A Work in Progress: Integrating Markets for Goods, Labor, and Capital in the East African Community
Author:
C. Emre Alper
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Ms. Wenjie Chenhttps://isni.org/isni/0000000404811396, International Monetary Fund

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Mr. Jemma Dridi
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Hervé Joly
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Mr. Fan Yang
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Publication Date:
13 Jan 2017
ISBN:
9781475560350
Language:
English
Keywords:
DPPP; DP; EAC country; country; Uganda; Kenya; Rwanda; EAC migrant; EAC imports; EAC emigrant; EAC border; EAC partner
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This paper assesses the extent of economic and financial integration among the East African Community (EAC) along a number of dimensions and, where possible, whether integration has increased in the wake of the major regional integration policy milestones.

Abstract

This paper assesses the extent of economic and financial integration among the East African Community (EAC) along a number of dimensions and, where possible, whether integration has increased in the wake of the major regional integration policy milestones.

Chapter 1. Analysis of Merchandise Trade Integration in the EAC

Evolution of Tariffs and Imports of EAC Countries since the Implementation of the CU

The CU is the first integration milestone in the EAC. The EAC member states have agreed to establish free trade on goods and services among themselves, and a common external tariff (CET) applying to goods and services imported from the rest of the world. The EAC CET has three tariff bands and broadly reflects the category of goods: raw materials and capital goods can generally be imported free of duty, intermediate goods generally attract a 10 percent duty, and finished goods a 25 percent duty. Higher rates, ranging from 35 to 100 percent, apply to a number of sensitive items.

Average weighted tariff rates (vis-à-vis the rest of the world) in EAC countries converged rapidly following the establishment of the CU (Figure 1). As countries started from very different tariff levels, their paths to the CET differed significantly. Burundi and Rwanda had to reduce their average weighted tariffs substantially, while Uganda initially had to increase it. For Kenya and Tanzania, the changes were much more limited. The average weighted tariff in all EAC countries has converted to a 12–14 percent range. For most EAC countries, imports from outside the EAC as a share of GDP have increased over the past 15 years.

Figure 1.
Figure 1.

Import by EAC Countries from the Rest of the World (ROW) and Tariff Rates

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: International Monetary Fund, Direction of Trade Statistics; and World Bank, WITS database.Note: MFN stands for most favored nation

Most of the goods imported from outside the EAC are intermediate goods (Figures 2 and 3). The ratio of these imports to GDP has increased over the past 15 years, but this mostly reflects a large increase in oil prices during this period, leading to much higher imports of petroleum products. The imports of industrial supplies have also increased significantly. Raw materials and capital goods constitute the second-largest category of imports from the rest of the world; their ratio to GDP, however, has fluctuated significantly. Final goods have the smallest import share, but their ratio to GDP has increased over the period. Although the average tariff for raw materials and capital goods has declined the most, it is still at about 5 percent, likely reflecting a number of sensitive items exempted from the zero tariff rate. Simple average tariff rates on intermediate and final goods are close to the prescribed rates of the CET, but they have not changed significantly since the early 2000s.

Figure 2.
Figure 2.

EAC Imports from ROW by End-Use

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: International Monetary Fund, Direction of Trade Statistics and World Bank, WITS database.Note: MFN stands for most favored nation. Raw materials and capital goods include Broad Economic Categories (BEC) sectors 111 (primary food and beverages mainly for industry), 21 (primary industrial supplies), 31 (primary fuels and lubricants), 4 (capital goods except transport equipment and parts and accessories). Intermediate inputs include BEC sectors 121 (processed food and beverages mainly for industry), 22 (processed industrial supplies), 32 (processed fuels and lubricants), 521 (other industrial transport equipment), and 53 (transport equipment parts and accessories). Final goods include BEC sectors 112 (primary food and beverages, mainly for household consumption), 122 (processed food and beverages, mainly for household consumption), 51 (passenger motor cars), 522 (non-industrial transport equipment), 61 (durable consumer goods), 62 (semi-durable consumer goods), and 63 (non-durable consumer goods).
Figure 3.
Figure 3.

EAC Imports from Rest of the world by Intermediate Inputs

(Percent of GDP)

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: International Monetary Fund, Direction of Trade Statistics and World Bank, WITS database.

