Remarks By Louis Kasekende (PhD.),
Deputy Governor, Bank of Uganda
At the Symposium to Mark 50 Years of the Central Bank of Kenya (CBK)
Nairobi, 13 September 2016
Topic: East African Monetary Union: What Lies Ahead?
Let me start by congratulating the Central Bank of Kenya upon reaching this milestone of its Golden Jubilee. I bring greetings from Governor Bank of Uganda, Professor Emmanuel Tumusiime-Mutebile, who is regrettably unable to join you on this momentous occasion due to official engagements back home. I am pleased and honoured to be invited to speak at this symposium on an issue that is central to the realisation of the development aspirations of our East African region and indeed the African Continent as a whole.
The five East African Community (EAC) countries – Kenya, Uganda, Rwanda, Burundi and Tanzania, have signed a protocol committing them to introducing the East African Monetary Union (EAMU) in 2024. Monetary unions potentially offer important benefits to economies which are closely integrated, but the problems experienced by some of the monetary unions already in existence around the world indicate that they also entail serious risks. Consequently the preconditions for realising tangible benefits and avoiding costs must be fully understood and put in place as we transit from national currencies to a common regional currency.
In these comments, I want to focus on three issues. The first is the imperative for meaningful economic integration within the EAC if the establishment of EAMU is to deliver tangible benefits for the partner states. The second issue is the need for strong, enforceable rules to ensure fiscal sustainability of each partner state, given that once EAMU has been established; they will no longer have the option of refinancing their public debt from their own central banks. The third issue is how to mitigate the adverse impact of asymmetric macroeconomic shocks within the EAC, the likelihood of which will be increased if one or more partner states becomes a major oil producer.
What is the rationale for monetary union?
The economic rationale for monetary union is to facilitate transactions within an integrated economic area, eliminating risks which might arise from unforeseen currency movements and the costs of exchanging currencies in order to complete transactions. This implies that the benefits of EAMU can only be fully realised when there is comprehensive economic integration within the EAC, not just free trade in goods but also free trade in services and free movement of factors of production.
We should acknowledge that economic integration in the EAC needs to be further strengthened as a precursor to an optimal common currency. Although the EAC partner states have implemented a customs union, trade in goods within the region still comprises only ten percent of the total merchandise exports and imports of the five partner states. The five partner states have a combined GDP of US dollars 147 billion, but their combined intra-EAC exports amount to only US dollars 3.2 billion, or two percent of their combined Gross Domestic Product (GDP). This is partly because of the obstacles to intra-regional trade created by non-tariff barriers but mainly because of the structure of the region’s economies, which can only produce a fraction of the traded goods consumed in the region.
Although the EAC Common Market came into force in 2010, some of its key provisions have not been fully implemented. There are residual barriers to the free movement of capital, the free movement of services and especially to the free movement of labour. There may be legitimate reasons for such barriers but they are not compatible with comprehensive economic integration and monetary union.
What are the risks of EMU?
Ensuring fiscal sustainability
As the experience of the European Union has demonstrated, the adoption of a common currency has profound implications for the fiscal policies of the member states. If the common currency is to command the confidence of the public and the markets, there must be strict rules to prevent the common central bank from having to finance the fiscal deficits of the member states. If the central bank could be used as a common budgetary resource by the partner states, each of them would have strong incentives to borrow from the central bank, which would obviously be ruinous for macroeconomic stability.
Unfortunately, rules against central bank refinancing of the public debt of partner states are time inconsistent. Faced with a fiscal crisis and the likelihood of sovereign default in one or more partner states, which could give contagion effects (for example on the banking system), the central bank might have little option but to provide support to the distressed sovereigns, as the European Central Bank (ECB) has been doing in Europe.
In theory, the probability of a fiscal crisis and a sovereign default can be minimised if the member states comply with appropriate fiscal rules, such as limits of fiscal deficits and public debt. This is the rationale for the ceilings on the fiscal deficits of each partner state in the EAMU convergence criteria, which restrict the overall fiscal deficit including grants to two (2) percent of GDP and the fiscal deficits excluding grants to five (5) percent of GDP. In the schedule for the realisation of the EAMU, which is an annex to the EAMU protocol, the macroeconomic convergence criteria must be attained by 2021. It would be useful if these fiscal deficit ceilings were complemented by ceilings on public debt.
However, fiscal rules alone might not be sufficient to ensure that a fiscal crisis within the EAC will never occur. There are two main sources of risk with regard to fiscal crises. The first is that the fiscal rules may be circumvented (as happened in Greece) because partner states want to implement more expansionary fiscal policies. Several governments within the EAC have ambitious plans for scaling up public investment programmes to build infrastructure. These plans and the attendant financing needs may not be consistent with the fiscal targets in the EAC macroeconomic convergence criteria and the requisite road map to a Monetary Union.
