Abstract

In April 2000, the leaders of the six non-WAEMU ECOWAS countries agreed to form a “second monetary union” by 2003, which would then be merged with WAEMU in 2004. Preparations are under way to monitor the economic convergence of these countries in areas that are deemed important for monetary union. Each of the six non-WAEMU countries has agreed to set up a macroeconomic coordinating committee to speed the process.23

In April 2000, the leaders of the six non-WAEMU ECOWAS countries agreed to form a “second monetary union” by 2003, which would then be merged with WAEMU in 2004. Preparations are under way to monitor the economic convergence of these countries in areas that are deemed important for monetary union. Each of the six non-WAEMU countries has agreed to set up a macroeconomic coordinating committee to speed the process.23

Given the importance of the undertaking, the steps leading to monetary union and its ultimate form need to be considered carefully. This chapter lays out some of the design and transition options and provides some tentative suggestions on the best strategies for implementing monetary union.

The “Second Monetary Union”

Design Issues

Fundamental choices must be made in designing a monetary union: whether (or when) to create a new currency or use an existing currency; what supranational institutions would be needed to ensure a single monetary and exchange rate policy; and what anchor would be provided for monetary policy—an external peg or an internal nominal target (e.g., targets for inflation, or for a money or credit aggregate)? The ultimate intention to merge the two unions should influence the design of the non-WAEMU monetary union; in particular, it only makes sense to invest heavily in the construction of new institutions if they are intended to be durable, rather than to be replaced when the broader union is established.

There would seem to be two major options for the non-WAEMU monetary union. In the first scenario, the non-WAEMU countries gradually would bring about convergence of their economies; this (perhaps accompanied by formal bands) would help to achieve exchange rate stability among their currencies, which would continue in existence and would not be irrevocably pegged. There would be no supranational central bank; instead, countries would interact through the ECOWAS Convergence Council to implement mutual surveillance over each others’ policies. Each country would retain its central bank and monetary autonomy, and its success in achieving monetary convergence would be judged by reference to the rate of inflation and the degree of monetary stability. The result would be what Corden (1972) terms a “pseudo exchange rate union”—since there would be neither an irrevocable fixing of exchange rates nor a single monetary policy—or an “informal exchange rate union” (Cobham and Robson, 1994). This scenario would be appropriate if full monetary union among the non-WAEMU countries was not judged desirable, either because it would be superseded immediately by full monetary union with WAEMU or because the preconditions for the second monetary union among a sufficient number of countries were judged as not met.

The second scenario would involve the creation of a true monetary union for the non-WAEMU countries. The institutions of the second monetary union would be intended to be durable either because they would provide the nucleus for the subsequent merger with WAEMU, or because the ultimate goal of a merger of the two zones would not be viewed as imminent, so that the two zones would coexist for an extended period of time. In this scenario, the first step would be to achieve convergence of macro policies. Next, it would be necessary to create a new supranational central bank benefiting from the public support of member governments and with statutes that clearly established its independence. Then, given the importance of making a credible commitment to irrevocable parities, national currencies would be eliminated and replaced by a new single currency.24

The two scenarios differ considerably with respect to the time and effort needed for their achievement. The first scenario resembles the strategy employed in the European Monetary System. At one time, it seemed feasible to achieve European Economic and Monetary Union by a gradual narrowing of the margins of fluctuation around the exchange rate mechanism (ERM) central parities. Once those margins were virtually zero, then one of the main objectives of monetary union, namely exchange rate stability, would have been achieved, and it would then be a relatively simple matter to replace national currencies by the single European currency. Since the ERM was anchored by the deutsche mark and the strong and credible commitment of Germany’s Bundesbank to price stability, not only the stability of the currencies among themselves, but also the stability of purchasing power of the common currency, would be assured. The ERM crises of 1992–93 destroyed this vision of monetary union in the EU. However, the speculative attacks against central parities were abetted by the removal of capital controls and the resulting high capital mobility.

ECOWAS would not face the same overwhelming weight of short-term capital flows; in any case, it could benefit from the ERM experience by not making exaggerated commitments to defend central parities that were out of line with fundamentals. By allowing flexibility in adjusting parities to large terms of trade shocks while requiring monetary authorities to stabilize their currencies in normal times, such a system could provide a zone of monetary stability without excessive rigidity and could be put in place within the planned timetable.

The second scenario resembles the institution building that was embodied in the Maastricht Treaty on European Union and implemented in the course of the 1990s in Europe. It is a difficult and time consuming process. In the EU, it was facilitated by public support for price stability, the strong political support for European integration, and the experience with functioning European institutions (including the earlier experience with monetary cooperation in the European Monetary System). As noted above, despite a relatively favorable starting point of macroeconomic convergence, the EU devoted much attention to designing a European Central Bank that would be insulated from political forces and to preparing surveillance procedures to limit fiscal deficits. It seems safe to say that the time and effort that would be needed for ECOWAS to design such institutions and make them work would be at least as great as the time and effort that was required for the EU, suggesting that this second scenario would not be possible within the horizon of 2003.

