Building Integrated Economies in West Africa
Chapter

Chapter 15. Monetary Policy in a Currency Union

Author(s):
Alexei Kireyev
Published Date:
April 2016
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Author(s)
Alexei Kireyev

Is there scope and need for monetary policy in the West African Economic and Monetary Union (WAEMU)? At first glance the answer would appear to be “no,” as the WAEMU is a currency union with a fixed peg to the euro. However, the limited de facto capital mobility provides some scope for monetary policy. The institutional and other characteristics jointly needed for an independent monetary policy under a fixed exchange rate regime are present. The Central Bank of West African States (BCEAO) can control regional interest rates, which diverge substantially from the euro area rates, as capital mobility is limited. Moreover, the BCEAO has substantial weight in the banking system and therefore can exercise sufficient influence on monetary conditions in the area. The BCEAO has the needed instruments (interest rates and reserve requirements) for achieving the goals of its monetary policy. In the absence of the exchange rate channel, all other channels of monetary policy transmission (through the volume of credit, interest rates, asset prices, and expectations) can, in principle be more active. However, shallow financial markets and interest rate rigidities impede the transmission of monetary policy signals and the link from the BCEAO’s policy actions to market interest rates and inflation remains extremely weak and can affect both only marginally. To improve monetary policy implementation, the BCEAO should also continue developing deep and functioning interbank, secondary debt, stock, and other financial markets. Improving the transmission of BCEAO policy actions to inflation by reducing price and interest rate rigidities, in particular by introducing more flexibility of deposit rates, is also important.

The goal of this chapter is to explore the preconditions needed for the BCEAO to have an impact on domestic demand and price conditions in the WAEMU. On theoretical grounds, under the constraints of a fixed exchange rate regime and capital controls, several preconditions should be met. First, the BCEAO should have an adequate monetary policy framework and functioning monetary policy instruments. Second, there should be a clear transmission between these instruments and market interest rates. This precondition requires that the BCEAO should be able to influence regional market rates and that they are not determined by exogenous forces, given the peg to the euro. Finally, there should be a clear link between BCEAO policy actions and inflation.

A priori, based on theoretical considerations, in a fixed exchange rate arrangement any central bank should have some scope for an independent monetary policy, if capital mobility is restricted. This follows directly from the so called “trilemma” in international macroeconomics, suggesting that countries cannot simultaneously enjoy full capital mobility, fixed exchange rates, and monetary autonomy (Obstfeld, Shambaugh, and Taylor 2005 and 2008; Montiel 2009). Recently, Klein and Shambaugh (2013) confirmed that extensive capital controls enable a country to have monetary autonomy, as suggested by the trilemma. Partial capital controls, however, do not generally enable a country to have greater monetary control than is the case with open capital accounts, unless they are quite extensive. According to Rey (2013), the global financial cycle has transformed the trilemma into a dilemma. Now, independent monetary policies are possible if and only if the capital account is managed directly or indirectly, irrespective of the exchange rate regime.

Monetary Policy Framework

The BCEAO prepares an annual macroeconomic framework to inform decisions on monetary policy. The framework includes projections for the real, fiscal, monetary, and external sectors. The level of credit to the economy is aligned with the nominal growth and is adjusted by changing the money supply using the assumption on velocity. The macroeconomic framework is used to inform decisions of the Monetary Policy Committee (MPC) and helps identify key challenges that may face the region in the upcoming year, in particular regarding inflation and growth.

The BCEAO is working on an improved model for inflation forecasting. The model is intended for forecasting inflation by components, such as underlying inflation (total inflation excluding energy and fresh agricultural products), petroleum products, solid fuels, electricity, and others. The projection horizons are 3, 12, and 24 months. Projections for the current year are made public on the BCEAO website. One of the purposes of the model is to identify the component of inflation controllable by monetary policy instruments. Preliminary results indicate that inflation in the zone is largely determined by import prices (because a substantial part of the Consumer Price Index basket is imported), local supply-side shocks (droughts and conflicts), public expenditure (mainly salary and other current expenditure increases), and, to a lesser extent, excess money supply.

The WAEMU region maintains a fixed exchange rate regime but defense of the exchange rate is not currently a binding constraint. The unlimited support and the convertibility guarantees provided to the CFA by the French Treasury reduce the need to build up reserves and therefore allow the BCEAO to change its balance sheet to achieve the goals of economic policy. The operations account with the French Treasury functions as a current account for the zone. All purchases or sales of foreign currencies or euros against CFA francs are settled through a debit or credit to the operations account. The stock of reserves cannot be less than 20 percent of the base money. This should drive corrective measures. In practice, the BCEAO’s official reserves have always exceeded this threshold substantially and have been about 100 percent of the base money in recent years. In principle, the operations account can turn negative in the case of balance of payments difficulties, but this has never happened. In such a case, the French Treasury would provide foreign reserve advances to the BCEAO account in its overdraft option.1

According to traditional metrics, the BCEAO’s official reserves have been adequate for defending the peg. They amounted to CFAF 6,942 billion (about US$12 billion) at the end of 2015. Reserves coverage remained adequate at 4.3 months of next-year imports, 40 percent of broad money, and about 80 percent of short-term liabilities. An alternative method to assess adequacy takes into account the cost of holding reserves, and their benefits in terms of mitigating the impact of macroeconomic volatility. According to this approach, the optimal reserve coverage in the WAEMU varies between 5 and 10 months of imports, depending on the interest rate differential with the rest of the world. This approach, however, does not take into account the access to reserves guaranteed by the French Treasury under the franc zone arrangement.

Capital Mobility

The WAEMU region maintains capital controls on most capital transactions with nonresidents. In all WAEMU countries, the mechanisms of capital controls are comparable and administered jointly by the national ministry of finance and the BCEAO. Although the rules differ slightly from country to country, in general, prior approval by the ministry of finance is required for virtually all outward capital transfers, except for the amortization of debts and repayment of short-term loans. In particular, the authorization by the ministry of finance is required for the following capital flows from residents to nonresidents: (1) all direct investment abroad by residents, including investment through foreign companies under direct or indirect control of residents; (2) purchases of foreign securities; (3) purchases of money market instruments; (4) granting of guarantees and sureties; (5) financial credits and loans; (6) reinvestment of liquidation proceeds; and (7) gifts, endowments, and other transfer of assets (AREAER, 2014). In addition, outward transfers necessary to service credit facilities to nonresidents require an exchange authorization, subject to approval by the BCEAO.

