CHAPTER V. MONETARY INTEGRATION IN AFRICA

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1 CHAPTER V. MONETARY INTEGRATION IN AFRICA 5.1. Introduction The last decade has been characterised by a renewal of interest in regional monetary arrangements in Africa. Actions have been taken by countries to activate regional integration initiatives, including propositions to form new monetary unions, and to enlarge or broaden the scope of existing ones. Guillaume and Stasavage (2000) argue that while there are few purely economic arguments in favour of these arrangements, they may, on political economic grounds, be a second-best solution for African countries that are seeking to make a credible commitment to pursue sound monetary policies. As demonstrated in chapters two and three, the creation of a monetary zone would attract foreign direct investment through a stable macroeconomic environment and a larger single market; facilitate free movement of goods, services, labour; reduce transaction costs; drive economic growth and reduce poverty, among other benefits. However, according to the theory of optimum currency, Guillaume and Stasavage (2000) suggest that African countries should not join a monetary union for two reasons. First, the transaction cost benefits of removing exchange rate volatility within an area are likely to be small for countries that trade relatively little with one another. Second, the loss of the nominal exchange rate instrument could potentially represent a very significant cost for countries hit by asymmetric shocks. Despite the above arguments, evidence from the past has shown that African countries which have participated in regional monetary agreements have often been characterised by sound and credible monetary policies, even in the context of widespread political instability. Indeed, there is evidence that monetary union will help to 71

2 formalise the huge informal cross-border trade and increase the overall trade within a region. In this chapter, the experience of two successful African monetary arrangements will be reviewed and the benefits and costs of having a common currency in the five East African countries analysed. Conditions for monetary stability and the setting up of convergence criteria towards monetary union in these countries will be discussed to facilitate the sustainability of a future economic union for the region The CFA Franc Zone Background The CFA Franc zone is composed of two zones of mainly francophone countries in West and Central Africa. The West African CFA zone is the West African Economic and Monetary Union (WAEMU), with its central bank being the Banque Centrale des Etats de l Afrique de l Ouest (BCEAO). The central African CFA zone is the Central African Economic and Monetary Community (CAEMC), with its central bank being the Banque des Etats de l Afrique Centrale (BEAC). The WAEMU members are Benin, Burkina-Faso, Cote d Ivoire, Guinea- Bissau, Mali, Niger, Senegal, and Togo while Cameroon, the Central African Republic, Chad, Congo, Equatorial Guinea and Gabon are members of CAEMC. Each regional grouping issues its own CFA franc, but they are exchangeable one-for-one against each other. The two CFA francs were, by design, pegged to the French franc at the same rate. The convertibility of the CFA franc at its parity against the French franc (100CFA=1FF) was provided by the French Treasury through an operation account, where overdrafts were potentially unlimited (Masson and Pattillo, 2000). Since 1999, the CFA franc has been pegged to the Euro via its French franc peg. This change leads to questions concerning the guaranteed convertibility of the CFA franc by France; the economic impact of the 72

3 EMU on the real effective exchange rate of the CFA franc; the external competitiveness of the CFA franc zone; and how the EMU will affect the ongoing efforts by CFA franc countries to enhance their regional economic and monetary integration. Carre (1997) and other authors argue that the EMU will not cause any substantive change in the CFA franc arrangements, except for the replacement of the peg against the French franc with a peg against the Euro. Carre notes that the convertibility of the CFA franc is provided by the French Treasury and not by the French central bank, and that the budgetary rather than monetary nature of the arrangement makes it compatible with the requirements of the Maastricht Treaty. Moreover, the CFA countries and France have indicated their intention to maintain the existing arrangements in the CFA franc zone, including the parity of the CFA franc. However, the above assessment was challenged by certain authors who suggested that the linking of the CFA franc to the Euro was an exchange rate arrangement, which under the Maastricht Treaty needed to be considered by the Council of Ministers. Besides, Hadjmichael and Galy (1997) argue that the potential economic consequences for the CFA franc countries could be positive over the longer term, given the general expectation that the creation of the EMU would be likely to result in a stable Euro, low inflation and interest rates, and stronger output growth in EMU countries than otherwise. It is generally recognised that the CFA franc zone does not meet the conventional criteria for the formation of an optimum currency area, even after some fifty years of existence. In 1994, the CFA countries decided to devalue their currency by 50 per cent, and to implement broadly restrictive incomes and credit policies, and a range of structural and institutional reforms. This policy package, with the devaluation as the critical element, has contributed to a resumption of growth in real per capita incomes in the CFA zone, and its inflation rate was brought down to single digit level by the end of 1996 (Hadjmichael et al, 1995). 73

