, especially in agriculture; the ratio of agricultural

trade to GDP ranged from 10 percent to 52 percent in 22 out of the 27 SDEs for

which data was available (Table 1). In addition, most SDEs depend on a single or a

few export commodities for a high proportion of their export earnings, making

them particularly vulnerable to changes in world markets. The major export crops

of SDEs include bananas, sugar cane, cocoa, coffee and coconuts. Most of the

SDEs are net food importers, with food constituting a large share of their total

imports.

2.2.3 Economic and environmental vulnerability

The interplay of the above-mentioned factors created specific handicaps for LDCs.

Others include:

1 Competitiveness and economies of scale - Because of their size SDEs face a

number of challenges in achieving and retaining competitiveness in international

markets for agricultural products. The small size and geographic isolation present

particular challenges in terms of achieving sufficient economies of scale to enable

producers to compete in international markets or, in many cases, to compete with

imported commodities in the domestic market. Scale diseconomies make them

dependent on imports for most of their consumption and investment needs as well

as on a narrow range of export products, resulting in a high vulnerability to

external economic shocks.

2 Vulnerability to changes in world markets - Agriculture, tourism and fisheries

are normally the prime economic activities, accounting for a substantial part of

GDP and exports in SDEs. Each of these sectors is highly sensitive to changes in

world market conditions. The small economies that are most dependent on

agricultural exports for a significant part of their export earnings have suffered

from a long-run decline in real world market prices and a slow growth in world

demand for their major agricultural products. In addition, their agricultural exports

are highly reliant on preferential agreements and thus they are exposed to some

risks from multilateral trade liberalization. Some of them fear that the new round of

negotiations on agriculture will increase their exposure to such risks, which would

in turn affect their import capacity, including that for food. In general, high

dependence on world market makes the achievement of sustainable agriculture and

food security for these countries more complex and difficult than for other

countries.

3 Environmental vulnerability - SDEs’ geographical location and size account for

their ecological fragility, particularly to inclemency of weather (e.g. tropical

storms) and geological forces (e.g. volcanic eruptions) because when damage

occurs, it occurs on a national scale. Epidemics introduced from outside quickly

devastate fragile ecosystems and put endemic species at particular risk of

extinction. Land erosion, as a result of sea waves and winds, is higher than in other

countries because of relatively larger exposure of coasts in relation to land mass.

The adverse impact of economic activities (that pervade the entire land area) on the

natural environment is felt more than in other countries. Natural disasters

exacerbate economic vulnerability because they create additional costs and divert

resources from directly productive activities, as well as disrupting the whole

economy. Besides, counteracting vulnerability requires a capacity to adapt and to

increase resilience that depends on certain features of the economic system. Thus,

economic and environmental vulnerability are inter-twined.

In sum, SDEs share some specific characteristics that may constrain their

integration into the global economy and their ability to take advantage of opportunities

arising from the multilateral liberalization of agriculture:

1 Limited population size, making economies of scale and labour specialization

impossible;

2 A narrow resource base, creating a dependence on imports of consumer and capital

goods and exposing the economies to natural disasters and hazards; and

3 High concentration of exports on a few primary products from agriculture, forestry,

fisheries, and mining, which make SDEs prone to considerable fluctuations in

output and prices.

2.3 HISTORICAL BACKGROUND

2.3.1 Earlier Thinking on Demand for External Reserves

A long literature has at different times, emphasized various motives for holding

international reserves. From the trade-based Bretton Woods view to sudden stops and

precautionary accumulation.

The modern study of optimal international reserves begins with Heller (1966), who

viewed the demand for reserves by a monetary authority as reflecting optimization

subject to a tradeoff between the benefits of reserves and the opportunity cost of

holding them. Heller’s work and the work that soon followed envisioned the benefits

as relating to the level and variability of balance of payments flows, primarily imports

and exports. Basically, reserves could buy time for more gradual balance of payment

adjustment, so the demand for them was viewed as a positive function of both the cost

of adjustment (through demand compression, devaluation, and so on) and the

likelihood that such adjustment measures might become necessary at a low level of

reserves. While such adjustment-based variables met with some empirical success, the

proxies for reserve costs showed no robust relationship to reserve holdings, at least

when countries were pooled. The collapse of the Bretton Woods regime after 1973

shifted the ground under the arguments about reserve holdings. At least in the

advanced countries, a new resolution of the dilemma emerged—a move to a different

“vertex” with capital mobility and floating exchange rates. But it was unclear what this

move meant for reserve holdings. On the one hand, a truly floating regime needs no

reserves and a liberalized financial account would minimize the need for reserve

changes to absorb a given set of balance-of-payments shocks. On the other hand,

governments are far from indifferent to the exchange rate’s level and a liberalized

financial account might in and of itself generate more balance-of-payments instability,

possibly augmenting reserve needs.

As if to support an array of confounding theoretical arguments, global

international reserves did not decline noticeably relative to output after the shift to

floating exchange rates. The exigencies of the 1980s debt crisis did lead to a decline in

the growth rate of developing-country reserves during the 1980s. But the new wave of

rich-to-poor capital flows starting in the 1990s led to new thinking on the role of

international reserves in a financially globalized world, one in which currency crises

originating in the financial account could in cause major reserve drains. An important

study in this vein is that of Flood and Marion (2002). They showed that a parsimonious

but successful specification based on earlier work by Frenkel and Jovanovic (1981)

remained robust, and they reinterpreted the balance-of-payments variability regressor

central to that specification in terms of the “shadow floating exchange rate” concept

from the theoretical crisis literature. However, their work left open the possibility that

variability in reserves is a proxy for more fundamental financial variables that generate

reserve (or shadow exchange rate) variability.

Perhaps the most in detailed view has been one based on the role of short-term

external debts as drivers and predictors of emerging-market currency crises.

Wijnholds and Kapteyn (2001, n. 13) recount that in December 1997, after the Korean

crisis erupted, the IMF board discussed a rule of thumb for reserve adequacy

incorporating short-term foreign-currency debt. It came to be known as the Guidotti-

Greenspan rule after policymakers Pablo Guidotti and Alan Greenspan both explicitly

proposed the idea in 1999 (see Greenspan 1999). The proposal came at a time of

mounting concern about “sudden stops” in capital in flows (Calvo and Reinhart 2000),

periods when access to foreign financing can dry up. A country may be able to pay

interest on external debt, but lack the wherewithal to repay a principal balance that it

had expected to roll over. Guidotti suggested a rule of thumb whereby emerging

markets should have sufficient reserves to cover full amortization for up to one year

without access to foreign credit. The idea was supported by empirical research

showing that short-term external debt appears to be a potent predictor of currency

crises. It is not much of an exaggeration to say that on this view, the economy itself is

a bank, and monetary (as opposed to credit) considerations are inessential. Despite its

recent notoriety, the Guidotti-Greenspan rule has a hallowed history going back at

least a century. In the second volume of his Treatise on Money (1930), John Maynard

Keynes discussed his view of the then accepted principles governing the optimal level

of free gold reserves. Because it is so very explicit and so clearly in line with current

discussion (including consideration of financial integration), the relevant passage is

worth quoting at length (Keynes 1971, pp. 247–8):

The classical investigations directed to determining the appropriate amount of a

country’s free reserves to meet an external drain are those which, twenty years ago,

were the subject of memoranda by Sir Lionel Abrahams, the financial secretary of the

India once, who, faced with the difficult technical problems of preserving the exchange

stability of the rupee, was led by hard experience to the true theoretical solution. He

caused to be established the gold standard reserve, which was held separately from the

currency note reserve in order that it might be at the unfettered disposal of the

authorities to meet exchange emergencies. In deciding the right amount for this reserve

he endeavored to arrive at a reasoned estimate of the magnitude of the drain which

India might have to meet through the sudden withdrawal of foreign funds, or through a

sudden drop in the value of Indian exports (particularly jute and, secondarily, wheat)

as a result of bad harvests or poor prices. This is the sort of calculation which every

central bank ought to make. The bank of a country the exports of which are largely de

pendent on a small variety of crops highly variable in price and quantity—Brazil, for

example—needs a larger free reserve than a country of varied trade, the aggregate

volume of the exports and imports of which are fairly stable. The bank of a country

doing a large international financial and banking business—Great Britain, for example

—needs a larger free reserve than a country which is little concerned with such

business, say Spain.

Keynes here focuses exclusively on external drains, and does not mention the

causal influence of internal drain on external drain that would surely have appeared

more important to him upon witnessing the global financial crisis that broke out in

1931, the year after the Treatise’s publication. In this respect his prescriptions mirror

the Guidotti-Greenspan perspective, which likewise concentrates on external drains,

largely ignoring the possible role of domestic residents’ financial decisions.

In more recent writing, Aizenman and Marion (2003) suggest a precautionary demand

for reserves as a cause of the rising international reserves in East Asia following the

Asian crisis. Aizenman and Lee (2006) estimate an empirical panel model in which

precautionary factors, represented by dummy variables marking past crises, play an

important role in explaining desired reserve levels. Like us, Aizenmann and Lee

(2007) find that China is not an obvious outlier. However, while the authors

motivate their regression tests in terms of a theoretical model of insurance against

sudden stops, their econometric results actually say nothing about the mechanism

through which past crises have influenced subsequent reserve holdings.

2.3 LITERATURE REVIEW

There is no doubt as to the usefulness of foreign reserves as a tool to avoid crises as

argued by

Fischer (2001), but there is a limit to the amount of foreign reserves needed to prevent

the financial crisis, going by the fact that holding large foreign reserves can imply

costs. If foreign reserves accumulation is driven, for instance, by precautionary

motives, it should stop at the stage where the optimal level has been reached. This,

however, does not happen in the present circumstance. This thus raises the question

about what constitutes an adequate foreign reserve.

Frenkeland Jovanovic (1981) states that most of the rules for a country’s demand for

foreign exchange reserves consider real variables, such as imports, exports, foreign

debt, severity of possible trade shocks and monetary policy considerations. Similarly,

Shcherbakov (2002) states that, there are some common indicators that are used to

determine the adequate level of foreign reserves for an economy. According to him,

some of these indicators determine the extent of external vulnerability of a country and

the capability of foreign reserves to minimize this vulnerability. These indicators

includes: import adequacy, debt adequacy and monetary adequacy.

The traditional and most prominent factor considered in determining foreign reserves

adequacy is the ratio of foreign reserves to imports (import adequacy). This represents

the number of months of imports for which a country could support its current level of

imports, if all other inflow and outflow stops. As a rule of thumb, countries are to hold

reserves in order to cover their import for three to four months. According to the

International Monetary Fund (IMF, 2000), the guideline of three months of imports has

been in force for a few years now. However, with the Asian crisis of the late 1990s this

measure has been questioned by experts. Currently some are of the view that twelve

months of imports is adequate, while others argue that the number of months of

coverage is of limited importance, since the focus is on the external current account.

This group argued that foreign reserves adequacy should focus on the vulnerabilities of

capital accounts. Countries that are vulnerable to capital account crisis should hold

foreign reserves sufficient enough to cover all debt obligations falling due within the

succeeding year.

This is known as the Calvo, Guidotti and Greenspan‟s rule (reserves equal to short

term external debt). See Greenspan (1999).

According to Rodrik and Velasco (1999), and Garcia and Soto (2004), a country is

considered prudent, if it holds foreign reserves in the amount of its total external debt

maturing within one year. The reserves to short-term debt measure have been proved

empirically relevant to currency crisis prevention. The feedback on the outreach

activities conducted by the IMF and the World Bank lend its support to this approach

(Marion, 2005). The last measure is reserves equal to 5-20 % of M2. This benchmark

is very useful for economies with high risk of capital flight and those that want to

shore up confidence in the value of local currency. It is also useful for the economies

that have weak banking sectors (Summers, 2006; IMF, 2000). However, Comelliet al

(2006) argued that, empirical analysis of all the three methods explained above,

confirmed that the international reserves of most countries are in excess particularly

that of the Asian economies (Table 3). However, it should be noted that, determining

the optimal level of foreign reserves has no straight forward measurement factors. It

sometimes depends also on institutional factors such as the degree of capital mobility

or financial liberalization.

Various models have been developed to measure the determinants of foreign reserves.

