FX Reserves: Borrowing from Yourself & Paying Someone Else

OUTSIDE THE BOX

BY ALEX OTTI 

I know many of my former colleagues in the banking industry and my fellow students of Economics will be up in arms against me for holding the view I will be expressing in this article. I know this because I am going to be departing from conventional wisdom and norms in this discussion of foreign reserves. Well, I am also prepared for the attacks.

According to Wikipedia, “Foreign-exchange reserves is money or other assets held by a central bank or other monetary authority so that it can pay its liabilities if needed, such as the currency issued by the central bank, as well as the various bank reserves deposited with the central bank by the government and other financial institutions. Reserves are held in one or more reserve currencies, mostly the United States dollar and to a lesser extent, the euro”. Breaking this down, foreign reserves should only exist to the extent that the country that owns the reserves has exported some goods and/or services for which payments are made to it and from which it chooses to save some of the foreign currency receipts. It is also grown through the inflow of foreign currencies from portfolio and foreign direct investments.

Strictly speaking, it is expected that if a country does not accrue any surpluses in its foreign currency transactions, then it should not have any reserves. In reality however, it hardly works that way as there are instances where an indebted country would have reserves that far outstrips its debts. In layman’s knowledge, the right thing to do will be to net the reserves from the debts to reduce its indebtedness. Why that does not happen in reality will become clearer in the course of this discussion.

Why does a country hold external reserves, one may ask? From a macroeconomic point of view, reserves are necessary to cover a country’s imports projected over a certain period of time. The convention is that a country needs to hold reserves to cover between three to six months of its average import bill. In reality, counties generally keep more than that. Countries that keep more are those that have done very well in the management of their economy. Take for instance China, on account of its ability to generate a lot of dollars from its exports to the US and other countries, it is able to keep a large amount of reserves in US dollars. China sees itself as an exporting nation and it is in a position to sell far more than its import needs.  This action, together with a deliberate government policy keeps the local currency rate low, relative to the US dollars. Bear in mind that because the Yuan is cheaper, Chinese exports become cheaper and more attractive, thereby increasing demand for Chinese products at the expense of US made goods. This helps to boost local manufacturing and thus create jobs in China and encourage even more exports from China. This is the main reason for the US outcry against China and the accusation of adopting unfair trade practices. It is interesting that the world’s biggest champion of Capitalism and free market, now cries wolf and accuses another country that adopted their sermon of embarking on unfair trade practices. Anyway, that is a story for another day. Note that the so-called unfair trade practices help China stabilize its economy and keep its people employed.  

It is also understood that foreign reserves are necessary to manage the local currency. For instance, in periods of shock or crises, holding enough reserves can help maintain some stability in a country’s exchange rate management efforts. During the 2008/2009 global financial crises, the external reserves war chest of over $60billion helped the managers of the Nigerian economy at that time to maintain some stability in the foreign exchange market and defend the economy from external shocks. For an import- dependent country like Nigeria, the buffer helped to maintain social stability beyond what the uninformed would contemplate.

Sometimes, Central Banks keep foreign reserves to boost the confidence of foreign investors. If for some reason, export volumes drop or the value of foreign currency received from exports reduce due to falling prices, the existence of foreign reserves theoretically protects the local currency against massive devaluation which would lead to the diminution of the value of foreign investments. For foreign direct investors and treasurers who indulge in portfolio investments, the implication is that they will receive relatively lower foreign currency as their repatriation will  be at much higher local currency rate leaving the investor with less foreign currency than it brought into the country. An example is the most recent experience in the country where, due to a combination of factors of oil price drop and other economic challenges, the value of the Naira dropped from about N200 to the dollar to over N500 to the dollar, a foreign investor who invested the Naira equivalent of $10m would exchange his investment at no more than $4m. He would, therefore lose 60% of his investment by that singular challenge. Moreover, a really extreme situation could be when the country does not even have enough foreign exchange to give those who wish to repatriate their principal investments or profits/dividends. So the foreign reserves help boost the confidence of investors and players in the economy who are assured that there will be foreign currency to back their repatriation needs.

Countries use the foreign reserves for savings for specific projects and expenditures. Nigeria could decide to draw from its foreign reserves to build refineries or other necessary infrastructure. Again, some economists believe it is necessary to diversify currency risk and hedge against unexpected drop in value of other currencies. Some others earn better rates when they keep foreign currency, depending on the local interest rate regime in the countries in question.

Following from the above, it is expected that Economies with the largest trade surpluses will naturally be the ones with the largest foreign reserves. This is because they earn more dollars than they spend and will therefore have them saved in foreign accounts.

As of December 2017, the following countries had the corresponding balances to their credit in foreign reserves: China, $3.194t; Japan, $1.233t; European Union, $741b, Switzerland, $680b; and Saudi Arabia, $509b

These countries are also some of the countries that have the world’s largest trade surpluses.