4 The CFA zone after the devaluation During the period of , the economic and financial situation of the CFA zone deteriorated as a consequence of two major shocks. First, the zone s terms of trade deteriorated by about fifty per cent during the half of the 1980s, owing mainly to a sharp drop in world market prices for its major export commodities, principally cocoa, coffee, cotton, and petroleum. Secondly, the external competitiveness of the zone weakened further as a result of the market appreciation of the French franc against the currency of the zone s other major trading partners. At the same time, the zone was increasingly handicapped by a number of structural and sectoral rigidities, particularly high unit labour costs. Under these shocks, the zone s attractiveness to foreign investors diminished substantially, despite the advantage of stable prices and exchange rates, and capital flight increased appreciably. Thus, in 1994, the fourteen African member countries of the CFA franc zone decided collectively to broaden their adjustment strategy through a large change in the parity of their currencies. The CFA franc countries also decided to strengthen their efforts towards economic integration. But a perceived need to preserve the special economic and political links to France appears to have dominated the decisions of policymakers in the CFA franc zone, at the cost of regional economic considerations. These links to France help in part to explain the protracted process of reaching a consensus on the need for a devaluation of the CFA franc (Hadjmichael and Galy, 1997). The latter author pointed out that the devaluation enforced the efforts to rationalise economic decisions within the zone and to give prominence to economic considerations over political ones. The CFA franc was devalued by fifty per cent in foreign currency terms, from CFA 50 to CFA 100 per French franc. The size of the parity change was determined on the basis of several indicators of the extent of the overvaluation of the CFA franc, including the evolution of the real effective exchange rate, the magnitude of the deterioration in the terms 74

5 of trade, and the need to restore domestic and external equilibrium in the medium term. The challenges facing the CFA franc countries after the devaluation were concerned with how to translate these early economic successes of the zone into long-term gains. The strategy adopted in the wake of the devaluation focused on the management policies that are consistent with the new level of the exchange rate anchor, with low inflation, and indicated that supply side actions are conducive to a generation and allocation of resources that will place the countries of the zone on a sustainable growth path (Clement, 1997). In addition, complementary structural reforms, at both the national and regional levels, need to be accelerated to create an environment that fosters private initiative, unlocks the potential for economic diversification, and thus raises the rate of growth of potential output. In particular, the removal of impediments to intrazone goods and factor mobility should buttress the countries resilience regarding external shocks The Common Monetary Area (CMA) or Rand Monetary Area (RMA) Background The present close monetary cooperation between South Africa, Lesotho, Namibia and Swaziland is based on the multilateral Monetary Agreement (MMA), creating a Common Monetary Area between these countries. This agreement has had a long historical development, which started even before the Union of South Africa was formed in After the establishment of the South African Reserve Bank (SARB) in 1921, the South African pound became the sole circulating medium and legal tender in the geographical area that is today called the CMA, but then including Bechuanaland (Botswana). 75

