3. Risk Sharing and Other Mechanisms to Mitigate the Impact of Shocks
- Paulo Drummond, Ari Aisen, Emre Alper, Ejona Fuli, and Sébastien Walker
- Published Date:
- July 2015
The previous sections described some of the challenges that are likely to emerge in the lead up to the EAC Monetary Union. First, there is wide prevalence of asymmetric shocks in the member countries. Second, the exchange rate has been playing a pivotal role in the macroeconomic adjustment following these shocks. While deeper economic integration can over time lessen somewhat the probability of occurrence of asymmetric shocks, EAC countries will still likely continue to be exposed to these shocks for quite some time as their economies are in a constant structural flux (for example, oil and other natural resources)1requiring policy responses.
These important stylized facts make it imperative for the EAC to adequately design mechanisms to adjust to shocks on the way to monetary union. Some of the traditional levers to mitigate the costs of common monetary policy include labor and capital mobility, price and wage flexibility, and various risk-sharing mechanisms. These levers would have to be agreed on among member countries before the introduction of the single currency to reduce risks and signal early commitment to macroeconomic stability and the union.
Fortunately, the EAC authorities are aware of these challenges, and work is underway to reach agreements on policies to mitigate the effects of asymmetric shocks.2This section will first review the current status of EAC-wide agreements to promote integration and facilitate the introduction of shock-adjustment mechanisms. Secondly, it will use the evolving experience of other monetary unions to support future discussions within the EAC. Finally, the section will conclude by providing policy recommendations that might be helpful for the EAC in its design of a monetary union.
Price and wage flexibility
Guided by market principles, prices and wages in the EAC are generally flexible. Price-setting is largely free of government controls, and anecdotal evidence suggests that wages are largely flexible as the majority of people in the EAC are small-scale farmers and/or employed in the informal sector.3 To further ensure price flexibility and competition within the EAC, partner states have agreed to allow free cross-border movement of goods and services.4 These important initiatives can help pave the way for higher trade integration, competition, and price flexibility within the EAC.5 Regarding wages, as discussed in the following section, removing any restrictions to the free movement of workers remains critical to ensuring greater wage flexibility.
Labor and capital mobility
Anecdotal evidence suggests that labor and capital have become more mobile in recent years. Recognizing the importance of labor mobility, the EAC Common Market Protocol establishes that governments should guarantee the free movement of workers and their dependents, citizens of any of the partner states, within their territories. Partner states shall also ensure that workers should not be discriminated on the basis of their nationalities in relation to employment, remuneration, and other conditions of work and employment, and be entitled to rights and benefits of social security as accorded to workers of the host partner state. Furthermore, partner states agreed to mutually recognize academic and professional qualifications; harmonize labor policies, laws, and programs; guarantee the right to access and use of land and premises; and establish residence and self-employment. In regard to capital mobility, partner states agreed to eliminate all restrictions on the free movement of capital and payments connected to such movement. The implementation of the agreements resulted in significant progress including the adoption of common travel documents, work permits and fees for education and tourism; creation of common negotiating frameworks; harmonization of academic and professional qualifications and transport facilitating instruments; and freer movement of capital.
Challenges preventing greater labor and capital mobility still remain.6 Weak capacity of implementing agencies, low level of awareness, inappropriate legal and regulatory frameworks, lingering nationalistic tendencies, a weak private sector, differences in education systems, cultural diversities, language barriers, differences in levels of economic development, inadequate safeguard measures and dispute settlement mechanisms, incomplete harmonization of examination and certifications, inappropriate labor policies and legislation, weak urban planning policies, and disparities in intra-regional trade are examples of impediments to job mobility in the EAC. Continuous efforts are needed to ensure labor, and capital mobility can continue to increase and play the important role of shock absorber once the common currency is adopted.
Managing shocks in the EAC
Creating mechanisms to manage economic shocks is an objective shared by all EAC partner states. The Monetary Union Protocol raises the key concern of building resilience and appropriately managing economic shocks in the context of a monetary union.7 It establishes prerequisites including among others the full implementation of the EAC Customs Union and the EAC Common Market; harmonization and coordination of fiscal, monetary, and exchange rate policies; integration of financial systems; and adoption of common principles and rules for financial systems regulation and supervision. It also commands partner states to establish mechanisms for managing economic shocks that may arise from exogenous factors.
The Protocol also highlights the central role of building strong institutions to monitor and reduce risks8. This includes the creation of a well-capitalized East African central bank as a functionally integrated system of central banks to perform the duties of a central bank independent of political influence from partner states. Moreover, the protocol establishes the formation of various supra-national institutions to support the monetary union, including those responsible for financial services, statistics, surveillance, compliance, and enforcement.
While the Protocol establishes a set of convergence criteria toward the adoption of the single currency, including ceilings on fiscal deficits, debt and inflation, and a minimum international reserves buffer, partner states are yet to establish mechanisms to manage shocks. In particular, partner states must ensure strong fiscal governance early on to reduce potential for fiscal risks to emerge in the aftermath of the adoption of the single currency. The experiences of other currency areas can be helpful to frame ongoing discussions.
