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References

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Appendix I

The Monetary History of São Tomé and Príncipe before Independence

Before its independence in 1975, São Tomé and Príncipe was under a currency board regime. The Banco Nacional Ultramarino was created in 1868 to act as Portugal’s private monopoly note-issuer for its colonies. In 1948 the separate colonial foreign-currency funds were centralized in Lisbon and in 1953, currency reform unified the Portuguese escudo and the currencies of the Portuguese colonies, making them a true currency area similar to the French franc zone. A Monetary Fund of the Escudo Zone was also established by Portugal. In February 1963, Portugal issued a ministerial decree liberalizing capital movements in the escudo zone. In March 1963, measures were taken to organize a new payments system for the zone and exchange controls on private transfers from overseas territories to Portugal were imposed by Portugal.

São Tomé and Príncipe’s economic performance under the currency board regime was favorable during 1956-73. Both inflation and its volatility were very low compared to the period of managed float 1990-2006. Inflation averaged only 2 percent. At same time production and electricity consumption increased substantially, while the trade balance was in surplus most of the time. Also, M1 and real credit to the private sector grew considerably during the period without significantly affecting inflation. Finally, the fiscal deficit averaged Escudos 33 million during 1956-73. With production indicators suggesting that GDP was growing during the same period, the fiscal deficit was actually declining as a percent of GDP.

São Tomé and Príncipe: Monetary and Exchange Rate Regimes, 1522-1974

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Sources: Kurt Schuler (http://www.dollarization.org); Portugal Gazette (1864); Banco Nacional Ultramarino (1977); Braga Paixão (1964).

Appendix II

Cape Verde’s Currency Peg

Pre-euro peg period (-1998)

Currency arrangement: Cape Verde introduced the Cape Verde escudo (CVEsc) in 1977 after becoming independent from Portugal. The CVEsc was initially pegged to the Portuguese escudo for and later re-pegged to a basket of currencies (approximately 70 percent of the basket is composed of euro currencies). The central bank’s main monetary policy instrument was to maneuver the basket, consistently devaluing the CVEsc by 6-10 percent a year, in order to maintain competitiveness. The central bank also rationed foreign currency when excess demand emerged. As a result, foreign exchange queues were frequent. Due to shortages in their foreign currency holdings, commercial banks accumulated approved but unmet applications for foreign currencies from importers.

Macroeconomic conditions: Cape Verde was a small open economy with a very narrow production base and heavily dependent on remittances and foreign aid. Exports, including tourism, virtually did not exist in the pre-euro peg period. Imports-to-exports ratios reached 27 for goods and 4 for goods and services in the 1990s. Cape Verde’s main trading partners were Portugal, France, and the Netherlands, making up over 80 percent of total trade.

Overall macroeconomic performance was poor during the period. Inflation often ran above 10 percent. Both the fiscal deficit and the current account deficit frequently exceeded 10 percent of GDP. The fiscal deficit was largely funded by the domestic banking system. The current account deficit was funded by foreign aid, although to some extent large remittances, equivalent to 20 percent of GDP, helped mitigate the imbalances. The country frequently suffered from very low levels of foreign exchange reserves due to the lack of currency credibility and large external imbalances. The country also held large external and domestic debt, reaching 56 percent and 40 percent of GDP, respectively, in 1998. Domestic public debt grew rapidly, reflecting budget deficits and the government taking on public enterprise debt and issuing bonds to absorb a liquidity overhang.