Effectively applied tariff rates1 within the EAC converged to zero at a fast pace and have remained at this level in recent years (Figure 4). Kenya and Uganda had already liberalized their tariff schedules with respect to all other EAC countries by 2005. All applied intra-EAC tariff rates reached zero in 2009 and have remained at that level since. All countries except Uganda have experienced an increase in intra-EAC imports as a share of GDP from 2002 to 2014—but with significant fluctuations in between and not always clear trends. Ratios to GDP of imports from the EAC are higher for Burundi, Rwanda, and Uganda—three landlocked countries—whereas for Tanzania and Kenya, the import ratios are very small.2

Figure 4.
Figure 4.

Imports by EAC Country from EAC Country and Tariff Rates

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: International Monetary Fund, Direction of Trade Statistics and World Bank, WITS database.Note: AHS stands for effectively applied tariffs.

Most of the goods imported from within the EAC are also intermediate goods (Figures 5 and 6). They still have by far the largest share of total imports from the rest of the EAC, although this share has decreased in the past 15 years. Within intermediate goods the largest category of imports is industrial supplies, whose share has increased over the past 15 years, unlike that of fuel and lubricants. Final goods, which have seen their average tariff rate drop most during that period, are the category of goods whose ratio to GDP has increased most.

Figure 5.
Figure 5.

EAC Imports from EAC by End-Use

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: International Monetary Fund, Direction of Trade Statistics and World Bank, WITS database.Note: MFN stands for most favored nation.
Figure 6.
Figure 6.

EAC Imports from EAC by Intermediate Inputs

(Percent of GDP)

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: International Monetary Fund, Direction of Trade Statistics and World Bank, WITS database.

Evolution of Intra-EAC Trade as a Share of Total Trade

The share of intra-EAC imports in total imports has not increased in the past 15 years, and most imports continue to come from outside sub-Saharan Africa (Figure 7). This share has been relatively stable at about 8 percent over most of the period before recording a small decline in the past two years. The share of imports from the rest of sub-Saharan Africa peaked in 2004 at 13 percent and declined subsequently to 5 percent in 2014, while the share of imports from the rest of the world (excluding sub-Saharan Africa) has recorded a trend increase in the past five years, reaching about 90 percent of the total in 2014. These shares vary considerably, however, across EAC countries, with the larger ones (Kenya and Tanzania) importing relatively little from other EAC countries, unlike Burundi and Rwanda. Uganda’s imports from other EAC countries have decreased as a share of its total imports over time (Figure 8).

Figure 7.
Figure 7.

EAC Import Share by Region

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Source: International Monetary Fund, Direction of Trade Statistics.Note: SSA = Sub-Saharan Africa.
Figure 8.
Figure 8.

EAC Import Shares by Origin

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Source: International Monetary Fund, Direction of Trade Statistics.

In comparison, the EAC and sub-Saharan Africa absorb a much larger, and relatively stable, share of EAC country exports (Figures 9 and 10). This share has fluctuated around 30 percent, with the EAC making about two-thirds of 30 percent. The situation varies across individual EAC countries. The three landlocked countries have increased their share of exports going to other African countries (including EAC ones), unlike Kenya and Tanzania. For the latter two, the increased share of exports to the rest of sub-Saharan Africa has been at the expense of the share of exports to other EAC countries.

Figure 9.
Figure 9.

EAC Export Share by Region

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Source: International Monetary Fund, Direction of Trade Statistics.
Figure 10.
Figure 10.

EAC Export Shares by Destination

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Source: International Monetary Fund, Direction of Trade Statistics.

Within the EAC, Kenya is the only net exporter (Table 1). Rwanda and Uganda are the largest net importers. Rwanda is emerging as a (small) net exporter to sub-Saharan Africa (excluding the EAC). With the rest of the world outside of sub-Saharan Africa, however, all EAC countries are running large trade deficits.

Table 1.

Trade Balance with the EAC, Sub-Saharan Africa, and the World

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Sources: International Monetary Fund, Direction of Trade Statistics; and IMF staff calculations.

Trade Integration in the EAC Compared with Other Regions

Trade integration appears higher in the EAC than in most other regions in sub-Saharan Africa, but lower than in other regions in the world. Trade integration can be assessed though a “gravity” model, which controls for basic factors thought to influence trade relations, such as the distance separating two countries and the size of their economies (which justify the “gravity” name for this approach), but also the existence of a common language or a shared history.3 According to this metric, trade integration within the EAC appears to be much lower than in other regions of the world (for example, Asia and Europe) but also significantly higher than in the rest of sub-Saharan Africa over the 2000–13 period. The only region in sub-Saharan Africa that appears more integrated than the EAC is the WAEMU (Table 2).

