Chapter 1: The Economics of Regional Integration: Current Challenges and Future Opportunities for Southern Africa

Joannes Mongardini, Tamon Asonuma, Olivier Basdevant, Alfredo Cuevas, Xavier Debrun, Lars Engstrom, Imelda Flores Vazquez, Vitaliy Kramarenko, Lamin Leigh, Paul Masson, and Genevieve Verdier
Published Date:
April 2013
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Joannes Mongardini

The Southern African Customs Union (SACU) celebrated its 100th anniversary in 2010. As the oldest customs union in the world, SACU has brought significant benefits to its five member countries, Botswana, Lesotho, Namibia, South Africa, and Swaziland (Figure 1.1). The significant degree of trade integration among its member countries has facilitated trade within and outside SACU and thus improved living standards. All members, excluding Botswana, also benefit from the Common Monetary Area (CMA), in which the currencies of Lesotho, Namibia, and Swaziland are fixed at parity with the South African rand, which is also accepted as legal tender in these countries. Regional and financial integration have improved the welfare of the people of Southern Africa.

Figure 1.1The Southern African Customs Union

Source: IMF staff estimates.

Note: Nominal GDP and nominal GDP per capita in U.S. dollars for 2011.

The opportunity in the future for the members of SACU is to reap the benefits of even deeper regional and financial integration. As articulated by the SACU heads of state, the vision is for SACU to become “an economic community with equitable and sustainable development, dedicated to the welfare of its people for a common future” (SACU, 2010, p. 2). This vision calls for the eventual establishment of a common market by eliminating fiscal frontiers; liberalizing the movement of goods, services, and factors of production; and harmonizing macroeconomic and fiscal policies in the context of a possible future monetary union.

This chapter outlines the existing benefits, current challenges, and future opportunities of this regional integration process in Southern Africa. It draws on the analytical research presented in the subsequent chapters to distill key findings and policy recommendations that would support the goal of deeper regional integration.

Benefits of SACU and the CMA

The economic benefits of membership in SACU are significant. As discussed by Engstrom and Verdier in Chapter 2, the analysis of bilateral world trade flows using a gravity model indicates that SACU membership has significantly facilitated trade creation, but has not created any significant trade diversion. Specifically, SACU outperforms all other African trade arrangements with regard to its positive impact on trade creation. Accordingly, further trade integration, including through the establishment of a common market within SACU, is likely to be beneficial in fostering further trade creation and increasing living standards. The study also finds no evidence of export diversion, and the evidence on import diversion is inconclusive at best. The public debate in SACU has often focused on the claim that there is a negative polarization impact on Botswana, Lesotho, Namibia, and Swaziland (BLNS) from being in a customs union with a much larger and more developed economy. Even if the negative effects from trade diversion are limited, the results are not inconsistent with the possibility that there are negative externalities on the production structure—that is, BLNS would produce a different set of goods if they were insulated from their neighbor. This could be related to the fact that BLNS are on the periphery of an industrial core (South Africa). In addition, even in the absence of trade diversion, a case for compensatory transfers can still be made if it is clear that the structure of the common external tariff benefits one member of a customs union at the expense of other members. For example, a significant proportion of SACU import tariffs is collected on automobiles, an industry almost entirely based in South Africa. BLNS could, therefore, make legitimate claims that they should be compensated for extra-normal profits earned by South African automobile producers as a result of the common external tariff. Overall, the main goal of future reforms should be to increase the benefits of trade integration.

Similarly, membership in the CMA also produces beneficial welfare effects. Using an intuitive model of the costs and benefits of currency unions, Asonuma, Debrun, and Masson (Chapter 5) conclude that membership in the CMA benefits all its members to varying degrees. The largest benefits go to the smaller members, with welfare gains (compared with an independent monetary policy) estimated to be between 1.7 and 6 percent of GDP. Although South Africa’s gain is less than 0.5 percent of GDP, it is still positive because the use of the rand in other countries reduces the incentives for South Africa to monetize its own deficit, the so-called inflation bias. The creation of a genuine CMA-wide monetary union with a regional central bank would come at the expense of some forgone anti-inflationary credibility. The authors apply the same analytical framework to calculate the net benefits of a hypothetical expansion of the CMA to other countries of the Southern African Development Community.1 Most countries would benefit from the CMA, with the exception of Angola, Mauritius, and Tanzania.

