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Should Africa’s Dream of Monetary Union be kept

Alive?

Joe Atta-MensahCapacity Development Division

ECA

May 2014

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Presentation

• Introduction

• Africa’s Experience with Monetary Union.

• Theory of Monetary Union.

• Links between Monetary Union and Price Stability.

• Policy Mix

• Conclusion

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Introduction

• African Nations are vigorously pursing an integration Agenda

• As part of their integration agenda, African regional economic

communities (RECs) have or are in the process of establishing

monetary unions.

• Monetary integration contributes significantly to deepening regional

integration, especially for RECs, which have objectives of creating

common markets.

• Regional economic cooperation in Africa dates as far back as the

beginning of the last century. The cooperation primarily focussed on

the facilitation of international trade and payments.

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Introduction (2)

• International monetary arrangements have been experiencing

instability since the breakdown of the Bretton Woods agreements in

the early 1970s.

• In the 1980s global economies were faced with misalignment of the

major currencies. The decade also saw massive capital flight towards

the United States and other industrialized countries from the

developing world, particularly after the debt crises and the cutting-off

of new loans.

• the 1990s and the beginning of the 2000s also brought with it deep

financial crises in Asia, Argentina and Brazil. These challenges

contributed in depressing economic growth. It also brought home the

importance of macroeconomic stability.

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Introduction (3)

• During the 1970s/1980s, developing countries have had to bear some costs

as their economies suffered immensely during the period.

• Low and declining share of world trade and the continent’s marginal

financial integration with the rest of the world, based on a share of GDP,

the average African country is far more open to trade than the average

developed country.

• Hence African countries are consequently more vulnerable to volatile shifts

in their terms of trade as well as shifts in exchange rates due to the need to

repay foreign borrowings in hard currency.

• This paper focuses on Africa's agenda of creating a monetary union as a

way of addressing macroeconomic instability with view of promoting

economic growth.

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Africa’s experience with Monetary Union

• Monetary cooperation between different countries in Africa has been

going on for a long time.

• During the colonial period, French and British colonies had in place

common monetary arrangements.

• At the time, these arrangements were established to facilitate the

administration of the colonies and the collection of seigniorage, rather

than to promote exchange rate management and fiscal policy.

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Africa’s experience with Monetary Union (2)

• The British and the French monetary cooperation arrangements were

not the same.

• The British currency boards were rooted in English central banking

and therefore performed functions similar to those of the Bank of

England.

• The French currency boards in the colonies followed the guidelines

and principles of French central banking. Hence, like the Banque de

France, the French currency boards lent significantly to the local

banking system as the currencies were backed by the French Treasury.

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Africa’s experience with Monetary Union (3)

• During the colonial period, a number of monetary arrangements existed in the

Eastern and Southern Africa regions.

• In East Africa, a common currency area was established in 1919 for Kenya,

Uganda and Tanganyika (now Tanzania) with the creation of the East African

Currency Board (EACB).

• In 1936, Zanzibar joined the common currency area. During the Second World

War, the East African shilling was used as legal tender in Somaliland as well as

in parts of Ethiopia and Eritrea, and in 1951 Aden was included in the currency

area.

• A monetary system similar to that of East Africa was established for the

Federation of Southern Rhodesia (now Zimbabwe), Northern Rhodesia (now

Zambia) and Nyasaland (now Malawi). A Southern Rhodesia Currency Board

(SRCB) was established in 1938 by a colonial Act.

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Africa’s experience with Monetary Union (4)

• South Africa, Basutoland (Lesotho), Bechuanaland (Botswana) and

Swaziland had their own currencies during colonial time. But after 1881,

the pound sterling became the standard currency in these countries and

remained in use until 1961.

• In 1974, the Rand Monetary Agreement (RMA) was signed and the rand

became the only legal tender in the RMA zone, which included Botswana,

Lesotho, South Africa and Swaziland. However, Botswana pulled out from

RMA in 1975.

• Political pressures caused most these monetary arrangements to be

dissolved after independence.

The Theory of Monetary Union

Mundell (19610 proposes four criteria for monetary union:

• Free movement of labour across member countries of the union. This

includes physical ability to travel (visas, workers' rights, etc.), lack of

cultural barriers to free movement (such as different languages) and

institutional arrangements.

• Open markets to ensure capital mobility as well as price and wage

flexibility across the Union. This is needed so that the market forces of

supply and demand automatically distribute money and goods to where

they are needed. It also ensures that asymmetric shocks could be

assimilated.

•

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The Theory of Monetary Union (2)

• There is a risk sharing system such as an automatic fiscal transfer

mechanism to redistribute money to countries/areas/sectors of the Union

which have been adversely affected by the observance of the first two

assumptions. The transfers will generally be in the form of tax-revenue

redistribution to less developed areas of a country/region in the Union.