Introduction of the euro-peg system (1998)

In 1998, the newly elected government announced a comprehensive economic reform program, including the full convertibility of CVEsc. The peg system was initially changed to the Portuguese escudo, with a 6 percent devaluation, at the rate of 0.55 CVEsc/PSE and then to the Euro at the rate of 110.3 CVEsc/€. The IMF provided a precautionary Stand-by-Arrangement for the period 1998 to 2000, to underpin a donor-supported domestic debt operation.14 The government undertook a serious reform program, in order to support the change in the exchange system, with the following main pillars:

  • Credit line arrangement with Portugal: In July 1998, Cape Verde and Portugal agreed on an Exchange Cooperation Accord. The Accord provides a short-term precautionary credit line from the Portuguese government of up to US$ 50 million, repaid by the end of each year with an annual interest rate of 0.5 percent. The Accord also set up a committee, consisting of the ministries of foreign affairs, the ministries of finance, and the central bank of both countries to monitor macroeconomic conditions. The committee can recommend to the Portuguese government the suspension of the credit line.

  • Fiscal reform: Cape Verde initiated large scale fiscal restructuring as the Accord demanded the country to abide by the Maastricht criteria. The government strengthened tax-collection efforts, prepared for the introduction of a value-added tax, and reduced current primary expenditure. It also halted bank financing in 1998 and adopted a law limiting its statutory advances from the central bank to 5 percent of the previous year’s revenues. The government also started a large scale reduction of domestic debt using privatization proceeds and foreign aid. Domestic debt was gradually replaced with securities issued by the Trust Fund, which pools privatization proceeds in order to avoid liquidity injections.

  • Current and capital account liberalization: A foreign exchange law was introduced in June 1998 with the aim to ultimately remove all restrictions on current and capital account transactions. In 2004, the country accepted Article VIII of the IMF’s Articles of Agreement.

  • Structural reform: The government launched large scale privatization to enhance economic efficiency and secure funding necessary for fiscal reform and debt reduction.

Post-euro peg period (a crisis in 1999-2000 and subsequent success in 2001 to present)

The economy grew at a rapid pace immediately after the introduction of the euro-peg system, led by rising foreign direct investment in export-oriented manufacturing, the development of tourism facilities, and increasing remittances. At the same time, the fiscal situation worsened in 1999 and 2000 (elections, severe drought, and mounting costs of cleaning the banking sector problems), despite the strict internal and bilateral monitoring. The government consequently breached its statutory limits on central bank financing. The fiscal expansion led to a rapid deterioration of the external balance. By mid-1999, the central bank depleted foreign reserves to defend the peg system. The government responded to the crisis by temporarily reintroducing foreign exchange rationing, using some privatization receipts for current budgetary obligations, and, as a last resort to defend the peg system, withdrawing the Portuguese credit line. In 2000, the government again withdrew the credit line but failed to meet the end-year repayment, triggering a temporary suspension of the facility. External assistance virtually dried out reflecting the deterioration of fiscal performance and the accumulation of external arrears to foreign creditors. The government, with significant help from the Portuguese government, reinitiated its reform efforts and the situation was normalized by late 2001.

After the crisis, macroeconomic conditions significantly improved in response to the government’s comprehensive reform efforts. The fiscal deficit was reduced to around 5 percent of GDP and the current account deficit declined to less than 10 percent of GDP. Inflation went down to low single digits. A dynamic private sector emerged and the export base became larger and more diversified, driven by foreign direct investment. Tourism income grew to over 10 percent of GDP. Foreign reserves were accumulated and the central bank developed a number of policy instruments to control inflation and currency pressures.

Appendix III

Managing Oil Wealth and Membership of a Monetary Union

Oil and Exchange Rate Pegs

The authorities of São Tomé and Príncipe will need to consider the impact of oil developments on the country’s real exchange rate. If, in the period ahead, the country chooses to peg its currency to the euro, for example, given that the euro is its current main trading currency, then consideration must be given to two issues. First, the appropriateness of the fixed exchange rate regime in the face of terms of trade shocks needs to be assessed. Once oil comes on stream, in theory, increased spending would imply a rise in the country’s real exchange rate, either through a rise in the nominal exchange rate or through higher inflation. In theory, the authorities will either need to adopt a flexible exchange rate regime, re-peg the currency at a more appropriate level, or engineer an improvement in competitiveness through structural reforms (increasing the flexibility of the economy or improving total factor productivity).15