Table 2.

Gravity Estimates

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Robust standard errors in parentheses Source: IMF staff calculations. Notes: CEMAC= Central African Economic and Monetary Community SACU= Southern African Customs Union WAEMU= West African Economic and Monetary Union

A more refined approach, trying to control for other factors affecting trade, contributes to explaining the differences in trade integration. When controlling for the rule of law, infrastructure, tariffs, and financing conditions in both exporting and importing countries, the gap in trade integration between EAC countries and those in Asia and Europe falls. The gap with other countries in sub-Saharan Africa is more than explained by these variables. This approach, however, does not allow the role of integration policies (such as the CU) in fostering trade integration in the EAC to be clearly established. Splitting the estimation period in two cannot be done easily, because the implementation of the CU has been progressive.4 A recent study by Mayer and Thoenig (2016) using a General Equilibrium Trade Impact (GETI) procedure that combines gravity regressions with general equilibrium simulations found that the CU has significantly increased bilateral trade among members.

Nontariff Barriers (NTBs) to Trade in the EAC

Despite the legal compliance of all partner states with the EAC tariff schedule, there is continued use of tariff-equivalent measures and NTBs (EAC Secretariat, 2016). Moreover, countries continue to face difficulties with the nonrecognition of their EAC certificates of origin. Partner states have resolved some of the NTBs identified as barriers to regional integration in the first CM Scorecard. With regard to new NTBs, Kenya performed best, resolving 60 percent of the NTBs reported against it. For other countries, the rate of resolution was at about half of the reported NTBs. The EAC average time it took to resolve NTBs between the 2014 and 2016 CM Scorecards declined from 24 to eight months. However, a number of unresolved NTBs have persisted since 2014, which include the lack of harmonization of the working hours for customs authorities, lack of coordination among institutions involved in testing goods, and lack of harmonization of road tolls.

Chapter 2. Labor Migration and Remittances in the EAC

The CM is the second regional integration milestone of the EAC. The EAC partner states are expected to maintain a liberal stance toward the movement of goods, services, labor, and capital, and toward the right of residence and establishment. Underlying the EAC CM are a number of key operational principles, such as nondiscrimination of nationals of other partner states on grounds of nationality.

The free movement of workers within the EAC is guaranteed by Article 10 in the CM protocol, but Annex II reduces its scope in the first phase of implementation. Article 10 grants workers the right to apply for employment and consent to job offers, guarantees them unrestricted movement within the partner states and nondiscrimination in national labor markets, and outlines their entitlements within the borders of the member states for employment. It gives the workers the right to stay in the country of a member state for employment, in agreement with the national laws and administrative measures governing the employment of workers of that member state, and to enjoy the freedom of association and collective bargaining for better working conditions and pay in accordance with the countrywide laws of the receiving state. Article 10 also reflects partner states’ binding commitment to create an environment that allows EAC citizens to move between different national labor markets for the purposes of providing services. However, the framework for implementation of Article 10 in Annex II of the CM protocol (EAC Secretariat, 2009b) is more restrictive. The schedule for the free movement of workers under Annex II clearly states the free movement of highly skilled workers,1 for which partner states committed to remove barriers by end-2015.2 Semi-skilled and unskilled workers and public sector employees, however, are not covered by commitments.

The free movement of workers remains hindered by a number of other obstacles.3 These include (1) weak provisions for mutual recognition of professional qualifications and experience, despite notable differences between educational systems in member states; (2) complex procedures for obtaining work permits; (3) concerns, in some member states, that lifting all barriers to EAC workers’ mobility would allow citizens from other member states to take away jobs from local citizens; (4) language, especially in countries where the command of English is limited; and (5) the uneven quality of training institutions to provide education and certification that is considered adequate by regional standards.

