Abstract

Existing currency unions can shed some light on the requirements for making a monetary union function smoothly and hence on desirable features of a possible currency union in West Africa. In this regard, it is also useful to survey the experience of other currency unions that have not survived.

Existing currency unions can shed some light on the requirements for making a monetary union function smoothly and hence on desirable features of a possible currency union in West Africa. In this regard, it is also useful to survey the experience of other currency unions that have not survived.

Presently, there are only five unions and among them the WAEMU currency area is the most directly relevant for ECOWAS since the eight WAEMU members are also ECOWAS members. Appendix III surveys the extensive literature on the effect of a common currency on the economic performance of WAEMU countries and the countries making up the other CFA franc zone in Central Africa, the Central African Economic and Monetary Community (CAEMC). The currency of both zones is convertible into French francs (and, since 1999, the euro) at a parity that is guaranteed by the French Treasury.

A third currency area, the Eastern Caribbean Currency Union (ECCU) is constituted by eight small island economies that share a single currency, the Eastern Caribbean dollar, and a central bank, the Eastern Caribbean Central Bank (ECCB). As in the case of the CFA franc zones, this currency area is a legacy of a colonial monetary arrangement and it operates as a quasi-currency board. However, it provides an example of a union with a strong external peg (the exchange rate against the U.S. dollar has remained unchanged since 1976), maintained purely through regional discipline and available reserves, rather than through an external guarantee.

Fourth, the Common Monetary Area (CMA) is constituted by South Africa and three smaller countries grouped around it: Lesotho, Namibia, and Swaziland. Given the dominant size of South Africa, this currency area uses the rand, although the other countries retain their own currencies, which are pegged to the rand.

The fifth currency area is the most recent and by far the most economically important—namely, the euro area. Although the euro has been in existence only since January 1, 1999, the European Union’s extensive process of institutional preparation for a new central bank and a new currency, as well as the efforts invested in convergence, provide important lessons for the creation de novo of a currency area.

In addition to considering existing currency areas, we also draw lessons from failed currency areas. We consider the breakdown of the ruble zone after the dissolution of the Soviet Union, which illustrates the pitfalls of inadequate institutional safeguards, and the currency area constituted by the East African Community (EAC) in the 1970s, which failed from lack of member solidarity and uncoordinated monetary expansion.

A detailed description of each of the five currency areas (as well as the ruble zone, the EAC, and several cases where the currency of a large country serves as legal tender in a smaller neighbor) is given in Appendix II, while essential features of existing currency areas are summarized in Table 5.1. The table suggests considerable diversity across monetary unions. The CMA is the weakest institutionally, in that separate currencies and central banks make the internal exchange rates revocable and dissolution of the currency union is itself relatively easy. This monetary area would be termed a “pseudo currency union” by Corden and doubts about its continued existence are consistent with Allen’s analysis. Indeed, Tjirongo (1998) questions whether the full credibility advantages of membership accrue to Namibia, given the union’s revocable nature. The euro area is the strongest, given the size of regional trade and the fact that it has followed the creation of other institutions manifesting regional solidarity and linking the countries together in numerous ways.

Table 5.1.

Characteristics of Monetary Unions

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The euro, the single European currency, will replace the national currencies of 12 member countries of the European Union over a three-and-a-half-year period that began on January 1, 1999. (Greece joined the initial group of 11 countries on January 1, 2001.) The euro area’s national currencies and the euro will coexist until mid-2002.

Based on data for 1998 in IMF, Direction of Trade Statistics.

A first lesson is that a true monetary union must be accompanied by the creation of a single institution with clear assignment of responsibility for formulating and conducting monetary policy. Decentralized decision making is not possible in the context of a monetary union. The “free rider problem” is well illustrated by the experience of the ruble zone. With the dissolution of the Soviet Union, the newly independent republics had some autonomy in money creation and most proceeded to extract seigniorage as quickly as possible, taking advantage of mechanisms that allowed them to borrow without limit from the Central Bank of Russia. Accelerating inflation was the result. The instability of the ruble and its failure to provide both the monetary services of a means of payment (it was not generally convertible against goods within the ruble zone) and a store of value quickly made it unattractive as a common currency. In the EAC, the tight controls on monetary expansion embodied in the currency board were progressively loosened, as member governments succeeded in expanding the amount of direct and indirect financing extended to them by their national central banks.

Decentralized execution of monetary policy, if accompanied by tight controls on monetary expansion or intervention, is, however, possible in principle, but the euro zone is unique in this respect. In the European Union (EU), it was decided to retain national central banks along with the new European Central Bank (ECB) as part of the European System of Central Banks. The ECB has a monopoly over monetary policy, however, and the tight constraints prohibiting any direct or indirect financing of governments make any attempts by national central banks at circumventing the ECB’s monetary policy improbable.