When considering monetary integration in Africa, Cobham and Robson (1994) argue that higher forms of integration constituted by full monetary union have all the benefits of lower forms (i.e., informal exchange rate unions) but fewer costs. This overstates the advantages of “tying the hands” of the monetary authorities, however.25 Retaining the ability to modify parities until it is clear that convergence of economic structures and performance has been achieved is good insurance. Thus, an informal exchange rate union, with separate currencies that are stable within margins, may well be a preferable medium-term objective.

The choice between the first and second scenarios (or some hybrid) should also depend very much on the role that WAEMU, and its central bank, the Banque Central des Etats de l’Afrique de l’Ouest (BCEAO), would play in the combined monetary union. With a functioning supranational central bank and a currency that has delivered price stability for most of five decades, WAEMU has the requisite track record and reputation to provide the nucleus of the larger monetary union. However, neighboring countries have reservations about the CFA franc because it is viewed as a relic of French colonialism.26 The French Treasury assures the currency’s convertibility and it has been pegged (with one change in parity) continuously to the French franc for more than half a century. Although the creation of the euro has assured exchange rate stability vis-à-vis a much wider set of European countries, the relationship with France remains. France has representatives on the boards of the central banks of the two CFA zones and thus retains some influence over monetary policy decisions.

A more fundamental criticism of the arrangement is that it has stifled the development of African financial markets, channeled transactions through France, and perpetuated dependence on decisions taken in Europe (Monga and Tchatchouang, 1996). Although the advantages and disadvantages of a link to the euro are discussed below, if WAEMU provides the nucleus for the ECOWAS monetary union, it seems likely that the link with the French Treasury would have to be abandoned. In any case, a decision of the European Council on November 23, 1998, requires that France must submit for the Council’s approval any change in the nature or scope of its exchange rate agreements with the CFA franc zone. Neither France nor its EU partners are likely to endorse an expansion of the French Treasury’s guarantee to a much wider set of countries.27 It is also unlikely that EU institutions would replace the French Treasury as a guarantor of convertibility. Any exchange rate link with an external currency would then have to be assured by the central bank’s own intervention and monetary policy settings, rather than by a European guarantee.

Transition Issues

As suggested above, the design of the monetary union should influence the transition process. Several issues take on considerable importance: (1) the time allowed for transition to monetary union; (2) whether and how the convergence criteria are to be used to select the countries ready to go to monetary union at some point; and (3) the role of the exchange rate in the transition.

Choosing the second scenario means that institutions would have to be designed and created before monetary union could begin. The transition process would necessarily have to be longer, because the non-WAEMU monetary union would be considerably tighter in this case. Indeed, the negotiation of a treaty setting up a new central bank, if the latter is to have its powers, instruments, and responsibilities spelled out, would require decisions on numerous technical details, as well as the resolution of political disagreements that could arise on such things as the location of the bank, the number and country of origin of its governing board members, the pooling of foreign exchange reserves, and the allocation of seigniorage.

The first scenario of a looser monetary union, retaining existing institutions, could begin earlier, perhaps without a firm decision as to the ultimate destination or how to get there. Other issues could be faced later—for instance, at a second stage when the merger with WAEMU was contemplated. Thus, in principle, an informal monetary union could exist by 2003—but that would depend on the degree of commitment of national policymakers to macroeconomic convergence.

The use of convergence criteria as qualifiers for entry to monetary union would also differ in the two cases. In the first scenario, a sharp distinction between those “in” monetary union and the “outs” would not be necessary. Instead, countries would be more or less able to meet the criteria and, among other benefits of macroeconomic stability, this would mean that their currencies would be more or less fixed in terms of some reference currency (discussed below). It would be in each country’s interest to meet the convergence criteria, but not doing so would not trigger exclusion from monetary union at this stage or produce strong externalities on other countries, as would be the case for a full monetary union. In the second scenario, however, it would be very important for the credibility and durability of the monetary union for countries to have demonstrated their ability to limit monetary financing, achieve low inflation, and limit their budgetary deficits. Admitting a non-convergent country would cause problems both for the country concerned (since it would not have the structures to support the monetary discipline of the union’s policies) and for the union as a whole (especially if the country were a large country, because it could derail the union’s monetary policy).