The most widely used of these models in the literature is the “buffer stock model”. The

model implies that the authorities demand reserves as a buffer to curb fluctuations in

external payment imbalances.

This is to avoid macroeconomic adjustment cost arising from imbalances in the

external payments. The advantage of the model over others is its adaptability to both

fixed and floating exchange regimes. The model is as relevant in a modern floating

exchange regime as it was the Bretton Woods regime.

Heller (1966) estimates the optimal stock of reserves by equating the marginal cost and

marginal benefit of holding reserves following rational optimizing decision. He

compares actual reserves with his results for each country to check for the adequacy of

reserves. Frenkel and Jovanovic (1981) in their effort to determine the optimal stock of

reserves modified Hellar‟s model based on the principles of inventory management.

Using pooled time series for the period 1971-1975 for twenty two countries, they

concluded that the estimated elasticities were close to their theoretical predictions.

In their study, Flood and Marion (2002) confirmed the applicability of the buffer stock

model in the modern regime of floating exchange rate as it was during the Bretton

Woods’ era. They submitted that with greater exchange rate flexibility and financial

openness, the model will perform better if these variables were well represented.

Disyatat and Mathieson (2001) adopted

Frenkel and Jovanovic model for fifteen countries in Asia and Latin America and

submitted that the volatility of the exchange rate is an important determinant of

reserves accumulation and that the financial crisis of the late 1990s produced no

structural breaks.

IMF (2003) standardized the buffer stock model and applied it on the emerging

markets economies of Asia. The study concluded that reserves accumulations were

driven by increases in current account and capital flow. Aizenman and Marion (2003)

used the buffer stock model on sixty four countries over the period 1980 to 1996 and

found that the standard variables in the model explain about 70.0 percent of the

movement in the observed reserves holding without country fixed effects and 86.0

percent with country fixed effects.

Ramachandran (2005) applied the buffer stock model for India covering the period

April 1993 –

December 2003, this was characterized by flexible exchange rate, and high level of

capital flows. He finds that the standard measure of volatility defined as the fifteen

years rolling standard deviation of change in trend adjusted reserves used by Frenkel

and Jovanovic (1981) produces biased estimates but when he adopted the GARCH

approach result of the estimated coefficient were closer to the theoretical predictions.

2.4.1 Reserve-Adequacy – Theoretical and operational issues.

International currency reserves have largely been viewed as inventory held

against an uncertain future in the balance of payment accounts. The uncertainty is

largely due to the status of the current account, where adequacy level is judged

compared to the size of trade flow. This reasoning is derived from the fact that

international trade historically accounts for the largest factor in the balance of

payment.

As such, to assess levels of reserves, the first benchmark ideally should be the reserves

to imports (R/M) ratio. The IMF has generally presented international currency reserve

data in the World Economic Outlook in this manner (Bird and Rajan, 2003). The R/M

ratio of a country is the number of months of imports capable of being financed by its

international currency reserves. In one of the earliest studies the IMF conducted in

1958 revealed that, in general, countries achieve an annual R/M ratio between 30 and

50 percent (Wijnholds and Kapteyn, 2001). However, this minimum benchmark figure

has been a matter of debate. A 30 percent or a four month of import cover has been

criticized as too low (Triffin, 1960). Over the years a three to four months worth of

import rule has emerged (Fischer, 2001). The R/M ratio also lacks a linear relationship

between the occurrences of deficit and value of imports, which may change if the trade

were to increase (Bird and Rajan, 2003).

Frenkel and Jovanovic (1981) developed a solution for optimal reserve levels

using the R/M ratio approach. They included in this analysis interest rates, an

allowance for trend movement governing international payments and receipts, and the

mean rate of net payments. The argument is straightforward. The demand for reserves

is a function of benefits in the form of smooth external transactions (trade) and a

negative function of the opportunity cost (forgone earnings) of holding them.

However, their assumption for interest rate as a measure of forgone earnings may not

be appropriate; thus the approach described by authors is merely “suggestive.”

Heller (1966) analyzes the necessary levels of reserves in terms of optimized

level. This includes a relationship where marginal utility equals marginal cost in the

framework of a random walk model. Using a rough average of long-term government

bond, the rate of return on reserves is compared to the social return on holding

reserves. The benefit in holding reserve is avoiding a situation where output is reduced

due to a balance of payment. Heller's findings are general, but varying sub-optimal

reserves for developing countries. Refining the model of Heller (1966), Hamada and

Kazuo (1977) and Frenkel and Jovanovic (1981) provide an approach where

international currency reserve demand depends on the marginal propensity to import, a

change in the balance of payment and the opportunity cost of holding the reserves.

Even in this arrangement, there has been a difference of opinion on the hypothesized

relationship of the reserve demand function and tendency to import. According to

Heller, a negative relationship is expected as currency reserves are built by import

policies such as reduction in aggregate expenditure. Frenkel (1978) argues that a high

(low) import/gross domestic product (GDP) ratio reflects a high (low) openness of an

economy which reflects vulnerability to external shock by presenting evidence on the

stability of the demand. We argue that the demand for reserves by developed countries

differs from that of less-developed countries. As such, a positive relationship is

expected between the reserve demand and propensity to import. However, evidence is

mixed whether the economies of scale are present. Since, the international currency

reserves finance payment imbalances and not the trade flow (Wijnholds and Kapteyn,

2001); the reserves should grow with increase in international transactions.

From another perspective, Ben-Bassat and Gottlieb (1992) consider sovereign

risk in their model for optimal international currency reserves and find the variable in

their risk premium equations as significant. The cost and probability of levels of

reserves can be related to the default of external debt. Countries with default on

external debt incurs a higher borrowing cost, hence the level of international currency

reserves depend on credibility rating of the country. A sudden drain on a country's

reserve may hurt creditor's confidence regarding the borrowing countries ability to

meet its payment obligations. Once a lender losses confidence in the borrowing

government, they are unable to restore assurances about the stability of its reserves

which are likely to decrease rapidly. The rate at which the reserves deplete may further

hurt the confidence in the borrowing country. This may even lead to a sudden capital

withdrawal from investors (Bird and Rajan, 2003). For most developed countries

which usually have a lower default risk rating, need for a large safety net is unjustified

(Flood and Marion, 2001). They can borrow in world capital market as requirement

arises.

Other factors which may affect the default risk rating may be the threat of war, trade

embargo or a banking crisis (The Economist, 2000). This also has been the reason why

explanatory valuation of opportunity cost is difficult. Central banks, especially in

countries affected by the currency crisis of 1990s and generally other developing

countries have been extremely risk aversive regarding maintaining a minimum

required currency reserves. We have observed year after year that reserves grow. In

such cases, the level of reserves demanded in current period is a merely a function of

reserves in previous year plus a growth factor (Bird, 1982).

The currency crisis of 1990s was predominantly a crisis associated with the

capital account, which could have been reduced by prudent management of asset and

liability position. The balance of payment vulnerability has since changed with

financial and trade openness that exists in many of the emerging markets (Bird and

Rajan, 2003; Fischer, 2001). It is, therefore, necessary to account for capital flow and

size of reserve to a country's short-term external debt when assessing a reserve

adequacy level for EMCs (Greenspan, 1999). Moreover, it is now possible for the

central banks of creditworthy countries to obtain reserves from private sources and not

just other central banks, which removes the “Triffin Dilemma” (Eichengreen and

Frankel, 1996). As such, the legacy version of operational values such as ratio of

reserves imports method for assessing international currency adequacy levels may no

longer be appropriate. This may be useful for poorer economies (Bird and Rajan,

2003), which cannot attract private capital and may have a highly concentrated export

base. However, for the case of emerging economies, this ratio may not correspond

optimally to reserve adequacy levels. The EMCs can correct the current account deficit

by managing the exchange rate flexibility and thereby reducing the need to hold

currency reserves.

2.4.2 INDICATORS FOR ASSESSING RESERVE ADEQUACY FOR

DEVELOPING ECONOMIES.

An important question arising from this discussion is whether a definitive

measure of reserve adequacy is possible? At the same time, it is necessary to know the

reserve levels because, as lessons from the Asian financial crisis suggests, the currency

reserve level can be an important explainer and predictor of a currency crisis (Fischer,

2001). A better reserve and debt management system may have reduced the possibility

of these crises. The conventional indicators of currency reserve adequacy based on

current account instability may be appropriate for some countries, which may be faced

with payment vulnerability due to trade related shocks (Bird and Rajan, 2003).

However, for other countries such as the EMCs, which carry a substantial short-term

external debt, the ratio of R/M are unlikely to capture the payment shocks. It is

necessary to relate the size of reserves and short-term external debt in case of EMCs

(Greenspan, 1999). The buildup of short-term debt has been found as a key indictor of

illiquidity in the financial crises such as that of Mexico in 1994-1995, East Asia in

1997-1998, and Russia and Brazil in 1998-1999 (Dadush et al., 2000; Hawkins and

Klau, 2000).

The importance of understanding reserve-to-short-term-ratio (R/STED) to

assess adequate international currency reserve levels for EMCs is increasingly obvious

for the following reasons:

1 The country with low R/STED ratio is likely to be vulnerable to speculative attacks

or external shocks which is likely to hurt investor confidence;

2 If the ratio is low the current account and exchange rate adjustments required to

balance the macroeconomic accounts are magnified and the crisis may be severe;

and

3 There is a general benefit to the international community with substantial benefits

for maintaining the minimum desired level, since the need for a “bail-out package”

could be reduced.

Bail-out packages are usually linked to the level of a country's short-term liabilities

in relation to international reserves (Calafell and Bosque, 2003). Pablo Guidotti[3], the

former Deputy Minister of Finance – Argentina, has been credited to suggest that

countries should manage their external assets and liabilities without foreign

borrowings for a year. This has come to be known as “Guidotti-rule.”

Later, Greenspan (1999) suggested two enhancements to the “Guidotti-rule”; first, the

average maturity of external liabilities of an economy should exceed a threshold figure

of about three years. Second, include liquidity as a risk standard, which will include an

economy's external liquid position. This policy is similar to the value-at-risk

methodology as used by commercial banks.

In both Guidotti-rule and Greenspan's enhancements, the R/STED fails to

include the effects of internal drain of reserves due risk of capital flight by residents.

This effect may best be captured by including M2 – measure of broad money

supply[4]. Whereas many emerging market retain a mixed system of restrictions and

flexibilities with regards to the capital movement, primarily associated new technology

and financial instruments, they may find it difficult to avoid capital flight during a

crisis (Wijnholds and Kapteyn, 2001). EMCs have been widely recognized as focusing

more on capital account liberalization approach in response to external debt crisis such

as India experienced in 1991 (Nayyar, 2000). This justifies the use of the broad money

supply measure in any assessment of reserve adequacy levels.

However, not all countries, including the emerging markets, face the same

probability of capital flight risk. As discussed earlier, investor confidence is likely to

be well-founded for countries with good economic, financial and political

fundamentals. Hence, to factor for risk of external drain of non-rolled over short-term

external debt and internal drain of capital flight, the country risk index can be used.

The risk index is based on several factors which measure the economic, political and

financial risks of conducting business in a particular foreign country.

2.4.3 RATIONALE FOR HOLDING RESERVES

Global official reserves have increased significantly and quite rapidly in recent

years. This phenomenal growth is a reflection of the enormous importance countries

attach to holding an adequate level of international reserves. The reasons for holding

reserves include the following:

1. TO SAFEGUARD THE VALUE OF THE DOMESTIC CURRENCY

Foreign reserves are held as formal backing for the domestic currency. This use

of reserves was at its height under the gold standard, and survived after the Second

World War under the Breton woods system. After the Breton Woods system, the use of

foreign exchange reserves to back and provide confidence in domestic currency

replaced the gold. Nevertheless, for most developed countries this is not, these days,

the prime use of reserves.

2. TIMELY MEETING OF INTERNATIONAL PAYMENT

OBLIGATIONS

The need to finance international trade gives rise to demand for liquid reserves

that can readily be used to settle trade obligations, for example to pay for imports.

While this is typically done through commercial banks, in many developing countries,

including Nigeria, the central bank actually provides the foreign exchange through

auction sessions at which authorised dealers buy foreign exchange on behalf of

importers. In industrialized countries where the manufacturing sector produces for

export markets, the transaction need for holding reserves is less important.