Although the regulation of inward capital transfers is more liberal, and many are subject to declaration just for statistical purposes, substantial restrictions exist. For example, authorized foreign exchange dealers must surrender to the BCEAO in exchange for CFA francs all assets denominated in euros and other currencies held in their establishments; securities and mutual funds issued outside the WAEMU by nonresidents may not be listed on a regional securities exchange; prior authorization by the Regional Council on Public Savings and Financial Markets is required for issue by nonresidents of securities, real assets, and money market instruments; sales of corporate securities to nonresidents resulting in foreign control of domestic establishments require declaration to the national ministry of finance.

The use of the CFA franc outside the WAEMU is not allowed. The CFA franc cannot be used as payment for current international transactions or as capital with countries outside the WAEMU. Swaps of CFA francs for foreign currencies are prohibited. Registered intermediaries must refrain from carrying out any transactions involving forward selling of CFA francs in their relations with nonresidents. Travelers can export CFA franc banknotes, and the BCEAO does not repurchase exported banknotes. In addition, the exchange of BCEAO banknotes between authorized intermediaries and their correspondents outside the WAEMU is prohibited. The export of BCEAO banknotes between licensed intermediary banks and their correspondent banks outside the WAEMU is strictly prohibited. The exchange system is free of restrictions on payments and transfers for current international transactions.

In the case of the WAEMU, limited capital mobility and different credit risks are also reflected in a substantial and persistent differential between the policy rates in the euro area and in the WAEMU. Until recently, the changes of the BCEAO policy rate have broadly followed the trend—but have not reflected the level—of the European Central Bank (ECB) policy rates. Since 2009, the BCEAO maximum lending rate has been historically higher than the ECB marginal lending facility rate by 250 basis points (Table 15.1). The gap between the BCEAO’s minimum bid rate and the ECB’s deposit facility rate has been even larger, at 300 basis points for the minimum policy rate, reflecting aggressive interest rate cuts by the ECB to forestall the impact of the financial crisis. The gap between both minimum and maximum policy rates declined in 2013 to 250 basis points as the BCEAO cut its policy rates three times during the year. In 2014, the differential increased again to over 300 basis points. This persistent divergence of policy rates may have reflected differences in macroeconomic priorities. While the ECB was concerned mainly with providing additional stimulus to the economy to address the crisis in the euro area, there was no visible crisis in the WAEMU area, and the BCEAO focused primarily on handling second-round inflationary pressures from import prices and domestic supply shocks.

Table 15.1BCEAO and ECB Policy Rates
Ceiling Policy RateCentral Policy RateFloor Policy Rate
ECBBCEAODifferentialECBBCEAODifferentialECBBCEAODifferential
Marginal lending facility rateMarginal lending rateMain refinancing operations rate (fixed rate)n.a.n.a.Deposit facility rateMinimum bid rate
20064.504.25−0.253.50n.a.n.a.2.503.250.75
20075.004.25−0.754.00n.a.n.a.3.003.250.25
20083.004.751.752.50n.a.n.a.2.003.751.75
20091.754.252.501.00n.a.n.a.0.253.253.00
20101.754.252.501.00n.a.n.a.0.253.253.00
20111.754.252.501.00n.a.n.a.0.253.253.00
20121.504.002.500.75n.a.n.a.0.003.003.00
20131.003.502.500.50n.a.n.a.0.002.502.50
20141.003.502.501.50n.a.n.a.1.002.501.50
Sources: Central Bank of West African States (BCEAO); and European Central Bank (ECB).ECBMarginal lending facility rate is the rate charged for the overnight provision of liquidity. It normally provides a ceiling for the overnight market interest rate.Main refinancing operations rate (fixed rate) is the rate set for regular liquidity-providing reverse transactions with a weekly frequency and a maturity of one week.Deposit facility rate is the rate paid for overnight deposits with national central banks. It normally provides a floor for the overnight market interest rate.BCEAOMinimum bid rate (taux minimum de soumission, Taux minimum des appeles d’offres), is the minimum policy rate at which commercial banks can submit their bids for liquidity at weekly or monthly liquidity auctions conducted by the BCEAO.Taux du guichet de prêt marginal is the maximum policy rate at which banks can borrow liquidity at the BCEAO outside auctions for one or seven days against an appropriate collateral.
Sources: Central Bank of West African States (BCEAO); and European Central Bank (ECB).ECBMarginal lending facility rate is the rate charged for the overnight provision of liquidity. It normally provides a ceiling for the overnight market interest rate.Main refinancing operations rate (fixed rate) is the rate set for regular liquidity-providing reverse transactions with a weekly frequency and a maturity of one week.Deposit facility rate is the rate paid for overnight deposits with national central banks. It normally provides a floor for the overnight market interest rate.BCEAOMinimum bid rate (taux minimum de soumission, Taux minimum des appeles d’offres), is the minimum policy rate at which commercial banks can submit their bids for liquidity at weekly or monthly liquidity auctions conducted by the BCEAO.Taux du guichet de prêt marginal is the maximum policy rate at which banks can borrow liquidity at the BCEAO outside auctions for one or seven days against an appropriate collateral.

Monetary Control

Three approaches have been suggested in the literature for checking monetary policy independence under the fixed exchange rate regime. The first approach, suggested by Shortland and Stasavage (2004) and Veyrune (2007), implies checking for cointegration between reserve money and net foreign assets of the central bank. The second approach is based on assessing the deviation of inflation, as the main target of monetary policy, in the country of interest from the country of the peg. Finally, the third approach views monetary independence as the ability of countries to set their own nominal interest rates and implies testing the sensitivity of the local interest rate to the foreign rate.

The first approach is based on the assumption that, with a fixed exchange rate, central banks cannot control money supply because they have to buy and sell foreign exchange to maintain the peg. Therefore, their balance sheets and the changes in reserve money may largely reflect the movements of net foreign assets, without leaving space for monetary policy, unless such movements are fully sterilized. In the case of the WAEMU, if the BCEAO is indeed successful in controlling its reserve money, irrespective of the fixed exchange rate arrangement, then there should be no correlation between its reserve money and net foreign assets. If changes in reserve money correlate with the changes in net foreign assets, the BCEAO most likely cannot control the net foreign assets counterpart of reserve money and therefore has no scope for an independent monetary policy. On the contrary, if changes in reserve money do not correlate with changes in net foreign assets, this may mean the BCEAO has scope for an active monetary policy aimed at changing its reserve money by influencing its key counterparts. The problem with this approach is that changes in net domestic assets may also lead to changes in reserve money. The results of this approach should hold only if the impact of net domestic assets on reserve money is controllable by the national governments and the BCEAO, which may be the case, as net domestic assets largely depend on the change in the net government position vis-à-vis the banking system and credits extended by the BCEAO to the commercial banks in the area. Therefore, in principle, the BCEAO, in close cooperation with the government, can control its net domestic assets and the impact of its changes on reserve money.