Second, the appropriateness of the peg currency will also need to be assessed. With oil coming on stream, the U.S. dollar will likely become São Tomé and Príncipe’s main trading currency. As such, pegging to the euro, if adopted, may no longer be appropriate at the time oil production begins. Issues to consider at the time include the euro/dollar exchange rate volatility and the euro/dollar medium- to long-term movements. Taking into account these factors, consideration must also be given to the impact on imported inflation, particularly given the country’s high dependence on imports, and to current account imbalances. 16

Experience has shown that over the past five years, with oil prices rising substantially, oil exporting countries have mostly encountered overheating economies. Credit was growing too rapidly, inflation was rising, and the prices of assets have exploded. For countries that have a pegged exchange rate, to the dollar or to the euro, interest rates were too low or often negative, reflecting those of the U.S. or the euro area. As such, it may be more appropriate to adopt a more flexible exchange rate regime that would allow countries to regain control of their monetary policies and have a direct impact on inflation developments. Furthermore, a more flexible currency would allow economies to better manage oil price shocks.

Oil and Currency Unions

Like with the impact of an upswing in oil on the choice and/or level of a peg, the authorities of São Tomé and Príncipe will need to consider the impact of oil developments on the country’s CEMAC membership requirements, if entry into CEMAC was chosen. Oil inflows will bring to the fore the need to assess the following issues, which are tied to the country’s responsibilities as a member of CEMAC:

Fiscal policy rules: CEMAC rules require that member countries to coordinate their fiscal policies in order to maintain a regional stable exchange rate of the CFA franc. With the discovery of oil in São Tomé and Príncipe and its coming on stream, the country must decide how much to spend, given its economy’s needs and absorptive capacity, and how much to save for future generations. These decisions must be within the CEMAC rules, which are the fiscal convergence rule of no negative balance and the reserve management rule that limits credit to member governments by the BEAC to 20 percent of tax revenues of the previous year. Therefore, these constraints may restrict the authorities in São Tomé and Príncipe from spending according to the country’s own needs. At the same time, however, any increase in fiscal spending that reflects oil inflows will put pressure on the real exchange rate and the country’s competitiveness, both of which will also affect regional arrangements and rules.

Exchange rate parity: Membership in CEMAC implies that São Tomé and Príncipe will have to adopt the CFA franc as its own currency, thus adopting a fixed parity with the euro. However, unlike independently pegging to the euro or the U.S. dollar, the CEMAC currency arrangement is much more rigid, bound by CEMAC institutional rules and strict agreements with the French treasury, which in turn is also bound by euro area institutional rules. If the arguments presented in the above section on the impact of oil on a peg currency are followed, then oil inflows in São Tomé and Príncipe may eventually put forward the question of the appropriateness of CEMAC membership to the country’s economic developments.

Reserve management: Another requirement of membership in CEMAC is the pooling of reserves. Member countries are obliged to repatriate all export earnings and deposit a minimum 65 percent of foreign exchange earnings at the French treasury (the remainder can be invested according to BEAC’s own reserve investment rules). At the same time, members are also allowed to invest amounts (that are consistent with the region’s fiscal policy) at the BEAC in oil stabilization funds. Currently, the return on these funds in specific and on BEAC’s pooled reserves in general do not provide adequate financial incentives for member governments to comply with reserve rules of CEMAC. The authorities of some CEMAC member countries have taken several ad hoc initiatives, in order to help ensure adequate remuneration, given the need to preserve the value of their oil wealth. In view of any possible increases in São Tomé and Príncipe’s deposits related to future oil inflows, the country must decide if CEMAC regional reserve management policies would remain appropriate, taking into consideration the country’s current and future consumption needs and the impact on the real exchange rate and competitiveness.