A second important lesson for the successful operation of a monetary union is that the central bank must be free from pressures to finance governments, whether directly or indirectly. Although the CFA zones respected formal limits on monetary financing, there were enough loopholes that some of the national governments managed to extract seigniorage. Specifically, because certain types of central bank loans were not subject to the ceilings, national governments induced their commercial banks to borrow from the central bank and then to transfer the funds to the governments, which used the proceeds for their own purposes. The banking crises that occurred in the 1980s in most countries of both WAEMU and CAEMC resulted, and the central banks of the two zones ended up bailing out insolvent institutions. In the end, the governments of the largest countries (Côte d’Ivoire and Cameroon, respectively) managed to appropriate a disproportionate amount of seigniorage through this process (Stasavage, 1996).

It is clear that neither monetary union nor pegged exchange rates per se are sufficient to discipline fiscal policy, as the CFA example shows. In fact, some have argued (e.g., Tornell and Velasco, 1995) that flexible rates may provide a more immediate signal of overexpansionary fiscal policies and make policy mistakes more visible. Therefore, a currency union needs reinforced surveillance over fiscal policies of its members, accompanied by effective sanctions and close supervision of banks. The fear of pressures on the European Central Bank explains the great pains taken in Europe not only to rule out monetary financing, but also to control excessive deficits.

A third lesson, or at least empirical regularity, is that monetary unions have usually been organized around a strong existing central bank or through a peg to a stable international currency. This is true of the CFA franc zones and the ECCU, and also of the euro zone, where the Deutsche Bundesbank (German central bank) provided the model of monetary stability. In some cases, asymmetry in the size of the countries concerned has given the large country effective control over the monetary union (e.g., South Africa in the rand area and the United States for Panama’s monetary policy). The more symmetric monetary unions with weaker intraregional institutions have relied on an external anchor: for example, in the ECCU, the peg was to the pound sterling and later to the U.S. dollar; WAEMU and CAEMC peg to the French franc (and, since 1999, to the euro). In contrast, the ruble zone at the break up of the Soviet Union had neither a strong stability-oriented institution at its center nor an external anchor.

Fourth, even long-standing monetary unions need not lead to strong regional integration in other dimensions, such as strong regional trade links or other regional institutions. For instance, the ECCU, WAEMU, and CAEMC all have relatively low internal trade. Empirical literature surveyed in Appendix III suggests that currency unions do provide some stimulus to trade, with a recent (high) estimate of the effect implying that membership increases trade by as much as a factor of three. However, the still relatively low level of internal trade has stimulated other initiatives in WAEMU—in particular, the creation of a common external tariff, indirect tax harmonization, standardization of business law, and the formation of a regional stock exchange. In both ECCU and CAEMC, monetary union has been accompanied by a lesser development of regional institutions. Conversely, strong trade ties do not have to be accompanied by monetary union or even fixed exchange rates. A notable example is the North American Free Trade Agreement (NAFTA), where Canada and Mexico are the United States’ main trading partners, and vice versa, although their currencies float against the U.S. dollar.

A fifth lesson is that the evidence is mixed on whether monetary union is an important stimulus to growth. Evidence from the CFA franc zones initially suggested a positive impact relative to the rest of sub-Saharan Africa (e.g., Guillaumont and Guillaumont, 1984: Devarajan and de Melo, 1987). As indicated in chapter III, however, these zones severely underperformed in the 1986–93 period.17 Frankel and Rose (2000) argue that currency unions promote growth through increased intraregional trade and Guillaumont, Guillaumont-Jeanneney, and Brun (1999) point to instability (including price instability, which should be reduced by monetary union) as a factor reducing African growth. However, it is clear that monetary policy on its own cannot ensure sustained growth without favorable real conditions in the economy, including more fundamental determinants of growth that include sound fiscal and structural policies, and trade liberalization.

Sixth, the existing currency unions that we have surveyed have all been associated with low inflation, but this is in no way guaranteed, as the example of the ruble zone indicates. Price stability is less a feature of currency unions per se than of the way that monetary policy is anchored and whether there are adequate safeguards against excessive monetary expansion. Inflation has been lower in CFA franc countries than in the rest of sub-Saharan Africa, but it is difficult to disentangle the effects of the discipline provided by the CFA franc’s link to the French franc, the indirect influence of France’s convertibility guarantee on the monetary policies of the CFA franc zone, and the effect of monetary union among WAEMU or CAEMC countries per se. Again, the ECCU has recorded low inflation, resulting from a peg to a strong currency. Except for the CMA, there are no examples of existing monetary unions among developing countries that do not anchor to an industrial country currency; therefore, it is hard to determine whether such a strategy is likely to be successful in bringing to bear greater monetary discipline than each country could achieve on its own.

However, there are two examples of failed monetary unions that did not have such an anchor. The ruble zone, which was centered on an inconvertible currency without an anchor to an international currency, collapsed amidst high inflation, but this was due to lack of structures for controlling monetary growth and in the context of a breakdown of existing political ties. The monetary union in the East African Community also broke down as a result of lack of effective supranational controls on national monetary creation. Indeed, (Guillaume and Stasavage 2000) argue that successful monetary unions must be accompanied by parallel regional arrangements and/or links to financial and technical assistance of industrial countries that make it costly to violate the rules of the monetary union or to withdraw from it.

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