Current Challenges

Notwithstanding the benefits mentioned above, SACU is experiencing significant challenges. The most pressing one at a regional level arises from the volatility of SACU revenue. For the smaller countries of the union, Lesotho and Swaziland, SACU revenue has over the past three years fluctuated by more than 20 percent and 15 percent of GDP, respectively, making it very difficult to manage public finances. A major factor behind the volatility of SACU transfers is that volatile customs duties are the main revenue source for the common pool. In Chapter 3, Cuevas, Engstrom, Kramarenko, and Verdier provide some practical solutions for reducing the volatility of SACU revenue. In the short term, one option would be to extend the period for correcting over- and underpayments to SACU members, currently set at two years. Alternatively, only the structural component of SACU revenue could be transferred to members, whereas the cyclical component could be saved in the common revenue pool. Over the medium to long term, SACU members could form an economic union by eliminating fiscal frontiers. They could distribute some of the revenue pool as regional funds, as in the European Union. SACU members would also benefit from preparing themselves for the effects of future trade liberalization, which is likely to erode revenue collection over the long term, by developing domestic sources of tax revenue. A move to a destination principle for the distribution of SACU revenue would be contrary to greater regional integration because it would erect stricter fiscal frontiers and hinder trade creation.

The recent decline in SACU transfers has also called for significant fiscal adjustment in BLNS. In Chapter 4, Basdevant discusses the best fiscal strategy for implementing the adjustment, based on simulations of a stochastic dynamic general equilibrium model presented in Mongardini and others (2011) and Basdevant and others (2011). The simulations indicate that the best fiscal strategy for minimizing the impact on growth is to reduce recurrent expenditure, particularly the wage bill, while relying mainly on consumption taxes to increase revenue. To maintain a sustainable fiscal position in the medium term, Basdevant also proposes a set of possible national-level fiscal rules appropriate for SACU members. Beyond the redesign of the SACU revenue-sharing formulas, SACU members could adopt fiscal balance or expenditure rules at a national level to strengthen the credibility of their policy frameworks.2 Both rules have pros and cons, and would need to be supported by independent supervision from fiscal councils and by appropriate communication strategies by the government. For Botswana and Namibia, these rules would also need to take into account the volatility of mineral wealth and the appropriate intergenerational considerations associated with the use of mineral resources.

Finally, all SACU members are facing unemployment crises of historic proportions. Available statistics show that the official unemployment rate ranges between 20 and 50 percent and is mostly a youth unemployment problem. Leigh and Flores indicate in Chapter 6 that the origin of the problem is the significant skills mismatch between the new entrants to the labor force and the needs of the labor market. Although there is no single solution to the problem, the authors identify a set of policies that, together with higher growth, could alleviate the unemployment crisis. In particular, public sector hiring practices and wage policies, reinforced by strong labor unions, have distorted the labor market. This clearly requires a shift in government employment and wage-setting policies to align them with private labor market standards. In addition, education policies in SACU urgently need to be aligned with the skills needs of the private sector. This alignment could be accomplished by improving the quality of educational spending to support public-private partnerships for skills development, with a focus on vocational and technical training.

Future Opportunities

The main objective of deeper integration within SACU is the establishment of a common market. To allow for the free movement of goods and services, fiscal frontiers have to be eliminated and standards harmonized. As a first noteworthy step in this direction, starting on April 1, 2012, all SACU members implemented a value added tax (VAT) with very similar rates. This structure could lead to a SACU-wide system of VAT refunds so that the refunds would not need to be claimed at the border. A second step would be the consolidation of intra-SACU customs borders, which would provide a one-stop shop for intra-customs clearance. This could then lead to the eventual elimination of intra-SACU customs posts, allowing for the free movement of goods across the entire SACU region. Third, product standards need to be harmonized so that goods can adhere to a unique SACU-wide set of standards. In this respect, a SACU-wide standards agency could be established with the authority to harmonize existing standards across SACU and set new standards. The authorities could draw on the successful experience of the European Union in each of these areas.

With the establishment of a single market, the challenges associated with a new distributional system for customs and excise revenue would arise. Clearly, the current SACU revenue-sharing formula could no longer be applied, given the lack of reliable data on intra-SACU trade. Accordingly, the authorities could consider a move to regional funds, as discussed by Cuevas, Engstrom, Kramarenko, and Verdier in Chapter 3. Although transitional arrangements would be needed to prevent macroeconomic instability in the smaller members of SACU, these funds could be articulated along common regional objectives for infrastructure, energy, or transport needs. They could play a redistributional role from richer to poorer regions within SACU.

Finally, the establishment of a common monetary union within SACU would require strong political will to adopt a single currency. The recent experience in the euro area demonstrates that a monetary union demands strong commitment, particularly from the largest country in the union, to transcend national interests and to come to the aid of smaller countries in the event of fiscal or balance of payments problems. It also suggests the need for strong fiscal coordination, including the possible use of fiscal rules, as discussed by Basdevant in Chapter 4, to avoid the inflation bias that smaller countries may have within a monetary union. The evidence in Chapter 5 indicates that any added benefit for existing CMA countries to move to monetary union with a common central bank is questionable.

The Southern African Development Community comprises Angola, Botswana, the Democratic Republic of the Congo, Lesotho, Malawi, Mauritius, Mozambique, Namibia, Seychelles, South Africa, Swaziland, Tanzania, Zambia, and Zimbabwe. Madagascar’s membership was suspended in 2009.

Improvements to the accuracy and transparency of public finance data are also essential to improving accountability, and should occur before numerical fiscal rules are set up.

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