Foreign Reserve

By Aliyu Nuhu

Here is the use and advantages of foreign reserve currencies for nations that take their economy serious and have development and growth of their nations in mind.

First, countries use their foreign exchange reserves to keep the value of their currencies at a fixed rate. A good example is China, which pegs the value of its currency, the Yuan, to the dollar. When China stockpiles dollars, that raises its value when compared to the Yuan. That makes Chinese exports cheaper than American-made goods, increasing sales.

Second, those with a floating exchange rate system use reserves to keep the value of their currency lower than the dollar.

They do this for the same reasons as those with fixed rate systems. Even though Japan’s currency, the Yen, is a floating system, the Central Bank of Japan buys U.S. Treasuries to keep its value lower than the dollar. Like China, this keeps Japan’s exports relatively cheaper, boosting trade and economic growth.

A third, and critical, function is to maintain liquidity in case of an economic crisis. For example, a flood or volcano might temporarily suspend local exporters’ ability to produce goods. That cuts off their supply of foreign currency to pay for imports. In that case, the central bank can exchange its foreign currency for their local currency, allowing them to pay for and receive the imports.

Similarly, foreign investors will get spooked if a country has a war, military coup, or other blows to confidence. They withdraw their deposits from the country’s banks, creating a severe shortage in foreign currency. This pushes down the value of the local currency since fewer people want it. That makes imports more expensive, creating inflation. The central bank supplies foreign currency to keep markets steady. It also buys the local currency to support its value and prevent inflation. This reassures foreign investors, who return to the economy.

A fourth reason is to provide confidence. The central bank assures foreign investors that it is ready to take action to protect their investments. It will also prevent a sudden flight to safety and loss of capital for the country. In that way, a strong position in foreign currency reserves can prevent economic crises caused when an event triggers a flight to safety.

Fifth, reserves are always needed to make sure a country meets its external obligations. These include international payment obligations, including sovereign and commercial debts. They also include financing of imports and the ability to absorb any unexpected capital movements.

Sixth, some countries use their reserves to fund sectors, such as infrastructure. China, for instance, has used part of its forex reserves for recapitalizing some of its state-owned banks.

Seventh, most central banks want to boost returns without compromising safety. They know the best way to do that is to diversify their portfolios. That’s why they’ll often hold gold and other safe, interest-bearing investments. 

How much are enough reserves? 

At a minimum, countries have enough to pay for three to six months of imports. That prevents food shortages, for example. Another guideline is to have enough to cover the country’s debt payments and current account deficits for the next 12 months. In 2015, Greece was unable to do this. It then used its reserves with the IMF to make a debt payment to the European Central Bank.

If Nigeria had been a prudent nation we should be having $900bn as our foreign reserve by now, and according to world bank, a Naira will exchange Dollar one for one.

But look at us. We neither have robust national saving, nor an infrastructure to show for the money we earned. A wasted nation. Aliyu Nuhu is a renowned social commentator on African affairs. He writes from Abuja, Nigeria.