Chapter

Chapter 3. Economic Convergence to Support the East African Monetary Union

Author(s):
Paulo Drummond, S. Wajid, and Oral Williams
Published Date:
January 2015
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Author(s)
Nabil Ben Ltaifa, Masafumi Yabara and Oral Williams 

Since 2000, the East African Community (EAC) has had a customs union and common market, and is now implementing a comprehensive regional infrastructure program to support the development of a single market for free trade among partner countries. To deepen integration, the EAC has set the goal of establishing an East African Monetary Union (EAMU) through macroeconomic convergence and the harmonization of monetary and exchange rate policies, payment and settlement systems, financial sector supervision, as well as harmonized statistics.

To benefit from a monetary union, convergence is needed to facilitate closer economic integration through trade, investment, and factor mobility. Convergence is also critical to foster strong economic performance to support the eventual adoption of a single currency. To support a shift to fixed bilateral exchange rates and a common monetary policy, the preparatory stages for monetary union typically involve steps to ensure a convergence of inflation rates and progressively greater bilateral exchange rate stability. Compliance with the convergence criteria would help establish a track record of maintaining sound macroeconomic policies for EAC member countries in a “nominal convergence.” This chapter briefly surveys convergence criteria in other monetary unions and reviews the degree of compliance by EAC member countries with nominal convergence criteria. While “real convergence” is not an explicit objective for monetary union, this chapter examines the degree of comparability in real per capita income.

Promoting Nominal Convergence

As in the Maastricht Treaty criteria establishing the European Union, the EAC criteria focus on nominal rather than real convergence. The EAC Council in 2007 revised and adopted the original macroeconomic convergence criteria (Box 3.1), but revised again in 2013 to encompass criteria outlined in Box 3.2. The original convergence criteria were set for three different stages spanning consecutive periods: 2007–10 (Stage I), 2011–14 (Stage II), and 2015 (Stage III).

Box 3.1East African Community: Original Macroeconomic Convergence Criteria

Stage I (2007–10)

Primary Criteria

1. Overall budget deficit excluding grants of not more than 6 percent of GDP, and including grants of not more than 3 percent of GDP.

2. Annual average inflation not exceeding 5 percent.

3. External reserves of more than 4 months of imports of goods and nonfactor services.

Secondary Criteria

4. Achievement and maintenance of stable real exchange rates.

5. Achievement and maintenance of market-based interest rates.

6. Achievement of sustainable real GDP growth of not less than 7 percent.

7. Sustained pursuit of debt reduction initiative on domestic and foreign debt (i.e., reduction of total debt as a ratio of GDP to a sustainable level).

8. National savings of not less than 20 percent of GDP.

9. Reduction of current account deficit excluding grants as a percentage of GDP to a level consistent with debt sustainability.

10. Implement the 25 Core Principles of Bank Supervision and Regulation based on the agreed Action Plan for Harmonization of Bank Supervision.

11. Adherence to the Core Principles for Systematically Important Payment Systems by modernizing payment and settlement systems.

Stage II (2011–14)

Primary Criteria

  • Reduced ceilings on overall budget deficit excluding grants (no more than 5 percent of GDP), and including grants (no more than 2 percent of GDP).
  • Target for annual average inflation as in Stage I.
  • External reserves target increased to 6 months of imports of goods and nonfactor services.

Secondary Criteria

  • Maintenance of market-based interest rates, real GDP growth target, pursuit of debt sustainability, domestic savings target, and sustainable current account deficit (as in Stage I).

Stage III (2015)

  • Introduction and circulation of a single East African Currency.
Source: EAC (2009).

Box 3.2Macroeconomic Convergence Criteria Under the East African Community Monetary Protocol

The agreed criteria to help pave the way for a common currency and to ensure consistency of policies under monetary union consist of four primary convergence criteria, complemented by three nonbinding, indicative convergence criteria to serve as early warning indicators.

Primary Convergence Criteria

1. Ceiling on headline inflation of 8 percent.

2. Fiscal deficit (including grants) ceiling of 3 percent of GDP.

3. Ceiling on gross public debt of 50 percent of GDP in net present value terms.

4. Reserve cover of 4.5 months of imports.

Indicative Criteria

1. Core inflation ceiling of 5 percent.

2. Fiscal deficit (excluding grants) ceiling 6 percent of GDP.

3. Tax-to-GDP ratio of 25 percent.

Source: EAC Monetary Union Protocol, Kampala, Uganda, November 30, 2013.