3. WEALTH ACCUMULATION

Some central banks use the external reserve portfolio as a store of value to

accumulate excess wealth for future consumption purposes. Such central banks would

segregate the reserve portfolio into a liquidity tranche and a wealth tranche, with the

latter including longer-term securities such as bonds and equities and managed against

a different benchmark emphasizing return maximization.

4. INTERVENTION BY THE MONETARY AUTHORITY

Foreign exchange reserves can be used to manage the exchange rate, in

addition to enabling an orderly absorption of international money and capital flows.

The monetary authorities attempt to control the money supply as well as achieve a

balance between demand for and supply of foreign exchange through intervention (i.e.

offering to buy or sell foreign currency to banks) in the foreign exchange markets.

When CBN sells foreign exchange to commercial banks, its level of reserves declines

by the amount of the sale while the domestic money supply (in naira) also declines by

the naira equivalent of the sale. Conversely, when the CBN purchases foreign

exchange from the banks its level of reserves increases while it credits the accounts of

the banks with the naira equivalent, thus increasing the domestic money supply.

5. TO BOOST A COUNTRY’S CREDIT WORTHINESS

External reserves provide a cushion at a time when access to the international

capital market is difficult or not possible. A respectable level of international reserves

improves a country’s credit worthiness and reputation by enabling a regular servicing

of the external debt thereby avoiding the payment of penalty and charges. Furthermore,

a country’s usable foreign exchange reserve is an important variable in the country risk

models used by credit rating agencies and international financial institutions.

6. TO PROVIDE A FALL BACK FOR THE “RAINY DAY”

Economies of nations sometimes experience drop in revenue and would need

to fall back on their savings as a life line. A good external reserves position would

readily provide this cushion and facilitate the recovery of such economies.

7. TO PROVIDE A BUFFER AGAINST EXTERNAL SHOCKS

External shocks refer to events that suddenly throw a country’s external

position into disequilibrium. These may include terms of trade shocks or unforeseen

emergencies and natural disasters. An adequate external reserve position helps a

country to adjust quickly to such shocks without recourse to costly external financing.

2.4.4. SOURCES OF NIGERIA’S EXTRERNAL RESERVE

Nigeria’s external reserves derive mainly from the proceeds of crude oil

production and sales. Nigeria produces approximately 2,000,000 barrels per day of

crude oil in joint venture with some international oil companies, notably Shell, Mobil

and Chevron. Out of this, Nigeria sells a predetermined proportion directly, while the

joint venture partners sell the rest. The joint venture partners pay Petroleum Profit Tax

to the Federal Government through the Federal Board of Inland Revenue.

The five categories of revenue from crude oil production and sales are:

1 Direct Sales (NNPC)

2 Petroleum Profit Tax (Oil Companies)

3 Royalties

4 Penalty for Gas Flaring

5 Rentals Other sources of external reserves in Nigeria include:

2.4.5 COMPOSITION OF EXTERNAL RESERVE

A number of items constitute the external reserve of a country which includes

mainly gold, foreign currencies (i.e. notes and coins) Special Drawing Rights (SDRs)

and the Reserve Tranche at the International Monetary Fund (IMF).

It also could include balance of payable on demand held with financial institutions

abroad, bill of exchange and promissory notes dominated in foreign currencies,

treasury bills issued by foreign governments and marketable securities issued or

guaranteed by foreign government or International Financial Institution.

The Central Bank of Nigeria Act 1991 vests the custody and management of the

country’s external reserves in the Central Bank of Nigeria (CBN). The Act provides

that the CBN shall at all times maintain a reserve of external assets consisting of all or

any of the following:

a) Gold coin or bullion;

b) Balance at any bank outside Nigeria where the currency is freely convertible and in

such currency, notes, coins, money at call and any bill of exchange bearing at least two

valid and authorized signatures and having a maturity not exceeding ninety days

exclusive of grace;

c) Treasury bills having a maturity not exceeding one year issued by the government of

any country outside Nigeria whose currency is convertible;

d) Securities of or guarantees by a government of any country outside Nigeria whose

currency is freely convertible and the securities shall mature in a period not exceeding

ten years from the date of acquisition;

e) Securities of or guarantees by international financial institutions of which Nigeria is

a member, if such securities are expressed in currency freely convertible and maturity

of the securities shall not exceed five years;

f) Nigeria’s gold tranche at the International Monetary Fund;

g) Allocation of Special Drawing Rights made to Nigeria by the International

Monetary Fund (IMF).

For proper understanding of the external reserve composition, the SDRs and the

“Reserve currency” shall be overviewed.

2.4.6 THE SPECIAL DRAWING RIGHTS

A Major development in the International Money System occurred in 1970

when a new international asset appeared. This development was the introduction of

the SDRs by the IMF. Unlike gold and other International reserve assets, the SDRs is

a paper asset (sometimes called “paper gold”) created out of thin air by the IMF.

On January I 1970, the IMF simply entered on the books of all participating member a

total of $3.5 billion worth of SDRs. The SDRs itself was defined as equal in value to

one US dollar. The total of $3.5 billion was divided among members’ countries in

proportion to the share of total IMF quotas of each member country. Additional SDRs

have been created on several occasions since 1970.

The SDRs that a country receives in an allocation add to international reserve

and can be used to settle BOP deficit in a fashion similar to any type of international

reserved asset. For example, if India needs to obtain Japanese Yen to finance a deficit,

it can do so by swapping SDRs for yen held by some other country (e.g. France) that

the IMF designates. Thus, the SDRs could help to alleviate the liquidity problem.

Further, since the SDRs is not a national currency, and since it might eventually

replace national currencies, like the dollar in reserve portfolios, the new instrument

could potentially alleviate the confidence problem.

In the India example above, where SDRs were exchange for yen, a skeptic might

question why France would be willing to part with some of its yen in exchange for a

book keeping entry paper asset. This question goes to the heart of a more basic

question; “why do some asset serve as money while others do not?” The answer to

this more basic question is that an asset serves as money if it is generally acceptable in

exchange”. One party to a transaction will accept the asset if that party knows that he

too can use the asset to acquire other asset. SDRs have become “International Money”

because the recipient of the SDRs knows that he can use them to acquire other

currencies form other countries later. Further, in the SDRs scheme, each participant

agrees to stand ready to accept SDRs to the extent of twice is accumulated SDRs

allocation.

Another feature of SDRs is that, if a country is not a recipient of SDRs meaning that it

holds more than it has been allocated by the IMF, it receives interest on its excess

holdings. Similarly, if a country holds less than its allocation of SDRs, that country

pays interest on its shortfall. These rules help to encourage caution in the use of SDRs.

A final aspect of the SDRs concerns its valuation. In the initial allocation of

this new asset, the SDR equal one US dollar with later devaluation of the dollar and

the advent of greater flexibility in exchange raJte during the 1970s, the quantity of the

SDRs and the dollar was discarded. The SDR is now valued as a weighted average of

the value of four (4) currencies: 39 percent for the US dollar

32 percent for the Euro (Replacing the previous 21 percent

for the deutsche mark and 11 percent

for French Francs)

18 percent for Japanese Yen and

11 percent for the British pounds.

By the end of May 2000, accumulated SDRs holding of central bank were 18.1 billion.

2.4.7 THE RESERVE CURRENCY

A reserve currency otherwise known as “Anchor or Primary Currency” is a

currency which is held in significant quantities by many governments and institutions

as part of their foreign exchange reserves. It also tends to be the International Pricing

Currency for product traded on a global market such as oil, gold etc.

Currently, the “US$ Dollar” is the primary reserve currency used by other countries.

A very large percentage of commodities such as gold and oil are usually priced in US

dollars causing other countries to hold their currency to pay for these goods. A large

debate still continues about whether or not the US dollar will stay the reserve currency

or if it will shift over the time.

The US dollar as the most important reserve currency in the world today shows that

from the midpoint of 2006, 65.4% of the identified official exchange reserve in the

world were held in US dollar,25.4% in Euros, 4.2% in pounds sterling 3.3% in

Japanese yen.(IMF,2006). For this reason, the US dollar is to have reserve currency

status, making it possible to run significant trade deficit (financed by seigniorage) with

limited economic impact as long as the major holders of reserve currencies do not

issue public statements suggesting otherwise.

The pound sterling was the primary reserve currency of much of the world in

the 18th and 19th centuries. But perpetual current account and fiscal deficits financed

by cheap credit and sustainable monetary and fiscal policies and relative decline of

British from the world pre-eminent military and economic power led to the pound

sterling loosing these status. The Japanese yen has been on decline as a reserve

currency for the past decade. The Swiss Franc is often included in the mix as well due

to its perceived stability.

The Euro is currently the second most commonly traded reserve currency and is a

strong candidate to display the dollar as the prominent reserve currency, although, it

may instead co-dominate. Since the Euro was launched in 1999, (largely replacing the

Deutsch Mark, as the major reserve currency), its contribution to official reserve has

risen automatically as banks seek to diversify their reserves and trade in the Euro zone

continue to expand.

Other nations and groups of nations have expressed their desire to see their currency or

future currency being used as reserve currency, such as Russian and the Gulf

corporation council.

2.4.8 OWNERSHIP STRUCTURE OF NIGERIA’S EXTERNAL RESERVE

Nigeria’s external reserves comprise of three components namely, the

federation, the federal government and the Central Bank of Nigeria portions. The

Federation component consists of sterilized funds (unmonetized) held in the excess

crude and PPT/Royalty accounts at the CBN belonging to the three tiers of

government. This portion has not yet been monetized for sharing by the federating

units. It is sometimes ignorantly referred to as the reserves of the country. The Federal

Government component consists of funds belonging to some government agencies

such as the NNPC; for financing its Joint Venture expenses, PHCN and Ministry of

Defence; for Letters of Credit opened on their behalf, etc. The CBN portion consists of

funds that have been monetized and shared. This arises as the Bank receives foreign

exchange inflows from crude oil sales and other oil revenues on behalf of the

government. Such proceeds are purchased by the Bank and the Naira equivalent

credited to the Federation account and shared, each month, in accordance with the

constitution and the existing revenue sharing formula. The monetized foreign

exchange thus belongs to the CBN. It is from this portion of the reserves that the Bank

conducts its monetary policy and defends the value of the Naira.

2.4.9 USES OF FOREIGN RESERVES IN NIGERIA

External reserve simple defined is a nation’s accumulate savings usually in

international currencies and kept in various international banks for future use. The

Nigeria’s external reserve that reached a peak of $63billion in September 2008 from $

4.98billion in 1999 has dropped to $52.7billion as at 2nd January, 2009; and even

dropped further to $ 43.3billion as at July ending.

The decrease is of no double the effects of the twin devils of continuous dwindling

prices of crude oil in the international market and the global financial crisis that has

dried up influx of foreign currency in the financial market. This has left the central

bank of Nigeria (CBN) as the sole provider of international trading currencies out of

the available foreign reserve. Furthermore, this has heightened the recent depreciation

of the naira because of the inability of (CBN) to meet the market demand. Also, was

meant to help protect the nations dwindling falling reserves and to prevent the

depletion of the reserves by strengthening the dollar. The external reserves as

maintained by the (CBN) enable it to regulate international money and capital flow,

this it does sometimes through achievement balance in supply and demand of foreign

exchange. Manufacturer and importers are constantly in need of liquid international

currencies from the commercial bank to pay for imported raw material used in

production. The commercial and other authorized dealers that are the source of

providing these international currencies get them from the (CBN) through auction

section which is then sold to finance international trade unlike industrialized nations,

where their manufacturing sectors produce for exports and thus do not overtly depend

on their reserve. The foregoing means that (CBN) maintain the foreign reserve for

purpose that include finance for import.

The external reserves also serves as a buffer for Nigeria in the world international

market as we are currently experiencing the recent global crisis that has affected most

industrialized with its resultant effect creping into our economic situation. The level of

our reserve is sufficient enough to help the country weather the storm of recession that

is taking over the globe for a period of time and the level of our reserve can also

encourage foreign investment because of naira.

