Abstract

There is an extensive literature concerning the advisability for a given country of joining a monetary union.18 There are two general issues that should influence the choice. A first issue is whether the economic structures of candidates to join a monetary union are similar enough or flexible enough to support a fixed exchange rate between their currencies. A second issue is whether the institutions created to carry out the common monetary policy are likely to lead to improved policies. It is important to distinguish these two issues because a monetary union goes beyond simply fixing exchange rates between member countries. It is also important to distinguish between monetary union among a set of countries, thus tying their currencies together, and the external exchange rate policy of the union (e.g., whether to peg to the U.S. dollar or the euro).

There is an extensive literature concerning the advisability for a given country of joining a monetary union.18 There are two general issues that should influence the choice. A first issue is whether the economic structures of candidates to join a monetary union are similar enough or flexible enough to support a fixed exchange rate between their currencies. A second issue is whether the institutions created to carry out the common monetary policy are likely to lead to improved policies. It is important to distinguish these two issues because a monetary union goes beyond simply fixing exchange rates between member countries. It is also important to distinguish between monetary union among a set of countries, thus tying their currencies together, and the external exchange rate policy of the union (e.g., whether to peg to the U.S. dollar or the euro).

For instance, the Ghanaian currency (cedi) could be pegged to the Nigerian currency (naira), through the intervention of Ghana’s central bank (and/or Nigeria’s central bank), but Ghana would retain its own currency and the possibility of changing its parity. Monetary union would be more constraining than a pegged rate because it would involve the irrevocable fixing of the cedi/naira parity and also would require institutions for carrying out a common monetary and exchange rate policy. The common currency could be pegged or could fluctuate against major currencies, with a greater or lesser amount of official intervention on the part of the union’s central bank, depending on the external exchange rate policy.

For a monetary union to be desirable, the basic criteria for a fixed exchange rate between the two currencies must be satisfied. In addition, there must be a willingness to give up the possibility of any adjustment of parities (except if the monetary union is abandoned), and a political commitment to enter into close ties with the other countries of the monetary union. Because of the stronger constraints involved in monetary union, it may have greater benefits than a fixed rate alone. In particular, it may provide a more effective way of tying the hands of the monetary authorities (to provide an “agency of restraint” in Paul Collier’s words), and may stimulate trade and promote other aspects of regional integration.

Benefits of a Fixed Exchange Rate Relationship

The benefits of a fixed rate between countries of a monetary union tend to be greater if the countries concerned already have a substantial amount of trade among themselves, since transactions costs and bilateral exchange rate fluctuations related to that trade will be reduced. The more asymmetric (and large) the shocks facing the countries, the greater are the costs of a fixed rate, increasing the attraction of retaining an independent monetary and exchange rate policy. Countries are less likely to face large asymmetric terms of trade shocks if they have diversified economies with similar structures. For instance, a country that exports oil and imports mainly manufactures is likely to experience different movements in its terms of trade than a country exporting cocoa and importing oil. Asymmetry of shocks will be less of a problem if there is substantial labor mobility or there exists a system of fiscal transfers across the region.

How do the countries of ECOWAS fare on the basis of these criteria?

Trade Patterns

Table 6.1 summarizes the trade patterns for ECOWAS countries. Internal trade within the region is relatively small, at a little over 10 percent of the average of exports and imports. Unfortunately, official statistics do not incorporate informal trade, which is thought to be considerable and to reflect efforts to avoid trade restrictions and trade taxes, as well as the difficulty in acquiring convertible currencies. Under-reporting of intra-union trade may also reflect traditional trade patterns (e.g., between coastal states and the Sahel) that are not picked up in the official statistics. Estimates of informal trade suggest that, if it were included, intra-ECOWAS trade might be increased by several percentage points. In any case, the aggregate figure hides quite different behavior for WAEMU countries and the remaining countries. The former countries trade considerably more among themselves than do the non-WAEMU, ECOWAS countries.19 The EU is the largest trading partner of the countries in the region, accounting for more than 40 percent of the region’s total exports and imports.

Table 6.1.

ECOWAS: Patterns of Trade

(1997–98 average)

article image
Source: IMF Direction of Trade Statistics, 1999.

