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International Operations

Reserve Management

Reserves Consumptions & Future Savings: What Options

Meaning of Reserves

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”

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:

• 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.
• 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.
• 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.
• 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.
• To Boost a Country’s Credit Worthiness External reserves provide a cushion at a time when access to the international capital market is difficult or not possible. A respectable level of international reserves improves a country’s credit worthiness and reputation by enabling a regular servicing of the external debt thereby avoiding the payment of penalty and charges. Furthermore, a country’s usable foreign exchange reserve is an important variable in the country risk models used by credit rating agencies and international financial institutions.
• 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.
• To Provide a Buffer Against External Shocks External shocks refer to events that suddenly throw a country’s external position into disequilibrium. These may include terms of trade shocks or unforeseen emergencies and natural disasters. An adequate external reserve position helps a country to adjust quickly to such shocks without recourse to costly external financing.

Historical Background Over the past three decades, Nigeria has taken numerous policy initiatives and measures in the management of its external reserves. Although very little was achieved because the structure in place then could not support efficient reserves management, enduring lessons could be distilled from the nation’s past experience. Thus, Since the 1970s, Nigerian economy has persistently depended on oil as the main source of foreign exchange earnings with the attendant cycles of economic booms and bursts.

From 1999, world oil prices began to rise again resulting in another but better managed boom and unprecedented accumulation in the level of reserves from USD4.98 billion in May 1999, to USD59.37 billion as at March 28, 2007.

Source: Foreign Operations Department, Central Bank of Nigeria

Sources of External Reserves in Nigeria
Nigeria’s external reserves derive mainly from the proceeds of crude oil production and sales. Nigeria produces approximately 2,000,000 barrels per day of crude oil in joint venture with some international oil companies, notably Shell, Mobil and Chevron. Out of this, Nigeria sells a predetermined proportion directly, while the joint venture partners sell the rest. The joint venture partners pay Petroleum Profit Tax to the Federal Government through the Federal Board of Inland Revenue.

The five categories of revenue from crude oil production and sales are:

• Direct Sales (NNPC)
• Petroleum Profit Tax (Oil Companies)
• Royalties
• Penalty for Gas Flaring
• Rentals Other sources of external reserves in Nigeria include:
  • Income from Investing foreign reserves
  • Repatriation of unutilized WDAS
  • Interest on WDAS Accounts held by Deposit Money Banks
  • WDAS Purchases
  • Inward Money Transfer
  • Value Added Tax (VAT)
  • Education Tax
  • Commission, Etc.

Source: Foreign Operations Department, Central Bank of Nigeria

Composition of External Reserves
The Central Bank of Nigeria Act 1991 vests the custody and management of the country’s external reserves in the Central Bank of Nigeria (CBN). The Act provides that the CBN shall at all times maintain a reserve of external assets consisting of all or any of the following: a) Gold coin or bullion; b) Balance at any bank outside Nigeria where the currency is freely convertible and in such currency, notes, coins, money at call and any bill of exchange bearing at least two valid and authorized signatures and having a maturity not exceeding ninety days exclusive of grace; c) Treasury bills having a maturity not exceeding one year issued by the government of any country outside Nigeria whose currency is convertible; d) Securities of or guarantees by a government of any country outside Nigeria whose currency is freely convertible and the securities shall mature in a period not exceeding ten years from the date of acquisition; e) Securities of or guarantees by international financial institutions of which Nigeria is a member, if such securities are expressed in currency freely convertible and maturity of the securities shall not exceed five years; f) Nigeria’s gold tranche at the International Monetary Fund; g) Allocation of Special Drawing Rights made to Nigeria by the International Monetary Fund (IMF).

Ownership Structure of Nigeria’s External Reserves
Nigeria’s external reserves comprise of three components namely, the federation, the federal government and the Central Bank of Nigeria portions. The Federation component consists of sterilized funds (unmonetized) held in the excess crude and PPT/Royalty accounts at the CBN belonging to the three tiers of government. This portion has not yet been monetized for sharing by the federating units. It is sometimes ignorantly referred to as the reserves of the country. The Federal Government component consists of funds belonging to some government agencies such as the NNPC; for financing its Joint Venture expenses, PHCN and Ministry of Defence; for Letters of Credit opened on their behalf, etc. The CBN portion consists of funds that have been monetized and shared. This arises as the Bank receives foreign exchange inflows from crude oil sales and other oil revenues on behalf of the government. Such proceeds are purchased by the Bank and the Naira equivalent credited to the Federation account and shared, each month, in accordance with the constitution and the existing revenue sharing formula. The monetized foreign exchange thus belongs to the CBN. It is from this portion of the reserves that the Bank conducts its monetary policy and defends the value of the Naira.

Ownership Structure of Reserves as at April 25 2007 Amounts in US Dollar Million

Uses / Consumption of Reserve
Source: Foreign Operations Department, Central Bank of Nigeria

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

Public Sector Uses

• 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)

Source: Foreign Operations Department, Central Bank of Nigeria

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)

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.

Source: Foreign Operations Department, Central Bank of Nigeria

Future Savings of External Reserves
The recent build up in the nation’s external reserves was attributed mainly to the upsurge in oil prices sustained by fiscal prudence. The quest to mitigate the burden imposed by high oil prices on the economy of highly industrialized nations is already driving research into the exploitation and utilization of alternative energy sources. Consequently, there have recently been calls for the Nigeria to establish a “Fund for Future Generations” in which to invest excess earnings from oil in order to insulate the economy from the uncertainty and volatility of oil prices. The establishment of such a fund in Nigeria can serve the twin objectives of stabilizing the volatility of fiscal revenues and creating pool of capital that can provide an alternative source of foreign exchange earnings.