The exchange rate could be given a role in the convergence process, as in the transition to European Economic and Monetary Union. Achievement of a degree of exchange rate stability, somehow defined, could either be a condition for entry into the non-WAEMU monetary union (scenario two) or into the ultimate ECOWAS monetary union. The question of a reference currency then arises. The European Monetary System created a parity grid and a basket currency (the European Currency Unit, ECU) so that the system was in principle symmetric. In practice, the system revolved around the deutsche mark, which provided the anchor given the strong anti-inflation credibility of the German Bundesbank and the strength of the German economy. In non-WAEMU ECOWAS, no currency plays a similar role nor does it seem useful to create a currency composite, with its technical difficulties. Instead, if an exchange rate stability criterion is desired, then the exchange rate against the euro or an existing basket currency like the special drawing right (SDR) would be a natural reference rate.28 Macroeconomic convergence between WAEMU and non-WAEMU countries would be facilitated by the choice of the euro, since the CFA franc is pegged to the euro. Exchange rate stability against the euro would then imply exchange rate stability among the countries of the region. This is consistent with the recommendation of Cobham and Robson (1994, p. 292):

“For countries that are not committed to the goal of monetary integration, but are interested in moving at least some way toward it, two policies can be suggested: first, they should peg their currencies to the same external anchor; and secondly they should make current and capital account transactions convertible.”

However, a firm peg to the euro would be exposed to fluctuations of the exchange rate between the U.S. dollar and the euro; in that regard, an SDR peg would be preferable.

The Second Stage: Full Monetary Union in ECOWAS

Assuming that a full monetary union is achieved, extending across both WAEMU and at least some non-WAEMU countries, the fundamental question to address is the choice of an anchor for monetary policy. The principal alternatives are an exchange rate peg and a target for domestic inflation or a monetary aggregate (accompanied by a flexible exchange rate, albeit with some central bank intervention in the foreign exchange market for smoothing purposes).

The literature on fixed versus flexible exchange rates, reviewed above, is relevant for the choice for the ECOWAS union. Although members of ECOWAS conduct about 10 percent of their international trade within the union, more than 40 percent of ECOWAS trade is with countries of the EU. Thus, a euro peg would provide exchange rate stability with regard to more than 50 percent of member countries’ international trade.

Nevertheless, the commodity composition of ECOWAS exports is, and would continue to be, very different from that of the EU. As a result, the terms of trade would continue to vary considerably and a drop in the world price of ECOWAS exports of oil, cocoa, etc. would have a depressing effect on the region’s equilibrium real exchange rate. If the exchange rate against the euro could not change, this might have deflationary consequences—as occurred in WAEMU in the 1986–93 period. Moreover, if the exchange rate of the euro against the U.S. dollar varied, this would also affect the competitiveness of ECOWAS exports. This latter problem could be addressed by pegging the currency to a basket composed of the euro and the U.S. dollar, with the former being given a larger weight, reflecting the relative importance of European and U.S. trade. Alternatively, the currency could be pegged to the SDR, which includes the dollar, euro, yen, and pound sterling.

An SDR peg would have the advantage of linking to other aspects of the ECOWAS integration process (i.e., the West African Unit of Account) and would distinguish the ECOWAS monetary union from WAEMU, with its peg to the euro. However, an SDR peg would be less immediately relevant to actual trade and capital transactions since it would not involve an existing national currency. It might, as a result, involve greater transactions costs and a less visible anchor for monetary policy.

There are three additional objections to an exchange rate peg, however. First, inadequate flexibility of the peg will at times lead to large overvaluations, since it will be difficult to match consistently the low inflation of the industrial countries. This has been the experience in much of sub-Saharan Africa (and other developing regions) and has contributed to a move away from pegged exchange rates. Second, adjustable pegs are inherently unstable because they do not involve a credible commitment to a fixed rate, so that in the presence of some degree of capital mobility they are subject to speculative attacks. Although the scope for capital movements in ECOWAS is presently restricted, this could become a factor with the passage of time. Finally, developing country exchange rate pegs that do not benefit from an external guarantee or a transparent institutional setup like a currency board have often been associated with multiple currency practices and the non-market allocation of foreign exchange at the official rate, with the scope that this allows for corruption and inefficiency.

The alternative of a domestic nominal anchor is more demanding, in that it requires establishing a credible and effective operating procedure for delivering monetary stability; in practice, sub-Saharan African countries have found this difficult to do. As already noted, non-WAEMU ECOWAS countries have experienced high and variable inflation. The choice of a domestic nominal anchor is likely to be between a monetary aggregate and inflation. In a number of countries, monetary aggregate targets have suffered from the instability of money demand. Regarding inflation targeting, there are several prerequisites for its effective implementation—in addition to monetary independence for the central bank, which is necessary for any effective monetary policy. These prerequisites include a quantified relationship between monetary instruments and inflation in 12–18 months, given the lags involved (see Masson, Savastano, and Sharma, 1997). Such a relationship may be difficult to establish in developing countries with administered prices and where inflation data are poor given the size of the informal sector. Another requirement for the success of the policy is a public consensus in favor of low inflation and support for economic policy based on it—a condition that is not necessarily present in ECOWAS countries. In sum, neither policy unequivocally dominates the other: an independent monetary policy would have the benefits of flexibility but would be demanding in terms of institutions and discipline, white a firmly pegged rate would be more rigid but would have the advantages of transparency and stability.

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