Central Bank of Nigeria maintains external reserves as another window of savings and

investment for the country whereby the revenue from crude oil in the international

market above the budgeted benchmark had been constantly kept as part of an

agreement between the three tiers of government as savings in international banks.

The attainment of over $50 billion in our reserve was due to the steady increase in the

price of crude oil during the last eight years and also the increase in the volume of our

non-oil export. The savings is meant for the country to have something to fall back on

when there is a reduction in the revenue generating capacity of the country.

In the same vain, the health of our nation’s external reserve serves as an

indicator to its credit worthiness in the international capital market. Nigeria as recently

deemed credit worthy to receive loans from international financial institution because

of the level of the nation’s reserve as can be seen when the IMF encourage her to

receive a loan of $500 million in November last year for infrastructural development

which was reflected by the National Assembly for fear of being plunged into another

debt of situation when we just managed to come out of one. The reserve can also be

use for servicing loan obligation in which the neglect can increase debt of a country as

had been witnessed in the past three decades. Nigeria now has an external loan of

about $3 billion after the debt relief and payment of the nation’s external loan owed

both the Paris and London clubs in 2003 and 2004 respectively.

One of the key challenges for Nigeria over the last eight years, especially under

a civilian administration was how to manage the phenomenal growth in foreign

exchange reserves resulting from the sustained high international oil prices. Broadly

speaking, there are four main options to which the reserves could be used:

1 Current consumption

2 Accumulate reserves in the short to medium term

3 Pay off foreign debt and

4 Set-up a Fund for the Future The selection and mix of the options was done within

the context of the national economic reform agenda. Specifically, Nigeria’s

external reserves are deployed to two major categories of uses, namely; public and

private sector uses.

Public Sector Uses

1 Debt Relief Deal

2 Paris Club - USD12.4 billion

3 London Club - USD0.5 billion •

4 Annual Debt service payments (now mainly Multilateral Institutions)

5 WDAS sales in respect of States and other Government agencies

6 Joint Venture Cash call payments

7 Infrastructural development (Power, Railway/Roads)

8 Contributions and subventions (International Organizations & Nigerian Embassies

and High Commissions)

9 Other public sector uses (Estacodes, Government LCs)

Private Sector Uses

Private Sector Uses include: WDAS sales in respect of private sector

institutions/individuals Sale of FX to Bureau de Change (including banks).

2.4.10 MONETIZATION OF RESERVES.

Monetization involves the purchase of foreign exchange receipts by the Central

Bank of Nigeria from the federation. Every year, the Federal Government sets a

benchmark oil price for its budgeted revenue. The federation receives naira from the

Central Bank of Nigeria in exchange for foreign exchange receipts within the

benchmark price. Every month, the Federation Accounts Allocation Committee

(FAAC) sits to share the monetized reserves and other revenues accruing to the

federation.

2.4.11 THE NIGERIA EXTERNAL RESERVE POSITION AND CRUDE OIL

PRICES (2007-2009)

The nations external reserve recorded mixed performance in the fourth quarter

of 2008, with an impressive surge in oil (to about US$63 billion) followed by two

months of slide. Stock of external reserves stood at about US$52.76 billion as at

December 2008, capable of financing 15 months of imports.

In the proceeding quarters, foreign exchange reserve reached an all time high

level of US$64 billion in August when oil prices were recorded high. By US$11

billion. The authority attributed the drop to the share drop in the prices of crude oil,

recalling of credit/trade facilities by foreign banks, lower inflow of direct portfolio

investment, relatively cheaper asset abroad, amongst other factors. In the upcoming

quarters, the reserve could be strained further, as the apex bank has indicated its

readiness to use part of it to stabilize the naira.

Crude oil prices in the international market crashed in an unprecedented

fashion in the fourth quarter of 2008, plummeting to a year low of about US$34 per

barrel in December. Crude oil tumbles almost US$115 a barrel from its July record

level of US$147.27. Thirst for oil in the first and second quarter led to surging prices,

driven by high demand in countries such as China and India. In the third and fourth

quarter, however, fear of sustainable global economic hitting hard on the revenues of

major producers.

Nigeria brand of crude oil, Bonny light, dropped about US$49 in the fourth quarter

from US$99 per barrel in October to US$44 as at the end of December. Industrial

analyst attributed the plunge to the effect of recession in major economies, lower

demand from power house economies, such as UsA, China and India, rising global

inventories and the growing trends of the dollar. Concerned about dwindling revenues,

OPEC announced it deepest cut ever of about 1.5 and 2.2 million barrels per day in

October and December respectively.

The move was however, insufficient to stem the plunge as a market drifted to about

US$40 dollar by the end of the year, 2008.

The economy has overdependence on the capital intensive oil, which provides 80% of

total GDP, 95% of external reserve earnings and about 60% of government revenue.

The Nigerian external reserve stood at US$46.54 billion as at 31st December, 2009.

2.5 THEORETICAL FRAMEWORK

According to the International Monetary Fund (IMF, 2004) guidelines for

foreign reserve management, official foreign reserves are held in support of a range of

objectives such as:

1 Support and maintain confidence in monetary and exchange rate policy, including

the capacity to conduct foreign exchange interventions;

2 Limit external vulnerability by maintaining foreign currency liquidity to absorb

shocks during times of crises or when access to borrowing is curtailed;

3 Provide a level of confidence to markets that a country can meet its external

obligations.

4 Building on these guidelines, three theoretical foundations for reserve

accumulation especially by developing countries are appraised. They include:

2.5.1 THE BUFFER STOCK MODEL

The earlier literature focused on using international reserves as a buffer stock,

part of the management of an adjustable-peg or managed-floating exchange rate

regime. Accordingly, optimal reserves balance the macroeconomic adjustment costs

incurred in the absence of reserves with the opportunity cost of holding reserves

(Frenkel and Jovanovic 1981). The buffer stock model predicts that average reserves

depend negatively on adjustment costs, the opportunity cost of reserves, and exchange

rate flexibility, and positively on GDP and reserve volatility, driven frequently by the

underlying volatility of international trade. Overall, the literature of the 1980s

supported these predictions (see Flood and Marion 2002).

Post 1998 trends in hoarding reserves, especially the large increase in hoarding

international reserves in East Asia, stirred lively debate among economists and

financial observers. Although useful, the buffer stock model has a limited capacity to

account for the recent development in hoarding international reserves—the greater

flexibility of the exchange rates exhibited post 1990 should work in the direction of

reducing reserve hoarding, in contrast to the trends reported earlier. As an indication of

excess hoarding, some observers noted that developing countries frequently borrow at

much higher interest rates than what they earn on reserves.

2.5.2 CRITICISM OF THE BUFFER STOCK MODEL

This development stirred lively debate among economist and financial

observers. While useful, the buffer stock model has limited capacity to account for the

recent development in hoarding international reserves, the greater flexibility of the

exchange rate exhibited in the recent decades should walk in the direction of reducing

reserves hoarding, in contrast to the trend reported above.

As an indication to excess hoarding, observers noted that developing country

frequently borrow at much higher interest rate than the one paid on reserve. The recent

literature provided several interpretation for these puzzles, focusing on the observation

that the deeper financial integration of developing countries has increased exposure to

volatile short term inflow of capital (dubbed “hot money”) subject to frequent sudden

stops and reversals (Calvo, 1998). Looking at the a980s and 1990s, Aizenmann and

Marion (2004) pointed out that, the magnitude and speed of the reversal of capital

flows throughout the 1997 to 1998 crisis surprised most observers. Most viewed East

Asian countries as being less vulnerable to the perils associated with money than Latin

American countries. After all, East Asian countries were more open to international

trade, had sounder fiscal policies, and much stonger growth performance. In

retrospect, the 1997-8 crises exposed hidden vulnerabilities of East Asian countries,

forcing the market to update the probability of sudden stops affecting all countries.

2.5.3 THE PRECAUTIONARY ADJUSTMENT APPROACH

From the criticism of the buffer stock model, it is clear that the observations

suggest that hoarding international reserves can be viewed as a precautionary

adjustment, reflecting the desire for self insurance against exposure to future sudden

stops.

The first focus on precautionary hoarding of international reserves needed to

stabilize fiscal expenditure in developing countries (Aizenmann and Marion, 2004).

Specifically, a country characterized by volatile output, inelastic demand for fiscal

outlay, high tax collection cost and sovereign risk may want to accumulate both

international reserve and external debt. External debt allows the country to smooth

consumption when output is volatile. International reserves that are beyond the reach

of creditors will allow such a country to smooth consumption in the event of adverse

shocks trigger a default on foreign debt.

Political instability, by taxing the effective returns on reserve can reduce desire current

reserve holdings. The test reported by Aizenmann and Marion (2004) are consistence

with this interpretation.

Another version of self insurance and precautionary demand for international

reserve follow the earlier work of Ben-Bassat and Gottlieb (1992), viein international

reserve as output stabilizers, also recent works of Aizenmann and Lee (2005),

international reserves applying the option pricing theory; the insurance perspective.

Accordingly, international reserve can reduce the possibility of an output drop induced

by a sudden shock and/or the depth of the output collapse when sudden stops

materialize (Kamisky and Reinhart, 1999).

2.5.4 THE MORDERN MERCANTILISM APPROACH

The Mercantilist model posits that many countries accumulate foreign reserves as a

means for effective exchange rate management and as a tool for maintaining low

exchange rates in order to promote trade and international competitiveness (Durdu et

al., 2007). On this model, Yeyati (2008) also noted that one reason for the recent surge

in the stock of foreign reserves in developing countries is to prevent real exchange rate

appreciation as a result of capital inflows, either due to the ‘mercantilist’ objective of

preserving competitiveness or to avoid a potential overvaluation that may eventually

create downside risks.

2.5.6 MACROECONOMIC STABILIZATION THEORETICAL MODEL

Macroeconomic stabilization remains at the fore of national economic policymaking in

order to aid conditionality in developing countries especially in Africa. This has

induced African countries to hold reserves to allow monetary authorities to intervene

in markets to influence the exchange rate and inflation (Lapavitsas, 2007; Elhiraika

and Ndikumana, 2007). Many African countries including Nigeria argued that

adequate foreign reserves may allow them to borrow abroad, attract foreign capital and

promote domestic private investment as a result of strengthened external position and

reduced vulnerability to external shocks. Thus, it is believed that maintaining adequate

reserves can boost investors’ confidence and enhance investment and growth

(Elhiraika and Ndikumana, 2007).

2.6 RECENT MACROECONOMIC PERSPECTIVE ON RESERVE

ACCUMULATION

The literature suggests that reserves are held for both transaction and

precautionary motives (Mendoza, 2004). In principle, countries hold reserves in order

to meet unexpected and temporary fluctuations in international payments. Thus, a

country’s demand for reserves will increase with its risk aversion and output volatility

(Gosselin and Nicolas, 2005). There is a relatively stable long-run reserve demand

function that depends on five categories of explanatory variables: economic size,

current account vulnerability, capital account vulnerability, exchange rate flexibility

and the opportunity cost of holding reserve (Gosselin and Nicolas, 2005).

Reserve-holding is expected to increase with economic size and the volume of

international transactions. Thus, in view of the nature of commodity-based production

and exports in Nigeria, both the level and growth rate of output are expected to

influence reserve accumulation. Increased current and capital account vulnerability

should motivate central banks to hold more reserves while exchange rate flexibility

reduces the demand for reserves. The higher the opportunity cost of holding reserves,

ceteris paribus, the lower should be the demand for reserves (Osabuohien and

Egwakhe, 2008). Aizenman and Marion (2003) established that countries with high

discount rates, political instability and political corruption find it optimal to hold

smaller precautionary balances. These three factors are predominant in Nigeria. Hence,

this study becomes relevant because the findings would serve as a check (or otherwise)

for accumulating foreign reserves and reconcile with the CBN’s advocacy. In a more

recent study, Aizenman et al. (2007) interpreted the recent hoarding of international

reserves by East Asian countries as precautionary demands. The study suggested that

precautionary demand depends positively on the ability of international reserves to

mitigate the probability of output collapse induced by sovereign partial default, and the

ability of international reserves to alleviate shortages of fiscal resources in bad states of

nature. They however stated that the present level of international reserves observed in

East Asia may not be optimal. In spite of these motives for reserve accumulation,

empirical literature provides evidence that, today, the level of foreign reserves in some

emerging economies appear excessive with respect to the level inferred by two rules—

(1) rule of thumb (the three months of imports) rule and (2) the Greensan-Guidotti-

IMF rule, which recommends that reserves should enable full coverage of total short-

term external debt in order to pay back the debt in the event of sudden stops (Jeanne

and Ranciere, 2006; Jeanne, 2007; Osabuohien and Egwakhe, 2008).