• The economic structures of the economies of the Union should be similar.

The need for this criterion is to ensure that the countries face similar

vulnerability to asymmetric shocks or have the same business cycle. This

allows the shared central bank to promote growth in downturns and to

contain inflation in booms. Should countries in a currency union have

idiosyncratic business cycles, then optimal monetary policy may diverge

and union participants may be made worse off under a joint central bank.

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The Theory of Monetary Union (3)

• Kenan (1963) expanded on Mundell’s work by concluding that countries

with highly diversified economies are good candidates for the formation of

a monetary union. This is because economic diversification helps countries

to adjust rapidly to negative external shocks quickly than economies that

are not diversified.

• McKinnon (1963) added to Mundell’s model by arguing that highly open

economies also good candidates for a monetary union since a common

currency is very important for their stability and prosperity. McKinnon

points out that monetary union is beneficial to open economies because it

reduces the uncertainty associated to exchange rate fluctuations,

particularly for the purpose of trade.

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Convergence Criteria

• Its inflation rate is not more than 1.5 per cent higher than the average of the

three lowest inflation rates among the EU member States

• Its long-term interest rate is not more than 2 per cent higher than the

average observed in these three low-inflation countries

• It has joined the exchange rate mechanism of the EMS and has not

experienced a devaluation during the two years preceding the entrance into

the union

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Convergence Criteria (2)

• Its government budget deficit is not higher than 3 per cent of its GDP (if it

is, it should be declining continuously and substantially and come close to

the 3 per cent norm, or alternatively, the deviation from the reference value

(3 per cent) should be exceptional and temporary and remain close to the

reference value (Art. 104c (a))

• Its government debt should not exceed 60 per cent of GDP (if it does, it

should diminish sufficiently and approach the reference value (60 per cent)

at a satisfactory pace.

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Monetary policy in a monetary union

• The central bank of the union should be independent and the clear objective

of price stability. To fulfil this mandate effectively, the central bank of the

union and the national central banks of member states should be free of

from political interference.

• The central bank of the union must ensure that longer-term inflation

expectations have been firmly anchored at levels consistent with the

definition of price stability (or agreed inflation target).

• The protocol governing the setting up of the monetary union should

prohibit monetary financing of public deficits.

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Monetary policy in a monetary union (2)

• Monetary policy should be separated from fiscal policy. In this regard, the

central bank shall conduct monetary policy, while member states shall

support the general economic policies in the union with the view of

achieving harmonious, balanced and sustainable development of economic

activities, including a high level of employment, sustainable growth.

• The general mandate to support general economic policies should be

carried out without compromising the primary objective of price stability.

In this regard the central bank of the union should not be given any further

“secondary objectives” of other economic policies.

• The central bank should use an interest rate as its instrument for the

conduct of monetary policy for the union. In this regard, it is very

important financial and capital markets are deepened in the area.

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Fiscal policy in a monetary union

• The protocol establishing the union should have clear budgetary rules as a

disciplinary mechanism in order to safeguard sound public finances within

single countries and also to limit negative externalities for the union as a

whole.

• Excessive budget deficits must be avoided by member states. In this regard,

there should be a ‘non bail-out clause’ rule in the protocol or Treaty

establishing the union such that either the union or national governments

can take on liabilities for the debts incurred by an individual Member State.

This should help to limit the risk that governments shift part of the burden

of high government debt to their partners in the union. In addition this

measure would prevent bad fiscal policies in one country does not lead to

higher risk premia for debt in the union as a whole.

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Fiscal policy in a monetary union (2)

• To ensure long-term debt sustainability and sound management of public

finances of member states in the union, the framework for fiscal policy

should have ceilings for deficit and debt-to-GDP ratio for member states.

(For example in the Euro area they have a 3% deficit ceiling and a 60%

reference value for the debt-to-GDP ratio.)

• The central bank should use an interest rate as its instrument for the

conduct of monetary policy for the union. In this regard, it is very

important financial and capital markets are deepened in the area.

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Conclusion

• In creating an African Monetary Union (AMU) is important appropriate

rules and institutions are designed. Perhaps AMU could be founded on

four pillars: financial union, fiscal union and economic union. The

sustainability of the monetary union means that there are:

1. strong institutions to supervise and stabilize the single financial

market;

2. strong institutions to guide fiscal policies; and

3. strong institutions to coordinate economic policy, guarantee

competitiveness and encourage sustainable growth.

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Conclusion (2)

• Africa's dream of a monetary union is achievable. This vision can be

realized. The challenges that will be faced along the path leading to the

creation of an African single currency should strengthen our resolve and

to adopt measures to mitigate the challenges so that the current multiple

currencies on the continent are replaced by one single currency.

• The central bank should use an interest rate as its instrument for the

conduct of monetary policy for the union. In this regard, it is very

important that financial and capital markets are deepened in the area.

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Thank You