FOREIGN RESERVE LEVELS AND EXCHANGE RATE VOLATILITY: EVIDENCE IN NIGERIA

Abstract

Globally, foreign reserves are crucial for determining the exchange rate. Nigeria's foreign reserves have been volatile due to the country's oil-dependency economic structure. At an all-time high of $62.1 billion in November 2008, supported by high global oil prices, it fell to a low of $23 billion in October 2016, caused by a decrease in foreign reserve accretion due to lower global oil prices. Thus, this paper explores how foreign reserve levels influence exchange rate determination in Nigeria. The study employs monthly foreign reserve and foreign exchange rate data sourced from the Central Bank of Nigeria's statistical bulletin, covering the period from 2015 to 2024. The study applied the Vector Autoregressive Model for the analysis. Findings from model one (1) suggest that historical values of the official exchange rate significantly influence current and future official exchange rate movements. Additionally, a decrease in foreign exchange reserves in the previous period is associated with a depreciation of the official exchange rate. Findings from model two (2) suggest that past values of the interbank foreign exchange market rate significantly influence current and future interbank foreign exchange market rate. While a decrease in foreign exchange reserves in the previous period appears to be associated with an appreciation of the interbank foreign exchange market rate, this relationship is not statistically significant in model two. The study demonstrates that Nigeria's foreign exchange reserves play an important yet time-lag and asymmetric role in exchange rate determination. The study underscores the limitations of relying solely on foreign reserve management for exchange rate stability and highlights the need for complementary structural reforms to mitigate systemic vulnerabilities. The study recommends that the Nigerian apex bank adopts forward-looking reserve management strategies like the Guidotti-Greenspan rule and stress testing for foreign reserve management to assess resilience against shocks like commodity price collapses and geopolitical crises.