6 After protracted negotiations, a formal agreement was signed in 1974 between South Africa, Swaziland and Lesotho, known as the Rand Monetary Area agreement, and the rand remained legal tender in all these countries. The Common Monetary Area (CMA) replaced the RMA in July 1986 under the terms of a Trilateral Monetary Area Agreement between the three countries, accommodating changes in the position of Swaziland. This trilateral agreement was replaced by the present MMA in 1992, when Namibia formally joined the CMA, of which it had been a de facto member from the beginning Objectives of the MMA The main objectives of the MMA can be summarised as the sustained economic development of the CMA, with special emphasis on the advancement of the less developed member states and the obtaining of equitable benefits for all members. It is particularly interesting to note that the MMA recognises that each of the contracting parties is responsible for its own monetary policy and the control of its financial institutions Achievements of the CMA One of the greatest benefits of the CMA arrangement is that it provides price stability in the domestic economy. By pegging the domestic currency to the currency of a low inflation country (South Africa), its ability to maintain price stability is enhanced, provided that there is a strong commitment on the part of the authorities to maintain the exchange rate. The arrangement constrains monetary expansion, restrains excessive government spending, and sends out credible signals to private agents about prospects for inflation. As stated by Mr Alweendo, the Governor of the Bank of Namibia at the twenty-fifth anniversary of the CMA, since 1993 the domestic inflation rate in Namibia has closely mirrored the prevailing rate in South Africa. 76

7 Another major achievement of the CMA is that it helps to avoid exchange rate fluctuations and reduces the unfavourable effects of exchange rate uncertainty on trade and investment. Mr Alweendo adds that South Africa is Namibia s main trading partner; a major benefit of CMA membership for Namibia is the eliminating of uncertainty associated with exchange rate variability. Since Namibia is a net importer of goods and services from South Africa, the benefits derived from the CMA membership may in this respect be large The East African Currency Board (EACB) Background The East African Currency Board (EACB) was the continuation of a monetary arrangement set up by the British colonial power in Kenya, Tanzania, and Uganda. Although the statutes of the EACB did not specify a legal minimum for reserves, convertibility for the East African shilling issued by the EACB was ensured by a 100 per cent reserve cover. Gradually, the EACB assumed the lending functions of a central bank. It was also authorised to back a small portion of its foreign reserves with East African government securities denominated in East Africa shillings, and possibilities for the EACB to lend to government and the private sector were gradually increased in the 1960 s. After the withdrawal of the British government from direct involvement with the Board in 1960, the governance structure of the EACB was changed radically to fit in with the new environment of independent member states. Though there is no record of written voting rules, in practice the representatives of each country held a veto over EACB decisions Monetary policy after the break-up of the EACB Following the break-up of the EACB in 1966, all three East African countries initially retained their fixed peg to the sterling as well as full 77

8 current account convertibility, but they soon abandoned the fixed peg following sterling s devaluation against the dollar in 1967 (Stasavage, 2000). The new national central banks were not independent, because ministerial representatives had substantial influence on their governing boards, but each government did establish rules to either limit central bank lending to governments or to specify a minimum level of reserves. The Kenyan central bank statute adopted a limit on central bank credit to government that was only slightly higher than its limit under the EACB. The Bank of Uganda Act limited direct advances to 15 per cent of estimated current revenues for the financial year in which the advances were made, and all advances were to be repaid within three months. The Bank of Tanzania Act limited the direct purchase of government securities to 25 per cent of the government s average annual current revenues over the preceding three fiscal years. In addition, the Bank could make advances to government equivalent to a maximum of 20 per cent of its revenues, but any advances had to be repaid in full within 300 days. The 45 per cent of revenue that could be loaned through these two facilities was greater than Tanzania s fiduciary limit under the EACB but contrary to the EACB rules were of limited duration. Following the dissolution of the former EACB, countries in East Africa negotiated a Treaty that established the East African Community in One of the objectives is the harmonisation of monetary and fiscal policies, which would encourage the creation of a monetary union Benefits and costs of monetary union in East Africa As demonstrated in the previous chapters, in order to join a monetary union, countries must have similar or flexible economic structures to support a fixed exchange rate in the union. They must also be sure that the institutions created to carry out the common monetary policy are likely to lead to improved policies. 78

