Monetary Unions in Africa: How Many Currencies Does Africa Need?

1. Monetary unions among developing and emerging markets:how many currencies does africa need? 50TH ANNIVERSARY CELEBRATION OF THE CENTRAL BANK OF NIGERIA, 4-6 MAY 2009 Thorvaldur Gylfason

2. Pan-continental africa • Despite Africa’s great diversity of culture and languages, many Africans identify themselves as Africans first, then as Congolese, Kenyans, Nigerians, South Africans, etc. • Most Europeans, North Americans, and Asians have it the other way round: country first, then continent • Yet, national boundaries within Africa are generally less open than those within Europe • Various restrictions on trade and migration • Restrictions need to be relaxed to spur growth • National currencies constitute a trade restriction

3. This is why we have Fewer currencies than countries • In view of the success of the EU and the euro, economic and monetary unions appeal to many Africans and others with increasing force • Consider four categories • Existing monetary unions • De facto monetary unions • Planned monetary unions • Previous – failed! – monetary unions

4. Existing monetary unions • CFA franc • 14 African countries • CFP franc • 3 Pacific island states • East Caribbean dollar • 8 Caribbean island states • Picture of Sir W. Arthur Lewis, the great Nobel-prize winning development economist, adorns the $100 note • Euro, more recent • 16 EU countries plus 6 or 7 others • Thus far, clearly, a major success in view of old conflicts among European nation states, cultural variety, many different languages, etc.

5. De facto monetary unions • Australian dollar • Australia plus 3 Pacific island states • Indian rupee • India plus Bhutan (plus Nepal) • New Zealand dollar • New Zealand plus 4 Pacific island states • South African rand • South Africa plus Lesotho, Namibia, Swaziland – and now Zimbabwe • Swiss franc • Switzerland plus Liechtenstein • US dollar • US plus Ecuador, El Salvador, Panama, and 6 others

6. Planned monetary unions • East African shilling (2009) • Burundi, Kenya, Rwanda, Tanzania, and Uganda • Eco (2009) • Gambia, Ghana, Guinea, Nigeria, and Sierra Leone (plus, perhaps, Liberia) • Khaleeji(2010) • Bahrain, Kuwait, Qatar, Saudi-Arabia, and United Arab Emirates • Other, more distant plans • Caribbean, Southern Africa, South Asia, South America, Eastern and Southern Africa, Africa

7. Previous monetary unions • Danish krone 1885-1938 • Denmark and Iceland 1885-1938: 1 IKR = 1 DKR • 2009: 2,300 IKR = 1 DKR (due to inflation in Iceland) • Scandinavian monetary union 1873-1914 • Denmark, Norway, and Sweden • East African shilling 1921-69 • Kenya, Tanzania, Uganda, and 3 others • Mauritius rupee • Mauritius and Seychelles 1870-1914 • Southern African rand • South Africa and Botswana 1966-76 • Many others No significant divergence of prices or currency rates following separation

8. Conflicting forces • Centripetal tendency to join monetary unions, thus reducing number of currencies • To benefit from stable exchange rates at the expense of monetary independence • Centrifugal tendency to leave monetary unions, thus increasing number of currencies • To benefit from monetary independence often, but not always, at the expense of exchange rate stability • With globalization, centripetal tendencies appear stronger than centrifugal ones • What does this mean for Africa?

9. Impossible trinity Free to choose only two of three options; must sacrifice one FREE CAPITAL MOVEMENTS 2 Monetary Union (EU) 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE

10. Impossible trinity Free to choose only two of three options; must sacrifice one FREE CAPITAL MOVEMENTS 2 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE Capital controls (China)

11. Impossible trinity Free to choose only two of three options; must sacrifice one FREE CAPITAL MOVEMENTS 2 Flexible exchange rate (US, UK, Japan) 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE

12. Impossible trinity Free to choose only two of three options; must sacrifice one FREE CAPITAL MOVEMENTS 2 Flexible exchange rate (US, UK, Japan) Monetary Union (EU) 1 3 FIXED EXCHANGE RATE MONETARY INDEPENDENCE Capital controls (China)

13. Fix or flex? • If capital controls are ruled out in view of the proven benefits of free trade in goods, services, labor, and also capital (four freedoms), … • … then long-run choice boils down to one between monetary independence (i.e., flexible exchange rates) vs. fixed rates • Cannot have both! • Either type of regime has advantages as well as disadvantages • Let’s quickly review main benefits and costs

14. Benefits and costs

15. Benefits and costs

16. Benefits and costs

17. Benefits and costs

18. Benefits and costs

19. Benefits and costs • In view of benefits and costs, no single exchange rate regime is right for all countries at all times • The regime of choice depends on time and circumstance • If inefficiencyand slow growth due to currency overvaluation are the main problem, floating rates can help • If high inflation is the main problem, fixed exchange rates can help, at the risk of renewed overvaluation • Ones both problems are under control, time may be ripe for monetary union

20. Benefits and costs • The real exchange rate always floats • Through nominal exchange rate adjustment or price changes • Even so, it does make a difference how countries set their nominal exchange rates because floating takes time • Currency misalignments can persist • Hence, a wide spectrum of options, from absolutely fixed rates anchored through monetary unions to completely flexible exchange rates • What do countries do?

21. What countries actually do (2004, 193 countries) No national currency 17% Other types of fixed rates 23 Dollarization 5 Currency board 4 Crawling pegs 3 Bilateral fixed rates 3 Managed floating 26 Pure floating 19 100 49% 51% Gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today, followed by increased interest in fixed rates through economic and monetary unions

22. overvaluation through inflation • Governments sometimes prefer fixed exchange rates so they can try to keep their national currencies overvalued • To keep foreign exchange cheap • To retain power to ration scarce foreign exchange • To make GNP in dollars look larger than it is • Another reason for persistent overvaluation, and thereby also sluggish trade and slow growth • Inflation! • Show by simple numerical example

23. overvaluation through inflation Real exchange rate Suppose inflation is 10 percent per year and exchange rate adjusts with a lag 110 Average = 105 105 100 Time

24. overvaluation through inflation So, increased inflation increases real exchange rate as long as nominal exchange rate adjusts with a lag Real exchange rate Suppose inflation rises to 20 percent per year 120 110 Average = 110 100 Time

25. overvaluation through inflation • Many African countries’ history of inflation, overvaluation, and slow growth is stark reminder that one of the keys to successful entry into monetary union is making sure that initial exchange rate at point of entry is not too high • European countries on euro zone’s doorstep – Baltic countries, Sweden, Iceland – face same challenge These slides can be viewed on my website: www.hi.is/~gylfason Thank you