The second approach to assessing monetary independence would consist of looking at the deviation of regional inflation in the WAEMU from inflation in the euro area. The efficiency of an active monetary policy could be then assessed by the degree of deviations between regional inflation and the inflation in the euro area. Because of exogenous price shocks affecting WAEMU countries, the WAEMU-euro area inflation differential may have justified an interest rate differential between the euro area and WAEMU rates. However, in the WAEMU context, large inflation differentials may not signal directly the absence of monetary control because inflation in the WAEMU is highly sensitive to WAEMU-specific shocks.

In this chapter, the third approach is used to check directly the impact of changes in the interest rates in the euro area on the interest rates in the WAEMU area (Annex 15.1). If the rates in the euro area and the WAEMU are each nonstationary and individually integrated, but a certain linear combination of them has a lower order of integration, then they could be considered cointegrated. Assuming changes in WAEMU rates depend mainly on changes in the rates in the euro area, in this case the BCEAO would not be able to conduct an independent monetary policy. In the opposite case, if no cointegration is found between the two rates, the BCEAO may have some scope for monetary policy. These results should be interpreted with caution. The existence of a cointegration relationship does not imply that changes in euro rates are directly translated to WAEMU rates. Cointegration would simply mean that the interest rates tend to move together in the long term.

Marginal lending facility rates, as reported by the ECB and the BCEAO, are used for the estimation. The data used are average monthly marginal lending facility rates (called money market rates in the WAEMU) for 2008-13 (through October) for the ECB and the BCEAO. The BCEAO published weekly, monthly, and quarterly marginal lending rates. The choice of the average monthly rate was based on the fact that it represents a weighted average rate for liquidity injections at both weekly and monthly liquidity auctions. Alternatively, interbank rates could have been used but in the case of the WAEMU, these rates are not representative of the financial system, as the interbank market is very limited. Although other researchers used mainly OLS regressions of the domestic interest rate on a foreign interest, this chapter applies a more sophisticated cointegration framework that allows testing simultaneously for a potential short-term and long-term impact of ECB marginal lending facility rates on corresponding BCEAO rates.

In the WAEMU, econometric testing finds no cointegration between ECB and BCEAO rates. A multivariate test for stationarity of each variable strongly suggests that both BCEAO and ECB rates are not stationary and that the search for a cointegration is legitimate. The cointegration rank is zero, which may be interpreted as evidence of no cointegration vectors between the two rates (Annex Table 15.1.1). The trace statistic with a degree of freedom adjustment is well below the 95 percent critical value. The estimated adjustment coefficient in the BCEAO regression is negative and in the ECB is positive, but both are not statistically significant. This suggests their linear combination cannot potentially converge to the steady state suggesting lack of a cointegration vector.

Therefore, the BCEAO has all of the institutional characteristics jointly needed for an independent monetary policy, at least in the short term: (1) a monetary policy framework with price stability as a primary target; (2) capital controls, mainly on outflows; and (3) the ability to set nominal interest rates in the region that are not sensitive to changes in the euro area rates.

Does the BCEAO have adequate monetary policy instruments and can it effectively control them? In principle, the BCEAO has at its disposal two main monetary policy instruments: interest rates and reserve requirements. Both are set by discretionary decisions of the MPC in pursuit of the goals of the BCEAO’s monetary policy. Since 2009, it has changed the policy rates five times (four of which came after 2012) and amended the reserve requirements three times.

Interest Rates

The BCEAO sets discretionarily two policy rates and targets the level of the interbank rate as an operational indicator for its monetary policy (Box 15.1).

The BCEAO targets the interbank interest rate as its operational target. In the past few years, the BCEAO has broadly succeeded in keeping the interbank rate within the corridor between the two policy rates. The one-week interbank rate has largely stayed within the targeted interval, with the exception of a period of high volatility in mid-2012 and again in mid-2014, although its behavior remains very erratic (Figure 15.1). Such behavior of the interbank rate may show that the interbank market is very narrow, segmented between a few relatively large international banks and many small local banks, and banks with abundant liquidity seem unwilling to lend to other relatively weaker banks. Moreover, the interbank rate is set mainly in transactions between banks of the same groups. Therefore, smaller banks, which do not belong to such groups, largely do not have access to liquidity on the interbank market.

Figure 15.1.WAEMU: Policy and Market Interest Rates

(Percent)

Source: Central Bank of West African States.

Note: BCEAO = Central Bank of West African States; WAEMU = West African Economic and Monetary Union.

Box 15.1.BCEAO: Policy and Market Interest Rates

Policy Interest Rates

  • The minimum bid rate (taux minimum de soumission) is the minimum rate at which commercial banks can submit their bids for liquidity at weekly or monthly liquidity auctions conducted by the BCEAO. It is the main policy rate.
  • The maximum lending rate (taux du guichet de prêt marginal) is the maximum policy rate at which banks can borrow liquidity from the BCEAO outside auctions for one or seven days against appropriate collateral. It is currently set at 100 basis points above the minimum bid rate.

Market Interest Rates. Other rates depend on market conditions. The money market rate—the marginal rate of liquidity injections (taux marginal)—is set by multiple rate auctions for the BCEAO’s liquidity injections. Historically, the BCEAO’s marginal rate of liquidity injections has always been close to the minimum bid rate, largely making the BCEAO a price maker at liquidity auctions. The interbank rate (taux interbancaire) is set in the interbank market. For statistical purposes, the BCEAO calculates an average weighted rate (taux moyen pondéré) and a reference rate (taux de référence contreparties éligibles) for the collateral used in each auction.

To steer the interbank rate within the corridor, the BCEAO uses liquidity injections operations. Short-term (one-week) liquidity injections are made mainly by a weekly tender (guichet hebdomadaire des appels d’offres). The amounts injected at each auction largely depend on the change in the interbank rate required to keep it within the corridor and forecasts of cash requirements by banks. The BCEAO offers liquidity at the marginal liquidity injection rate, which generally has been close to the minimum bid rate, currently set at 2.5 percent. Although historically the marginal liquidity injection rate diverged from the minimum bid rate, in particular at end-2010, later the gap between the minimum bid rate and the marginal rate narrowed sharply to almost zero. Long-term (1–12 month) liquidity injections are performed by a monthly tender (guichet des appels d’offres à un mois). Through this window, the BCEAO offers liquidity at auctions at variable or fixed interest rates. Monthly amounts offered at weekly liquidity auctions in 2014 amounted to about CFA 5,000 billion compared with CFA 750 billion injected at monthly auctions.

Liquidity Injections

In the past several years, the WAEMU region has been characterized by structural liquidity surpluses. In 2002–14, commercial banks held, on average, half of their reserves in excess reserves with the BCEAO (Figure 15.2).

Figure 15.2.WAEMU: Required and Excess Reserves

(CFA billions)

Source: Central Bank of West African States.