The macroeconomic convergence criteria represent only one pillar of a sustainable monetary union. Although important, they are not sufficient (Figure 3.1). A country may perform well by the standards of convergence criteria, but still be implementing policies that pose risks to monetary union. Two more pillars are needed to support the framework of sustainable monetary union. One supports a periodic comprehensive review of macroeconomic conditions and policies. For the EAC, country performances would be assessed according to individual circumstances. The other needed pillar for monetary union in the EAC supports a set of region-wide policies to ensure that national policies are corrected, in which the convergence criteria or broader surveillance activities identify risks to monetary union. In addition, highly harmonized statistics are needed to support the entire framework.

Figure 3.1Elements of a Macroeconomic Convergence Framework

Source: Authors.

Other Monetary Unions

The convergence criteria adopted by other prospective monetary unions share features with the EAC and euro area. Annex Table A3.1 summarizes the criteria adopted prior to monetary union by the Caribbean Monetary Union, the European Monetary Union (EMU) in its preaccession phase prior to the adoption of the euro, the Gulf Cooperation Council, and the West African Monetary Zone, as well as three existing monetary unions—the West African Economic and Monetary Union, the Central African Economic and Monetary Community, and the Eastern Caribbean Currency Union. Probably reflecting the influence of the EMU, all the preaccession criteria of these monetary unions, whether prospective or existing, include limits on inflation and fiscal deficits. All except the West African Monetary Zone have limits on public debt, and four of seven regimes have criteria for interest rates. Convergence criteria on inflation and exchange rates also reflect the influence of the EMU, which strongly emphasized the importance of nominal convergence prior to the adoption of the euro.

The limits for these core nominal convergence criteria vary across regions:

  • Inflation is subject to ceilings varying from 3 percent in the Communauté Financière Africaine (CFA), 8 percent in the EAC, and 10 percent in the West African Monetary Zone, or requirements not to exceed the zone inflation average by more than 1.5 percentage points (Caribbean Monetary Union and EMU) or 2 percentage points (Gulf Cooperation Council).
  • The limit on the overall fiscal deficits ranges from 3 percent of GDP in the Caribbean Monetary Union, EAC, EMU, and Gulf Cooperation Council to 4 to 5 percent in the West African Monetary Zone, with the CFA adopting a limit on the basic budget balance.1
  • Public debt is required to remain below 60 percent of GDP for the EMU and Eastern Caribbean Currency Union, and 70 percent of GDP for the CFA and Gulf Cooperation Council. For the Caribbean Monetary Union, limits are imposed only on external debt service obligations (15 percent of exports), while the EAC has established a limit of 50 percent of GDP in net present value terms.
  • Interest rate criteria vary from a requirement that rates not exceed the zone average by more than 2 percentage points (defined for the EMU in terms of long rates and the Gulf Cooperation Council as short rates), and that real interest rates be positive (the West African Monetary Zone).

The EAC differs in not explicitly constraining currency flexibility in the preaccession period. Gulf Cooperation Council and Eastern Caribbean Currency Union members peg to the U.S. dollar, thereby enforcing bilateral currency stability. For the CFA franc zone, the equivalent peg is to the euro.2 For the EMU and the West African Monetary Zone, an exchange rate mechanism is established prior to accession, with limits on deviations from the mechanism.3 For the Caribbean Monetary Union, a similar regime restricts bilateral exchange rate movements to no more than 1.5 percent over a three-year period. By contrast, the EAC has agreed to allow the exchange rate to float prior to the adoption of a single currency. With divergent inflation across EAC countries in the preaccession period, stable real exchange rates could be consistent with differing rates of nominal depreciation. Equally, to the extent that the trade weights used in calculating real exchange rates vary across the EAC, real exchange rate stability may be consistent with widely varying movements against a third currency, such as the euro or U.S. dollar.4

Despite some common features, regional convergence criteria also have unique elements. For the CFA franc zone and the West African Monetary Zone, fiscal targets are unusually detailed, with goals for revenues (17 percent of GDP in the West African Economic and Monetary Union, and non-oil fiscal revenue greater than or equal to 17 percent of non-oil GDP for Central African Economic and Monetary Community), domestically financed public investment (at least 20 percent of revenues for the West African Monetary Zone), and public sector wages (less than 35 percent of revenues for both the West African Monetary Zone and CFA). The West African Monetary Zone and CFA rules also prohibit the accumulation of domestic expenditure arrears.