Although Nigeria is already saving the excess oil revenue above the budgeted benchmark price (USD 9,574.21 million saved as at April 25, 2007) as a result of “the gentleman agreement” among the three tiers of Government, the constitutional provision however is that whatever is earned by the federation should be shared by the three tiers of government.

It is therefore imperative that the three tiers of government that constitute the federation (Federal, State and Local Governments) should totally buy-in, into the initiative (Fund for Future Generations) for it to be successful. A legislative backing through an appropriate constitutional provision is also essential, in addition to supporting Investment Policy and Guidelines.

In this regard, it is pertinent to mention that many countries have successfully established and managed such funds for future generations including Botswana and Chile which export diamonds and copper respectively, Venezuela, Norway, Kuwait and Iran which are major oil exporting countries, to mention a few. Most of these countries sterilize the proceeds from oil and other minerals and finance their budgets through other sources. Sao Tome and Principe also has adopted a similar plan, ahead of anticipated commercial production of oil, expected to commence in 2012.

Consumption Versus Saving

In the recent past, reserves accumulation or saving has mainly been associated with the emerging Asian economies following the Asian bubble burst of the early 90’s. Today, it has become a global phenomenon traversing oil exporting nations and other non renewable resource dependent economies.

For Nigeria, the period beginning from the later end of 1999 marked a turning point from a hitherto culture of fiscal indiscipline characterized by frivolous spending, to a new dawn of prudent consumption and saving.

Consumption and saving are “twin” features associated with revenue management and both are typical of not only the Nigerian economy but of all emerging and developed economies of the world. It is therefore important to say that the two do not compete for choice; rather there is a need to ensure prudent consumption and judicious management of savings.

To attain optimal consumption and saving, it might be necessary to address the following questions:

1. How much should be spent or saved at any given time? In order to manage inflation and excess liquidity, consumption should depend on the absorptive capacity of the economy. This will not only prevent the erosion of the purchasing power of the local currency (naira) but will also protect the poor who are usually the ultimate victim of inflation.
2. What are the reserves being spent on? Fiscal prudence demands that consumption expenditure impact positively on the citizenry and create value added for the overall economy. To this end, the reserves should not be spent wastefully or for personal aggrandizements.
3. How do you ensure accountability and transparency in managing consumption and saving? The IMF Code of Good Practices on Transparency in Monetary and Financial Policies: Declaration of Principles, September 1999 (MFP Transparency Code) addressed the main issues in the context of good governance and accountability in reserve management. The code requires proper disclosure of the following:
   • Release of summary central bank balance sheets on frequent and pre-announced schedule;
   • Preparation of detailed central bank balance sheets in accordance with appropriate and publicly documented accounting standards,
   • Public disclosure of financial statements on a pre-announced schedule that have been audited by an independent auditor,
   • Internal governance procedures necessary to ensure integrity of operations including internal arrangements.

It is gratifying to note that the Central Bank of Nigeria reserves management operation has been consistent with the MFP Transparency code. It is however important to mention that adherence to this disclosure requirement by the fiscal authorities is imperative for accountability and transparency in consumption and saving; more so because they are the “consumption conduit”. More importantly, is the need for all the three tiers of government to imbibe the culture of corporate governance by ensuring proper accountability and transparency in managing their allocations of federally collected revenue.

Challenges of Managing External Reserves

Volatility of Foreign Exchange Inflow
Nigeria’s dependence on oil for over 90% of its foreign exchange earnings makes its capital account vulnerable to the fluctuations in crude oil prices. This, in addition to its high import bills contributed to the fluctuations in the level of reserves over the years and consequently the way the reserves are being managed. During the oil boom of the mid-seventies which has resulted in the build up of reserves, the external reserves were diversified into an array of financial instruments including foreign government bonds and treasury bills, foreign government guaranteed securities, special drawing rights (SDRs), fixed term deposits, call accounts and current accounts. This provided significant investment income as well as liquidity. However, during the glut in the global oil market which led to collapse in the crude oil prices and consequently a drawdown in the reserves, the reserves were held mainly in current accounts and treasury bills. This underscored the need to diversify the sources of foreign exchange inflow of the country.

Fiscal Federalism
Sections 162(1) and 162 (3) of the Constitution of the Federal Republic of Nigeria made it mandatory for all revenues accruing to the nation to be paid into the Federation account and to be distributed among the Federating units in accordance with the existing revenue allocation formula. The implication of this constitutional provision is that each tier of government has the right to spend its own share of the revenue and when this happens, in view of the limited instruments for sterilization, the Bank has to sell more dollars in order to mop up the excess liquidity.

Development of Productive Non-oil Economy exploit
Nigeria should invest heavily in infrastructural development in order to create the enabling environment for a non-oil economy. In this regard, the provision of steady power and water supplies as well as good road and communication net works is very crucial.

It is also important for Nigeria to explore ways of reviving its huge agricultural potential which has been neglected since the discovery of oil in addition to exploiting its rich untapped solid mineral deposit in order to promote diversification of the economy away from a mono cultural product base.

Natural Challenge
Oil is a wasting asset and would be exhausted some day, this poses a very big challenge to reserves management in Nigeria as to what would become of the economy when this single most important source of national revenue is fully depleted.

Training and Retention of Staff
Reserve Management task is becoming more complex as central banks are moving into new asset classes with higher risk/return profile in search of higher risk adjusted returns. In the case of CBN, we are moving from the hitherto investment in money market instruments such as time-deposits; treasury bills etc into longer dated instruments like treasury and agency bonds (having explicit guarantee of a sovereign government). Although these are default-free instruments, they however have market risk. This development has necessitated the need for highly skilled personnel who could measure and control the associated risks. Although the Bank is making efforts to develop capacity in reserves management, the challenge is how to retain these staff in view of the high demand for their skills in the private sector.