Why the Naira is Falling as Foreign Reserves Rise




By Chinedu Okoye 



Naira Subdued as Foreign Reserves Increase

Naira continues to be subdued in the foreign exchange market despite significant increases to the 30-day moving average of the CBN's foreign reserves. Naira has shed more value against the USD since our last paper on exchange rate policy, where we advocated for a Crawling Peg.

Whilst there could be factors that make the suggested approach impractical, those same factors we believe are responsible for the current underbidding of the Naira - an encumbered FX Reserves.

Under a managed float, it is normal to experience a divergence between growth in reserves and the value of the currency. Changes in reserves don't passthrough to an exchange rate appreciation where there is no change in the 'core' components of the balance of payments. Hence the need for intermittent interventions. 

The general factors that affect reserves include external borrowings, exports, foreign direct investment, remittances. Of all these exports and foreign direct investments are what we refer to as 'core' because they are more sustainable and cost nothing.



Explaining the Reserve Growth - Naira Exchange Rate Divergence:

The major drivers of the increases in the 30-day moving average have been, Foreign portfolio investments into government securities, external borrowings and remmitances.

These increases in FX inflows hasn't translated to Naira strength because of the source of the increases. Foreign portfolio investments carry interest and would be repatriated on maturity, and Diasporan Remittances are variable. 

Whilst the country has maintained a balance of trade surplus throughout the first half of the year, the surplus has had more to do with exchange rate induced inflation and the erosion of both producer and consumer purchasing power. Thus, even as foreign exchange is more accessible, the market pricing of the Naira has suppressed importer demand. Nigerian importers simply have lesser purchasing power for the same Naira amount. 

Oil still accounts for over 80% of Nigerian exports and so the struggle to raise production is also a worry for traders, and a drag on export earnings. Foreign direct investments have been slow as well, making the two 'core' components of foreign currency supply weak.



Zero Equilibrium Take:

Naira holds the not so flattering position of the worst performing Sub-Saharan African Currency in 2024. And this is despite a 55% increase in net foreign exchange flows in H1 2024 and an increase in foreign reserves to $39 billion (Gross).

Below is a summary of the reasons for the divergence.whicj include; FPI Dependence, Lagging Exports and FDI (Core FX Supplh or reserve components), whoch leads to, Sustainability Concerns.

FPI Dependence: Debt including external borrowings and local and foreign denominated FGN Securities make up a large portion of the reserve increases. A repatriation of capital upon maturity would see the Naira flood the FX market and in the event that there isn't sufficient new foreign subscription to new issuances, reserves would be severely depleted.

Lagging 'Core' FX Supply Components: With minimal increases in both oil and non oil exports l, the rrade surplus has been dominated by Oil and with the output challenges faced ny NNPCL, it would take longer for balance of trade to significantly improve. 

Sustainability Concerns: The growth in reserves is perceived as transitory, and until there are changes to the core components of Balance of Payments (Overall FX Flows), the Naira would stay bid around current levels, on the NAFEM as an essentially an (exchange rate) risk premium place on a volatile asset (Naira)

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