All monetary unions set limits on central bank financing of fiscal deficits. Some have a zero limit on such financing, while the West African Monetary Zone requires that such financing not exceed 10 percent of the previous year’s tax revenues. In the Central African Economic and Monetary Community, central bank financing is limited to 20 percent of the previous year’s fiscal revenue, but this provision is expected to be phased out. In the EAC, central banks finance only temporary shortfalls in government revenue, governed by their respective national rules: (1) in Burundi up to a maximum of 12.5 percent of previous years’ revenue, but to be phased out by 2016; (2) in Kenya, up to a maximum of 5 percent of the latest audited revenue; (3) in Rwanda, 11 percent of the previous year’s revenue; (4) in Tanzania, 12.5 percent of the three-year average revenue collected; and (5) in Uganda, 18 percent of the previous year’s revenue.

Outside the EMU, requirements for reserve cover are relatively common. More than 3 months of import cover are required for the Caribbean Monetary Union and the West African Monetary Zone, and 4.5 months cover by the EAC and Gulf Cooperation Council. Under the Eastern Caribbean Currency Union currency board regime, international reserves should be sufficient to cover at least 60 percent of currency in circulation, but in practice coverage is in excess of 90 percent.

East African Community Compliance with Primary Convergence Criteria

The EAC convergence criteria are not precisely defined in statistical methodology or breadth of coverage. To ensure effective and even-handed monitoring of compliance, there is a need to harmonize data based on common statistical definitions. To underpin the collection of harmonized data, oversight over compilation of data for verification of the convergence criteria should be assigned to a qualified body. The EAC Secretariat currently lacks a well-resourced regional statistics department, and this might be one priority for institutional development to underpin the EAMU process.

Fiscal Deficit

The EAC has embraced the principle that member countries should demonstrate strong public debt and fiscal deficit positions ahead of monetary union. Large fiscal deficits could hamper the ability of new monetary authorities to deliver low inflation if deficits are monetized. Equally, a country with a high debt-to-GDP ratio has an incentive to press for high “surprise” inflation to erode the real value of their debt stock. Recognizing these risks, low-debt countries will seek a reduction in debt ratios for the most highly indebted countries prior to entry into a monetary union.

The EAC ceiling on country fiscal deficits is a core convergence criterion and is key to anchoring fiscal policy. The primary convergence criteria have established an overall deficit of 3 percent of GDP, including grants. Most monetary unions (Annex Table A3.1) feature a convergence criterion of this type. In principle, fiscal deficits and debt should be monitored on a common, broad basis to best capture the full breadth of public activities that have a macroeconomic impact. EAC member-country compliance with the overall deficit including grants has been uneven for several reasons, including the need to scale up investments to address infrastructure gaps and responses to the global financial crisis.

On average, EAC countries met the fiscal deficit criterion including grants prior to the start of the crisis in 2008, but not subsequently when the fiscal performance of EAC countries was mixed (Figure 3.2). Rwanda and Uganda met the 3 percent deficit ceiling on balance for a few years compared with other member countries. Since 2009, however, fiscal deficits have increased across the region, partly in the context of the global financial crisis.

Figure 3.2Primary Criterion: Overall Fiscal Deficit-to-GDP Ratio (Including grants)

(Not more than 3 percent)

Source: IMF, African Department database.

At the same time, the fiscal deficit measure excluding temporary incomes is an important gauge of fiscal sustainability. Where grant incomes are volatile, a surge in funding tends to strengthen the deficit measured including grants, even if underlying fiscal performance is deteriorating. This will only become evident when grant inflows return to more normal levels. For this reason, there are strong grounds for monitoring deficits excluding grants, even if they are at very different levels across EAC countries, reflecting underlying differences in grant inflows.