This section focuses on progress in eliminating restrictions to labor mobility and then on recent trends in migration and remittances to assess labor mobility. Even for these variables, the analysis is constrained by data availability and quality issues. National manpower surveys are irregular and incomplete and, as a result, there is a lack of data on stock of skills, characteristics, distribution, and skill supply and demand (EAC Secretariat 2012). While the situation may have improved in the past three years, data timeliness and accuracy remain an issue for the analysis of migration and remittance flows. Another major constraint is the estimation of payment flows sent via informal channels.4

Progress in Eliminating Legislative Restrictions to the Movement of Workers in the EAC

Partner states have not fully aligned their national laws with the CM requirement that guarantees the right of EAC citizens to move freely and to establish residence in another EAC partner state (Ogalo 2012).5 CM Protocol Articles 7, 13, and 14 stipulate that EAC citizens are guaranteed the right to reside in any partner state—along with their spouse, dependents, and children—for the purpose of living, visiting, touring, transit, education, training, and working. They also provide the right for citizens to establish their business in any partner state and pursue economic activities in accordance with the national laws of the partner state. This also includes self-employed persons who are free to carry out their work across the region. At the same time, they are all subjected to limitations justified by partner states on the grounds of public policy or public security. Some partner states have complied with these rights and freedoms. For instance, the Kenyan and Rwandan governments have made some improvements, including “waiving off the work permit fees for EAC citizens” (Ogalo 2012) to allow free movement of labor and persons, and those two governments have repealed their immigration laws. However, Burundi, Tanzania, and Uganda have not repealed their respective citizenship and immigration laws in conformity with the CM.

The EAC CM Scorecards (2014 and 2016) found that most measures that are inconsistent with commitments to liberalize services trade within the EAC relate to professional services. A review of more than 500 key sectoral laws and regulations of the EAC partner states identified 63 measures inconsistent with commitments to liberalize services trade, of which 46 were in the area of professional services. Engineering accounted for 16 cases of noncompliance, legal services for 14, accounting services for 10, and architectural services for six. The measures were most common in Kenya and Tanzania (11 and 10, respectively), followed by Burundi and Rwanda (nine each), and Uganda (seven). The 2016 Scorecard revealed some progress since 2014, with the number of nonconforming measures (NCMs) in professional services declining to 42. Kenya undertook the most reforms, eliminating three NCMs; Tanzania and Rwanda each eliminated one NCM. However, Uganda had added an NCM in professional services. The remaining NCMs affect the entry and operations of service providers in areas such as licensing, education requirements, restrictions on the number of suppliers, and mandatory membership in professional associations.

The harmonization and mutual recognition of professional and academic qualifications, which has advanced at a slow pace, might be facilitated by a new tool. The East African Qualifications Framework for Higher Education (EAQFHE) was approved in May 2015 (EAC Secretariat 2015).6 The EAQFHE is a generic instrument for the region and aims to guide the partner states’ qualifications frameworks for alignment with the regional framework, so that the regional education and training systems and the qualifications attained are appropriately harmonized. Some professional associations in the region—such as the Engineers’ Association, Architects’ Association, Medical Doctors’ Association, and Lawyers’ Association—are also playing a key role in facilitating the mutual recognition of qualifications, by recognizing and accrediting individuals’ qualifications and experiences.

Recent Migration and Remittances Trends in the EAC

Migration flows in the EAC, like in the rest of the continent and in other regions, are driven by both economic and social factors. To a large extent, the migration destination is more developed areas, which for an individual migrant means higher income (De Haan 1999). Kenya, Tanzania, and Uganda, which are large and booming economies in East Africa, have attracted the largest number of EAC migrants. Other factors have played an important role in regional migrations, particularly internal conflicts, which have generated large numbers of refugees. As a result of these conflicts, Somalis represent about 60 percent of migrants in Kenya; Congolese, about 50 percent of migrants in Rwanda; and Congolese and South Sudanese, about 45 percent of migrants in Uganda (World Bank 2014).

Migration flows within the EAC increased significantly in the 2000s but have bottomed out in recent years (Figure 11).7 The number of immigrants in EAC countries coming from another EAC country increased by over 40 percent between 2000 and 2013, and exceeded 1.1 million in 2013. The increase took place in the 2000s, with a slight decrease observed between 2010 and 2013 (Table 3).

Figure 11.
Figure 11.

Emigrants from and Immigrants to the EAC

(Percent of each country’s population)

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: World Bank, Migration and Remittances Factbook, 2011-13; and IMF staff calculations.
Table 3.

Estimated Total Migration from, to, and within the EAC

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Source: World Bank, Migration and Remittances Factbook, 2013.