Asymmetry of Shocks

An important source of shocks, especially for countries whose exports are primary commodities, is the terms of trade. Figure 6.1 presents the evolution of the terms of trade for each of the region’s economies, while Table 6.2 calculates the correlations of changes in those terms of trade. Several features stand out.

Figure 6.1.
Figure 6.1.

ECOWAS Members: Terms of Trade

(1980=100)

Source: World Bank, World Tables 1995; IMF staff estimates.1 Guinea-Bissau joined WAEMU in 1997.
Table 6.2.

ECOWAS Members: Correlation of Changes in Terms of Trade

(1980–96)

article image
Source: Calculated from the Terms of Trade Index (1987=100, U.S. dollar based), from World Bank, World Tables 1995.

Significant at 5 percent level.

Significant at 10 percent level.

Guinea-Bissau is not included with WAEMU above because the country was not a member of WAEMU during the 1980-96 period covered in the table.

First, there are very large movements of the terms of trade for several of the countries. The amplitude of the swings is especially large for Nigeria and the swings are related in large part to changes in the world price of oil, Nigeria’s major export. Other countries also face large changes in the terms of trade; those in Côte d’Ivoire and Ghana, for instance, are substantially related to the world price of cocoa.

Second, these shocks to the terms of trade are typically not well correlated, due in large part to differences in commodity exports, and the fact that the world prices of the various commodities do not move together. Although some primary commodities are common to a number of countries in the region—coffee, cocoa, cotton, fish products, timber, and groundnuts—others are found in only one or two countries (bauxite in Guinea, phosphate in Senegal and Togo, uranium in Niger, and oil in Nigeria). Nigeria, Guinea, Niger, and Guinea-Bissau are each dependent on a single commodity for 50 percent or more of their export earnings (Cashin and Pattillo, 2000). Nigeria is a substantial oil exporter, while most of the other countries of the region are net oil importers. As a result, Nigeria’s terms of trade changes are substantially negatively correlated with those of Côte d’Ivoire, Niger, Ghana, Liberia, and Sierra Leone, and either weakly negatively or weakly positively correlated with the rest, except for Guinea.

Third, the correlations tend to be higher for the WAEMU countries among themselves than either the correlation of WAEMU with non-WAEMU countries or the correlations among non-WAEMU countries.

A broader assessment of the possibility for asymmetric shocks hitting the economies of the region can be obtained by comparing production structures. The production structure (Table 6.3) is quite varied across countries. While most are heavily agricultural, the share of agriculture in GDP in 1997 ranges from 54 percent (Guinea-Bissau) to 9 percent (Cape Verde). There are large differences in the share of manufacturing in GDP, with Burkina Faso (18 percent), Côte d’Ivoire (18 percent), Senegal (15 percent), and Ghana (10 percent) having the largest shares.

Table 6.3.

ECOWAS Members: Production Structure

article image
Source: World Bank, African Development Indicators database.

Labor Mobility

Hard data on labor mobility are difficult to obtain. However, it seems likely that mobility is high between some countries of the region and follows traditional migratory and trading patterns that cut across national boundaries, for instance between the Sahel and coastal areas. According to World Bank estimates, the countries having the largest proportions of resident foreigners in ECOWAS are Côte d’Ivoire (26 percent), The Gambia (14 percent), and Guinea (8 percent) (World Bank, 2000). ECOWAS has facilitated mobility by eliminating visa requirements, but citizens of one ECOWAS country seeking to establish residency in another ECOWAS country still seem to encounter administrative difficulties.

Fiscal Transfers

Federal or unitary states that constitute monetary unions have a mechanism that helps to cushion different shocks hitting different regions. In Europe, the absence of fiscal federalism among countries has been viewed as a considerable drawback to the sustainability of monetary union (Sala-i-Martin and Sachs, 1992). Although it does not have a federal system of taxes and transfers, the EU has set up a “Cohesion Fund” that is designed to subsidize poorer regions.