The ceiling for the deficit excluding grants still has a role in fiscal surveillance. Any ceiling on the deficit excluding grants has the potential to constrain the use of donor funding, which continues to play a significant role in the majority of EAC countries (Figure 3.3). Since the narrow deficit criterion including grants is the critical measure for purposes of gauging financing needs and debt sustainability, the criterion on the deficit excluding grants would still be useful for fiscal surveillance as it provides a measure of the degree of domestic revenue mobilization over time. This would align member countries, efforts to raise domestic revenues with donors’ objectives of gradually unwinding grants over the medium to long term.

Figure 3.3Secondary Criterion: Overall Fiscal Deficit-to-GDP Ratio (Excluding grants)

(Not more than 6 percent)

Source: IMF, African Department database.

EAC countries were less successful in meeting the fiscal deficit criteria excluding grants (Figure 3.3). On average, these were substantially above the 6 percent of GDP ceiling, and by a steadily increasing margin. Only Kenya, which receives limited grant receipts,5 met the deficit ceiling excluding grants on a sustained basis. Burundi’s deficit excluding grants is more than 15 percent of GDP, reflecting massive aid inflows in recent years following substantial postconflict development needs.

Deficits measured excluding natural resource revenues also need be monitored carefully. The recent discovery of nonrenewable resources in several EAC countries will have implications for assessing the fiscal stance as these resources are exploited. Typically, natural resource incomes have a finite lifetime, based on the size of the oil or mineral deposits. In the Central African Economic and Monetary Community, for example, national inflation is closely linked to the size of non-oil fiscal deficits rather than the overall deficit. Exploiting these resources produces a period of high incomes associated with license fees, royalties, and other taxes. While this can support a temporary period of higher expenditure, countries often save part of their income stream to extend the period over which higher expenditures can be sustained, and to avoid the sort of sharp rise and subsequent reversal of spending that poses the strongest risk of Dutch disease. Natural resource revenues are also subject to volatility, linked to changes in global commodity prices. Periods of high prices can strengthen fiscal performance, even when there is an underlying deterioration in the nonresource accounts. Given these considerations, the deficit measured excluding resource incomes provides a more reliable guide to longer-term fiscal sustainability as well as to the short-term “fiscal impulse” in aggregate demand terms. That said, as with donor grants, the appropriate deficit measured excluding resource incomes will vary across EAC countries depending on the projected lifetime value of incomes from the resource base.

Public Debt

A broad debt sustainability framework will help underpin the criterion on fiscal deficits. The EAC convergence criteria define a limit on public debt of 50 percent of GDP in net present value terms. Explicit gross public debt limits under the EMU, Eastern Caribbean Currency Union, CFA franc zones, and Gulf Cooperation Council are in the range of 60–70 percent of GDP. A more explicit debt framework rooted in debt sustainability analyses for the member countries would establish the EAC’s capacity to accumulate debt given the cost of debt, growth prospects, and the existing debt levels.

In 2011, most EAC countries had debt-to-GDP ratios in the range of 23–50 percent of GDP, although the composition of this debt is highly concessional (Figure 3.4). A debt criterion of 50 percent of GDP in net present value terms would provide more fiscal space because of the current concessional nature of the debt, but this will change over time as some EAC countries scale up public investments through increased recourse to nonconcessional borrowings. During the 2000s, EAC countries benefited from a cumulative $4.2 billion in debt relief in net present value terms, which reduced the stock of debt considerably. The associated reduction in debt service costs permitted a corresponding increase in priority spending. The challenge will be to maintain debt on a sustainable path over the medium-term while permitting the scaling up of investments to address the EAC’s infrastructure gap and other developmental needs. A prudent deficit and how it is financed is key to avoiding unsustainable debt levels that could have significant negative effects on economic activity. High debt requires high taxes to finance it and puts upward pressure on real interest rates, thereby “crowding out” private investment. Countries that have defaulted on their debt have, on average, a higher ratio of public debt to GDP, a higher debt-to-revenue ratio, a higher proportion of external debt in total public debt, and a lower ratio of broad money to GDP (IMF, 2003). Ideally, a broad definition of public sector debt would incorporate the borrowing activities of not only the central government but also local governments, the central bank, public enterprises, and other public agencies.

Figure 3.4Gross Public Debt

(Percent of GDP)

Source: IMF, African Department database.