EAC countries present different immigration patterns (Tables 4 and 5, Figures 12 and 13). On average, across EAC countries, more than half of EAC emigrants are in another EAC country; 20 percent, in an African country outside the EAC; and the rest, outside Africa. However, the situation differs substantially across EAC countries. Kenyans migrate mostly to North America and Europe. Burundian emigrants are mostly in the EAC, and Rwandan and Ugandan emigrants are mostly in the EAC or the rest of Africa. Geographic proximity seems to be an important factor, perhaps also reflecting cultural and ethnic proximity; Burundians for example migrate mostly to countries that have a border with Burundi, but very few go to Kenya. Emigration patterns also differ with regard to the education level of migrants. Available information suggests that more than 30 percent of Kenyans, Rwandans, and Ugandans with tertiary education levels migrate.8 Most immigrants in EAC countries are from Africa, including other EAC countries.

Table 4.

Emigrants from the EAC by Country of Destination

(Percent of total emigrants)

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Sources: World Bank, Migration and Remittances Factbook, 2011–13; and IMF staff calculations.
Table 5.

Immigrants to the EAC by Country of Origin

(Percent of total immigrants)

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Sources: World Bank, Migration and Remittances Factbook, 2011 –13; and IMF staff calculations.
Figure 12.
Figure 12.

Emigration Rate of Tertiary Educated, 2000

(Percent of total tertiary educated population)

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: World Bank; and IMF staff calculations.
Figure 13.
Figure 13.

Migration in the EAC

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: World Bank, Migration and Remittances Factbook, 2011 and 2013; and IMF staff calculations.

Figure 13 visualizes the relative volumes of migration. The three panels describe flows of people in and out of the EAC in two particular years: 2000 and 2013. The width and color intensity of the arcs/arrows are such that the more people moving between countries, the wider the arcs and darker the color. The data were normalized to be a proportion of total flows in and out of the EAC, not counting flows between countries outside the EAC. In all charts, Somalia was removed from the underlying data as it appeared to be an outlier; keeping it would have severely overemphasized the flows into the EAC from the rest of the world.

The two top panels display some differences. One cannot necessarily infer that these snapshots reflect changing trends, but trends in migration typically do not change much from year to year, absent major geopolitical events.

One might thus be able to conclude that migration into the EAC from the RoW remains low, and flows out to the RoW are still led by Kenyans— although in 2013 there were also a sizable number of flows into Kenya. Flows into the EAC countries are still primarily from other sub-Saharan African countries rather than intra-EAC, although in 2013 the main destination was Uganda rather than Tanzania (dominant target in 2000). Lastly, a large number of Burundians continued to migrate to Tanzania in 2013. These changes can be more aptly summarized in Figure 13.

In the bottom panel of Figure 13, the flows are the differences from 2000 to 2013. Green is positive and red is negative change in migration flows; the data are normalized as a proportion of total change. Although their relative volumes are small, intra-EAC flows have mostly increased over the 13 years, particularly into Rwanda.

Intra-EAC remittances have decreased in recent years and represent only a small fraction of the total (about 20 percent; Figures 14 and 15). They amounted to $550 million (or 0.5 percent of regional GDP) in 2013, down from about $650 million in 2010. Remittances from migrants residing in advanced countries are much higher, accounting for about 60 percent of the 2013 total.9 This likely reflects a number of factors, such as higher income levels in Europe and North America, but also the fact that EAC migrants who reside outside the region are younger and better educated. The average amount of money sent also varies across recipient countries. Kenyan migrants send the highest amount on average, whereas Burundian migrants send the lowest amount.10

Figure 14.
Figure 14.

Source of Remittance Inflows (Net)

(Percent of GDP)

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: World Bank, Bilateral Migration and Remittances Factbook, 2011–2014; and IMF staff calculations.
Figure 15.
Figure 15.

Emigration and Remittances

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: World Bank, World Bank Development Indicators; and IMF staff calculations.

Chapter 3. Financial Integration in the EAC

The CM protocol requires EAC countries to eliminate restrictions on the free movement of capital. Article 24 of the protocol eliminates capital flow restrictions among the member states based on nationality, place of residence, current payments, and where capital is invested based on securities, credit, direct investment operations as well as personal capital transactions. These are intended to help mobilize capital, bolster competition, facilitate information flows, and improve corporate governance among member states.