Current reserves holding do not seem to correspond to the optimal behaviour of

a sovereign that can both choose the levels of debt and hold reserves. Some form of

transaction costs could rationalize countries holding some small amount of reserves

(Alfaro and Kanczuk, 2009). Stiglitz (2006) established that the total opportunity cost

of reserves is roughly equal to the amount of funds needed by developing countries to

finance necessary investments to meet the Millennium DevelopmentGoals (MDGs).

To Stiglitz (2006), developing countries earn 1 to 2 per cent in real return on their $3

trillion reserves whereas they could invest these reserves locally with returns up to 10

to 15 per cent. Thus, assuming a difference of 10 per cent between domestic and

foreign returns, the opportunity cost of holding reserves is

quite high, well in excess of $300 billion per year, i.e. more than 2 per cent of GDP.

A European Central Bank (ECB, 2006) report showed that the build-up of

foreign reserves creates new risks. As the bulk of foreign exchange reserves is held in

US assets and used to finance current account deficits in developed countries, reserve

holding countries become susceptible to risks and costs emanating from adjustments in

reserve currency countries. These risks and costs include inflationary pressures, over-

investments, asset bubbles, complications in the management of monetary policies,

potentially sizeable capital losses on monetary authorities’ balance sheets, sterilization

costs, segmentation of the public debt market, and misallocation of domestic bank

lending. ECB (2006) therefore counsels that developing countries should exercise

active reserve management and diversification to mitigate these risks and costs.

Elhiraika and Ndikumana (2007) however stated that this is

a major challenge in Africa especially for resource-rich countries including Nigeria.

2.7 RESERVE BUILDUP IN AFRICA

2.7.1 Sources of Reserve: Key Balance of Payment (BOP) Identities.

Evidence indicates that the origins of reserve accumulation differ across

countries. In Latin America, a persistent current account deficit was balanced by a

current account surplus for most of the last decade. Larger capital account surpluses

helped some countries such as Brazil and Venezuela to accumulate reserves. Since the

1997 crisis, East Asia has run capital account deficits and continuous current account

surpluses, except for China that maintained twin surpluses (UN-DESA 2007). The first

task in our study involves a careful examination of the sources of reserves

accumulation and factors/determinants of reserves accumulation in African countries.

This exercise allows us to investigate the extent to which reserve accumulation is the

outcome of explicit decisions by the monetary authorities, rather than a result of

exogenous events such as commodity prices, debt forgiveness, or external factors such

as foreign investors’ appetite for domestic assets.

The analysis will be based on the following standard Balance of Payments

(BoP) identities:

OR

Where CA is the current account balance,

KFA the capital and financial account balance, and

RES change in Reserves.

Net errors and omissions are generally added on the left-hand side to account for

statistical discrepancies.

Where: GSA is the balance on goods and services,

IA the balance on income, and

TA the balance on transfers.

For African countries, most of the movement is in the GSA (imports and exports). But

TA also has gained increasing importance due to, among other things, worker

remittances. The capital and financial account balance is given by:

KFA = KA + FA………………………. (4)

Where KA is the capital account balance, which includes debt forgiveness; FA the

financial account, which is equal to the sum of FDI plus portfolio investment and other

investments. Reserves include gold, SDRs, the reserve position in the IMF, and foreign

exchange. The foreign exchange component of reserves includes currency (mainly US

dollars) plus deposits with monetary authorities and banks plus securities (US/foreign

government securities, equity, bonds and notes, money market instruments and

derivatives).

2.7.2 Trends and motivation for Reserve buildup in Africa

Accumulation of foreign exchange reserves by African countries may best be

understood in the context of reserves behavior in developing regions in general. Global

official foreign exchange reserves rose from US$1.2 trillion in January 1995 to

US$5.04 trillion in December 2006, and the share of developing countries in world

reserves increased from 50 to 72 per cent over the same period. This large share needs

explanation especially in view of the fact that developing countries accounted for only

41 per cent of world trade in 2005. The question here is why developing countries

need to accumulate relatively more reserves than developed countries? And how does

reserve accumulation relate to foreign trade and output growth?

The regional breakdown of reserves buildup suggests a positive correlation

between reserves buildup on the one hand and trade and output on the other. On

average the East Asia and Pacific region has accumulated more foreign exchange

reserves than other developing regions over the last decade (figure 1). However, in

addition to relatively high trade-driven growth, the East Asia and Pacific region

witnessed the severest financial crisis in the last two decades. In this context analysts

identify three factors, beside high oil prices, for the buildup of reserves in developing

countries (ECB 2006). The first factor is the need for insurance against future crisis.

The second factor relates to the strong export-led growth in Asia following large

exchange rate depreciation in the region as a result of the financial crisis. Finally

certain features of the domestic financial markets of emerging economies in general

and the Asian markets in particular have stimulated the unprecedented accumulation of

reserves.

These include weak financial intermediation between domestic savers and

investors and inefficient hedging markets; the tendency towards dollarization of

international assets; and excess domestic savings over investment. The accumulation

of official reserves as an outcome as well as a means of integration into global

financial market is a common factor behind the recent reserve buildup in emerging

markets (ECB 2006). Emerging economies, especially in Asia, have had to accumulate

reserves to protect their economies against financial market fluctuations because while

they are major players in international trade, they still lag behind in terms of financial

market development. However, the buildup of reserves creates new risks. As the bulk

of foreign exchange reserves is held in US assets and used to finance current account

deficits in developed countries, reserve holding countries become susceptible to risks

and costs emanating from adjustments in reserve currency countries. These risks and

costs include inflationary pressures, over-investment, asset bubbles, complications in

the management of monetary policy, potentially sizable capital losses on monetary

authorities’ balance sheets, sterilization costs, segmentation of the public debt market,

and misallocation of domestic banks’ lending (ECB 2006).

TABLE 1: Sources of Reserves Accumulation in Africa (US$million)

To mitigate these risks and costs, developing countries must exercise active

reserve management and diversification. This is a major challenge in Africa especially

for resource-rich countries. Ultimately these countries need policies to slowdown

reserves accumulation given the high opportunity costs in terms of returns. These

policies may include adoption of a more expansionary fiscal policy emphasizing

productive public investments, macroeconomic measures to enhance domestic demand

and regional demand, domestic and regional financial market development including

bond market development, increased exchange rate flexibility together with money

market reforms, and regional economic and monetary cooperation (ECB 2006:3).

The trend of foreign currency reserves relative to imports and external short-term debt

clearly illustrates the strong influence of the recent factors discussed above in relation

to reserves accumulation in Africa. In all the developing regions, reserves have

generally increased as a ratio of imports of goods and services during the last ten years

(Figure 2). This ratio is an indicator of the country’s current account vulnerability and

it is generally held that a ratio of 3 to 4 months is considered adequate for the country

to finance its imports. On average official reserves in Africa rose from the equivalent

of about two months of imports in 1990 to about 5 months in 2004. This suggests that

on average reserve holdings of African countries are just adequate. But the average

reserve-import ratio masks huge variations across African countries. For example,

Algeria had total reserves, excluding gold, of $66.1 billion (the equivalent of 32

months of imports) in 2006 compared to $56.3 billion (34.5 months of imports) in

2005, while Morocco had $17.7 billion (10.1 months of imports) in 2006 and $16.2

billion (10.3 months of imports) in 2005 (UNECA 2008). For Chad and Eritrea,

foreign exchange reserves represented only two months of imports in 2006. For the 40

African countries with available data, reserves represented 10 months of imports in

2006. The respective import cover for oil-exporting and oil-importing countries was 15

months and 5 months. This raises the question of why some African countries are

accumulating excess reserves in recent years and what policies they should adopt to

avoid this in the future.

The literature suggests that a ratio of reserve to short-term external debt of

more than one indicates adequate capacity of the country to service its external

liabilities and face unexpected financial risk in case of deteriorating external financial

conditions. Conversely a ratio of less than one indicates vulnerability to capital

account risks (IMF 2003). Figure 3 shows that since around 2004 this ratio has risen

above 2 for African countries. By 2005, on average, African reserves as a ratio of

short-term external debt exceeded that of all other developing regions with the

exception of South Asia. The higher ratios for relatively poorer developing regions

may reflect greater desire for self insurance against external shocks.

The above ratios underline reserve adequacy in African countries in general, but they

cannot explain the recent strong upward trend of reserves among resource-rich

countries in particular. Indeed, figure 4 shows that oil-exporting African countries

have accounted for about 75 per cent of total African reserves in 2005-2006. Tables

A2 to A5 on reserve accumulation and composition distinguishing between oil-rich

and non-oil-rich countries. Oil-exporting countries are also the main recipients of

private capital flows, especially FDI. Noting that none of the top 10 countries in terms

of reserve-GDP ratio is a high aid recipient county, it is clear that commodity revenue,

especially oil revenue, and related private capital inflows are the key source of reserve

buildup in Africa.

TABLE 2:

Sources of Reserve accumulation in Africa US$ million (oil Rich countries)

TABLE 3: Sources of Africa Reserve accumulation in Africa US$ million

(Oil Rich countries)

TABLE 4: Sources of Africa Reserve accumulation US$ million

(Non-Oil Rich countries)

Reserve accumulation could also be the result of as well as an instrument of

attracting aid flows when donors perceive reserves as a signal of sound

macroeconomic management. Both private and official capital flows to Africa

increased especially since 2002 but at a rate far less than the rate of reserve growth

(Figure 5). In fact official flows have leveled off in the last 3 years.

2.7.3 Sources and Composition of African Foreign Exchange Reserve

The figures in table 5 shows that the 21 African countries for which detailed

data exist have recorded very high rates of growth of foreign exchange reserves since

the turn of this century. Reserve flow is the sum of the current account balance and the

capital and financial account balance. This sample of African countries as a group

recorded current account surpluses for most of the period under review, mainly

because of high current account surplus in resource-rich countries and net transfers; the

income balance has always been in deficit.

Regarding the capital and financial account balance, while the capital account

switched between surplus and deficit over the years, the financial account balance has

shown net financial inflows to Africa since 1990. These financial flows, including

ODA and increasing remittances by African nationals working abroad, contributed to

the high rate of reserves accumulation during this period. Overall sustained current and

capital account surpluses in mainly resource-rich countries are behind the high growth

in reserves in Africa. However, exchange rate policies that favor overvalued currencies

are perhaps the root cause of the general trend in the continent. Large reserve holding

countries in Africa in particular need to carefully assess the risks relating to the

security of their reserves as well as the opportunity costs in terms of investment and

growth. In fact maintaining large stocks of reserve and overvalued exchange rates at a

time of low trade capacity encourages imports of consumer goods and retards

investment, economic diversification and growth. The composition of African reserves

highlights high exposure of reserve holders to global financial risks. Over the last few

years, more than 95 per cent of African non-gold reserves were held in foreign

exchanges including currency (mainly the US dollar) and deposits with monetary

authorities and banks and securities (US/foreign government securities, equity, bonds

and notes, money markets, derivatives). Thus the value of African reserves is expected

to change with fluctuations in the reserve currency (especially the US dollar) or wider

global financial market fluctuations. The safest reserve asset, treasury bills, pays the

lowest rates of return. Again this makes efficient reserve management a top priority for

reserve holders.

TABLE 5: Reserves and selected economic indicators for 21 African countries,

1980-2005 (average)

CHAPTER THREE

RESEARCH METHOD

3.1 INTRODUCTION

The study adopts both economic assessment and econometric model in

evaluating and analyzing the determinants of external reserve in developing

economies, taking the Nigerian case in both the short and long run deterministic

equilibrium.

Accordingly, countries hold external reserves in foreign currencies in order to

maintain a desirable exchange rate policy by interfering significantly in foreign

exchange market optimal reserve conventional indicators (determinants) are based on

current account instability which is appropriate for developing countries, coupled

especially with the Nigeria payment vulnerability due to trade related shocks (Biro and

Rajan, 2003).