Inflation

Establishing the inflation convergence criterion is relatively demanding because the region is subject to large external shocks. As shown in Figure 3.5, EAC countries have missed the inflation criterion of 8 percent in recent years primarily because of large food and fuel shocks. In theory, the transition to monetary union could be managed at any inflation level, provided that cross-country differences in inflation are not large and sustained enough to distort internal competitiveness over time. In practice, however, it is difficult to stabilize national inflation at moderate or high, rather than low rates. Thus, aiming for the EAMU based on common inflation of close to 15 percent, for example, would not be practical. At the same time, however, the EAC has little experience of sustained low inflation in the 2–3 percent range achieved in many advanced economies. This is because food and fuel purchases represent a larger part of the consumer-price-index basket for EAC households than for advanced economies, so that shocks to global energy prices or imported food prices have a larger impact on headline inflation. Since these shocks are external to the EAC region and do not significantly impact on internal competitiveness, it is not clear that they should be an impediment to monetary union, provided that other convergence indicators are favorable.

Figure 3.5Primary Criterion: Annual Average Inflation Rate

(Not exceeding 8 percent)

Source: IMF, African Department database.

By contrast, in some regional arrangements the inflation ceiling is defined in terms of regional trends. Thus, in several convergence frameworks (such as the Caribbean Monetary Union, Gulf Cooperation Council, EMU), inflation ceilings are not set in absolute terms, but rather in relation to the zone average, or relative to an average for the best-performing members. In the EMU, for example, inflation should not be more than 1.5 percentage points above the three best-performing EMU countries. To the extent that headline inflation rises for all EAC members during food or fuel price shocks, this would allow a region-wide increase in inflation while preventing exceptional increases for individual members. However, in practice, the weight of food and fuel products in the overall price index varies across EAC countries, and some countries see much larger headline inflation effects from a given food or fuel price shock. This would require a relatively large margin to accommodate differential price movements, which would undermine the effectiveness of the convergence criterion in more normal inflationary environments.

Reserve Coverage

Strong international reserve cover provides the resources to support the currency in the event of balance of payments shocks. This could be in the context of an exchange rate mechanism ahead of monetary union, or for smoothing intervention in support of the new currency after accession. The EMU is unusual among current and prospective monetary unions in not setting a target for reserve cover (Annex Table A3.1). For the EMU, the ability to support national currencies during the preaccession period was gauged in terms of European rate mechanism compliance, while reserve cover after accession was less critical given the float of the euro against other currencies. For the smaller, more open African economies, the exchange rate is a more important determinant of inflation than for the euro area, and this tends to foster interest in a degree of currency stability. Given that the EAC will adopt a managed float regime for its new currency, this will require an adequate reserve base, and members acceding to the currency union will be expected to contribute to this reserve stock (Figure 3.6).

Figure 3.6Primary Criterion: Foreign Exchange Reserves

(At least 4.5 month’s imports of goods and nonfactor services)

Source: IMF, African Department database.

Achieving higher reserve targets may be quite demanding and difficult to justify given the role of exchange rates as a shock absorber. For example, if EAC countries were to target 6 months of imports as initially envisaged to achieve this, countries would need to tighten their balance of payments significantly (Box 3.1). This would require the adoption of restrictive domestic demand policies with repercussions for economic growth. For example, governments could increase spending by widening the deficit but not absorb the aid (i.e., no corresponding widening of the current account so that a portion of donor inflows is saved in international reserves rather than spent). This response would be problematic as the aid dollars stay in reserves, so the increase in government spending must be financed by government borrowing from the domestic private sector or by printing money. Alternatively, the central bank could purchase foreign currency from the banking system, while sterilizing the associated liquidity creation through bond sales. The latter would tend to raise interest rates and slow private sector credit growth. On the assumption that the future single currency would float with only light intervention, the criterion of 4.5 months of import cover broadly matches current EAC practices.6

A recent study on reserve adequacy in the EAC countries found that reserve levels toward end-2009 provided adequate safety buffers (Drummond and others, 2009). At that time, reserve coverage ranged from about 3.5 months of imports in Kenya to about 6 months in Burundi, with Rwanda, Tanzania, and Uganda in the range of 4 to 5 months of cover. While the authors noted that their findings were sensitive to model specification and assumptions, they concluded that the appropriate level of pooled reserves for the EAC region under a common currency would decline with the flexibility of the exchange regime to be adopted (i.e., the more flexible the exchange rate, the less reserves would be needed). The degree of integration between the countries would also likely decline, as higher integration makes the region less vulnerable to external shocks. These conclusions are consistent with recommendations in other studies, which also argue that reserves only provide a temporary and partial solution to vulnerabilities that stem from a lack of economic diversification and weak policy and institutional frameworks in low-income countries (Dabla-Norris, Kim, and Shirono, 2012).

