Optimum Currency Areas: Is Southern Africa ready to form a Monetary Union?

CONTENTS

List of Figures

List of Tables

List of Abbreviations

1 Introduction

2 Theoretical Foundations of the Optimum Currency Area Theory
2.1 Benefits and Costs of Monetary Integration
2.1.1 Benefits of Monetary Integration
2.1.2 Costs of Monetary Integration
2.2 Criteria of Optimum Currency Areas
2.3 Endogenous Effects in Monetary Integration
2.4 Policy Implications
2.5 Fiscal Distortions and Monetary Credibility
2.6 Theoretical Conclusions

3 Theory and Empirical Evidence in the Southern African Development Community
3.1 The Economic Situation and Convergence in Southern Africa
3.2 Empirical Approaches of the Optimum Currency Area Theory and Evidence in Southern Africa
3.3 Correlation and Structure of Output Shocks and Business Cycles
3.4 Results

4 Evaluating the feasibility of the SADC as a Monetary Union and future Prospects
4.1 The Experience of the Common Monetary Area
4.2 Lessons from the European Monetary Union
4.3 The role of Monetary and Fiscal Policies in Southern Africa
4.4 Challenges and the Path to a Monetary Union

5 Summary and Conclusion

A Appendix
A.1 Appendix for Section 2.5
A.2 Appendix for Section 3.3

Introduction and Course of Work

In 2007, at their meeting in Tanzania, the central bank governors of the Southern African Development Community (SADC) laid out a strategy to strengthen regional integration, containing the development of a common market by 2015, fixed exchange rates by 2016, and, ultimately, a monetary union with a single currency in 2018. In pursuit of this agenda, a free trade area absent of intra-regional tariffs was arranged in August 2008 with a regional customs union to follow this year. The currently fourteen member countries of the SADC committed themselves towards achieving economic convergence and to deepen monetary cooperation. In the 21st century, Africa finds itself increasingly separated from economic developments in the remaining world and fails to prosper from increased globalization. Despite a large abundance in natural resources, many countries have suffered from an extremely poor economic performance, which mainly originated from internal strives and weak and distortionary policies. Inward looking governments, conducting clientele policies, are focused on reaping economic rents rather than on fostering growth. Furthermore, tribal conflicts and civil war have sparked recurring border conflicts with neighboring countries. Although Africa has seen a large number of regional arrangements and trading blocs throughout the continent, the overall success for growth and trade expansion was limited. Against this background, the formation of a monetary union is believed to counteract economic and political weaknesses, to improve regional cooperation and to enhance both the political and economic standing in the world.

A monetary union and a common currency entails both gains and losses for its members. On the cost side, countries in a monetary union effectively loose the ability to pursue independent monetary policies and to use the exchange rate as adjustment instrument to stabilize the economy. On the other hand, countries inside a monetary union benefit from reduced transaction costs and the elimination of internal exchange rate volatility. Furthermore, countries which suffer from weak internal stability and high inflation rates benefit by using the fixed exchange rate in a monetary union as external anchor. By transferring the power over monetary policy to a supranational central bank, the risk of homegrown inflation and currency devaluations is banished and economic agents are able to borrow at more favorable interest rates. Both the gains and losses from a monetary union are determined by structural characteristics inside the countries. If, in total, the benefits from a single currency exceed the costs in that the constraints imposed by fixed exchange rates are not harmful to the economy, the countries constitute an optimum currency area. In essence, the theory of optimum currency areas considers the desirability for each country to join a monetary union. The trade off between costs and benefits is affected by three features: First, the degree of intra-country trade influences the gains in efficiency and reduced uncertainty from fixing the exchange rate. Second, the degree of correlation in output fluctuations determines whether a common monetary policy is adequate for all countries. And third, the response to output shocks is eased by several adjustment mechanisms, including price flexibility and factor mobility, which restore the initial equilibrium.

The purpose of this study is to evaluate whether a monetary union in Southern Africa is both desirable and feasible from an economic point of view, to discuss institutional challenges and requirements, and to give direction for which countries are best candidates to form a monetary union. Both the motivation and requirements for a successful monetary union are drawn from the theory of optimum currency areas. Unfortunately, the various aspects of the theory have been gradually developed over time and are often confounded and fragmentary in theoretical work. The aim is therefore to first derive a framework that includes relevant benefits and costs, which are subsequently related to country-specific structural criteria.

Since economic integration is an important aspect for Africa, emphasis will be put on the endogenous trade effects of monetary integration. Similarly, special attention is given to fiscal distortions and weak institutions, which are sources of high inflation rates and low monetary credibility. Next, the theoretical foundations are applied to the SADC to examine the suitability of countries to form a monetary union. Although a number of studies have discussed monetary integration in various parts of Africa (Masson and Pattillo 2001, Debrun, Masson and Pattillo 2005, and Houssa 2008, for instance, cover monetary unification in West Africa while Kishor and Ssozi 2009 analyze the East African Community), relatively little has been done concerning the SADC in particular. Relevant exceptions are Agbeyegbe (2008), Bayoumi and Ostry (1997), Buigut and Valev (2006), Karras (2006) and Khamfula and Huizinga (2004). However, while the studies mentioned typically focus on one aspect of the theory of optimum currency areas, there are very few attempts so far to include all relevant aspects in one framework (one exception is Masson and Pattillo 2005).

Overall, the findings suggest that a monetary union encompassing the whole SADC is infeasible at this stage, and unlikely in the foreseeable future. However, there is evidence for a monetary union consisting of a smaller group of countries, based on the long standing CMA arrangement. In addition to South Africa, Lesotho, Namibia and Swaziland, countries proposed for a monetary union are Botswana, Mozambique and Zambia. On the other hand, there is little evidence that the remaining countries would benefit from monetary unification in any time soon. Countries in the SADC generally differ much in their economic and political development. While some countries, namely South Africa, feature a relatively advanced economy, other countries like Congo and Zimbabwe experienced economic deterioration and high inflation rates. Especially the findings of low regional trade intensities do not hold much promise of large gains from transaction cost savings. Furthermore, both the comovement of business cycles and the correlation of output disturbances are strikingly low, indicating that a common monetary policy is unsuited for most countries. For a small number of countries with a history of high and volatile inflation rates, a common, stable currency would be however attractive in giving higher price stability and an institutional framework to insulate monetary policy from domestic fiscal pressures. Nevertheless, this path is unrealistic since it will be impossible to merge the interests of undisciplined countries with those of low inflation countries like South Africa. In sum, it is inadvisable to proceed with monetary unification to rashly. A monetary union is far from certain to promote regional integration and should not be seen as substitute for political initiatives to solve regional problems and restraining poor fiscal policies.

The analysis is divided into three main sections: Section 2 reviews the theoretical implications from the theory of optimum currency areas. After introducing the benefits and costs from monetary unification, both the traditional and endogenous criteria are described to judge the desirability of a monetary union. Next, two models of monetary policy are presented so as to formalize the concept of monetary cooperation. Section 3 subsequently applies the criteria to the SADC. Special attention is given to the correlation of business cycles and comovement of output shocks. A structural vector autoregression analysis is carried out in order to separate underlying supply and demand shocks from output disturbances. Section 4 evaluates the feasibility of a monetary union in the SADC by drawing lessons from the CMA and EMU. Finally, further challenges in the transition to a monetary union are pointed out. Section 5 summarizes and concludes.

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