The Determinants Of Foreign Reserves In Nigeria

Abstract

Foreign exchange reserves’ adequacy is a key component of good macroeconomic

management. Foreign reserves can be used to smoothen exchange rate volatility in illiquid foreign

exchange markets. This study adopts a modified version of buffer stock model to analyze the

determinants of Nigeria’s foreign reserves. Using annual time series data from 1970 to 2009, the study

regresses international reserve variable on macroeconomic variables: real income, interest rate

differential (a measure of opportunity cost), exchange rate volatility, financial openness, openness to

trade (a measure of current account vulnerability), benchmark stock of reserves, and the demand for

foreign exchange. In order to avoid any spurious regression results, the time series data was subjected

to stationarity tests. The ADF - cointegration procedure was used to examine if there exists any

potential long run relationships. The result indicates that the variables are cointegrated together.

Hence, the short run dynamics was examined by means of an error correction model. The empirical

evidence shows that growth in Nigeria’s foreign reserves is not influenced in the long run by trade

openness (Top), the opportunity cost of holding reserves (DID) and the benchmark stock of reserves

but by other determinants such as the real Gross Domestic Products (Y), exchange rate volatility (Ev),

financial openness (Fop), and the demand for foreign exchange (DFex). Further, in the short run,

growth in Nigeria’s foreign reserves is only not influenced by trade openness (Top), but by other

determinants such as real Gross Domestic Products (Y), exchange rate volatility (Ev), financial

openness (Fop), the demand for foreign exchange (DFex), the opportunity cost of holding reserves

(DID), the benchmark stock of reserves (DFr*), and the error correction mechanism (ECM (-1)). It is

also found that both in the long run and short run, the opportunity cost of holding reserves is

about 2.5%, and about 6.0%. However, since the risk in reserve holding both in the long and

short run is very low, management strategies that will aid in more reserve accumulation

should be reconsidered by Nigerian government. More so, since in the long run the

benchmark stock of reserves does not affect Nigeria’s foreign reserves (but does affect it in

the short run), Nigerian government should make sure that adequate amount of reserves must

be kept at all times (not only in the short run but also, in the long run) to help smooth the

volatility in exchange rate. Finally, the study also found that there exists a disparity between

foreign reserves (Fr) and the benchmark stock of reserves (Fr*) hence, Nigerian government

should adopt management strategies that will equilibrate the two of them at least, in the short

run.

Keywords: Foreign, Exchange, Reserves, Volatility, Determinants, Buffer, Stock, Variable,

Macroeconomic, Benchmark, Spurious, regression, Stationarity, Cointegration, Long-run,

Short-run, Error Correction.