Promoting Real Convergence

For countries to benefit from a regional monetary union, optimal currency theory suggests that their economies should be highly integrated, with ideally somewhat similar economic structures. This could be referred to as real convergence. Since the member countries share a common monetary and exchange rate policy, they should be subject to the same sort of shocks, so that corrective monetary and exchange rate adjustments are mutually beneficial. Where shocks are asymmetric, a high degree of structural flexibility, such as real-wage flexibility and mobility of labor, can help avoid lasting shifts in intraunion competitiveness.

Real convergence can be measured in several ways. The literature tends to focus on whether cross-country differences in per capita incomes and productivity are narrowing over time (see the “sigma” and “beta” convergence approaches in Barro and Sala-i-Martin, 1995).7 Consideration is also given to whether differences in labor markets and economic structures are narrowing. Moves to more synchronous business cycles and closer trade integration are also two aspects of real convergence.

Progress toward real convergence is commonly treated as implicit by prospective monetary unions. The regional country groups considering currency union in Africa (Annex Table A3.1) are based, to some degree, on a view by members that they have achieved, or are achieving, sufficient real convergence to represent optimal currency areas. However, the degree of real convergence between members, and whether it is adequate to support monetary union, is rarely assessed explicitly.8

Some argue that real convergence is not critical ex ante, and that monetary union will foster real converge ex post. There is support in the economic literature for the idea that nominal convergence leads to real convergence. With the benefits of currency union (price stability, fiscal discipline, reduction of uncertainty, and so on), investment and trade will respond favorably, leading to stronger economic growth. The growth impact is expected to be larger for countries that were formerly more unstable and at lower levels of income relative to their peers, resulting in real convergence through catch-up growth. Real convergence can also benefit from structural reforms within a currency union. For example, the adoption of the euro was associated with an accelerated pace of deregulation and other structural reforms in product markets.

Real convergence within currency unions is not guaranteed, however. Although the poorest members of the euro area experienced rapid catch-up growth, a legacy of inflexible labor markets, excessive and inefficient state intervention, and restrictions on product market competition remained. This has cautionary implications for prospective currency unions that anticipate that issues of real convergence can be assumed away on the grounds that they will be resolved by the currency union process itself.

East African Community Convergence in Income per Capita

There is evidence that the EAC has achieved a degree of real convergence in recent years. One proxy for this is provided by real income per capita. Although similar levels of income per capita are not strict criteria for an optimal currency area, similar income levels may help align countries’ institutional capacities and policy priorities. From this perspective, Rwanda, Tanzania, and Uganda have closed their income gaps relative to Kenya through rapid per capita growth in the 1.5–2.5 percent annual range over the past 30 years (Figure 3.7). By contrast, the income gap between Kenya and Burundi has widened over the same period, reflecting average declines in Burundi’s income per capita of about 0.5 percent per annum after years of conflict.

Figure 3.7East African Community: GDP per Capita (Constant 2000 U.S. dollars)

Sources: World Bank, World Development Indicators; and authors’ calculations.

Empirical tests confirm progress in income convergence in the EAC. The standard deviation of real income per capita across countries (sigma) has significantly declined in the last 15 years, with the exception of Burundi (Figure 3.8). That said, the data show income divergence when Burundi is included. When Burundi is excluded, countries with lower income levels grew more in the period from 1996–2010 (Table 3.1).

Figure 3.8EAC Sigma Convergence of Income per Capita

Sources: World Bank, World Development Indicators; and authors’ calculations.

Note: EAC = East African Community.

