12 October 2008
analysis
There has been quite some anxiety by the public regarding the safety or otherwise of our foreign reserves, over 90 percent of which are held in U.S. dollar assets.
This anxiety has increased as the financial crisis on Wall Street deepens - in spite of the infusion of a staggering US$700 billion into the financial system by President George W. Bush. The question remains an insistent one: should our monetary authority move our sovereign assets out of the dollar to other - presumably safer - currency denominations? What are the possible risks in maintaining the status? Given current realities, what are the prospects of the dollar's further weakening and to what extent are we to expect the erosion in the value of our sovereign assets should the current crisis metamorphose into a recession or worse?
For the avoidance of doubt, we will follow the official IMF definition of international reserves as, "official sector foreign assets that are readily available to, and controlled by the monetary authorities, for the 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". The liquid cash or investment assets held by private individuals, banks and government agencies and bodies corporate clearly do not fall under the official definition of foreign reserves. A few years ago, private Nigerians were estimated to hold a staggering US$120 billion in overseas accounts, none of which could be officially defined as part of our official reserves, which at the latest count amount to some US$63 billion.
Many today wonder why we should continue to accumulate such a huge outlay of reserves when there are so many vital needs crying out for funding in areas such as infrastructures, power, health, education and social services. The truth is that it has contributed to the restoration of our international credibility and has boosted our creditworthiness. Although ours constitute the largest on the African continent, they are quite modest in comparison to emerging markets such as China (in excess of US$1 trillion), India (US$400 billion) and Singapore (US$350 billion). Over the last decade, developing countries have accumulated large outlays of external reserves to shield themselves against manipulation by international financial agencies as well as to enhance capacity to maintain confidence in monetary policy and exchange rate management. It also enables such countries to easily service their foreign currency liabilities and external obligations while providing a vehicle of defence in times of emergency and acting as a source of income from investment.
The CBN Act 1999 devolves the custody and management of our country's external reserves on the Central Bank of Nigeria, which may be denominated in gold coins or bullion, bank balances at any bank outside Nigeria, treasury bills, government securities and guarantees and in gold tranches, Special Drawings Rights (SDRs) and other securities of international financial institutions.
The CBN has defined its reserves management objectives in terms of (a) safety and preservation of capital; (b) liquidity; and (c) enhanced return on investment. For all central banks as it is indeed for ours, the most critical objective is safety and preservation of capital. Clearly, the overriding priority is to ensure that sovereign capital is preserved at all costs. This explains why the bulk of Central Bank assets are normally held in government securities, treasury bills and bonds and through foreign banks that possess the highest credit ratings.
The most pressing issue that concerns the public today is whether or not, under the current turmoil, our safety of principal could be said to be guaranteed. The CBN has always kept the bulk of our sovereign assets in dollars on the flawless logic that over 90% of our forex inflows and outflows are in greenbacks. Most of our crude oil and non-oil transactions are invoiced in U.S. dollars, as are our internal forex interventions. A few years ago, it was acknowledged that the continuing slide of the greenback could not have done our reserves any good. But the general thinking was that these were short-run volatilities that would stabilise in the long run, being merely part of a cyclical movement that does not amount to a fundamental change.
The issue of safety relates not only to the question of currency allocation, but also to the type of instruments and their riskiness. The CBN Act 1991 restricted the types of investment windows in which our external reserves could be deployed, especially equities, corporate bonds and agency instruments not explicitly guaranteed by sovereign governments. The new CBN Act 2007 (Section 24), on the other hand, has removed such restriction, and instead, gives the monetary authority greater flexibility in the selection of instruments on the argument that the dynamics of modern reserves management make it imperative for central banks to retain some flexibility in determining the choice of instruments and to leverage on the best available opportunities in the international business environment.
There are two obvious problems with this line of reasoning. The first is that the Act offers almost a blank cheque for the monetary authority to do any and everything in the name of exploring 'opportunities in the international business environment'. The second relates to the constitutional legitimacy of the new Act itself, as there is little evidence that it benefited from a full debate or went through all the hoops in the legislative process. One gets the impression that it was passed in the manner of a last-hour offer in an English pub, as members of the National Assembly were rushed into passing the bill in May 2007 as they were preparing to leave. As a consequence, there are some who see the Act as a pestiferous piece of self-serving humbug that should never have seen the light of day. In any case, most members of the National Assembly want to revisit it in all its material particulars.