In spite of excess liquidity, the BCEAO has injected additional liquidity. In addition to steering the interest rate, an important reason for these injections was that the BCEAO had to step in for a narrow and highly segmented interbank market and help weaker banks to get liquidity, which they could not obtain from the interbank market. As a result, the level of reserves in the banking system stayed broadly unchanged. Moreover, their composition remained also broadly unchanged, with roughly half attributable to required reserves and half to excess reserves (Table 15.2).

Table 15.2Banks’ Reserves: Composition and Sources of Financing(Percent)
Required and excess reserves
Dec-11Jun-12Sep-12Dec-12Mar-13Jun-13Sep-13Dec-13Mar-14Jun-14Sep-14Dec-14
Composition of reserves100100100100100100100100100100100100
Required reserves514244494847495552494947
Excess reserves495856515253514548515153
Sources of reserves100100100100100100100100100100100100
BCEAO refinancing41667389838892134131145140134
Banks’ own reserves5934271117128−34−31−45−40−34
Own reserves/required reserves1.10.80.60.20.40.20.2−0.6−0.6−0.9−0.8−0.7
BCEAO refinancing/excess reserves0.81.11.31.71.61.71.83.02.72.92.72.5
Source: IMF staff calculations based on Central Bank of West African States information.Note: Bank reserves = Banks’ own reserves + BCEAO injections.
Source: IMF staff calculations based on Central Bank of West African States information.Note: Bank reserves = Banks’ own reserves + BCEAO injections.

However, the sources of financing of banks’ reserves have changed. In the past, accumulation of net foreign assets was a main factor behind the fluctuations of banks’ excess reserves. But since mid-2011, banks’ own reserves (that is, reserves net of BCEAO interventions), have been declining, reflecting a decline of net foreign assets, driven by a growing current account deficit and nonrepatriation of export proceeds by some exporters (Figure 15.3). The coverage ratio of banks’ required reserves by their own reserves fell from 1.4 to −0.7 between 2011 and 2014. Banks found themselves in a structural liquidity deficit. The BCEAO had to step up injections and became the leading source of liquidity, providing 134 percent of all banks’ reserves, compared with 41 percent just three years earlier. Therefore, the BCEAO became virtually the single source of both required and excess reserves in the region.

Figure 15.3.Evolution of Banks’ Own Reserves

(CFA billions)

Source: Central Bank of West African States.

Therefore, the BCEAO is facing a precarious situation. A relatively narrow group of strong banks holds most excess liquidity in the region. This excess liquidity is well isolated from the rest of the banking system, as stronger banks cannot use it at all to buy government securities because most of them have already reached their internal statutory ceilings on country-specific exposures imposed by their headquarters. These banks do not lend to the private sector either, as outside seasonal financing of agricultural campaigns there are not feasible projects meriting financing in the region. Finally, they do not lend to weaker banks through the interbank market either, as strong banks simply do not trust them. At the same time, the majority of banks in this fragmented banking system have so little liquidity that they are not capable of meeting the reserve requirement ratio.

Therefore, excess liquidity seems to be isolated in a few banks and does not spill over into the rest of the banking system. This precarious situation creates a de facto structural liquidity deficit and should, in principle, help the BCEAO in conducting monetary policy. Therefore, the BCEAO has an active tool for monetary policy in the form of liquidity injections and can, in principle, influence the interest rate level in the region. However, this interest rate does not fully reflect liquidity conditions, as the interbank market is very shallow and consists of several relatively weak banks trading with each other, with stronger banks not participating at all. Moreover, in addition to managing the interest rate, the BCEAO has to use these injections to provide liquidity to banks facing structural liquidity needs, mainly to preserve the integrity of the financial system. Such injections allow weaker banks to engage in the carry trade by acquiring government paper and remain afloat profiting from the interest rate differential.

Massive liquidity injections by the BCEAO have adverse implications for the development of the interbank market. With a segmented banking system across individual WAEMU countries and inside each country between large national and small local banks, continued BCEAO injections used to replenish reserves create strong disincentives for weaker individual banks to actively seek liquidity in the market, ultimately delaying further development of a functioning interbank market.

The increased provision of liquidity to commercial banks and their rising exposure to governments may also pose risks to financial stability. In particular, it exposes banks to sovereign risks and potential maturity and liquidity mismatches should the BCEAO be required to tighten monetary policy in the future. The rising share of credit to sovereigns financed by central bank liquidity provision also stifles financial market development.

There may be an alternative view of the sharp increase of BCEAO’s refinancing operations. This increase can be seen as temporary and necessitated by the nascent stage of development of the interbank market. With the development of the interbank market, the need for central bank refinancing will abate.

In sum, interest rates are the BCEAO’s single most active monetary policy instrument. Liquidity injections have played an important role in steering the interbank rate, signaling to market participants the BCEAO’s clear intention to conduct a more active monetary policy and influence financial conditions in the area. Such injections have also sent an important signal of the BCEAO’s ability to step in temporarily for an inactive interbank market and address liquidity shortages in certain parts of the segmented financial system to preserve its stability. At the same time, the BCEAO’s role in the financial system has become substantial, which poses prudential risks and may delay market development.

Reserve Requirements

The BCEAO sets reserve requirements and uses them mainly as a monetary policy instrument, and also as a tool of prudential regulation. The reserve requirement ratio is calculated as a share of banks’ deposits, short-term credit, and gross external assets. For many years, the required reserve ratios were differentiated by country to address country-specific problems, primarily differences in liquidity conditions among individual countries (Table 15.3). The highest ratios applied to commercial banks in Benin, Burkina Faso, Mali, Niger, and Senegal. Guinea-Bissau, Togo, and Côte d’Ivoire had the lowest required reserve ratio. Because the differentiated reserve requirements led to a number of distortions, the BCEAO gradually reduced the differences in the required coefficients among the WAEMU countries and ultimately unified the reserve requirement at 5 percent for all banks in the region in 2012.

Table 15.3Reserve Requirements Ratio(Percent)
11/16/2000–04/15/200204/15/2002–03/15/200403/16/2004–06/15/200505/16/2005–05/15/200906/16/2009–05/16/201005/16/2010–12/16/201012/16/2010–03/15/2012After 03/15/2012
Benin9.009.0013.0015.009.007.007.005.00
Burkina Faso3.003.003.007.007.007.007.005.00
Côte d’Ivoire5.005.005.005.005.005.007.005.00
Guinea-Bissau3.003.003.003.003.005.007.005.00
Mali3.009.009.009.007.007.007.005.00
Niger5.005.005.009.007.007.007.005.00
Senegal9.009.009.009.007.007.007.005.00
Togo3.003.003.003.003.005.007.005.00
Average5.005.756.257.506.006.257.005.00
Source: Central Bank of West African States.
Source: Central Bank of West African States.