The econometric model will be used to determine the relationships between the

external reserves and some selected macro-economic variables (Gross domestic

product, exchange rate, balance of payment, and exported crude oil production);

towards adopting a policy option.

The methodology adopted is based on the improvement suggested on the

recommendation by Guidotti and Greenspan (Wijnholds and Kapteyn, 2001, Bird and

Rajan, 2003) whose work and suggestion is a good starting point for this study, by

examining the long run effect of external reserve determinant on developing

economies, taking the Nigerian case. The following are three indicators proposed by

them; trade-based indicator, money-base indicator and Debt-based indicator.

Basically, external reserve is a function of macro-economic variables, while

this study examine the econometric model, analysis will be made on the economic

assessment of Nigeria external reserve using the excess value of reserve or the excess

holding represented by the difference between external and 3 multiplied the value of

external reserve and divided by the value of import equivalent.

3.2 MODEL SPECIFICATION

The model for this paper assumes an underlying relationship between same

macroeconomic variable that can influence or determine the level of external reserves

(ER). This is informed by information gained in literature and the theoretical

foundation on foreign reserves, which were discussed in previous chapter.

For the purpose of this study, the model relating external reserve determinants,

taking the Nigerian case is specified as follows:

The explicit form of equation 1 is represented as:

Where:

ER= External Reserve

GDP= Gross Domestic Product

EXR= Exchange Rate

BOP= Balance of Payment

COP= Crude Oil Production

µ= Stochastic Disturbance (Error term)

f = Functional relationship

β0 - β4 = Parameters

Specifying the model by log – linearizing, it becomes;

Log (ER) = β0 + β1log (GDP) + β2 log (EXR) + β3log(BOP)+ β4 log(COP) + µ .....

(3)

Where :

log = Natural log

β0 = Intercept of the relationship in the model

β4 - β4= Coefficients of each variables.

From equation (3), the model can be specified in a time series from as:

Log (ER)t= β0 + β1 log (GDP)t + β2 log (EXR)t + β3 log (BOP)t + β4 log (COP)t +

µ ......(4)

From equation (3), an error correction (ECM) model formulation can be express as:

Where:

Error Correction term

t-1 meaning the variables were lagged by one period

White Noise Residiual

To test the existence of long run relationship, equation (5) can be conducted by

placing some restriction some restrictions on estimated long run coefficient of variable.

Hence, the hypothesis for the test is formulated as follows:

3.3 ESTIMATION TECHNIQUES

The Augmented Dickey Fuller (ADF) test of unit roots will be employed to test

for the presence of unit roots and order of integration of time series data. The presence

of unit roots culminated in the need to further test for co-integration between the

variables. The Johnson’s co-integration framework will be adopted with respect to the

ECM model specified for the model.

Once co-integration is established, alongside its extent and form, the next step

is to develop an over parameterized autoregressive distributed (ADL) model (ECM1)

and a Parsimonious Error Correction Model (ECM2) that incorporates long-term

equilibrium relationship and the short run dynamics.

The choice of the technique is the ability to determine the long run

determinants and relationship among the variable unlike the traditional regression

analysis prone to spuriousity of result, and short run result oriented.

3.4 ESTIMATION PROCEDURE

3.4.1 THE UNIT ROOT TEST

There has been a move in recent times towards the issues of unit roots,

cointegration and error correction modeling in econometric analysis of time series

data.

Classical econometric theory assumed that t underlying data processes are stationary.

However, most economic variables have been shown to be non-stationary. In other

words, the means and variances are not constant. For valid estimation and inference to

be made, a set of non-stationary variables must be co-integrated. This means that a

linear combination of these variables that is stationary must exist (Woods, 1995)

The starting point in the unit root (stochastic) process is

Yt = ρ∆Yt-1 + Ut .........................(i)

- 1 ≤ ρ ≤ 1

Where Ut is a white noise error term.

To allow for the various possibilities, the Dickey Fuller test is estimated in three

different forms, that is, under three different null hypothesis is defined as:

Yt is a random walk ∆Yt = ∂ Yt-1 + Ut .......................... (ii)

Yt is a random walk with drift ∆ Yt = β1 +∂ Yt-1 + Ut ….................. (iii)

Yt is a random walk with ∆ Yt = β1 + β2t + ∂ Yt-1 + Ut .. ........ (iv)

drift around a stochastic trend

Where: t is the time or trend available

Ut is a white noise error term

In each case, the null hypothesis is that ∂ = 0; that is there is a unit root, hence the time

series is non-stationary. The alternative hypothesis is less than zero, that is, the time

series is stationary.

3.4.2 THE ERROR CORRECTION MODELLING (ECM)

The ECM modeling procedure involves estimation of the external reserve

function in an unrestricted form, after which it is progressively simplified by

restricting statistically insignificant coefficient to zero until a parsimonious

representation of the data generation process is obtained.

The aim is to minimize the possibility of estimating spurious relations, while at the

same time retaining long-run information. The major advantage of this methodology

is that it yields an equation with a stationary dependent variable which also

appropriately retains long run information in the data. In applying this estimation

technique, we set the initial lag length on all the variables in the unrestricted equation

at one period. This is the maximum to go in order to preserve the degree of freedom.

The ECM is mode of models in both the levels as differences of variables and

is compatible with long run-equilibrium behaviour. The notion of an ECM is a very

powerful organising principle in applied econometrics and has been widely applied to

such important problems in developing economies.

The steps involved in the process were as follows:

i. Studying the temporal characteristics of the variable in the external

reserve function. This basically involves testing for unit root for the

entire time series variable in the model.

The presence of a unit root implies that the series under investigation is a non-

stationary while the absence of a unit root shows that the stochastic process is

stationary; using Augmented Dickey Fuller for this purpose (Dickey and Fuller, 1981)

ii. Formulating the static (long-run) theoretical relationship and test for

stationary among non-stationary series of the same order. We employed

the Johansen Cointegration procedure, while relying on both the Trace

and Maximum – Eigen statistic to determine the cointegration rank

(Johansen, 1991)

iii. Estimating the error correction or dynamics (short run) representation

of the relationship and test for the adequacy of the resulting equation.

This short run equation includes the lagged error term and a regressor. This is to

correct any deviation from long run equilibrium.

Conclusively, if actual equilibrium value is too high, the error correction term

will reduce it, while if it is too low, the error correction will raise it.

3.5 DATA SOURCES

The external reserve equation was estimated using annual data for the period of

1970-2007. The study basically employ secondary data to obtain the desired variables,

and also textbooks, journals, magazine and other related materials were employed.

Sources of these data include:

i. Central Bank of Nigeria (CBN’s) Statistical Bulletin

ii. Central Bank of Nigeria (CBN’s) Annual report and Statement

iii. Extracts from E-journals

iv. Zenith Quarterly Publications for variables update

v. Textbook and other foreign publication.

3.6 DATA JUSTIFICATION AND APRIORI EXPECTATION

1. External Reserves

The country’s external reserves are in liquid external assets under the control of

Central Bank. It consists of Gold, the country’s reserve position with IMF, the special

drawing rights (SDRs), and foreign exchange. It is proxied as the dependent variable.

2. Gross Domestic Product (GDP)

The GDP is the country’s overall monetary transaction for a given year. It is

proxied in the model to capture the economic size and wealth against the ER. It is

expected to be positively related to ER, as an underlying principle of “economic size

increases reserve”.

The apriori expectation is mathematically represented as

ER = f (GDP)

∂ER > 0

∂GDP

3. Exchange Rate (EXR)

The EXR measures the vulnerability of changes of the naira to the major

currency (i.e. the dollar N/$). It is a very important variable in the model because it

reflects the responsiveness of the changes in EXR to its effect on the ER. It is

expected that an increase (decrease) in EXR will cause the ER to decrease (increase),

indicating an expected negative relationship. This is represented as:

ER = f (EXR)

∂ER >< 0

∂EXR

If ∂ER > 0

∂EXR - it means an increase in EXR or conservation of ER

3. Balance of Payment (BOP)

The value of the BOP is purposely included in the model to reject the effect of

“Trade Balance” on the ER. It has been argued that the balance in importation and

exportation of a country determines its reserve. Hence, the BOP rejects surplus on

deficit of the country’s trade, hence a very important parameter in the model. The

BOP is expected to be positively related with the ER if in surplus, while a deficit BOP

require the withdrawal of the ER to be financed.

Hence, this is represented functionally as:

ER = f (BOP)

∂ER >< 0

∂BOP

If ∂ER > 0 - favourable BOP (Surplus)

∂BOP

But if ∂ER < 0 - unfavourable BOP (deficit)

∂BOP

4. Crude Oil Prices (COP)

The COP is the major variable that reflects the country’s major revenue

earnings. It is purposely included in the model to capture the effect of crude oil

production on the Nigeria external reserve.

Traditionally, with respect to the underlying assumption, taking inferences

from oil-producing nations like U.A.O, Qatar etc, the COP is expected to be positively

related to the country’s ER and significantly increase the savings income, without not

also playing an important role in the economic development.

ER = f (COP)

∂ER > 0

∂COP

CHAPTER FOUR

DATA PRESENTATION AND RESULTS INTERPRETATION

4.1 INTRODUCTION

This chapter deals extensively with the presentation of data which are primarily

secondary data and the analysis interpretation of results. The study examines the

determinants of external reserve in developing economies, in which the Nigeria

economy is given a preference. The data employed for this study are corrected for

necessary adjustment in order to reflect the existence of short and long run equilibrium

among the variables.

The model formulated for the model revealed the External Reserve (ER) as the

dependent variable while the Gross Domestic Product (GDP), Exchange Rate (EXR),

Balance of Payment (BOP), and Crude Oil Price (COP) were proxied as independent

variables, that is, determinants of external reserve.

4.2 DATA PRESENTATION

The data for the study, as expressed are the external reserve(ER) proxied as the

dependent variables while the GDP, EXR, BOP and COP are proxied as the

determinants to be analysed with respect to the ER.

The table showing the data in detail is presented in the appendix

4.3 RESULTS INTERPRETATION AND DISCUSSION

This section presents the result of the findings while the interpretations and

discussions were logically presented.

4.3.1 RESULTS OF STATIONARITY (UNIT ROOT) TEST

Testing for the existence of unit roots is a principal concern in the study of time

series models and cointegration. The presence of a unit root implies that the time

series under investigation is non-stationary; while the absence of a unit root shows that

the stochastic process is stationary (Iyoha and Ekanem, 2002). The unit root or

stationary test for each variable in the model is carried out using the hypotheses

formulated below:

H0: Xt has a unit root, (hence not stationary)

H1: Xt has no unit root, (hence stationary)

Decision Rule:

If the Augmented Dickey–Fuller Test statistics is greater than the Mackinnon

Critical values (in absolute value), the null hypothesis (H0) that Xt contains a unit root

is rejected and the alternative hypothesis (H1) is accepted and indicates that Xt is

stationary.

The result of the ADF unit root test which can be found in the appendix are

summarised below in table 4.1, 4.2 and 4.3

Table 4.1: Result of Stationary Test before Differencing

Variables ADF Test

Statistic Value

Mackinnon Critical

Value @ 5%

No of

times

difference

Remark

ER 3.260224 - 2.948404 1 (0) Non-stationary

GDP 0.849351 - 2.948404 1 (0) Non-stationary

EXR 0.485545 - 2.948404 1 (0) Non-stationary

BOP - 1.074681 - 2.948404 1 (0) Non-stationary

COP - 2.532054 - 2.948404 1 (0) Non-stationary

Sources: Extracted from computer output (see Appendix)

From the table, the summary of the unit root test at level reveals that the

absolute values of Mackinnon critical value at 5 percent are greater than the ADF test

statistics in all the variables. This means that the null hypothesis which signifies the

presence of unit root is accepted, while the alternative hypothesis is rejected for all the

variables.

