Demand for foreign exchange reserves in Nigeria: a cointegration approach

Abstract

There have been significant accretions to foreign exchange reserves over the last decade in Nigeria, especially since the return to democratic governance in 1999. The study tries to find out the underlying factors driving the demand for reserves by the monetary authority. To estimate the demand for foreign exchange reserves in Nigeria, Johansen cointegration and error correction methodology was utilized for the period 1985:Q 1-20I0:O4. The results show that the long-run demand for foreign exchange reserves in Nigeria is driven by economic size, capital account vulnerability, exchange rate flexibility and opportunity cost. In the short-run, the major determinant of demand for foreign exchange reserves in Nigeria is current account vulnerability. This implies that foreign exchange reserves should be held as a precaution against current account vulnerability since Nigeria is a high import-dependent country. The study recommends that policy should be tailored towards accumulating reserves during oil boom to serve as a buffer against external shocks and that trade policy should discourage heavy importation of consumption goods in favour of domestic locally produced consumption of locally produced goods.