Reserve requirements have had an impact on excess reserves in the regions. Based on historical trends, there has been an obvious correlation between the reserve requirement ratio and the level of excess reserves (Figure 15.4). For example, in 2002–05, the BCEAO increased, in steps, the average reserve requirement, which was associated with a decline in excess reserves. The cuts in the reserve requirement ratio in 2009 and 2012 were associated with increased excess reserves. In 2005–09, however, when the reserve requirements did not change, the trend in excess reserves was not clear, with sharp swings in both directions.

Figure 15.4.Reserve Requirements and Excess Reserves

Sources: Central Bank of West African States; and IMF staff calculations.

Therefore, reserve requirements can be viewed as a supplementary monetary policy instrument available to the BCEAO. Obviously, as many other factors affect excess reserves in addition to the reserve requirement ratio, this visible negative correlation between the required reserve ration and excess reserves suggests that potentially reserve requirements also can be used as instruments of monetary policy, in particular to create and, if needed, to enlarge a structural liquidity shortage needed for effective conduct of monetary policy.

Monetary Policy Transmission Mechanism

Is there a functioning transmission mechanism between BCEAO’s instruments and market interest rates? The monetary transmission mechanism describes how changes in monetary policy instruments impact inflation, output, and employment. In a pursuit of broad macroeconomic objectives, the BCEAO sets policy rates or changes the reserve requirements to control a certain financial market variable, which serves as an intermediate target (the money market rate, the interbank interest rate, or the level of reserves in the banking system). The value of this intermediate target is linked through a feedback rule to the ultimate target, which in the WAEMU, is the level of inflation and growth.

The monetary transmission mechanism in the WAEMU can be presented in a stylized way as seen in Figure 15.5. However, not all channels of monetary policy transmission are active.

Figure 15.5.Transmission Mechanism of Monetary Policy

Source: Author’s presentation.

The credit channel allows the BCEAO to affect the volume of banks’ lending and influence market interest rates indirectly. Through this channel, the BCEAO changes the volume of funds available for lending, which adjusts their costs for potential borrowers. Cuts in the policy rate, liquidity injection, or reduction in reserve requirements increase banks’ free liquidity, which allows them to increase the volume of loans and reduce the lending rate. In parallel, the lower lending rates would attract potential borrowers, increasing demand for credit. With higher credit, borrowers would increase their investment or consumption expenditure with a direct impact either on real growth, inflation, or both.

The interest rate channel consists of the BCEAO directly influencing interbank rates. Cutting the policy rate reduces the marginal rate of liquidity injection at which the BCEAO provides liquidity to regional banks at their demand. With the liquidity available at lower cost from the BCEAO, banks are induced to reduce the rates on the interbank market at which they trade liquidity with each other. The overall lower cost of funds allows banks to reduce their lending rates, not only to the private sector but also to governments, therefore driving down the cost of government borrowing. The impact on the volume of credit and nominal demand for credit is broad, as in the credit channel.

The exchange rate channel is applicable only under a flexible exchange rate regime. Cuts in the policy rate usually lead to a nominal depreciation of the local currency as deposits in local currency become less attractive. Depreciation makes domestic goods cheaper in foreign currencies and stimulates net exports. Expenditure switches in favor of domestically produced goods. Export demand increases and stimulates growth. This channel for the transmission of the monetary policy is not applicable in the WAEMU because of the fixed exchange rate arrangement.

The asset channel should allow the BCEAO to influence stock prices and real estate prices, which exert wealth effects on private investment and consumption. Regarding stock prices, a cut in interest rates tends to raise stock prices and reduce the cost of capital, expanding investment and growth. Such policy also has balance sheet effects, as higher stock prices increase the net worth of firms and households and lead to higher lending, higher investment and consumption expenditure, and, ultimately, higher growth. Regarding real estate prices, an expansionary monetary policy reduces the cost of housing financing, leading to higher real estate prices, and higher individual wealth, consumption, and expenditure.

Finally, the impact of monetary policy through the expectations channel is most uncertain because it depends on the public’s perception of monetary policy signals. In principle, the BCEAO’s changes in monetary policy stance can affect expectations of the general public in the region regarding inflation, employment, and growth. For example, a cut in the policy rate may be viewed as a signal that the economy is going to expand in the future, boosting confidence to consume and invest. On the other hand, cuts in policy rates may also be viewed by the public as evidence that the economy is weaker than previously expected, thus forcing the central bank to take policy measures, and therefore lowering confidence and ultimately consumption and investment.

Financial Markets and Monetary Policy

For monetary policy to be efficient, financial markets should be fully operational to serve as a conduit of monetary policy signals. Four financial markets (Figure 15.5) should be capable of efficiently redistributing liquidity and transmitting policy signals from the BCEAO to the real economy. These are the money market (between the BCEAO and commercial banks), the interbank market (among commercial banks), the government securities (public debt) market (mainly between the banking sector and governments), and the equity and real estate (assets) market (among private agents and banks). Unfortunately, none of these is sufficiently developed in the WAEMU.

The money market is critical for an appropriate functioning of the credit and interest rate channels of monetary policy. In the WAEMU, this market is relatively large but is essentially limited to the BCEAO’s liquidity injections. Using the two available windows, the BCEAO regularly auctions liquidity and sets the marginal rate of liquidity injections. On a monthly basis, the BCEAO calculates an average weighted rate of the money market and communicates this rate to all banks in the region. The banks usually use this rate as the base for setting their deposit rates. There are no other highly liquid instruments with short maturities available for trading. Moreover, only weak local banks, which represent a small part of the banking system, usually bid for the BCEAO’s liquidity injections. Therefore, the average money market interest rate set in this market cannot be viewed as fully representative of the market conditions in the regional banking system as a whole and cannot be seen as a basis for a representative short-term reference interest rate. With the absence of such a rate, the expectation channel lacks the reference point and would not be fully functional either.

The interbank market is also needed for the credit, interest rate, and asset price channels to function. In the WAEMU, this market is very small and interbank loans do not exceed 2 percent of total loans. While loan maturity has increased in recent years and a yield curve has emerged, the interbank market does not yet have a major role in the reallocation of liquidity. The banking system remains segmented, and weaker banks that need liquidity cannot get it from larger banks that have abundant liquidity but cannot lend it out because of their internal restrictions, risk management procedures, and absence of collateral.