Table 3.1Estimated Beta Convergence
All EACEAC excluding Burundi
1981–20101981–951996–20101981–20101981–951996–2010
0.001−0.030 **0.018 ***−0.028−0.053−0.029 **
[0.007][0.012][0.005][0.025][0.036][0.014]
Source: Authors’ calculations.Note: *** denotes significant at the 1 percent and ** at the 5 percent levels. EAC = East African Community.
Source: Authors’ calculations.Note: *** denotes significant at the 1 percent and ** at the 5 percent levels. EAC = East African Community.

Trade Integration

EAC countries have taken significant steps to promote trade integration. A customs union was established in 2005, followed by the launch of a common market in 2010. Internal tariffs on goods from other EAC countries were eliminated over a five-year period to end-2009. A common external tariff was established for imports from outside the region. These efforts resulted in a reduction of tariff rates in the EAC. While nontariff barriers are found to be remaining in wide-ranging fields, such as lengthy customs administrative procedures and lack of harmonized standards, member countries are committed to further reducing these barriers, including through time-bound programs for eliminating identified nontariff barriers (Okumu and Nyankori, 2010).

There is only limited progress to date toward greater trade integration among EAC countries. The U.S. dollar value of intra-EAC exports has broadly trebled from $0.6 billion in 2000 (the start of the customs union) to $2.3 billion in 2012 (Figure 3.9). At the same time, exports beyond the EAC have also risen quite rapidly, and the share of intra-EAC exports in total exports rose only modestly from 18 percent in 2005 to 20 percent in 2012. Moreover, intra-EAC trade represented a larger share of total exports in 2000, at a time when commodity export prices were lower, than they are today. With EAC countries continuing to develop new resource exports (oil in Uganda, gold and natural gas in Tanzania), it appears likely that intra-EAC trade will remain only a small fraction of total exports for the foreseeable future, especially if global commodity prices remain strong.

Figure 3.9Intraregional Exports, 2000–12

Source: IMF, Direction of Trade Statistics database.

Note: EAC = East African Community.

Conclusions

EAC countries are adopting common convergence criteria that share similar features with those of other monetary unions. Compliance with these criteria is mixed and will need to be revisited and supported by common statistical definitions. Agreement among EAC countries on nominal convergence criteria represents the first pillar toward establishing a monetary union. The criteria are designed to provide simple, easy-to-interpret rules for macroeconomic management. They will need to be accompanied by a period of surveillance to ensure compliance to underpin macroeconomic stability and to safeguard the convergence process. A successful EAMU will require an institutional apparatus to enforce sound macroeconomic policies at the national level. Consideration will need to be given to designing a workable institutional setup under which EAC regional authorities have the necessary capacity to constrain policymaking at the national level, when the latter poses risks to monetary union.