Following the successful banking consolidation, for which full credit must be given to the management and board of CBN, the bank took further steps to rationalise the framework for foreign reserves management. An Investment Management Committee was established. Training of staff as well as management on aspects of modern portfolio management was rigorously pursued. The World Bank provided technical assistance through its Reserves Advisory Management Programme (RAMP). A new Strategic Asset Allocation Framework was adopted while a modern functional dealing room was created with top-of-the-range streaming technology.
Perhaps the most important aspect of the new reserves management framework was the choice of a global custodian (JP Morgan) and external asset managers consisting of Nigerian and foreign banks. By July 2006, some $7bn (representing some 18.40% of total external reserves at the time) were apportioned to 14 Nigerian banks and their 14 global asset management partners. The idea was to ensure that our own financial institutions enjoy a piece of the action while benefitting in terms of knowledge and skills transfer.
What worries most Nigerians today is not whether the CBN is effective in managing our reserves but whether such funds, as currently denominated in dollar assets, could be said to be ultimately safe. Recall that by the 1970s, some 80% of all international reserves were held in dollar assets. By 2008, however, this figure had reduced to a more modest 67 percent. The second most important currency in which foreign assets are held are in Euros, which lag far behind at 24% of the global total, with the British sterling and the Japanese Yen trailing at 3.7 and 3.6% respectively. The Swiss franc stands at a surprisingly paltry 0.1 percent.
The continuing popularity of the dollar in the face of adversity reflects the general confidence in which most trading countries still repose in the world's de facto reserve currency. Not only is the U.S. the world's industrial motor, it is still the world's pre-eminent military power; a country without peer in technology, innovation and entrepreneurial energy. Its system of laws and its constitution provide are a model for property rights, sanctity of contracts and the rule of law, elements which are most crucial to a free enterprise economy. This is why people still believe in the long-term fundamentals of the American economy and the impregnableness of the dollar. The American juggernaut is also enmeshed in a web of complex interdependencies with Japan, China and much of the Asia Pacific, in which the dollar offers the most convenient means of exchange and store of value.
With the ongoing financial tsunami in Wall Street though, some doubts have begun to creep in. For one thing, doubts have been cast on the efficacy of the $700 billion already pumped into the system. The IMF believes the credit crunch would require a further $500 billion in resources. Others put the price tag at an astronomical $1.8 trillion, a figure that the U.S. Treasury cannot be expected to raise without recourse to international borrowers, a factor that would deepen the domestic deficit while further eroding international confidence. Another alternative would simply be to set the printing houses to work, a scenario that would simply fuel domestic and international inflation while putting pressure on the value of the dollar.
If the long-term room for manoeuvre appears so bleak, shouldn't we begin to look elsewhere - the Euro - for example? In a world of such uncertainty, is it not wise to err on the side of caution? Countries such as Iran and Venezuela, for geopolitical reasons, long ago began to hold their foreign assets predominantly in Euros rather than dollars. Several Middle Eastern corporations and wealthy individuals have divested from the dollar to the Euro following sabre-rattling by Washington after 11 September, 2001. Remarkably, many of the Middle Eastern Asian and some western hemisphere currencies fluctuate less against the dollar than against the euro or yen, indicating that the centre of gravity of international high finance is already shifting elsewhere. As the Euro stabilises and comes into its own, it is estimated that over the coming decade, some US$1 trillion in long-term funds are likely to migrate from the dollar zone to the Euroland area.
Wise men from Warren Buffett to Joseph Stieglitz tell us that what America and the world face today is not business-as-usual. It may well turn out to be a non-contagious tremor; but it may equally transmute into a global recession or perhaps something worse. We face a lot of uncertainty for which no economist has yet devised a foolproof forecasting algorithm. Much will depend on the vision and creativity of America's leaders and their willingness to share the burden of global responsibility with others in a new compact of solidarity and hope. Under such uncertainty, it would be prudent, in my view, for us to diversify our risks away from the dollar. To do otherwise would amount to fishing in the dark.
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