Scholar urges caution over single currency

Recently, the East African Community Heads of State signed a protocol establishing the East African Monetary Union (EAMU) that will come with a single currency in the next 10 years. In an online interview, The Sunday Times’ James Karuhanga asked Dr Josephine Kibe, a guest scholar at the Africa Growth Initiative, an arm of the US-based think tank, Brookings Institution, on how best to go about the implementation of the single currency. What are basics prerequisites for the EACMU to function? One is flexibility of the labor market. Swahili is spoken in all five countries and English is also the official language in Kenya, Uganda and Tanzania. Rwanda has taken steps to make English the official language. The fact that there is a common language, Swahili, is an advantage. Given that four out of five countries use English in official business is also a fundamental foundation. However, there are numerous indigenous languages spoken mostly in the rural areas. This diversity can cause challenges because such people may encounter difficulties getting employment across borders. Then there is political will. Lack of trust threatens the success of the union. The expulsion of Rwandese from Tanzania casts a doubt to the willingness to integrate. Additionally, the perceived isolation of Tanzania and Burundi, in the recent trilateral agreement involving Uganda, Kenya and Rwanda – termed ‘coalition of the willing’ – seems to have elicited mistrust. Third is effective fiscal integration. This is crucial in dealing with asymmetric shocks between member countries. For example, if Kenya experiences a positive aggregate demand shock, and Rwanda experiences a negative aggregate demand shock, the central bank of the Monetary Union will find it difficult to conduct effective monetary policy that is crucial for both countries. Research shows likely deterioration of terms of trade following integration—which is made even worse with the discovery of natural resources in Kenya, Uganda and Tanzania. Tests for co-integration between real effective exchange rates also emphasizes that the region currently is not ready for integration. Another is the flexibility of prices and wages. The fact that the most people in the EAC are small-scale farmers and work in the informal sector is good because prices and wages in these sectors tend to be flexible. Additionally, wages tend to respond strongly to unemployment. However, there is inflexibility in the formal sectors, and there is a huge wage disparity between workers in large and small firms. Finally, there is product diversification. Product diversification is important in relation to industry-specific shocks so that a fall in demand of one sector will not create high unemployment. Looking at sectors’ contribution to GDP as a measure of diversification shows that a lot needs to be done in this area. In Kenya, for example, 56 per cent of the value added to GDP comes from the service sector. It is same in Rwanda where the economic structure is dominated by services. Tanzania’s economy is dependent on agriculture which accounts for more than 25 per cent of its GDP, and that sector employs more than 80 per cent of the population. What immediate benefits should rural east Africans expect? The realization of benefits may not be immediate or short term, but more medium term and long term as there are phases in integration. If the preconditions are in place, there will increase in trade opportunities – producers will have a larger market to sell their goods, regionally and also globally, but will also strive to be efficient so as to remain competitive. However, they will reap economies of scale and thus lower costs. Another positive is less vulnerability to external shocks – for instance, commodity price shocks and exchange rate volatility as nominal exchange rate variations are extinguished. Regional agreements compel policymakers to follow prudent macroeconomic policies for the benefit of the entire region and commitment to price stability implies that there will be less inflation uncertainty, which is good for all the economic units. There is also decrease in transaction costs such as cross-border travel costs and lower interest rates—that means lower costs of borrowing. Any similarities in the EAC and EU models? A Customs Union and a Common Market are pre-requisites for a common currency. Then there is a regional central bank: the East Africa Monetary Union will be characterized by a regional central bank. The European Union has its central bank located in Germany. Another is an integrated payment system and removal of capital controls at national level. All these are basics for any monetary union, not specifically just the EAMU and EU models. Is it not risky for the EAC to get into a single currency before achieving considerable convergence in fiscal and monetary platform across the five countries? Yes, it would be risky. As I mentioned, one of the pre-conditions necessary for the monetary union to work is effective fiscal integration. This is because it would be difficult for the central bank of the monetary union to deal with asymmetric shocks. Studies show that there are asymmetric shocks in these countries and a likely deterioration of terms of trade should the countries implement a common currency. A country with a high debt or GDP ratio is a challenge to the success of the monetary union. This is because of the likelihood of surprise inflation from this country. Thus, it is crucial that any high-debt country reduces its government deficit because such a country would also be predisposed to default risk and, as such, be a burden others. Kenya’s debt or GDP ratio is 43 per cent, Tanzania is at 47.7 percent, Rwanda’s is at 25.10 percent, Uganda is at 33.3 percent and Burundi is at 18.8 percent. What possible issues or challenges come with single currency? Changeover costs as countries move from their individual to the common currency: A study shows that restaurant prices increased substantially in the Euro area after the introduction of the Euro. Other prices that are likes to increase are, for instance, postage prices and vending machine prices. Consumers are likely to experience decreased welfare as producers convert prices from domestic currencies to the regional currency. There is possibility of weaker nations such as Burundi becoming uncompetitive. This is seen in the Euro case where several weaker economies are now uncompetitive as compared to when they were not part of the Euro. The inability of individual countries to control their monetary policies becomes an impediment when responding to national economic crises. Greece is a perfect example where a country is facing excessive fiscal deficits and the contraction in GDP and unemployment cannot be reduced by devaluation of the currency, leading to an increase in exports and a reduction in imports. How would countries deal with these challenges? The probable solution would be to delay the common currency integration until other important issues are addressed, such as getting the customs union and common market working properly, as they are fundamental to the proper functioning of the union.