The regional government securities market is needed to make the interest rate channel more active. In the WAEMU, this market is limited to the primary market for mainly short-term government paper. Governments issue most of their debt to banks through auctions organized by the BCEAO in T-bills with short average maturities. There is no significant secondary market for government debt. Debt securities have also been issued by private companies and governments on the regional stock exchange. With the capitalization at about 2 percent of GDP at end-2014, debt securities do not represent a significant source of financing for the private sector. There is no significant secondary market for both government and private paper. Without a secondary debt market for debt and given a very weak transmission through the bank lending channel, the BCEAO cannot fully influence the short-term interest rates on government T-bills and, thus, the cost of government borrowing.

Finally, the regional equity and real estate market is needed for the asset prices channel of monetary transmission to work properly. In the WAEMU, this market is also very shallow. With less than 40 listed companies, equity market capitalization is only about 10 percent of GDP. Most activities consist of bond issuances by governments, while private stock trading is very secondary. The market is dominated by investors from Côte d’Ivoire and there are very few foreign investors. With the BCEAO’s very limited impact on interest rate policy for short-term Treasury bill rates, this impact does not translate into the long-term rates on government bonds. And, with the shallow equity market, this impact does not visibly affect most asset prices. Therefore, the assets channel of monetary transmission cannot fully function either.

Therefore, the limited depth of financial markets reduces the effectiveness of the BCEAO’s instruments of monetary policy. Among all available channels of transmission, only the credit channel seems relatively active, with a visible impact on the volume of credit, mainly to governments, through liquidity injection. The interest rate channel has some marginal impact on interbank and lending rates in individual countries. Shallow financial markets obstruct the transmission of monetary policy signals. Only the money market is relatively active, but still very limited in scope and depth.

Impact on Inflation

Finally, is there a link between BCEAO policy actions to inflation? Earlier estimates suggest that the impact has been limited. According to the BCEAO’s estimates (BCEAO 2012b), an increase of 1 percentage point of the BCEAO’s policy rate has no impact on inflation in the short term but may lead to a reduction in inflation of 0.05 percent after a 14-month lag. An increase in broad money by 1 percentage point may lead to an increase in inflation by 0.07–0.12 percent in the short term and by 0.16–0.21 percent in the long term. Among the components of money supply, only credit to the economy has an impact on inflation, with a lag of 16–24 months. The BCEAO estimates that an annual increase in credit to the economy up to 20 percent has no inflationary impact and translates mainly into real growth. Any credit increase above this benchmark usually leads to an increase in the component of inflation linked to the monetary factor. An increase in the policy rate has a very marginal impact on growth, with an elasticity of −0.12 (BCEAO 2012a). Other estimates (Kolerus and Zdzienicka 2013) suggest that an increase in the BCEAO policy rate of 1 percent reduces growth of credit to the private sector by about 4 percent and the inflation rate by 0.05 percentage point in the long run. The BCEAO also estimates that cuts to the policy rate translate into a decrease in banks’ lending rates with a lag of two months (BCEAO 2013b).

Our estimations are based on a distributed lag model. It links key variables in the monetary transmission chain as Yt = α0 + βr+1Xt-r + εt, where Yt is the dependent variable of interest regressed on an independent variable Xt and r of its lags. The independent variable Xt is sequentially represented by the BCEAO policy rate, the marginal rate of liquidity injections, and the interbank rate, under the assumption that these three common interest rates are directly linked to the BCEAO’s monetary policy actions, and then by the deposit and lending rates of each individual WAEMU country. The dependent variable Yt is sequentially represented by the marginal rate of liquidity injections, by the deposit and lending rates, and by the core and overall inflation in the region. Separate estimates are performed for each possible transmission link.

Our estimation strategy aims at establishing dynamic causal effects from changes in the BCEAO’s policy rates on all other interest rates and inflation. The strategy consists of three steps: (1) run an ordinary least squares regression on the effects of unit changes in each Xt on Yt and get the contemporaneous (zero period) dynamic multiplier or impact effect; (2) if the impact coefficient is significant and has the right sign, augment the model by adding 12 lags of the independent variable; (3) choose the appropriate lag structure by an autometric model reduction (Ericcson 2011). The estimation period is February 2007–September 2013 on monthly data (80 observations). The selected estimation period reflects the most active recent period of the BCEAO’s monetary policy, when it started managing liquidity more actively by introducing liquidity injections in February 2007 and discontinued the discount rate (taux d’escompte), which was used mainly for penalty calculations. At the same time, the BCEAO established the marginal lending window with a corresponding maximum lending rate, which replaced the repo rate (taux de pension), and the minimum bid rate at liquidity auctions.

The BCEAO’s changes in policy rates have been associated with some changes in interest rates in the region, other than the deposit rate (Table 15.4). For example, there seems to be a statistically significant impact of changes in BCEAO policy rates on the money market rate and the interbank rate, at the average lending rate and average inflation in the region. However, the impact of money market rates has been probably the most pronounced, as both estimates, with and without lags, give approximately the same results: An increase by 1 percentage point in the BCEAO policy rates is associated with about a 1.4 percentage point increase in the money market rate and a 1.9 percentage point increase in the interbank rate, a 0.7 percentage point increase in the lending rate, 0.03 percentage point decline in core inflation, and a 0.05 percentage point decline in overall inflation. The impact is either contemporaneous or with one lag because coefficients on both lags are significant and close in magnitude. There is, however, no significant impact on the average deposit rate, and even the sign of the coefficient is wrong.

Table 15.4The Impact from Policy Rate Changes on Market Interest Rates and Inflation
LagsCoefficientT-valueSign
Policy Interest Rate On
Money market rate01.3512.3
00.702.78
10.973.49
Interbank rate01.918.11
01.899.66
Average deposit rate0−0.22−3.35wrong
3−0.24−3.45wrong
Average lending rate00.694.79
10.725.53
110.673.88
Average core inflation0−0.03−1.95
12−0.04−3.50
Average inflation0−0.05−3.95
1−0.05−2.77
Money Market Rate On
Interbank rate01.3611.2
01.005.61
20.482.65
Average deposit rate0−0.14−3.52wrong
1−0.15−3.56wrong
Average lending rate00.252.56
60.444.35
Average core inflation12−0.02−2.29
Average inflation0−0.02−3.07
12−0.03−2.52
Interbank Rate On
Average deposit rate0−0.12−5.33wrong
1−0.13−5.85wrong
Average lending rate00.061.01
100.172.04
Average core inflation12−0.02−2.68
Average inflation0−0.01−1.55
12−0.01−2.59
Average Deposit Rate On
Average lending rate0−0.10−0.35wrong
Average core inflation50.042.72wrong
Average inflation50.042.35wrong
Average Lending Rate On
Average core inflation0−0.02−2.43
Average inflation0−0.03−3.95
0−0.02−2.32
3−0.03−3.16
Source: IMF staff estimates.Note: The number of zero lags appears twice, as the model was estimated in two specifications, the first with no lags (first zero) and, second, if the coefficient is significant, again with up to 12 lags. In the cases of the money market rate and the interbank rate, the model with lags, the zero lag (second zero), and some other lag were significant. Only statistically significant coefficients are shown in the table.
Source: IMF staff estimates.Note: The number of zero lags appears twice, as the model was estimated in two specifications, the first with no lags (first zero) and, second, if the coefficient is significant, again with up to 12 lags. In the cases of the money market rate and the interbank rate, the model with lags, the zero lag (second zero), and some other lag were significant. Only statistically significant coefficients are shown in the table.

