CHAPTER 1
INTRODUCTION
Background
Africa is currently actively pursuing regional integration with monetary integration being within its policy agenda. In 1963, the Organization for Africa Unity (OAU) was created and one of its objectives was a monetary and economic integration of African countries. In 2001, the intergovernmental organization was transformed by the 53 OAU member states into the African Union (AU). The AU aspires for African countries to have one currency and one central bank by 2021.
Currently, there are 3 monetary unions in Africa. These are the CFA franc zones, the West African Monetary Union (UEMOA)1 and the Central African Economic and Monetary Community (CEMAC)2. The third is the Common Monetary Area (CMA) located in Southern Africa. Performance of these unions has been encouraging and this is evidenced by the two CFA zones having lower inflation rates compared to other African countries (Gurtner, 1999, p.51). Africa in its quest to create a monetary union faces a unique challenge since Africa is the continent with the highest number of currencies despite the existing monetary unions (Debrun, Masson and Patillo, p.4, 2010). Due of this unusual challenge, the AU’s strategy for monetary integration is to encourage the creation of monetary unions in the already existing regional community blocks3 in
1 Members of UEMOA are Togo, Senegal, Niger, Mali, Guinea-Bissau, Cote d’Ivoire, Burkina Faso, and Benin. 2 Members of CEMAC include Equatorial Guinea, Republic of the Congo, Chad, the Central African Republic (CAR), Cameroon, and Gabon.
3 The eight regional community blocks and their member states are listed in the appendix in Table A1.
Africa. The plan is for the monetary unions to merge to form an African-wide currency union with one central Bank and African currency.
One such regional bloc is the East African Community (EAC). Interest in monetary and economic integration in the region is high due to the numerous benefits that accrue to currency union members countries. The EAC member countries signed a protocol in 2013 to establish a monetary union by 2023. The East African Community Monetary Union (EAMU) protocol lays the groundwork for the EAC monetary union and outlines the macroeconomic convergence criteria meant to ensure coordination of the monetary and fiscal policies of the EAC partner states. This research investigates whether the EAC states are ready for one currency by comparing the countries’ performance vis-à-vis the targets set in the EAMU protocol. In addition, this study utilizes Generalized Purchasing Power Parity (GPPP) model to analyse whether the EAC constitutes an optimum currency area (OCA). Previous researches in this region have had inconclusive results on whether it is an OCA or not. This research will include the new member states and utilize recent data in the analysis.
The optimum currency area theory “can trace its roots to the long-standing controversial discussion of the optimal exchange rate regime. The controversy revolved around the pros and cons of fixed or flexible exchange rate system” (Ishiyama, 1975, p.345). From this debate, the theory of OCA was developed by Mundell (1961), McKinnon (1963), and Kenen (1969) in three very noteworthy papers. These authors are considered to be the founding fathers of OCA theory.
There is a general agreement that the European monetary integration in the 1960s played a huge role in continuing to propel OCA theory and its development into the limelight. The establishment of the European Union was a huge influence as a catalyst for other countries to form monetary
unions in regions outside Europe. In addition, contemporary OCA theory postulates greater benefits than costs to the potential currency union members. When countries form a monetary union, they forsake their independent national currencies in order to use a single currency. On one hand, they gain in terms of reduced transaction costs mainly in trade, elimination of exchange rate risk, economies due to pooling of international reserves, price stability and harmonization while on the other hand, they forfeit their ability to utilize their monetary policy and national exchange rate policy as stabilization tools for their economies.
The existing monetary unions in Africa have performed fairly well in terms of economic stability, however, findings from some studies have shown that they are not an OCA and they are not even fairly close (Gutner, 1999). This is perhaps because the traditional OCA theory was developed and tested in advanced countries and the possibility of it working properly in developing countries will be a wonder. Baghume (2013, p.25) asserts that “the theory was mostly developed with the European Union as a backdrop and as such certain elements disregard the important differences that exist between African and European countries.”
