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, heres 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!!!, Youve 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 ROBIL ALAMIN, WA SOLATU WASALAMU ALA
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,
youve 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 Gods 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 (Seidu), Bode
Babalola, Adeniyi Yinka (UI), Oyetola (UNAAB), Majekodumi (OSU), Savaoda Toyin
(UNILORIN), Peters Oluwaseun (RUN), Akinlolu Femi, Awosika Lanre, Ijeoma
Nduka, Obinna Cyprian, Maaruf 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 Zhulnurain (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 youre
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, 20052009)

TABLES OF CONTENTS
Title page

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.

40
2.4.3

Rationale for holding Reserves

40-43

2.4.4. Sources of Nigerias external Reserve

43-44

2.4.5

44-46

Composition of external Reserve

37-

2.4.6

The Special Drawing Rights

46-49

2.4.7

The Reserve Currency

49-50

2.4.8

Ownership structure of Nigerias 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)
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

56-

2.7.1

Sources of Reserve: Key Balance of Payment (BOP) Identities.

2.7.2

Trends and motivation for Reserve buildup in Africa

2.7.3

Sources and Composition of African Foreign Exchange Reserve

67-69

69-76
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

(Oil Rich countries)

74

TABLE 3:

TABLE 4:

Sources of Africa Reserve accumulation in Africa US$

Million(Oil Rich countries)

75

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 OverParameterized 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

Bibliography
Appendix

Durbin Watson (Serial Correlation) Test

106

117-121

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 countrys 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 countrys international or external reserve holdings. This
fixation with international reserve is to a degree understandable; its ability to boost
investors 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.
Nigerias 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
Nigerias 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 2 nd January, 2009 and further to
$43.087 billion as at January 2010. The decrease is of no doubt the effect of the twindevils 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, Chinas 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 countrys 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 reservesaccumulating 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 commodityrich developing countries that need to finance highyield
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 investors 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 countrys 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 1970s, 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 1970s
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 countrys external reserve; the aftermath effect made the burst period to bit
harder than they should ordinarily have been.
With respect to the above, a countrys 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 countrys 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 countrys 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 countrys 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 investors 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 countrys 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 countrys 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 countrys 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 countrys 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:

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.

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.

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.

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.

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;

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

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

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. Hellers 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 emergeda 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 rates 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. 2478):
The classical investigations directed to determining the appropriate amount of a
countrys 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 quantityBrazil, for
exampleneeds 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 businessGreat 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 Treatises 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 countrys 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 Greenspans 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 Hellars 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;

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

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 COUNTRYS 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 countrys credit worthiness and reputation by enabling a regular servicing

of the external debt thereby avoiding the payment of penalty and charges. Furthermore,
a countrys 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 countrys 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 NIGERIAS EXTRERNAL RESERVE
Nigerias 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:

Direct Sales (NNPC)

Petroleum Profit Tax (Oil Companies)

Royalties

Penalty for Gas Flaring

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
countrys 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) Nigerias 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 NIGERIAS EXTERNAL RESERVE

Nigerias 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 nations accumulate savings usually in

international currencies and kept in various international banks for future use. The
Nigerias 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 nations 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 nations 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 nations 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:

Current consumption

Accumulate reserves in the short to medium term

Pay off foreign debt and

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, Nigerias external
reserves are deployed to two major categories of uses, namely; public and private
sector uses.

Public Sector Uses

1

Debt Relief Deal

Paris Club - USD12.4 billion

London Club - USD0.5 billion

Annual Debt service payments (now mainly Multilateral Institutions)

WDAS sales in respect of States and other Government agencies

Joint Venture Cash call payments

Infrastructural development (Power, Railway/Roads)

Contributions and subventions (International Organizations & Nigerian Embassies

and High Commissions)

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
PRICES (2007-2009)

OIL

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;

Limit external vulnerability by maintaining foreign currency liquidity to absorb

shocks during times of crises or when access to borrowing is curtailed;

Provide a level of confidence to markets that a country can meet its external
obligations.

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 reservesthe 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
countrys 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 CBNs 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-GuidottiIMF rule, which recommends that reserves should enable full coverage of total shortterm 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, overinvestments, 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 countrys 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 nonoil-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 reserveGDP 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
= Stochastic Disturbance (Error term)
f = Functional relationship
0 - 4 = Parameters

Specifying the model by log linearizing, it becomes;

Log (ER) = 0 + 1log (GDP) + 2 log (EXR) + 3log(BOP)+ 4 log(COP) + .....
(3)
Where :
log = Natural log
0 = Intercept of the relationship in the model
4 - 4= Coefficients of each variables.
From equation (3), the model can be specified in a time series from as:

Log (ER)t= 0 + 1 log (GDP)t + 2 log (EXR)t + 3 log (BOP)t + 4 log (COP)t +
......(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 Johnsons 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 = Yt-1 + Ut .........................(i)
-11

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 is a random walk with

Yt = 1 + Yt-1 + Ut .................. (iii)

Yt = 1 + 2t + 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 nonstationary 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.
ii.
iii.
iv.
v.

Central Bank of Nigeria (CBNs) Statistical Bulletin

Central Bank of Nigeria (CBNs) Annual report and Statement
Extracts from E-journals
Zenith Quarterly Publications for variables update
Textbook and other foreign publication.

3.6

DATA JUSTIFICATION AND APRIORI EXPECTATION

1.

External Reserves
The countrys external reserves are in liquid external assets under the control of

Central Bank. It consists of Gold, the countrys 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 countrys 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
GDP

>0

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
EXR

3.