The second source of fiscal risk arises because, even if countries consistently pursue prudent fiscal policies, and comply with the fiscal rules of the EAMU, a systemic shock to their economies could threaten fiscal sustainability. There is often no feasible alternative to fiscal policy in mitigating the impact of systemic shocks, such as banking crises or large natural disasters. Consequently, a partner state which suffers a systemic shock to its economy may have no alternative but to allow a large increase in its fiscal deficit if it is to try and reduce the impact of the shock on the welfare of its citizens. The key question is how such an increase in the fiscal deficit could be financed, should the need arise. In the final analysis, the fiscal problems of individual partner states in a monetary union may not always be resolvable without financial support from their partners.
A sustainable monetary union is thus likely to require some degree of fiscal union, in which fiscal resources can be transferred between partner states in the event that an individual partner state is threatened with a fiscal crisis.
Asymmetric macroeconomic shocks
Membership of a monetary union implies that each partner state irrevocably foregoes its own independent monetary and exchange rate policies. In addition, the fiscal policies of each partner state must unavoidably be constrained by the need for strict fiscal rules which are intended to ensure that no partner state risks defaulting on its public debt, as discussed above. As a result, individual partner states will be highly circumscribed in their capacities to implement discretionary macroeconomic stabilisation policies.
Furthermore, the fiscal deficit ceilings in the EAC macroeconomic convergence criteria, because they entail conventional, non-cyclically adjusted measures of the fiscal deficit, encourage governments to implement pro-cyclical fiscal policies.
This might not matter if macroeconomic shocks are uniform across all five partner states. A uniform macroeconomic shock can be addressed by a uniform monetary policy. Unfortunately there are no grounds for assuming that macroeconomic shocks within the EAC will always be uniform, given that there are substantial differences between the individual economies of the partner states.
Furthermore, it is likely that one or more partner states will become major oil producers over the medium term, which will make the probability of asymmetric shocks affecting the EAC even more likely. For example, a boom in oil prices would have opposite effects on the net oil exporters in the EAC and the net oil importers, but both sets of economies would share the same monetary and exchange rate policy and be subject to the same fiscal rules. In such circumstances, a monetary union would exacerbate macroeconomic instability in both sets of economies; booms would be larger (and less sustainable) and recessions deeper.
What options are available for mitigating the impact of asymmetric shocks within a monetary union? Free movement of factors of production will help to dampen the adverse impact of such shocks. If labour and capital can flow into the booming economies from those hit by recession, inflationary pressures in the former will be reduced while the welfare of people in the latter will be supported by higher factor incomes.
This will only be possible if all partner states remove all barriers to the free movement of labour and capital within the EAC.
A second prerequisite for macroeconomic stabilisation in the face of asymmetric shocks is some form of common stabilisation fund, which will channel financial resources to those economies suffering from negative macroeconomic shocks. This would require each partner state to make regular payments into a common stabilisation fund during “normal or good” periods, to ensure that there are sufficient resources in the fund to finance transfer payments to those economies facing adverse shocks. There will need to be strict rules covering payments into the fund (e.g. each government should pay (x) percent of annual revenue) and very clear criteria for making payments from the fund to economies in need.
A third prerequisite pertains to the fiscal rules. As currently formulated these threaten to impart a pro-cyclical bias to fiscal policy. If a country’s public revenue falls because the economy is in recession, a government must reduce public expenditure to avoid breaching the fiscal targets, which would worsen the recession, unless it is already operating well within the targets. The ideal solution would be to formulate fiscal deficit ceilings in cyclically adjusted or structural terms, thereby allowing for wider deficits during recessions and smaller deficits during booms.
The drawback is that the measurement of cyclically adjusted fiscal deficits is much more open to different interpretations than is the measurement of conventional deficits, and hence the former may allow for fiscal slippage which might threaten fiscal sustainability. There would need to be some independent agency at the regional level with responsibility for assessing cyclically adjusted deficits and whether they comply with the fiscal rules of the monetary union.
The time frame for Monetary Union
The EAMU Protocol envisages that EAMU will begin in 2024. Governors of the EAC central banks remain committed to doing all that is within their mandate to support the integration process. A lot of work has been undertaken and is ongoing with regard to the strengthening coordination and harmonisation of policies, operational and legal frameworks; the development and integration of the financial system including modernisation and integration of the payments system; and the development of the requisite instruments for the legal and institutional frameworks for the EAMU institutions. Central Banks are also jointly developing the requisite capacity to undertake preparatory work for the EAMU.
However the institutional and policy requirements for EAMU as set out in the annex attached to the Protocol remain very demanding. As I have already discussed, the partner states have some way to go before fully implementing the Common Market and their medium-term fiscal plans may need to be reviewed in line with the fiscal targets in the convergence criteria.
The work required to achieve all the prerequisites for EAMU within the next eight years is therefore enormous, and we must use the available time to design and fully implement an appropriate time-consistent program of policies and actions to realise the EAMU.
Louis Kasekende is the Deputy Governor, Bank of Uganda.