This study, therefore, places greater emphasis on the cost-benefit analysis of currency unification which takes centre stage in the ‘new’ OCA theory. The GPPP model which is utilized in this research is in step with the fundamentals of the contemporary OCA theory. So far among the growing pool of empirical studies done in East Africa, two studies stand out. Mkenda (2001) and Falagiarda (2010) are the only studies which used the GPPP model and found that East Africa is a feasible monetary union. This study will seek to extend their work by including the new EAC member states and use recent data in the analysis
Problem Statement
A monetary union once existed in the East African Community (EAC) from 1919 to 1977. It collapsed when the old EAC dissolved in 1977. East African Community was established again by Uganda, Tanzania, and Kenya by a treaty that was signed in 1999. Rwanda and Burundi joined the community in 2007 while South Sudan joined in 2016. The new EAC launched a customs union and a common market in the year 2005 and 2010 respectively. The third milestone is to establish a monetary union (MU) which is set to be launched by 2025 after which the countries seek to proceed to a political federation.
The Maastricht Treaty in the European Union had stringent convergence criteria for the members of the newly proposed currency union and it is believed to have opened up the way for the euro to be introduced in 1999. In a similar vein, EAC adopted macroeconomic convergence criteria (MCC) in 2007 so as to eliminate any disharmonies in the EAC member states economies and to ease the process of countries losing sovereignty over their monetary policies. Performance of member states vis-à-vis these criteria will be examined.
Previous research to determine the readiness of this region to form a currency union on this region have had contradicting results; Mkenda (2001) used GPPP approach and found a monetary union is feasible between Kenya, Uganda, and Tanzania by virtue of cointegration of their real rates of currency exchange for the period 1981 to 1998. Buigut and Valev (2005), Kishor and Ssozi (2009) and Sheikh (2014) used SVAR models and business cycle synchronization approach and they concluded that both the demand and supply shocks are disproportionate in the EAC and thus, the EAC is not ready to form a currency union. Debrun, Masson, and Pattillo (2010) developed and used DPM model, their results showed that large asymmetric shocks and financial needs exist in the EAC.
Generally, these studies do not recommend that a monetary union be formed in the east African region. Further convergence of the countries is required before embarking on monetary integration. While it is evident from the studies that the EAC has not met the convergence criteria it spelt out in the EAMU protocol, one has to wonder if the EAC should continue with its quest of forming a monetary union.
In contrast to other studies, Mkenda (2001) concluded that forming a monetary union between Kenya, Tanzania, and Uganda is feasible. The EAC has new member states, Burundi, Rwanda, and South Sudan. Does EAC still constitute a monetary union as per the analysis that was done by Mkenda (2001). This study will therefore seeks to extend her work by using the same methodology and including the new member states and utilize recent data in the analysis.
Objectives of the Study
The main objective of this study is to examine the feasibility of the EAC using the GPPP analysis framework. The specific objectives of this study are:
- To examine whether the EAC constitute a currency union based on the long-run relationship between the EAC countries bilateral real exchange rates.
- Empirically ascertain whether the EAC partner states will be able to achieve the macroeconomic convergence targets set out in the EAMU protocol.
Research Questions
The objectives seek to answer the subsequent research questions fundamental to this study.
- Are the real exchange rates cointegrated in the EAC countries?
- Are the macroeconomic convergence criteria target set out in the EAMU protocol achievable for the EAC member states?
Significance of the study
The study adds to the few empirical studies on monetary union in East Africa that exist such as; Mkenda (2001), Buigut and Valev (2005), Kishor and Ssozi (2009), Falagiarda (2010), Debrun et al., (2010) and Sheikh (2014). Given the drive to form a monetary union in the region is a fairly recent4 phenomenon, empirical literature is rather scarce and this study, therefore, constitutes an addition to the pool of findings being created and serve as a reference for future studies in this area. This study brings to light the viability of EAMU and this has an impact on the policy implications being pursued by EAC and by extension AU in their pursuit of monetary integration.
Scope of the study
EAC comprises of six partner states but the study limits itself to five of them namely Burundi, Kenya, Rwanda, Tanzania, and Uganda. South Sudan is excluded due to her very recent admission into the Community in 2016. The treaty re-established the EAC in 2000 and Burundi and Rwanda joined in 2007, hence data to be analysed for the region starts from 2007 and cannot be extended to earlier years if proper trend analysis is to be conducted.