This section assesses progress in financial integration since the implementation of the CM. In the absence of comprehensive and reliable information on capital flows between EAC countries, four different (and indirect) approaches are used. First, progress toward eliminating restrictions on the free movement of capital since the ratification of the CM protocol is evaluated. To that end, a summary review of laws and regulations on the movement of capital across the EAC borders is provided, based on the EAC CM Scorecards (2014 and 2016).1 Second, openness to capital flows is assessed using two capital control indicators, based on de jure information available in the IMF’s Annual Report on Exchange Rate Arrangements and Exchange Rate Restrictions (AREAER).2 Third, deviations from the covered interest parity (CIP) condition are analyzed, based on available data on nondeliverable forward market rates (for Kenya, Tanzania, and Uganda). Fourth, convergence in investment returns among securities and debt instruments of various maturities in EAC countries is empirically analyzed.

Progress in Eliminating Legislative Restrictions in EAC Capital Markets

The EAC CM Scorecards (2014 and 2016) provided comprehensive legislative assessment of capital integration after implementation of the CM protocol. In the five EAC countries, 124 laws and regulations were first reviewed as of end-September 2013 to determine their compliance with Article 24. Of the 20 financial operations considered by the review, 17 were subject to no restrictions in Kenya, 15 in Rwanda and Uganda, and four in Burundi and Tanzania;3 only two were subject to no restrictions across all five countries (external borrowing by residents and repatriation of proceeds from sale of assets). All EAC countries had restrictions on inward direct investment from other EAC economies. Kenya, Rwanda, and Uganda imposed no restrictions on lending within the EAC by residents (including purchases by residents of EAC shares or securities, credit operations across EAC borders, participation of residents in initial public offerings in other EAC capital markets, and outward direct investments in the EAC). Burundi and Tanzania restricted such EAC lending by residents.

The 2016 Scorecard revealed some progress since 2014. Both Kenya and Uganda adopted a regulatory framework for derivatives and thus removed four of the restrictions recorded in 2014. Uganda also harmonized the tax rate to 20 percent on interest from investment in government securities for both residents and nonresidents. Kenya has met the threshold of no restrictions on the 14 operations measures relating to securities. Uganda also enacted reforms affecting two of the operations but continues to have residency restrictions on the local purchase of shares or other securities of a participating nature. In terms of credit operations, no reforms were recorded with respect to credit operations and restrictions that affect inward investment from other EAC economies.

The Scorecards conclude that overall progress to eliminate legal restrictions on free movement of capital had been sluggish, hindering development of the common market. The review identified many legislative restrictions on the free movement of capital that inhibited entry into the market or made it unduly expensive; uncovered several forms of regulatory discrimination that persisted even after entering the market—such as ceilings on the value of transactions and higher taxes for foreign firms; and noted that some barriers, such as restrictions on personal financial transactions and on the transfer of shares in firms, affected even firms seeking to exit a particular economy. To fully comply with the protocol, EAC partner states need to repeal provisions in at least 27 laws and regulations. Besides existing restrictions, the 2014 Scorecard identified at least 10 new legislative restrictions on free movement of capital in Rwanda, Tanzania, and Uganda since the protocol came into force in 2010.

Openness to Capital Flows in the EAC: A Comparative Perspective

This section analyzes the evolution of capital controls in the EAC based on de jure information from the IMF’s AREAER. The aim is to complement the EAC CM Scorecard by analyzing the evolution of capital market controls for a longer period and a larger set of countries in sub-Saharan Africa. Specifically, aggregate capital control indicators from Chinn and Ito (2006) based on the narrative portion of the AREAER are used to analyze recent trends in sub-Saharan Africa.4 The underlying drivers are examined using a recent data set by Fernandez and others (2015), which covers 100 countries—14 sub-Saharan African countries, of which three are EAC partners: Kenya, Tanzania, and Uganda—and includes disaggregated de jure capital control indicators on inflows and outflows for 10 asset categories.5

Uganda, Kenya, and, more recently, Rwanda have had relatively high degrees of financial account openness in the EAC (based on the Chinn-Ito Index; Figure 16).6 The degree of capital account openness—normalized to range between zero and one, with one indicating no controls—shows a marked increase in openness for the EAC region in the mid-1990s but no significant improvements subsequently, with the exception of Rwanda in the last few years.7

Figure 16.
Figure 16.