Annex 3.1
Table A3.1Comparison of Convergence Criteria Across Monetary Unions
ObjectivesEast African CommunityCaribbean Monetary UnionWest African Monetary Union (the West African Monetary Zone)CFA Franc Zone (WAEMU)CFA Franc Zone (Central African Economic and Monetary Community)Gulf Cooperation CouncilEuropean Monetary UnionEastern Caribbean Monetary Union (Eastern Caribbean Currency Union)
Exchange rate convergenceAchievement and maintenance of stable real exchange rates.Maintain a stable exchange rate for at least three years before monetary union (with bilateral exchange rates not fluctuating more than 1.5 percent).± 15 percent against the West African Monetary Zone, Exchange Rate Mechanism (ERM) II, under the European Monetary System.Peg to the euro.Peg to the euro.Peg to the U.S. dollar.Applicant countries should have joined ERM II under the European Monetary System for two consecutive years and should not have devalued their currencies during the period.Peg to the U.S. dollar.
International reservesFour months of imports.Three months of imports for at least one year.Three months of imports.n/an/aFour months of imports.n/aInternational reserves should back at least 60 percent of currency in circulation.
Public debtpublic-debt-to-GDP ratio of 50 percent in net present value terms.External debt service of no more than 15 percent of exports.n/aLess than 70 percent of GDP.Less than 70 percent of GDP.Total public debt less than 70 percent of GDP; central government debt less than 60 percent of GDP.Gross government debt not above 60 percent of GDP. If this ceiling cannot be met, the ratio should be approaching the reference value at a satisfactory pace.Gross public and publicly guaranteed debt not to exceed 60 percent of GDP.
Fiscal deficitOverall budget deficit (including grants) not more than 3 percent of GDP; deficit excluding grants not more than 6 percent of GDP (secondary criterion).Below 3 percent of GDP.4 to 5 percent of GDP.Basic budgetary balance to be zero or positive.Adjustable criterion on non-oil basic budget balance.Not above 3 percent of GDP.Not to exceed 3 percent of GDP. Exceptional and temporary breaches of the ceiling may be granted.Primary balance of the public sector to be consistent with achieving and maintaining an agreed public debt target by 2020.
InflationAnnual average inflation not to exceed 8 percent.In the year prior to monetary union, inflation not to be more than 1.5 percentage points higher than the three countries with the lowest (positive) inflation.Less than 10 percent.Less than 3 percent.Not more than 2 percentage points above the average for Gulf Cooperation Council members.Not more than 1.5 percentage points higher than the average for the three best-performing European Union member states.n/a
Interest ratesMaintain market-based interest rates.n/aPositive real interest rates.n/an/aShort-term interest rates should not be more than 2 percentage points higher than the average for the lowest three members.Long-term interest rates should not be more than 2 percentage points higher than in the three member states with lowest inflation.n/a
TaxationSecondary criterion of tax-to-GDP ratio of 25 percent.n/aTaxes should be greater than 20 percent of GDP.Taxes should be greater than 17 percent of GDP.Non-oil fiscal revenue should be no less than 17 percent of non-oil GDP.n/an/an/a
Public expenditure arrearsn/an/aZeroNo accumulation of domestic or external arrears.No arrears of more than 120 days maturity.n/an/an/a
Savings and investmentn/an/an/an/an/an/a
Public sector wagesn/an/aNo higher than 35 percent of revenues.No higher than 35 percent of revenues.n/an/an/a
Central bank credit to the governmentn/an/aLess than 10 percent of the previous year’s tax revenues.Less than 20 percent of the previous year’s tax revenues.Less than 20 percent of previous year’s revenues (criterion to be phased out by 2012).n/aZero ceiling.Up to 40 percent of reserves.
Source: Authors.Note: n/a = not applicable; WAEMU = West African Economic and Monetary Union.
Source: Authors.Note: n/a = not applicable; WAEMU = West African Economic and Monetary Union.
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1Tax and nontax revenues plus budget grants, minus current expenditures and domestically financed capital expenditures.
2For the CFA and Eastern Caribbean Currency Union, the choice of an external nominal anchor reflected a pattern of trade inherited from a colonial past. For the Gulf Cooperation Council, the choice of a U.S. dollar peg reflects the fact that trade is predominantly denominated in dollars.
3The exchange rate mechanism for EMU countries specified a grid of bilateral central exchange rates between the potential partners and a set of country-specific bands within which exchange rates were allowed to fluctuate. The central rates could be adjusted by mutual agreement, but for the two years leading to entry countries were not to devalue their central rates, and had to manage their economies so as to remain within a ±2.5 percent band of the parities (Adam and others, 2012).
4In a rather extreme case, if one EAC member traded entirely with U.S. dollar–based economies and another with euro-based economies, they could achieve stable real exchange rates by pegging to the U.S. dollar and euro, respectively. However, if they did so, bilateral exchange rates within the EAC would not converge, and would vary in line with U.S. dollar–euro movements.
5Kenya received grants equivalent to 0.7 percent of GDP in 2010–11.
6In the context of IMF programs, 3–4 months of reserve cover of imports is usually considered as a minimum for a low-income country. A slightly higher target might be advisable to provide a buffer against a very volatile environment.
7Sigma (σ)-convergence occurs if the cross-sectional distribution of income per capita decreases over time. Beta (β)-convergence evaluates whether growth rates have a tendency to converge toward the baseline rate.
8Although real convergence was not a formal test for membership of the euro area, this was effectively the approach adopted by the United Kingdom in 2003 when it established “five economic tests” for its adoption of the euro. These were as follows: (1) Are economic structures and business cycles sufficiently compatible for the permanent adoption of the euro? (2) If problems emerge, is there sufficient flexibility to deal with them? (3) Would adopting the euro promote investment in the United Kingdom? (4) Would euro membership benefit the United Kingdom’s financial services industry? and (5) Will the euro boost growth, stability, and employment creation in the United Kingdom?

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