Although there may be some impact from the BCEAO’s policy actions on regional interest rates and inflation, this impact is very marginal. The main reason is that the strength of transmission from the BCEAO’s policy rates to the intermediate targets (the interbank rate) and from the intermediate target to the ultimate targets (inflation and GDP) is different. The transmission between the policy and the interbank rates is already relatively weak because of shallow financial markets, and it usually breaks at the points marked by an “X” on Figure 15.5. But the overall transmission mechanism seems to be even weaker because of substantial problems in the transmission between the interbank rate and the ultimate target. The main underlying reasons may lie (1) in the segment’s interbank market where intragroup rates differ substantially from the rates set between small independent banks, and (2) in largely rigid deposit rates, which do not respond at all to the changes in the policy rate and where even the signs of coefficients are wrong. This leads to the low efficiency of both the BCEAO’s monetary policy instruments and the weaknesses of the transmission mechanism.

The BCEAO has the capacity for monetary policy in the short-to-medium term. The institutional characteristics jointly needed for an independent monetary policy under a fixed exchange rate regime (a monetary policy framework, capital controls, and the capacity to manage regional interest rates) are present. In addition, the BCEAO has substantial weight in the banking system because its balance sheet represents about a third of the consolidated balance sheet of the banking system. The BCEAO, therefore, can exercise sufficient influence on monetary conditions in the area.

The BCEAO’s ability to conduct active monetary policy remains constrained. While both monetary policy instruments (interest rates and reserve requirements) are available and can be used simultaneously, their efficiency is very limited in the presence of excess liquidity, which the BCEAO has to maintain to help weaker banks. While all channels of monetary policy transmission (through the volume of credit, interest rates, the exchange rate, asset prices, and expectations) can, in principle, be active, none of them can fully transmit policy signals, which are blocked shallow financial markets. Finally, while there is a link from the BCEAO’s policy actions to market interest rates and inflation, it remains extremely weak and can affect both only marginally. The main underlying problem in the transmission mechanism may be the segmented interbank market and rigid deposit rates.

Important structural changes are needed before the BCEAO can reap the full benefits of its potential for an active monetary policy. These include (1) creating a true structural liquidity deficit by gradually disengaging the BCEAO from the market and adequately calibrating the liquidity injections to market conditions based on improved liquidity projections; (2) developing a deep and functioning interbank market by introducing adequate infrastructure and collateral procedures, and instilling mutual confidence in market participants; this market will allow banks to exchange liquidity and will reduce the need for BCEAO liquidity injections; creating a functioning secondary debt market and deepening the equity market; (3) allowing a gradual emergence of an interbank reference rate and an interest rate curve by developing an institutional framework and supporting infrastructure, adapting regulations to encourage banks to trade liquidity between them, and gradually reducing the injections of liquidity through auctions (a once-a-week interbank rate would be an appropriate reference interest rate); and (4) understanding better the impediments hampering the transmission of BCEAO policy actions to inflation and how to remove them.

The BCEAO is undertaking important reforms to improve the effectiveness of its monetary policy. Authorities are continuously upgrading their model for inflation and liquidity projections. To improve the transmission mechanism of monetary policy, the BCEAO has launched an electronic platform to computerize liquidity injections and absorptions, auctioning of government securities, and monitoring of banks’ compliance with the established reserve requirements. Also, the WAEMU Securities Agency was created to help governments mobilize resources on the capital markets needed to finance their economic development policies, provide assistance to national treasuries, and coordinate their activities. In addition, a regulatory framework for primary dealers and markets was adopted. The authorities have embarked on a set of projects to upgrade their regulations to international standards and strengthen prudential supervision. A deposit insurance fund has been established. A number of other important initiatives are also underway.

Annex 15.1 Empirics of Monetary Control

Fitting a simple error-correction model may help clarify the relationship between BCEAO and ECB money market rates. Based largely on Ericsson (2011), the methodology suggests that if ECB rates and BCEAO rates are each I(1), that is, nonstationary and individually integrated, but if a certain linear combination of them has a lower order of integration such as I(0), then ECB rates and BCEAO rates could be considered cointegrated. Therefore, changes in ECB rates would translate directly into changes in BCEAO rates. If changes in BCEAO rates depend only on the changes in ECB rates, the BCEAO cannot conduct an independent monetary policy. In the opposite case, if no cointegration is found, the BCEAO may have some scope for monetary policy.

The estimated model is:

where αΔECBt can be interpreted as an immediate impact of the change in ECB rates on the change in BCEAO rates and, therefore, α as a short-run elasticity; β(BCEAOt-1 - γECBt-1) can be viewed as a disequilibrium effect, with BCEAOt-1 - γECBt-1 as an error-correction term, β as a feedback coefficient, and γ as a long-run elasticity. With short-term rates and long-term elasticities built into the model, testing for cointegration between BCEAO rates and ECB rates would reveal the time-dependent properties of the model, because the impact of ECB rates on BCEAO rates may differ, depending on the time horizon. The cointegration framework tests two hypotheses: (1) In the short term, there may be some scope for an independent monetary policy; in this case α = 0, and BCEAO rates and ECB rates are not cointegrated; (2) In the long term, there may still be a scope for an independent monetary policy; in this case, γ = 0 and BCEAO and ECB rates are not cointegrated. However, the opposite may also be true; in this case, γ ≠ 0, and BCEAO rates and ECB rates are cointegrated.

The test for cointegration between BCEAO rates and ECB rates is performed in four steps: (1) visual analysis of data plots in level, logs, and first differences to assess their time-varying properties and comovements; (2) evaluation of the order of integration of each variable by an augmented Dickey-Fuller test; only nonstationary variables integrated of order 1 and above can be cointegrated; (3) estimation of the cointegration vector by the Johansen procedure; and (4) testing the restrictions on the long-term and short-term elasticities.

The data plot suggests several important statistical properties of BCEAO rates and ECB rates. Both series are trending downward and most likely are not mean stationary. It is difficult to establish whether they follow the same pattern, other than in late 2008 to mid-2009 when both decreased substantially as both central banks cut their policy rates in response to the financial crisis. The distance between two series changes insignificantly and even switches the sign in late 2008, as ECB money market rates, which exceeded BCEAO rates, suddenly become substantially lower than those of the BCEAO (Annex Figure 15.1.1).