Financial Account Openness

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

The EAC is more open to capital flows than other monetary unions and regional groupings in sub-Saharan Africa. The Common Market for Eastern and Southern Africa (COMESA) is slightly less open than the EAC, but the other groupings are much less so.8

Detailed and disaggregated capital control indices reveal the underlying drivers of these broad trends (based on Fernandez and others 2015; Figure 17). We focus on Kenya, Tanzania, and Uganda from the EAC (based on data availability from 2015 AREAER), and South Africa as a comparator from sub-Saharan Africa. While Kenya and Uganda have slightly lower degrees of restrictions on capital outflows, Tanzania has substantial restrictions on both inflows and outflows.9 In terms of asset classes, Uganda has no restrictions in any asset category, Kenya has no restrictions on direct investment but some restrictions on other instruments, and Tanzania has significant restrictions on all asset classes, with the exception of equity flows, which have been eased recently. Appendix III provides more detail on this analysis.

Figure 17.
Figure 17.

Capital Account Restrictions

Citation: Departmental Papers 2017, 001; 10.5089/9781475560350.087.A001

Sources: Fernandez et others. (2015).1/ Lower values represent more restrictions.

An Empirical Assessment of the CIP Condition in Kenya, Tanzania, and Uganda

This section complements the de jure analysis by empirically investigating the interest parity arbitrage in the EAC. Specifically, deviations from the CIP condition among Kenya, Tanzania, and Uganda are examined applying statistical analysis to available data on NDF market rates in the post-2010 period. The magnitude of deviations from the CIP from 2011 to 2015 in each country is then compared to an emerging market comparator in sub-Saharan Africa, South Africa. The presence of capital controls and the unavailability of onshore forward markets necessitate the use of NDF rate data in the analysis. The NDF markets are for frontier and emerging market economies with substantial cross-border investment and trade flows, where currency convertibility restrictions and capital controls remain (Box 1).

CIP deviations, however, need to be interpreted carefully.10 The NDF exchange rate does not involve actual capital inflows and transactions in the onshore markets, and the assumptions for the CIP condition to hold are unlikely to be met.11 CIP deviations can therefore reflect a range of things beyond the existence of capital controls.

Nondeliverable Currency Forward (NDF) Markets*

Created in the early 1990s, the NDF contract is a derivative product generally used to hedge exposure or speculate on a move in a currency where local authorities limit such activity. An NDF is similar to a foreign exchange contract, except at maturity the NDF does not require physical delivery of currencies, and is typically settled in U.S. dollars outside the borders of the currency’s home jurisdiction (“offshore”). The other currency, usually a frontier or other emerging market economy currency with capital controls, is “nondeliverable.” Therefore, NDF prices reflect market expectations and supply and demand factors that cannot be fully manifested in onshore currency product prices in a country with capital controls.

The pricing of NDF contracts, like most forward contracts, is primarily based on the CIP formula. At the settlement date of an NDF contract, if the settlement exchange rate, “the fixing rate”—generally the spot rate traded for the currency onshore—is greater (in foreign currency per U.S. dollar) than the previously agreed forward exchange rate, then the holder of the NDF contract who sells U.S. dollars in exchange for emerging market currency must pay the other side the contract the difference in U.S. dollars. NDF prices, similar to forward exchange contract prices, can be affected by expectations on changes in foreign exchange rate regime, speculative positioning, and conditions on local onshore interest rate markets. When nonresident investors have little or no access to a country’s onshore capital markets, the NDF market for that currency is primarily based on the expected future level of the spot exchange rate (for example, interest parity calculations do not affect NDF prices in Chinese yuan given the limited access to onshore Chinese yuan interest rate products.)

The liquidity of the NDF market largely comes from (1) multinational firms and international portfolio managers hedging the exchange rate risk in nonconvertible currencies, (2) nonresidents wishing to speculate on the NDF underlying currency without any exposure to the country, and (3) arbitrageurs who attempt to exploit the differentials in the prices in the two markets without any outlay of capital on their part by two offsetting transactions. Given that NDFs are primarily over-the-counter, rather than exchange-traded, products, it is quite challenging to measure the volume of contracts traded and identify the counterparts and the place where the trade occurs. The Bank for International Settlements Triennial Central Bank Survey in 2013 showed that NDFs constitute a fifth of the global foreign exchange market in outright forwards and a little above 2 percent of overall foreign exchange trading (McCauley, Shu, and Ma 2014).