The six non-WAEMU countries in ECOWAS have announced their intention to set up a Stabilization and Cooperation Fund to make temporary transfers among the converging economies of the monetary union.20 Details on how the fund would function await the results of a study to be prepared by the ECOWAS Technical Committee on the West African Monetary Zone. According to the ECOWAS Task Force assisting the Technical Committee, the fund will begin operating once 75 percent of the proposed initial capital amount of US$50 million has been raised. It is envisaged that no country would be permitted to borrow more than 25 percent of the fund’s proposed total resources of US$100 million. Countries seeking to draw on fund resources reportedly would be obliged to submit applications that would indicate proposed measures for addressing the adjustment problems caused by shocks to their economies.

Notably, for such a fund to operate, the commitment of each country to help its neighbors must be strong. In the past, some countries have not paid their dues to the ECOWAS institutions for many years. In addition, given the size of Nigeria relative to its neighbors, the operation of such a fund may well be asymmetric. Transfers to the smaller countries encountering difficulties could be sizable, but if Nigeria were to draw it could quickly exhaust resources available from the fund.

Conditions for Monetary Stability of the Currency Union

A currency union requires an investment in the institutions necessary to guarantee irrevocably fixed exchange rates and a single monetary policy. A single monetary policy has several different implications. On the one hand, it further reduces nominal flexibility relative to fixed but adjustable exchange rates. On the other hand, supranational institutions may constitute an “agency of restraint,” so that monetary union can improve the stability of monetary policy, provided the central bank is given the independence and instruments that allow it to achieve its objectives. To achieve the benefits of monetary union, however, the political commitment must exist, as well as a considerable degree of solidarity among the countries of the union; otherwise, the monetary union will not be credible or durable. As in the EU context, commitment to a stable monetary union and an independent central bank can best be demonstrated by achievement of “convergence criteria” at the national level. The ECOWAS countries planning the “second monetary union” have introduced convergence criteria, but it is unclear how these criteria would be used to decide whether countries were ready to proceed to monetary union.

Tying the Hands of the Monetary Authorities

An important theme in discussions of monetary union, as well as in the literature on exchange rate arrangements, is that monetary policy flexibility often is not well used. For instance, Hausman and others (1999) argue that flexibility of exchange rates in Latin America has served no useful purpose because monetary authorities have succumbed to the temptation of overexpansionary policies leading to recurrent devaluations. As a result, countries with flexible rates pay a risk premium and they would benefit by simply giving up flexibility of the exchange rate (however, this is a view that is contested by others). Thus, Hausman and others argue for “dollarization,” the replacement of the national currency by a stable international currency.

Why are the advantages of exchange rate and monetary policy flexibility not always obtained? National central banks often are not independent of fiscal authorities that are myopic and concerned primarily with financing their expenditures. In the absence of other sources of financing, they may turn to the central bank; higher than desirable inflation frequently results. Even independent central banks may face incentives to create excessive inflation. At a general level, Barro and Gordon (1983) stress the value of “tying the hands” of the monetary authorities. According to their arguments, if a central bank uses expansionary monetary policy to attempt to correct a distortion in the economy causing excessive unemployment, but the private sector correctly anticipates the central bank’s actions, unemployment would fail to improve while inflation would rise.

Monetary union, by creating supranational institutions, may in principle provide a constraint on central banks (“tying their hands”), making it easier for the monetary authorities to resist pressures to finance any particular government’s fiscal deficit. Going in the other direction, however, monetary union may also encourage governments to allow fiscal positions to get out of hand—either with the expectation that they will be bailed out, or because the costs (in terms of higher interest rates, an overappreciated exchange rate, etc.) will be shared by other countries in the union, and not internalized in the high-deficit country. The experience of WAEMU showed that monetary union alone was not sufficient to lead to fiscal discipline (see Appendix II). Consistent with this potential problem, the EU has imposed strict rules to prevent monetary financing or bailouts of governments and an elaborate procedure to prevent excessive government deficits. Thus, tying the hands of the monetary authorities is not enough—one must also tie the hands of the fiscal authorities. Monetary union involves a major commitment, which only makes sense if the countries concerned are committed to a major transfer of sovereignty and a willingness to support supranational institutions.