Appendix IV

CEMAC, WAEMU, and Other Currency Arrangements

CEMAC and WAEMU: Institutional Framework

The CFA franc zone was created in 1945 to consolidate the French colonial economies. The currency of the zone, the CFA franc, was first fixed to the French franc. The parity was changed in 1994 to reflect a euro-zone decision to devalue their currencies. The parity then shifted to the Euro at the time of the euro’s inception in 1999. The currency is issued by two regional central banks: the Banque centrale des Etats l’Afrique de l’Ouest (BCEAO)— responsible for the WAEMU states, and the Banque des Etats de l’Afrique centrale (BEAC)—responsible for the CEMAC states. France participates in the executive boards of both banks. The two banks issue two different currencies that are only legal tender in their respective regions. Both currencies are referred to as the CFA franc. The convertibility of the currency is guaranteed by the French treasury.17

The treaties establishing the WAEMU and the CEMAC were ratified in 1994 and 1999, respectively, with the following objectives: (i) harmonizing indirect taxes and business laws; (ii) harmonizing macroeconomic conditions; (iii) creating a common market; (iv) freeing the movement of capital, services, and people; and (v) coordinating sectoral policies. Economic policies are coordinated through a multilateral surveillance arrangement, with binding treaties between France and the zone that impose financial and budgetary discipline on members. Four convergence criteria are defined under surveillance: (i) non-negative fiscal balance; (ii) average inflation not exceeding 3 percent; (iii) public debt not exceeding 70 percent of GDP; and (iv) no increase in internal or external arrears in any current year.

CEMAC: Reserve Management and Oil Inflows

Currently, reserve management takes place in the context of existing monetary cooperation agreements with France, which are based on the regional pooling of reserves. All export earnings must be repatriated and a minimum of 65 percent of foreign exchange earnings must be deposited in the operations account with the French Treasury.18 The remainder can be invested according to BEAC’s own reserve investment rules.19 This arrangement aims to limit drawings on the overdraft facility provided by the French Treasury by imposing a floor on BEAC’s foreign assets with the French Treasury, a minimum level of net foreign assets equivalent to at least 20 percent of sight liabilities, and a limit on credit to the governments by BEAC to 20 percent of tax revenues. The current interest rate paid by BEAC on member countries’ government deposits range between 50 to 75 basis points below the euro Libor 90 days. Net returns on pooled regional reserves are distributed to member states according to an agreed formula.20

While a prime consideration of the current reserve pooling framework at the regional level is to keep adequate reserves for balance of payments needs, the BEAC does not have a strategy to assess the needed level of reserves to support the CFA franc.21 At the same time, however, the reserve management arrangement also allows countries to hold oil stabilization funds at the BEAC (CFA-denominated accounts remunerated at an interest rate linked to what BEAC earns on its French Treasury accounts (ECB rate plus 100 basis points)).22 There are no region-wide limits and no reserve-pooling-limits must be satisfied before channeling savings to oil funds. Moreover, oil stabilization funds are not currently based on public financial management strategies or on medium-term fiscal frameworks in member countries.

Currency Board

A currency board combines three elements: an exchange rate is pegged to a foreign currency, an automatic convertibility (exchanging domestic currency at a fixed rate whenever desired), and a credible (often legally set) long-term commitment. Under a currency board arrangement, the monetary authority can be divided into two independent agencies: a currency board with exclusive power to issue currency and a central bank (to undertake all other responsibilities). This can speed up the implementation of the currency board and prevent any disruption of other central banking functions. A currency board can only be credible if the central bank holds sufficient official foreign exchange reserves to at least cover a 100 percent of base money, to assure financial markets and the public that every domestic currency bill is backed by an equivalent amount of foreign currency. The main benefit of a currency board is a transparent and credible anti-inflationary policy.