* See Lipscomb (2005) for a comprehensive overview of the development and characteristics of the NDF market.

Descriptive statistics reveal the presence of significant CIP deviations in EAC countries (Table 6 and Appendix IV). In Kenya and Tanzania, the deviations are significant for all maturities. CIP deviations are smaller in Uganda for short maturities (three months) but large for longer maturities. In comparison, CIP deviations are much smaller in South Africa for all maturities.12

An Assessment of Financial Market Convergence in the EAC

This section provides evidence on financial market integration based on two complementary convergence concepts. It extends work by Yabara (2012) by using higher-frequency data (weekly and biweekly) over a more recent period. The two convergence concepts—β-convergence and σ-conver-gence—capture complementary aspects of financial integration.13 When the dispersion of yields on comparable assets across a group of economies falls over time, σ-convergence occurs, β-convergence measures the extent to which shocks to spreads (the difference between a country’s yield on a specific asset and the yield on a benchmark asset) dissipate (Appendix V).

Table 6.

Median Absolute CIP Deviations for Kenya, Uganda, and South Africa 1/

(Percent)

article image

CIP deviations relative to US$ for each country/currency pair.

Sources: Bloomberg; Federal Reserve Bank of Saint Louis; World Economic Outlook database; and IMF staff calculations.

Both β- and σ-convergence analyses point to convergence of short-term market returns within the EAC. Overnight rates provide evidence of β-convergence, except in Rwanda. Weekly stock market returns also exhibit β-convergence for all EAC countries (with the exception of Burundi, which does not have a stock market). The half-life of deviations suggests quite rapid convergence in stock market returns (half a week) following a shock, and slower convergence in overnight market rates (two weeks in Kenya to 11 weeks in Burundi, and 5 to 9 percent on average). The dispersion of spreads for overnight rates and stock market returns also tends to decrease over time, providing evidence of σ-convergence.

There is little evidence, however, of β- and σ-convergence for longer-maturity instruments, β-convergence occurs for Kenya’s spreads for three-, six-, and 12-month maturities; Tanzania’s spreads for three- and six-month maturities; and Burundi’s and Uganda’s spreads for the 12-month maturity only. There is no evidence of β-convergence in Rwanda for these maturities. Nevertheless, half-lives of deviations for longer maturities are large, suggesting very slow convergence. Average EAC half-lives are over four months for three-month maturity and over one month for 12-month maturity. There is no evidence for σ-convergence in the EAC for three-, six-, and 12-month maturities.

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Cover Departmental Papers
A Work in Progress: Integrating Markets for Goods, Labor, and Capital in the East African Community
Author:
Mr. Emre Alper
,
Ms. Wenjie Chen
,
Mr. Jemma Dridi
,
Mr. Herve Joly
, and
Mr. Fan Yang
Volume/Issue:
Volume 2017: Issue 001
Publisher:
International Monetary Fund
ISBN:
9781475560350
ISSN:
2616-5333
Pages:
76
DOI:
https://doi.org/10.5089/9781475560350.087
Figure 1.

Import by EAC Countries from the Rest of the World (ROW) and Tariff Rates
Figure 2.

EAC Imports from ROW by End-Use
Figure 3.

EAC Imports from Rest of the world by Intermediate Inputs

(Percent of GDP)
Figure 4.

Imports by EAC Country from EAC Country and Tariff Rates
Figure 5.

EAC Imports from EAC by End-Use
Figure 6.

EAC Imports from EAC by Intermediate Inputs

(Percent of GDP)
Figure 7.

EAC Import Share by Region
Figure 8.

EAC Import Shares by Origin
Figure 9.

EAC Export Share by Region
Figure 10.

EAC Export Shares by Destination
Figure 11.

Emigrants from and Immigrants to the EAC

(Percent of each country’s population)
Figure 12.

Emigration Rate of Tertiary Educated, 2000

(Percent of total tertiary educated population)
Figure 13.

Migration in the EAC
Figure 14.

Source of Remittance Inflows (Net)

(Percent of GDP)
Figure 15.

Emigration and Remittances
Figure 16.

Financial Account Openness
Figure 17.

Capital Account Restrictions