>0
- it means an increase in EXR or conservation of ER

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 countrys 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 countrys 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 countrys ER and significantly increase the savings income, without not
also playing an important role in the economic development.
ER = f (COP)

ER
COP

> 0

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 DickeyFuller 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

Mackinnon Critical

No of

Remark

Statistic Value

Value @ 5%

times
Non-stationary

ER

3.260224

- 2.948404

difference
1 (0)

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 timeseries data. The first difference unit root test is reported below;

Table 4.2: Result of Stationary Test at First Difference

Variables

ADF Test Statistic

Mackinnon Critical

Value

Value @ 5%

Remark

ER
-0.003475
-2.951125
GDP
-4.893779
-2.951125
EXR
-3.477362
-2.951125
BOP
-4.954265
-2.951125
COP
-5.527457
-2.951125
Sources: Extracted from computer output (see Appendix)

Non-stationary
Stationary
Stationary
Stationary
Stationary

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

Mackinnon Critical

Remark

ER

Value
-4.11319

Value @ 5%
-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:
Variable

ADF Test Result Table

Coefficient

Standard

Probability

statistic
-4.11931
0.583772
1.107609

value
0.003
0.5638
0.2768

R2

D(ER(-1),2)
D(ER(-1),3)
C

-1.055294
0.109388
56456.4

Error
0.255182
0.187389
50971.44

D(GDP(-1))
D(GDP(-

-2.473887
0.435095

0.505514
0.284308

-4.89377
1.530366

0.0000
0.1361

1),2)
C

419834.5

232473.8

1.805943

0.0806

D(EXR(-1))
D(EXR(-

0.835778
-0.071374

0.240348
0.179320

-3.47736
-0.39802

0.0015
0.6933

1),2)
C

3.251906

2.344623

1.386963

0.1763

D(BOP(-1))
D(BOP(-

-1.104854
0.352503

0.223011
0.173206

-4.954265
2.035625

0.0000
0.0504

0.465113

1),2)
C
D(COP(-1))
D(COP(-

53881.91
-1.289384
0.291880

49125.27
0.233269
0.165351

1.096827
-5.52745
1.765207

0.2812
0.0000
0.0874

0.548387

1),2)
C
8680.245
15397.77
0.563734
0.5770
Sources: Extracted from computer output (see Appendix)

0.46802

0.870942

0.453223

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:
Eigen value

Result of Johansen Co-Integration Test

Likelihood

5% critical

1% critical

Ratio
value
value
0.989023
2.11.0247
68-52
76-07
0.558872
53.10522
47.21
54.46
0.384363
24.47188
29.68
35.40
0.191751
7.493431
15.41
20.04
0.001212
0.042400
3.76
6.65
*(**) denotes rejection of the hypothesis at 5% significant level

Hypothesized no of
(CEs)
None **
At most 1*
At most 2
At most 3
At most 4

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 countrys 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 cointegration 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:
Variable

The OverParameterised Model

Co-

Standard

Probabilit

efficient

Error

statistics

D(ER(-1),2)
D(GDP,2)
D(GDP(1),2)
D(EXR,2)
D(EXR(1),2)
D(BOP,2)
D(BOP(1),2)
D(COP,2)
D(COP(1),2)
ECM (-1)

0.717629
-0.025323
-0.004075
7032.334
-2.509.295
0.969587
-1.102594
-0.012253
0.065609
-0.440093

0.185310
0.017127
0.013535
1278.705
1818.222
0.122429
0.082215
0.159916
0.146075
0.050454

3.872590
-1.478373
-0.301120
5.499575
-1.380082
7.919570
-1.247801
-0.076624
0.44.9153
-1.757171

0.0007
0.1523
0.7657
0.0000
0.1803
0.0000
0.2241
0.9396
0.6574
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 overparameterised ECM model.
Table 4.8: PARASIMONIONS MODEL

Dependent variable = D (ER,2)

Variable
D(ER(-1),2)
D(GDP,2)
D(EXR,2)
D(BOP,2)
D(COP(1),2

Coefficient
0.553855
-0.018236
7980.860
0.90586
0.008439

)
ECM (-1)
-0.523721
R2 =0.934167

Standard

Probabilit

Error
0.111495
0.009386
983.5246
0.095630
0.117221

statistics
4.967531
-1.942941
8.114550
0.832126
0.071991

y
0.0000
0.0021
0.0000
0.0000
0.9431

0.201006

-2.605505

0.0145

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:
Variable

D(GDP,2)
D(GDP(1),2)
D(EXR,2)
D(EXR(1),2)

T-Test Statistics
Co-

Coefficien

Standard

efficient

Error

0.025323
-0.004072
7832.4076
-2509.295

2
0.0126615
0.002036
3916.2038
1254.6475

0.01727
0.013535
1278.705
1818.22

Decision

Not significant
Not significant
Significant
Not

D(BOP,2)
D(BOP(1),2)
D(COP,2)
D(COP(1),2)
ECM (-1)

0.969578
-1.102594
-0.012253
0.65608
-0.440993

0.484788
0.051297
0.006127
0.2204965
0.050454

0.122429
0.082215
0.159916
0.146073
0.050454

Significant
Significant
Not significant
Not significant
Significant
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 countrys
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
variables 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.
comparing the F-calculated and the F-tabulated.
formulated as:

It is carried out by

The hypothesis for the study is

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

Decision
F calculated F -tabulated
H0
H1
138.6729
2.69
Reject accept

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: = 0

There is no autocorrelation in the models variables

H1: 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.
Inconclusive
Region

Inconclusive
Region

No
Auto-correlation
Region

Region of
Positive
Auto-correlation

4-dL
2.94

Region of
Negative
Auto-correlation

dL
1.06

dU
1.517

4-dU
2.49

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 countrys 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 cointegrating 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
Nigerias foreign reserves motivated this study.
In making the case for robust level of Nigerias 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, Chinas

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
countrys 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 countrys 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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