Dollarization

Official dollarization occurs when a government adopts foreign currency as the predominant or exclusive legal tender. Most often, dollarized countries choose such an option due to their exceptionally difficult conditions. For example, Kosovo suffered total loss of confidence in its domestic currency. Timor Leste was facing considerable inefficiencies in the absence of institutional frameworks. In most dollarized economies, the arrangement often helps reduce inflation expectations by imposing fiscal discipline and enhancing policy credibility. In addition to losing monetary policy independence and the lender of last resort capacity, dollarization has high setting up costs (using official reserves to buyback national currency) and lost income from both official reserves and seignorage from issuing national currency.

1

The authors would like to thank Laurean Rutayisire, Thierry Nguéma-Affane, Thomas Krueger, Jean A. P. Clément, Piroska Nagy, Lamin Leigh, Peiris Shanaka, and Ali Alichi for their helpful comments and suggestions, and Anne Grant for her editorial assistance. This study benefited from discussions with public and private sector participants in a seminar on the topic held in São Tomé in October 2007. The authors are responsible for any remaining errors and omissions.

2

In 1977, the dobra replaced at par the São Tomé and Príncipe escudo, which had been introduced earlier at par with the Portuguese escudo.

3

The CFA zone comprises 14 African countries.

4

Excluding Sudan.

5

The countries are Burundi, Cape Verde, Central African Republic, Comoros, Eritrea, the Gambia, Guinea-Bissau, Seychelles, Sierra Leone, and São Tomé and Príncipe.

6

In the period between December 1999 and July 2007, the disparity between inflation rates in the U.S. and São Tomé and Príncipe had a statistically significant impact on the share of foreign currency deposits in total deposits.

8

Chang (2000) and Goldfajn and Olivares (2000) report that developing countries with more rigid exchange rate systems grew slower and had larger fluctuations in output.

9

Financial sector development is not uniform across CMA countries, influenced by country specific factors. Small member countries also have to reply heavily on fiscal and structural policies to regain external competitiveness when they are facing exogenous shocks.

10

A recent study finds that for a group of 42 developing countries, many of which are relatively large emerging market economies, a flexible exchange rate helped smooth output response to external shocks (Hoffman, 2007).

11

See Yehoue (2005) for a discussion on a monetary union in the South African Development Community.

12

This ranking of currency preferences is robust regardless of assumptions about the weight used in aggregating criteria-specific preference—i.e., it remains unchanged whether equal weight is given to all criteria or higher weight is given to criteria related to market potentials than to those related to synchronization of business cycles.

13

On average, intra-WAEMU trade was only about 11 percent of total trade in 2006, and intra-CEMAC trade was even lower at about 1.5 percent.

14

The arrangement expired without any withdrawals.

15

Alternatively, favorable bilateral trade agreements may also help boost trade.

16

The recent experience of Kuwait is an interesting example. With a sliding dollar increasing the cost of Kuwaiti imports and stoking up inflation to double its historic average, the authorities reverted to a basket of currencies to mitigate the effects of the weak dollar.

17

The cost to the French treasury of maintaining the CFA franc was only 2.8 percent of the French franc before the devaluation in 1994, and 1.4 percent afterwards to present.

18

Reserve pooling arrangements currently require that oil-related foreign currency inflows are deposited at BEAC.

19

The BEAC has agreed with the French Treasury to gradually lower the share of foreign exchange reserves held with the French Treasury from 65 percent to 50 percent by July 2009.

20

BEAC’s net profits are distributed to member states as follows: 15 percent to all members in an equal amount; 15 percent according to each member’s share in currency in circulation; and 70 percent according to each member’s relative contribution to the BEAC’s profits.

21

Reserve coverage varies by country; Equatorial Guinea and the Central African Republic have more reserves than average, while the reserves of Congo and Chad are below average.

22

A number of member countries invest their oil reserves in offshore accounts instead of at the BEAC.

The Choice of Monetary and Exchange Rate Arrangements for a Small, Open, Low-Income Economy: The Case of São Tomé and Príncipe
Author: Mr. Jian-Ye Wang, Nisreen H. Farhan, Amar Shanghavi, Mr. Márcio Valério Ronci, and Ms. Misa Takebe