Since the entire variables are non – stationary, at the level difference, there is

needed to carry out the test at the first difference to ensure the stationary of the time-

series data. The first difference unit root test is reported below;

Table 4.2: Result of Stationary Test at First Difference

Variables ADF Test Statistic

Value

Mackinnon Critical

Value @ 5%

Remark

ER -0.003475 -2.951125 Non-stationary

GDP -4.893779 -2.951125 Stationary

EXR -3.477362 -2.951125 Stationary

BOP -4.954265 -2.951125 Stationary

COP -5.527457 -2.951125 Stationary

Sources: Extracted from computer output (see Appendix)

From the table above, the unit root test analysis shows that only the dependent

variable (ER) is non-stationary, while other independent variables (GDP, EXR, BOP

and COP) are stationary at their respective first difference. The results shows that ADE

test statistics of (ER) is less than that of its Mackinnon critical value, but this is not so

for (GDP, EXR, BOP and COP), as a result, there is a need to carry out further test of

second difference, to ensure the dependent variable, ER is stationary.

Table 4.3: Result of Stationarity Test at Second Difference

Variables ADF Test Statistic

Value

Mackinnon Critical

Value @ 5%

Remark

ER -4.11319 -2.954021 Stationary

Sources: Extracted from computer output (see Appendix).

The table above shows that ER is stationary at the second difference. This is

because the ADF Test statistic values of the variable are greater than the Mackinnon

critical value, indicating the stationary of the variable.

4.3.2 Summary of Order of Integration

From the summary of each unit root test above, the summary of the order of

integration is presented below.

Table 4.4: Summary of Order of Integration

Variables Order of Integration

ER I(2)

GDP I(1)

EXR I(1)

BOP I(1)

COP I(1)

The summary shows that only the ER is stationary at the second difference

while the other independent variables (GDP, EXR, BOP and COP) are stationary at the

first difference.

4.3.3 THE ADF TEST EQUATION

The table below shows the result of ADF test equation on each of the variables

with their different level of stationarity and lagged period. Also shown is their

corresponding co-efficient of multiple determination (R2). The variables in each of the

multiple are regressed together expressing one as dependent variable is (ER) and

others as independent variables. The test of significance was also conducted for each

of the equation.

Table 4.5: ADF Test Result Table

Variable Coefficient Standard

Error

T –

statistic

Probability

value

R2

D(ER(-1),2) -1.055294 0.255182 -4.11931 0.003

D(ER(-1),3) 0.109388 0.187389 0.583772 0.5638 0.46802

C 56456.4 50971.44 1.107609 0.2768

D(GDP(-1)) -2.473887 0.505514 -4.89377 0.0000

D(GDP(-

1),2)

0.435095 0.284308 1.530366 0.1361 0.870942

C 419834.5 232473.8 1.805943 0.0806

D(EXR(-1)) 0.835778 0.240348 -3.47736 0.0015

D(EXR(-

1),2)

-0.071374 0.179320 -0.39802 0.6933 0.453223

C 3.251906 2.344623 1.386963 0.1763

D(BOP(-1)) -1.104854 0.223011 -4.954265 0.0000

D(BOP(-

1),2)

0.352503 0.173206 2.035625 0.0504 0.465113

C 53881.91 49125.27 1.096827 0.2812

D(COP(-1)) -1.289384 0.233269 -5.52745 0.0000

D(COP(-

1),2)

0.291880 0.165351 1.765207 0.0874 0.548387

C 8680.245 15397.77 0.563734 0.5770

Sources: Extracted from computer output (see Appendix)

4.3.4 CO-INTEGRATION TEST

The co-integration test in this study employed the method established by

Johansen (Johansen, 1991). This is a powerful cointegration test, particularly when a

multivariate model is used. Moreover, it is robust to various departures from

normality in that it allows any of the five variables in the model to be used as the

dependent variable while maintaining the same cointegration result.

By employing the Johansen Maximum likelihood estimation approach, the trace

test statistics (likelihood ratio) was used on testing whether a long run relationship

exist among the variables. If this test establishes that at least one co-integrating vector

exist among the variables under investigation, then a long term equilibrium

relationship exist between them.

Table 4.6: Result of Johansen Co-Integration Test

Eigen value Likelihood

Ratio

5% critical

value

1% critical

value

Hypothesized no of

(CEs)

0.989023 2.11.0247 68-52 76-07 None **

0.558872 53.10522 47.21 54.46 At most 1*

0.384363 24.47188 29.68 35.40 At most 2

0.191751 7.493431 15.41 20.04 At most 3

0.001212 0.042400 3.76 6.65 At most 4

*(**) denotes rejection of the hypothesis at 5% significant level

L.R test indicates 2 co integrating equation(s) at 5% (1%) significant level.

The result presented above reveals the existence of co-integration or long run

relationship among the external reserve (ER), gross domestic product (GDP), exchange

rate (EXR), balance of payment (BOP) and crude oil price (COP). The condition for

cointegration among the variables is that the critical value at 5% must be less than the

likelihood ratio.

4.3.5 THE LONG RUN MODEL

From the co-integration result, it is evident that the long run test indicates 2 co-

integrating equations at 5% significance level.

The long run or co-integrating equation is presented as:

ER = -0.197830 GDP - 6.486.912 EXR - 3.1216BOP - 0.057703COP +

218109

(0.01595 ) (343.51) 0.17293) (0.04033)

From the above, all the independent variable will have a negative relationship

on ER on the long run, while holding all the independent variables constant, it will

generate 218109.3 increases to the country’s ER in the long run.

The equation also posited that there is tendency for all the variables to meet at

equilibrium, though considering the speed of adjustment, it is very slow, but on the

long run, there is tendency of being co-integrated.

4.3.6 ERROR CORRECTION MECHANISM

The above analysis denotes that long run relationship have been established

among the variables. The long run relationship was established through the Johansen

co-integration test, in which the test result rejects the null hypothesis of no co-

integration among the model at both 5% and 1% (one percent) significant level.

The next step is to switch to the short run model and regression result for External

Reserve (ER) with the error correction. The unit root test was conducted on the error

correction mechanism (ECM)model, and it shows that the Augmented Dickey Fuller

(ADF) test statistic is -2.580226 and 1% and 5% critical value are -3.6289 and -2.9472

respectively, at level difference with R2 of 0.27022. This shows that the error

correction model is stationary at the level difference.

An over-parameterised error correction model is estimated by setting the lag

length long enough in order to ensure that the dynamics of the model have not been

constrained by a too short lag length. The result of the over-parameterised error

correction of the model is presented below.

Table 4.7: The Over–Parameterised Model

Variable Co-efficient Standard Error T –statistics Probability

D(ER(-1),2) 0.717629 0.185310 3.872590 0.0007

D(GDP,2) -0.025323 0.017127 -1.478373 0.1523

D(GDP(1),2) -0.004075 0.013535 -0.301120 0.7657

D(EXR,2) 7032.334 1278.705 5.499575 0.0000

D(EXR(1),2) -2.509.295 1818.222 -1.380082 0.1803

D(BOP,2) 0.969587 0.122429 7.919570 0.0000

D(BOP(1),2) -1.102594 0.082215 -1.247801 0.2241

D(COP,2) -0.012253 0.159916 -0.076624 0.9396

D(COP(1),2) 0.065609 0.146075 0.44.9153 0.6574

ECM (-1) -0.440093 0.050454 -1.757171 0.0916

The table above shows the over-parameterised error correction of the

determinant or macroeconomic factor driving the Nigerian external reserve. The over

parameterised ECM results shows that the co-efficient of error correction term for the

estimated external reserves equation, is the significant and negative. Thus, it will

rightly act to correct any deviations from the long-run equilibrium. The coefficient of

ECM is – 0.440093, indicating that, the speed of adjustment to long run equilibrium is

44% when any past deviation will be corrected in the current period.

In addition to the above, it is expedient to draw a more empirical analysis from

the results of the ECM; this is because the ECM has the tendency of adjustment. If

actual equilibrium value is too high, the error correction term will reduce it, while if it

is too low, the error correction will raise it.

This call for a more specific test of determining the parsimony of the variables;

by estimating the equations of only those variables that is significant in the over-

parameterised ECM model.

Table 4.8: PARASIMONIONS MODEL

Dependent variable = D (ER,2)

Variable Co-efficient Standard Error T –statistics Probability

D(ER(-1),2) 0.553855 0.111495 4.967531 0.0000

D(GDP,2) -0.018236 0.009386 -1.942941 0.0021

D(EXR,2) 7980.860 983.5246 8.114550 0.0000

D(BOP,2) 0.90586 0.095630 0.832126 0.0000

D(COP(1),2

)

0.008439 0.117221 0.071991 0.9431

ECM (-1) -0.523721 0.201006 -2.605505 0.0145

R2 =0.934167

DW = 1.665007

The table above presents the result of the parsimonious model. It shows that

the coefficient of the ECM is 0.523721. This is an indication that the speed of

adjustment of any past deviation to long run equilibrium is 52.37% which is more

faster than obtained in the over parameterised model .

The result also indicates that all the variables are significant except the lagged

value of COP. It indicates that in the short run, it is only the GDP, EXR, and BOP that

has relationship with ER while the COP has to be adjusted to equilibrium in the long

run. Also, any changes affecting the ER are determined by BOP, EXR, and GDP in

the short run and COP in the long run.

4.3.7 THE LEAST SQUARE ESTIMATION RESULTS

From the parsimonious model result above, it can be seen that the coefficient of

lagged values of gross domestic product (GDP) and the error correction mechanism

(ECM) are negative, while the coefficient of the EXR, BOP and COP, which

represents the independent variable are positive.

The result exert a negative figure of 0.013236 between the GDP and ER, which

reveals than a million naira increase (decrease) in the GDP will lead to a decrease

( increase) of 0.018236 in the external reserve. Though, this does not conform with the

apriori expectation and the positive value of (0.079055) before the model correction,

but its a clear picture of the Nigeria ER behaviour in the long run with the GDP.

The result also shows, that a positive relationship exist between the EXR and ER,

indicating that a N/$ variation in the exchange rate, will result to N7980.860 changes

in the ER. Also, the 0.920586 coefficient value of the BOP indicates a positive

relationship with the ER. It further shows that a million increases (decrease) in BOP

will result to the above value increment (decrease) in the external reserve (ER). Also,

the Nigerian Crude Oil production has a direct relationship with the ER, indicating that

an increase in the production of COP will result to an upshot of the ER by N0.008439.

The explanatory power of the model is estimated at 0.734169 which indicates that

93.42% variations or changes that occurs in the present state ER is determined by

changes of past value in the independent variables (BOP, GDP, EXR and COP); while

the remaining 6.58% is explained by other variation outside the model or captured by

the error term. Thus, the model sufficiently determined the study of determinants of

the Nigerian external reserves.

4.3.8 TEST FOR THE STATISTICAL SIGNIFICANCE OF THE

PARAMETER

(T-Test)

To test for the statistical significant of each of the parameters, the standard

error of statistical significance will be employed. This involves the comparison of the

half of the coefficient of the variables with the standard error test. The over

parameterised result will be used to capture the lagged parameters. The standard error

test of statistical significance will be employed on the over parameterised model, in

order to capture the variables, and the lagged variables.

The T-test result is presented in the table below

Table 4.9: T-Test Statistics

Variable Co-efficient Coefficient

2

Standard Error Decision

D(GDP,2) 0.025323 0.0126615 0.01727 Not significant

D(GDP(1),2) -0.004072 0.002036 0.013535 Not significant

D(EXR,2) 7832.4076 3916.2038 1278.705 Significant

D(EXR(1),2) -2509.295 1254.6475 1818.22 Not Significant

D(BOP,2) 0.969578 0.484788 0.122429 Significant

D(BOP(1),2) -1.102594 0.051297 0.082215 Not significant

D(COP,2) -0.012253 0.006127 0.159916 Not significant

D(COP(1),2) 0.65608 0.2204965 0.146073 Significant

ECM (-1) -0.440993 0.050454 0.050454 Significant

From the table above, it can be seen that only the GDP and its lagged value are

not significant simultaneously. This is an indication that, the variables (GDP) does not

play much of important role to the determination of ER in the country. Also, the

Exchange Rate (EXR) is significant, while its lagged value is not significant. This

shows the level of importance it is to the movement and direction of the country’s

external reserve. The BOP has a bi-directional significance; the variable is significant

while its lagged value is not significant. This is also a clearer indication of the

variable’s importance in the determining the level of external reserve. Also, the crude

oil production (COP) as a variable is not significant, but the lagged value is significant.