Annex Figure 15.1.1.Evolution of BCEAO and ECB Money Market Rates, 2007–13

Sources: Central Bank of West African States; and European Central Bank.

Plotting the same data in first differences the same series may be stationary, suggesting an I(1) process. Reserve money is more volatile than net foreign assets, in particular after 2003 (Annex Figure 15.1.2).

Annex Figure 15.1.2.BCEAO and ECB Money Market Rates in First Differences (logs)

Sources: Central Bank of West African States; and European Central Bank.

Note: DLBCEAO = first difference of the log of Banque Centrale des Etats de I’Afrique de I’Ouest (BCEAO) money market rate; fSLECB = first difference of the log of European Central Bank (ECB) money market rate.

A more formal test for the order of integration confirms that both series are integrated of order 1. The augmented Dickey-Fuller (1981) statistics and the tested leg length are selected by the Akaike information criterion on a model with a maximum of six lags, with an intercept and no trend or seasonal component (Annex Table 15.1.1). The tests are presented for the levels of both variables (LBCEAO and LECB), their first differences (DLBCEAO and DLECB), and second differences (DDLBCEAO and DDLECB), all in logs. The null hypothesis presence of a unit root is not rejected at the 1 percent critical level for levels of both variables but is strongly rejected for the first differences of BCEAO rates and second differences of ECB rates. Therefore, BCEAO and ECB money market rates in levels do not seem to be stationary, and ECB rates may not even be stationary in first differences. Both series should be differenced at least once or more to achieve stationarity. Therefore, both series can be treated as at least I(1), and their cointegration analysis in levels is possible.

Annex Table 15.1.1AFD Statistics for BCEAO and ECB Money Market Rates, Monthly 02/1997–09/2013 (T = 80)
VariableNull hypothesisSelected lag lengthtADFEstimated rootσAIC
LBCEAOI(1)5−1.08−0.050.0386−6.407
DLBCEAOI(2)4−3.578**−1.000.0387−6.418
DDLBCEAOI(3)4−8.798**−4.240.0413−6.284
LECBI(1)1−2.005−0.020.0497−5.959
DLECBI(2)0−2.863−0.240.0509−5.927
DDLECBI(3)0−8.309**−1.050.0540−5.807
Source: Author’s estimates.Note: ADF = augmented Dickey–Fuller test; AIC = European Central Bank, Akaike information criterion; BCEAO = Banque Centrale des Etats de l’Afrique de l’Ouest; D = first difference; L = log.
Source: Author’s estimates.Note: ADF = augmented Dickey–Fuller test; AIC = European Central Bank, Akaike information criterion; BCEAO = Banque Centrale des Etats de l’Afrique de l’Ouest; D = first difference; L = log.
Annex Table 15.1.2Cointegration Analysis of BCEAO and ECB Money Market Rates (Logs, with 12 Lags and Unrestricted Intercept, 2008[2] – 2013[9])
rank of πr = 0r ≤ 1r ≤ 2
Log-Likelihood log(λτ)249.58256.64256.72
Eigenvalue λτ0.18750.0023
Null Hypothesis
Trace Statistic λmax14.120.160.1
95% Critical Value47.2129.6815.41
VariableEigenvectors
BCEAO1.00−29.50
ECB−0.191.00
VariableAdjustment coefficients
BCEAO−0.48620.00023
ECB0.014890.00097
Statistics for testing the significance of a given variable in β’x
BCEAOECB
X2(1)−3.6692**32.450**
Multivariate statistics for testing stationarity
BCEAOECB
X2(2)10.619**1.2308
Source: Author’s estimates.Note: BCEAO = Central Bank of West African States; ECB = European Central Bank.
Source: Author’s estimates.Note: BCEAO = Central Bank of West African States; ECB = European Central Bank.

Testing for cointegration using the Johansen procedure suggests no cointegration between ECB and BCEAO rates. The multivariate test for stationarity of each variable using a wider information set than the regular ADF test, and taking into account the potential for cointegration, strongly suggests that both BCEAO and ECB series are not stationary and that the search for a cointegration between them is legitimate. All eigenvalues are small and statistically are not different from zero (Annex Table 15.1.2). The eigenvalue statistic λτ accepts the null hypothesis of no cointegration and assigns it the cointegration rank of r = 0. This may be interpreted as evidence of no cointegration vectors between ECB and BCEAO money market rates. The trace statistic λmaxa with a degrees of freedom adjustment is well below the 95 percent critical value. The normalized eigenvector β′ in a common notation presented in the table with the opposite signs can be normally written as BCEAO = 0.19 ECB if the cointegration relationship is present. The estimated adjustment coefficient for the BCEAO equation, which shows how much of its past disequilibrium affects the current disequilibrium, is −0.049 and negative. This suggests the linear combination of variables may potentially converge to the steady state. The estimated coefficient on the ECB rate is 0.01, very small and positive, suggesting their possible divergence from the steady state. Moreover, both coefficients are not significant for the potential cointegration vector.

The ECM model may still contain useful information about the long- and short-term elasticities of responses to changes in the ECB on BCEAO rates. The restrictions on parameters α = 0 and γ ≠ 0 can be tested in their autoregressive distributed lag presentation of the ECM. From ΔBCEAOt = αΔECBt + β(BCEAOt-1 - γECBt-1) + ϵt it follows that BCEAOt - BCEAOt = α0(ECBt - ECBt-1) + β(BCEAOt-1 - γECBt-1) + ϵt. Removing the lagged term BCEAOt = α0ECBt - α1ECBt-1 + α1BCEAOt-1 + ϵt, where α = α0; β = α2 - 1 and γ=α0+α1α21.

Testing amounts to exclusion restrictions on parameters in the autoregressive distributed lag equation. The estimated autoregressive distributed lag equation is BCEAOt=0.0572(0.691)ECBt0.0582(0.066)ECBt1+0.6592(7.571)BCEAOt1. The restriction α0 = 0 has test statistics χ1(1)= 0.47748 [0.4896] and the null hypothesis that α = 0 in the ECM equation is not rejected. From γ=α0+α1α21=0.05720.5820.65921=0.029, which is clearly very close to zero. Therefore, it seems that the fact that in the ECM equation α = 0 supports the hypothesis that in the short term there may be some scope for an independent monetary policy because changes in the ECB money market rates do not affect BCEAO rates contemporaneously. Because γ = 0, there may be some scope for an independent monetary policy even in the long term, because changes in the ECB money market rates still do not affect BCEAO rates, even after a lag.

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1

Although convertibility is guaranteed by the French Treasury, it does not mean that this guarantee is without any limits. For instance, large imbalances in the region ultimately led to a devaluation of the CFA franc in 1994.

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