There has been an unspoken policy of building up a massive war chest of foreign reserves by all means by the managers of the Nigerian economy. Recall that at the inception of this Republic in 1999, the country had just about $5billion in external reserves. It reached an all time high of $62billion in September 2008 before going down again quite significantly in the wake of the adverse oil shocks of the past few years.

From the analysis made above, there may be sufficient reasons to build up foreign reserves. However, in the light of competing demands for funds and the equally massive build up of debts, some of us are concerned that we may not be considering all the issues and may also not be managing our resources in the most efficient manner. Like we had argued earlier, a major reason for building up foreign reserve is to cover at least 3 to 6 months of imports. Statistics show that our imports are in the region of $35billion annually, therefore, we require between $9b and $18b in foreign reserves. In the recent times, we have seen an aggressive build up of foreign reserves, such that from less than $26b at the end of 2015, we have now accumulated $47.3billion in April this year, though this had dropped, as at last week, to about $41.5billion. In fact, had it not been for the determination of the monetary authority to have a ‘stable naira’, the foreign reserves would have been much more in quantum. It is a well known fact that the CBN periodically steps in with some hundreds of millions of dollars to keep the naira stable at around N360/$

While there is nothing fundamentally wrong with this build up if the economy was running smoothly, some of us are concerned that we may just be focused purely on keeping a large foreign reserve just for the sake of it. So, we are asking questions about the efficiency of the policy option. The government had made it clear that to provide critical infrastructure for the populace, it needs a lot of money. The estimate is that we require over $300b in the next 10 years to close the infrastructure gap. The government has also gone ahead to ramp up borrowing in a very aggressive fashion, such that as per the figures from the Debt Management Office,(DMO), our total external debt stock has risen from $10.718b in 2015 to $22.1b as at June 2018.

It is safe to estimate that the average interest rate of these loans is about 7% per annum. From a layman’s point of view, we have over $40billion in our account abroad where we earn an interest rate of around 1.7%p.a. while we are borrowing $22b for which we are paying about 7% p.a. The cardinal rule in foreign reserve investment, just like pension and insurance funds, is the preservation of the principal amount. Returns are a secondary concern and as such the interest income is usually very conservative.  The stark reality is that it means we are losing over 5% p.a. on the $22b or about $1.1b every year on the loan, just putting it in its simplest form.

We must also acknowledge that part of what makes up the foreign reserve is the foreign loans that the federal government has been taking. As at June this year, Nigeria had an outstanding euro bond of about $8.5b. With the approval to issue another $2.8b to fund the 2018 budget, we should be talking of an outstanding of over $11b. All these would be part of the accretion to foreign reserve. Typically, when euro bonds are issued, Naira proceeds are made available to the Federal Government while the actual funds are held by the Central Bank in foreign currency, which are calculated as part of our foreign reserve. The only problem with this is that those funds are no longer available to be spent by the CBN or the Federal government. So, what exactly would we say we have done? We have become more indebted and for the debt, we are paying interest at a high rate. We then go ahead and issue local currency to match the debt and receive a much lower interest for same funds, deposited in a foreign bank like Chase. To add another dimension to this, some of our local banks and corporates issue foreign currency bonds also. Investors buy those bonds and make proceeds available to the banks or corporates. For the banks, it is usually a concern on how to use the funds in the most profitable manner. This concern stems from  the risks of currency mismatch and exchange rate volatility. The banks may just move the foreign currency to the CBN in what is referred to as a swap arrangement, such that the CBN enters into a forward contract to refund the foreign currency at a future date and at a predetermined exchange rate. In some cases, the banks would leave the funds in a foreign correspondent bank at rates lower than their cost. The ideal scenario for the banks though, is to ensure that they match foreign currency risk assets with the foreign currency loans.

The other part of the foreign reserve is what bankers refer to as “hot money”. Hot money refers to foreign currency brought in by investors to buy bonds and shares of corporates and governments in the country. It is hot money because, it can vote with its feet once it notices any impending shock. I believe that the major reason our foreign reserve dipped from $47billion in April to the present $41.5b in just six months is the impact of hot money. As we approach the 2019 election, it is expected that foreign private investment will dip. The Central Bank does not have a choice but to keep such monies in near liquid form in order to respond when the call is made.

While I agree with the idea of keeping some reasonable part of our funds in foreign reserve, I do not think that accretion to foreign reserve and the sheer size of our balances in foreign bank accounts should be a yard stick to measure the performance of the economy. In fact, I will contend that leaving a huge balance in foreign reserve is like a manufacturing company leaving a huge chunk of cash in savings accounts. What that tells me is that the company needs a consultant since it is veering away from its core function. I expect that the company should spend the money expanding and conquering new markets and making more profits. I will pass a harsher judgement on the company if in spite of the huge balances, the company turns around to borrow money from the bank to fund it’s activities. I say this because it is not in dispute that the only way a bank makes money is to borrow cheap and lend high. As we struggle to develop the country, in the face of massive infrastructure deficit and decaying institutions, one of the things we shouldn’t be encouraging is stashing money away in foreign accounts, except that part that is absolutely necessary. Another thing we shouldn’t be doing is borrowing high and saving low.