Guillaume and Stasavage (2000) consider in some detail the experience in Africa with the use of monetary unions as a form of commitment to financial stability. They argue that monetary unions can effectively provide that commitment, but only if they satisfy three conditions: (1) exit from the union must be made costly by the loss of other benefits of regional integration or of assistance from industrial countries; (2) governance structures must be designed to enforce monetary rules; and (3) attempts by one country to break the rules of the union must be actively opposed by other governments in the union.

What practical steps does this imply for ECOWAS? First, making national central banks more independent is important, since they will continue to exist and have some influence (at least for a transition period) on monetary policy. Second, a monetary union is likely to be more successful and durable if accompanied by parallel linkages and agreements that make exit costly. Third, a stable monetary union requires both carefully drafted formal rules on monetary financing as well as the experience of mutual surveillance and the effective exercise of peer pressure to ensure de facto monetary and fiscal discipline.

Convergence Criteria

Following the example of the EU and WAEMU, the non-WAEMU countries have set various targets for convergence. By end-2000 (end-2003), countries are expected to lower inflation to 10 percent (3 percent); raise gross official reserves to at least three months (six months) of imports; reduce central bank advances to no more than 10 percent of the previous year’s tax revenues by end-2003; and cut the overall fiscal deficit (excluding grants) to no more than 5 percent (4 percent) of GDP. Exchange rate stability is to be added to the list of criteria, but it has not yet been defined precisely. Table 2.2 on page 5 presents the latest data for the existing convergence criteria.

ECOWAS countries currently are very far from achieving all the criteria. Ghana and Sierra Leone are experiencing very high inflation, as well as large fiscal deficits that are well over the target (Nigeria also has a large deficit). Four of the six (all except The Gambia and Nigeria) would not currently satisfy the relatively loose reserve target of three months of imports for 2000 (much less the criterion of twice that for 2003). Moreover, it should be recognized that achievement of exchange rate stability may lead to a rundown of reserves by some countries. Central bank advances as a percent of tax revenues are currently a multiple of the ceiling in all countries except Liberia and Ghana.

For comparison’s sake, Table 2.3 on page 6 presents the position of WAEMU countries with respect to the convergence criteria agreed to by the countries of that region. Except for Guinea-Bissau, Niger, and Togo, WAEMU countries are much closer to achieving their convergence criteria, which are more stringent than those for ECOWAS as a whole.

The starting point for the countries of the proposed “second monetary union” is also much farther from convergence than was the case for most countries in the EU, where the transition period took about seven years from the signing of the Maastricht Treaty on European Union in February 1992.21

Some of the EU conditions required achievement over several years, not just on the basis of one year’s performance.22 Moreover, many of the European countries had a long period of sound finances and low inflation. Nevertheless, qualification for monetary union was subject to intense scrutiny and efforts to harmonize data and close loopholes that might permit a temporary or unsustainable achievement of the criteria. For ECOWAS, it will be important to remove any ambiguity in defining convergence criteria, to ensure that they are calculated in the same way in all countries, and for countries proceeding to monetary union to have demonstrated their ability to meet the criteria in a sustained and durable fashion.

Can a Common Currency Stimulate Other Forms of Integration?

A reputed advantage of monetary union is that it can stimulate other forms of integration. This point was debated extensively in the context of European integration between the “monetarists” (who argued in the affirmative) and the “economists” (who argued that monetary union must follow, not precede, other forms of integration). Whatever the merits of the argument, the views of the “economists” prevailed in the design of European Economic and Monetary Union.

As discussed in Appendix III, it seems that the evidence of a positive impact of monetary union on other aspects of integration is at best mixed. The comparison of WAEMU and CAEMC is instructive, since both have evolved from monetary unions formed at the same time, and both have the same external peg. Trade among the countries of the former is much greater than among the latter. WAEMU has achieved some success in harmonizing policies and in instituting surveillance; CAEMC has achieved much less. It seems likely that, by itself, a monetary union among disparate countries will not produce the other integration benefits. The objective of monetary union, however, could be a positive force if it initiates a sustained economic convergence process and involves building the basis for regional cooperation. The risk is that an ill-planned and premature monetary union might fail and endanger progress in other areas. If countries are not tied together in other ways, so that leaving the monetary union would mean losing other benefits (access to regional grants, for instance), the monetary union is unlikely to be durable.

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