9 The benefits of a fixed rate between countries of a monetary union tend to be greater if the countries concerned already have a substantial amount of trade among them, since transaction costs and bilateral exchange rate fluctuations related to that trade will be reduced. The more asymmetric the shocks facing the countries, the greater are the costs of a fixed rate, increasing the attraction of retaining an independent monetary and exchange rate policy (De Grauwe, 1992). Countries are less likely to face large asymmetric shocks regarding terms of trade if they possess diversified economies with similar structures. In the East African region, countries have enjoyed close commercial, industrial and other ties for many years, and these governments are determined to continue and strengthen these links through the creation of the East African Common Market. Table 5.1 shows the linkages between these economies, and as Krichene (1998) suggested, prices and nominal exchange rates in the region are found to be highly interdependent to constitute an integrated trading zone. These economies are at similar stages of development, have a labour surplus, and have approximately the same productivity and wage levels. Indeed, they have an integrated transport network for merchandises and passengers, and participate jointly in a number of regional trade arrangements. They also have similar economic and international trade structures, characterised by the importance of subsistence activities, primary exports, particularly coffee and tea exports, as well as similar consumption patterns. These common features tend to support the feasibility of establishing a monetary union in the region. In general, the common market allows participants to reap the advantages of specialisation and international division of labour, and to exploit internal economies of scale. External economies of scale and forward and backward linkages between industries can also be more fully developed. 79

10 Table 5.1. Direction of trade matrix in East Africa. (In millions of U.S. dollars) Importers Exporters BUR KEN RWA TZA UGA SSA 1990 Burundi (BUR) Kenya (KEN) Rwanda (RWA) Tanzania (TZA) Uganda (UGA) Sub-Saharan Africa ,982 (SSA) 1991 Burundi (BUR) Kenya (KEN) Rwanda (RWA) Tanzania (TZA) Uganda (UGA) Sub-Saharan Africa ,253 (SSA) 1996 Burundi (BUR) Kenya (KEN) Rwanda (RWA) Tanzania (TZA) Uganda (UGA) Sub-Saharan Africa ,341 (SSA) 1997 Burundi (BUR) Kenya (KEN) Rwanda (RWA) Tanzania (TZA) Uganda (UGA) Sub-Saharan Africa ,670 (SSA) 2000 Burundi (BUR) Kenya (KEN) Rwanda (RWA) Tanzania (TZA) Uganda (UGA) Sub-Saharan Africa ,317 (SSA) 2001 Burundi (BUR) Kenya (KEN) Rwanda (RWA) Tanzania (TZA) Uganda (UGA) Sub-Saharan Africa ,588 (SSA) 2002 Burundi (BUR) Kenya (KEN) Rwanda (RWA) Tanzania (TZA) Uganda (UGA) Sub-Saharan Africa (SSA) ,706 Source: World Bank, African Development Indicators, various issues. 80

11 However, in East Africa, the uneven and inequitable distribution of industrial activity remains a major problem facing the member states. But even in the developed economies (such as the European Union), regional imbalances in the distribution of industry are common. It is therefore arguable that the essential strength or weakness of a common market is found in the policies adopted to ensure a more balanced or equitable distribution of industry if this is thought to be necessary or desirable. If one or more countries have developed industrially to a far greater extent than the other member states (Kenya and Rwanda or Burundi), and if measures are not taken to counteract this, the monetary union may face the possibility of failure or an inequitable amount of trade that will nullify the beneficial development of the union. Asymmetry of shocks for countries in East Africa whose exports are primary commodities stems from the terms of trade. These shocks are not well correlated, due to some differences in commodity exports, and the fact that the world prices of the various commodities do not move in conjunction with each other. Although most primary commodities are common to a number of countries in the region - coffee, tea, cotton, fish products - others are found in only one or two countries (petroleum in Kenya and gold in Tanzania). Rwanda and Burundi are each dependent on a single commodity - tea and coffee - for 50 per cent or more of their export earnings. 81

12 Table 5.2. Commodities exports in East Africa (In millions of U.S. dollars) Years Kenya Total exports 2,060 2,012 1,755 1,773 1,881 2,017 Coffee Tea Petroleum products Pyrethrum Horticulture Cement Soda ash Hides & skins Fruits& vegetables Other exports Tanzania Total exports Coffee Cotton Tea Tobacco Cashew nuts Fish Horticulture Mineral & metals Of which gold Manufactured goods Other exports Uganda Total exports Coffee Cotton Tea Fish products Cereal Beans Other exports Rwanda Total exports Coffee Tea Cassiterite and tin Coltan Wolfram Hides and skins Pyrethrum and Quinquina Other exports Burundi Total exports Coffee Tea Hides and skins Manufactured prod Other exports Source: IMF Country Report