This shows that present value of the ER will only be affected by the past COP in the

country.

4.3.9 TEST OF OVERALL SIGNIFICANCE OF THE MODEL (F-Test)

The F-test shows the overall or aggregate significance of the model. The aim of

the test is to find out whether the entire explanatory variable put together does actually

have any significance influence on the dependent variable. It is carried out by

comparing the F-calculated and the F-tabulated. The hypothesis for the study is

formulated as:

H0: There is no overall significance in the model

H1: There is overall significant in the model

For F-tabulated, the F-distribution value with K-1 and N-K degree of freedom at 95%

confidence level equivalent to 5% significance level.

Hence V1 =K –1 = 5 – 1 = 4

V2 =N -K =35 -1 = 34

(F tab ~ V1,V2) dof

(Ftab ~ 4,34) dof

(Ftab ~ 4,34) dof

Ftab = 2.69 (as obtained from statistical table)

Fcal* = 138.6729 (as obtained from result output; see Appendix)

From the above analysis, it can be deduced that the f-calculated (138.6729) is

greater than the value of f-tabulated (2.69). This is a clear indication that the whole

model is statistically significant, and that all the explanatory variables, i.e. GDP, BOP,

COP, and EXR and their lagged value are significant in determining the variations and

level of external reserve in the country.

The above result can be summarised in the table below.

Table 4.10: F- statistics

4.3.10 TEST FOR SERIAL

CORRELATION

The test is purposely to determine the presence or absence of autocorrelation

called social correlation in the model. The Durbin Watson test will be employed to

carry out this test, and the hypothesis required for this test will be formulated as

follow:

H0:µ = 0 There is no autocorrelation in the models variables

H1:µ ≠ 0 There is Auto-correction

The tabulated Durbin Watson value being estimated with;

N=37 and K1=K-1= 5-1=4

Gives dL= 1.06 and dU=1.517

Therefore 4 – dL = 2.94 and 4 – dU = 2.49

The values are presented on the graph below to allow for a meaningful analysis.

Decision

F –calculated F -

tabulated

H0 H1

138.6729 2.69 Reject accept

0 dL dU 2 4-dU 4-dL 4 1.06 1.517 2.49 2.94 DW*=1.809

Region ofPositive

Auto-correlation

Region ofNegative

Auto-correlation

InconclusiveRegion

InconclusiveRegion

No Auto-correlation

Region

Fig. 1: Durbin Watson graph

From the above graph, it is concluded that there is no serial correlation among

the variables in the model. This is because the Durbin Watson value of (1.809) falls

within the No autocorrelation region. Hence, we accept the alternative hypothesis and

reject the null hypothesis H0.

4.4 SUMMARY OF FINDINGS

This study examines the macroeconomic determinants of external reserve. The

analysis from the OLS result shows that positive relationship subsist between the GDP

and ER, also the EXR and BOP demonstrated a direct relationship with the ER while

the COP reveals a coefficient with an inverse relationship with the ER. The result also

show that a unit increase in GDP, EXR, and BOP will lead to a rise in ER by 0.07905,

9233.45 AND 1.71955 respectively while an increase (decrease) in the COP will lead

to a decrease (increase) in the ER.

In order to determine the goodness of fit of the model, the coefficient of

multiple determination (R2) was considered. The R2 is estimated as 0.945457

approximately 95%. This means that about 95% variation or changes in the present

state of ER is being explained by the variation in past value of GDP, EXR, BOP and

COP; while about 5% changes in the present value of ER is being explained by the

stochastic error term or accounted for by disturbance variable. The findings also

revealed that the whole model is statistically significant at 5% significant level, and

also indicates that there is no serial correlation among the variables in the model. In

achieving the long run equilibrium model, the unit root test was carried out for all the

variables. The stationarity test shows that only the External Reserve (ER) is stationary

at the second difference, while other explanatory variables (GDP, EXR, BOP and

COP) are stationary at their respective first difference.

Also, the cointegration test used in establishing the long run relationship after the

confirmation of the variables stationarity was carried out. The test reveals and indicates

two (2) co-integrating equations on the long run at 5% significant level. This led to the

rejection of the null hypothesis and accepting the alternative hypothesis which

supports the existence of cointegration among the variables.

4.5 IMPLICATIONS OF FINDINGS

A careful observation of the aforementioned results shows that, all the variables

are positively related with the ER except the COP which has an inverse relationship;

while all the lagged explanatory variables are negatively related with ER except the

COP. The implications of this is that, though the COP does not conform with the

apriori expectation, which is expected to be positive, but its impact being the major

export product of the country, could not contribute immensely to the accumulation of

ER.

From the result also, both the GDP as a variable and its lagged value were

found to insignificant, while the Exchange Rate is significant but the lagged value is

not significant. Also, the BOP and lagged value of COP were statistically significant,

while the lagged value of BOP and COP were found to be insignificant.

This stem from the fact that the accumulation and effective management of

reserves of a country cannot be overstressed. Though the GDP might be statistically

insignificant, but its economical importance to external reserve accumulation is very

significant. In theory, the volume of international financial transactions and foreign

reserves holding are expected to increase with economic size. Also, GDP and GDP

per capital have been used as indicators of economic size in literature, which had been

argued earlier to be one of the prime factors driving a country’s foreign reserve.

The implications of the significance of both the exchange rate and its lagged

value has well being established in theory and literature. This also is in conformity

with the apriori expectation; as a positive and significant relationship is expected.

Osabuohion and Egwakhe (2008) noted that countries usually hold foreign reserves to

have a favourable level of exchange rate especially with a view to stabilizing it and

removing possible volatility. Also they noted, while writing on “External reserve and

the Nigerian Economy” that holding of foreign reserves promotes exchange rate

stability and in turns increase the reserve.

On the part of balance of payment (BOP), which is highly significant while its

lagged value is insignificant; it reveals that the major essence of the accumulation of

reserve is to meet eventualities of BOP crisis. Heller (1996) concludes that emerging

market economies hold reserve as a buffer stock to smooth unexpected and temporary

imbalances in international payment.

The COP, as a very important variable in the model is purposely included to

capture the economy’ major source of income and export. The COP is estimated to be

insignificant while its lagged value was found to be significant. The explanation to

this is the Nigerian context is that, though the COP is statistically insignificant but

economically significant because of its economical impact on the economy at large.

Also, the apriori expectation posited a direct relationship with the ER; though its

lagged value is in conformity.

CHAPTER FIVE

SUMMARY, CONCLUSION AND RECOMMENDATIONS

5.1 SUMMARY

This research work has been carefully and meticulously carried out despite the

timing and financial constraints, to determine and re-examine the macro-economic

determinants of external reserves in developing economies with a special preference to

the Nigerian case. In achieving these objectives, attempts were made at examining the

conceptual rigidities revolving around external reserve, and its various compositions.

Furthermore, various scholastic views were reviewed as well as the underlying

theoretical frame works, such as the Buffer stock adjustment model, the precautionary

and mercantilist model.

In addition, it was discovered that the major essence of holding balance of

payment is to meet eventuality of BOP crisis, this call for the reviewing of the BOP,

items, the cost, rationale and composition of foreign reserve were equally put into

cognizance. Also, the various test carried out to determine the significance of both the

parameters and the model, while it was established that all the variable were stationary,

which is a condition for the co-integration test.

The result of the Johansen test reveals that long run test indicates 2 co-

integrating equations at 5% significance level. This is an indication that, there is

tendency for the variable to be at equilibrium on the long run, with a speed of

adjustment of any past variation of about 44% in the over-parameterized model and of

about 52% in the parsimonious model.

5.2 CONCLUSION

In this research work, we have empirically verified and discussed the major

macro-economic determinants of external reserve in developing economies, taking the

Nigeria case. The existence of a variety of debatable discourse regarding the level of

Nigeria’s foreign reserves motivated this study.

In making the case for robust level of Nigeria’s external reserve, the Central Bank of

Nigeria (CBN) argued that China has over one million dollars in her external reserves

even though her population is very large (Soludo, 2006). For example, China’s

external reserve population was estimated at US$822 billion in 2004, while the value

for Nigeria in the same year was about US$17trillion , which has increased to about

US$51.33 billion in 2007 and dwindled to US$46 in 2009 (Russell and Torgerson,

2009)

One of the major reasons for foreign reserves accumulation put forward by

CBN is the need to make Nigeria more credit worthy; this is believed to be essential

for attracting foreign capital. However, it has been noted that other issues such as a

country’s institutional structure play key role in attracting foreign capital (Hassan et al,

2007). Consequently, based on the result obtained and interpreted in chapter four (4),

we concluded that the COP has not play significant in driving the ER as a result of its

negative relationship with ER and insignificancy, while the GDP, EXR and BOP plays

a well significant role in determining the level of external reserve in Nigeria. Thus

from the foregoing, we concluded that the production crude oil ( domestic

consumption and export) despite its positive effect on the growth of the Nigeria

economy has not significantly improve the growth of the economy, due to many

factors such as misappropriation of public funds (corruption) and poor administration.

Also, the Gross Domestic Product (GDP) is positively related to ER but

insignificant. The relationship is in conformity with the apriori expectation, but the

insignificancy poses lots of worry, because the level of economic development is a

function of the level of external reserve holding. Hence, the case of Nigeria is

different. The foregoing is a result of the facts that the major revenue yielding sector

is the crude oil which is the main source of the external reserve accumulation, and just

a part of the GDP statistics. The GDP fails to play a significant role in moving

external reserve because the country has shifted to a mono-cultural economy, which

solely depends on its revenue from crude oil.

Conclusively, the EXR and COP are significant factor in the model driving the

ER. Thus, the model is well represented as the explanatory power of the model is very

high and corroborate the listed variables as determinants of external reserve in the

country.

5.3 POLICY RECOMMENDATION

In the reviews of the findings in this study, it is not only desirable but also

necessary to recommend some policy measures to developing economies with respect

to their accumulation of external reserve.

For developing economies, especially Nigeria, it should be noted that if the ability to

meet BOP eventualities, exchange rate stability and macro-economic stability is the

main reason for accumulating external reserve, as argued by Aizenmann (Aizenmann,

2006), effort should be diverted toward domestic production efficiency rather than

external accumulation. Thus, the increment in domestic production will eventually

leads to exchange rate stability and aid appropriate external reserve holdings.

Also, the economy should be diverted from the current state of it “mono-cultural” to a

more dynamic economy which will exploit all sector of the economy for maximum

economic benefit. In addition to the above, the government is advice to play an active

role in the extraction and production of the country’s crude oil production process,

being the highest generating revenue of the country. The study reveals COP plays no

significant role in driving the ER despite its enormous contribution to the economy,

hence, appropriate management of the COP is essential. Other appreciable suggestion

includes:

1. The government should encourage more private company participation so that

better equipped refineries can be built and the cost of refining crude oil will

reduce.

2. Security should be boosted on the high sea where crude oil products are being

smuggled. This will help reduce the cost from illegal export of crude oil.

3. Government should give immediate attention to the indigenes of the region

where crude oil is being extracted from. This will reduce the unrest in the

region.

The above aforementioned, if put in place will enhance the productivity of COP and

make its impact well felt on the ER and the economy at large.

Hence, it is specifically doubtful if the underlying assumption of ER ability to

accelerate macro-economic performance can be sustained in Nigeria because of the

political imbalance, corrupt public office holders and lack of visionary and dedicated

leaders.

In the long run, there is a need for an alternative reserves system. Furthermore,

government need to stimulate domestic demand along with growth in export and real

GDP, strengthen domestic financial market and integrate them into the global market

in order to reduce pre cautionary demand for reserves.

To effectively manage foreign exchange reserves, policy makers

need to understand the major determinants of reserve in a

globalized economy. This is essentially in determining the optimal

reserves level that provides them with necessary security at

minimum cost, to enhance the achievement of the macroeconomic

objectives.

Conclusively, the paper suggest that domestic production efficiency is required

in Nigeria, and ensuring exchange rate stability with appropriate level of external

reserve holdings rather than accumulating external reserve build-ups to signal financial

credit worthiness or strength as stressed by the central bank.

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