Experiences from Other Currency Unions
The African experience with monetary unions, the West African Economic and Monetary Union (WAEMU) and Central African Monetary and Economic Union (CEMAC), offers relevant lessons for the EAC. Gulde (2008) argued that their experience has been positive to maintain macroeconomic stability—particularly low and stable inflation—and stimulating institutional development. Nevertheless, according to the 2014 Staff Report for the WAEMU, the frequency and asymmetry of shocks in the region are still high, and observance of the key fiscal convergence criterion remains limited. In this context, preserving debt sustainability and the stability of the WAEMU in the medium term will require better coordination of fiscal policies. Additionally, both the design of the main convergence criteria and their enforcement could be reconsidered. For example, the criterion on nominal public debt could be lowered to reduce the risk of debt distress.
The European crisis has also exposed critical gaps that may be relevant for the EAC. Despite several years of integration and sharing of a single currency, country-specific shocks have remained more prevalent than initially expected.9 In addition, prices and wages continued to display strong downward rigidities in several euro zone countries, preventing the real exchange rate adjustments necessary after a negative shock. Likewise, labor mobility continued to be sub-optimal because of language and cultural barriers and institutional constraints related, for example, to the inability to transfer pensions and unemployment benefits across borders, negatively affecting migration. The high degrees of trade and financial integration have created room for significant contagion, and problems were compounded by weak fiscal governance and the absence of effective market discipline. The crisis prompted European policymakers to discuss frameworks to better manage country-specific shocks and contain spillovers and exposed the need of a common backstop for the banking union. The crisis also highlighted the importance for individual countries to adhere to credible euro area fiscal rules and at the same time hold fiscal buffers to ensure the needed space to conduct countercyclical fiscal policies. In addition, given that nominal exchange rate devaluations are no longer available to individual countries in the euro area, one potential way to address internal union imbalances is through fiscal devaluations.10
This sub-section reviews policy options for the EAC taking into account the current status of discussions and applying the most important lessons from other monetary unions to the EAC context.
Implementation of agreements contained in the EAC Customs Union and Common Market protocols will be key to ensure greater price and wage flexibility, and increased labor and capital mobility within the EAC. In the absence of bilateral exchange rates, these can be critical adjustment levers to restore real exchange rate equilibrium following large shocks.
The early discussion and eventual adoption of risk-sharing mechanisms is critical to help mitigate costs emanating from shocks. There is a wide range of potential risk-sharing mechanism options that could be established before the single currency is formally introduced in 2024. These include (i) setting up a system of government transfers; (ii) issuance of supra-national EAC bonds along the lines of the European Financial Stability Facility; (iii) creation of an EAC fiscal stabilization fund; and formation of a banking union. The viability of these risk-sharing options depends on the willingness of member countries entering the monetary union and resource availability. The former requires fiscal solidarity; the latter requires sufficient fiscal buffers of contributing EAC members beyond those envisaged to meeting the convergence criteria established in the EAC monetary union protocol. EAC members should discuss these various alternatives early on.
- Inter-governmental fiscal transfers can play a significant macroeconomic stabilization role. Such transfers could serve to counteract an adverse asymmetric shock on a member state. This stabilization role is key because it will discourage individual member states from undertaking fiscal measures that conflict with the price stability objectives of the EAC central bank.
- Supra-national EAC bonds can offer a partial risk-sharing alternative via a facility providing assistance to members through bond issuance backed by the guarantees based for instance on revenues of member sovereigns. If the EAC borrows collectively, market access could be secured at sustainable yields even when one or more member countries come under stress following an adverse shock.
A regional stabilization fund could provide temporary funding for members to finance any fiscal shortfalls in the event of a country-specific adverse shock. Such a stabilization fund or a “rainy-day fund” needs to be set up from initial contributions of the members and could be replenished at a time when output returns to long-run trend in the affected members. For the European Union, Allard and others (2013) estimate that such an ex-ante support could be setup through 1½ to 2½ percent of GNP annual contributions by member states, and these would provide sufficient resources to guarantee overall income stabilization where 80 percent of regional income shocks are smoothed.11 For the WAEMU, according to Hitaj and others (2013), stabilization mechanisms aimed at absorbing common and idiosyncratic shocks are absent or ineffective. The 2014 Staff Report for the WAEMU estimates that a contribution of about 1–1¼ percent of GDP would be needed to insure WAEMU countries against severe downturns.
- A banking union can significantly reduce financial risks. The union would complement the adoption of common financial rules and supervision already prescribed in the EAC Monetary Union protocol. But it would go a step further by creating a common bank-resolution framework relying on funding from the industry accumulated in a resolution fund and a common backstop, in exceptional cases, through a credit line from the EAC central bank and from pooled fiscal resources.
The introduction of risk-sharing mechanisms requires strong fiscal governance and safeguards to prevent the buildup of large risks. As with any insurance scheme, “free riding” and moral hazard are risks especially if the risk-sharing mechanisms end up allowing for transfers to a member state for longer than warranted. To prevent “free-riding,” the EAC could choose among several options; one extreme is self-imposed budget constraints, reliance on strong market discipline, and no bailout rule (Canada and the United States). At the other extreme, coordination and centralization of fiscal governance along the lines of the Fiscal Compact in the European Union, aim to limit the fiscal risks taken by member states. Intermediary systems may involve intergovernmental coordination (Australia and Belgium) or direct democracy (Switzerland) to instill sound fiscal policies by the members of the monetary union. Such safeguards will reduce the temptation by member countries to implement riskier policies and free ride on the introduced safety net.