13 A broader assessment of the possibility of asymmetric shocks hitting the economies of the region can be obtained by comparing production structures. Table 5.3. East African countries: Production structure in 2002 Countries Real GDP Agriculture Industry Manufacturing Services (US $ Value Value Added Value Added Value million) Added (% of GDP) (% of GDP) (% of GDP) Added (% of GDP) Kenya 10, Uganda 8, Tanzania 7, Rwanda 2, Burundi 1, Source: World Bank, World Development Indicators, The production structure is quite varied across countries. While most are heavily agricultural, the share of agriculture in the GDP in 2002 ranges from 56 per cent in Burundi to 19 per cent in Kenya. There are differences in the share of services in the GDP, between Kenya (63%), Uganda (43%), Tanzania (39%), Rwanda (38%), and Burundi (25%). Labour mobility is low between countries of the region, but there are traditional migratory and trading patterns between some countries (Rwanda and Burundi, or Kenya and Uganda) that cut across national boundaries. The East African Community (Kenya, Tanzania, and Uganda) has also facilitated mobility by eliminating visa requirements, but citizens of one EAC country seeking to establish residency in another EAC country still seem to encounter administrative difficulties. Besides, the structure of intra-regional trade (table 5.4) shows that, during the period of , intra-regional trade ranged between 3.2 per cent and 12.3 per cent of the region s imports and 7.1 per cent and 21.0 per cent of the region s exports. These ratios are important considering the asymmetric shocks that can face the region. The increase of intra-regional trade over time, both in terms of value and relative 83

14 importance, will strengthen the benefits of a fixed rate between countries in the region and reduce bilateral exchange rate fluctuation. Moreover, the composition of trade dominated by manufacture, as reflected by the predominant trade position of the relatively more industrialised countries Kenya and Tanzania, also includes primary products. This will limit asymmetric terms of trade shocks and encourage countries in the region to adopt policies that will ensure a more balanced distribution of industry if the proposed monetary union would be strong and durable. 84

15 Table 5.4. Intra-regional Exports and Imports in East Africa. Countries (In millions of U.S. dollars) Country exports to Region (1) Total country exports (2) Country imports from Region (3) Total country imports (4) (1)/(2) in % (3)/(4) in % 1990 Burundi Kenya , Rwanda Tanzania , Uganda Total for Region 333 1, , Burundi Kenya 93 1, , Rwanda Tanzania , Uganda Total for Region , Burundi Kenya 586 2, , Rwanda Tanzania , Uganda , Total for Region 667 3, , Burundi Kenya 583 2, , Rwanda Tanzania , Uganda Total for Region 621 3, , Burundi Kenya 495 1, , Rwanda Tanzania , Uganda Total for Region 591 2, , Burundi Kenya 546 1, , Rwanda Tanzania , Uganda Total for Region , Burundi Kenya 579 2, , Rwanda Tanzania , Uganda , Total for Region 641 3, , Source: World Bank, African Development Indicators, various issues. 85

16 In a monetary union, there is a mechanism that helps to cushion different shocks hitting different regions. That mechanism can be operationalised by creating a fund that would make transfers among the converging economies in the union. The fund would function as follows: countries seeking to draw on fund resources would be obliged to submit applications that would indicate their proposed measures for addressing the adjustment problems caused by shocks to their economies. For such a fund to function, the commitment of each country to help its neighbours must be strong Conditions for monetary stability in East Africa Monetary stability within a region requires an investment in building institutions capable of guaranteeing irrevocably fixed exchange rates and a single monetary policy. In creating a monetary union, governments in the five East African countries should know the implications that could result from a currency union. First, a currency union reduces nominal flexibility relative to a fixed but adjustable exchange rate. Secondly, Masson and Pattillo (2000) argue that supranational institutions may constitute an agency of restraint, so that a monetary union can improve the stability of monetary policy, provided the central bank is given the independence and instruments that allow it to achieve its objectives. Generally in Africa, national central banks are not independent of fiscal authorities that are myopic and concerned primarily with financing their expenditures. In the absence of other sources of financing, they may turn to the central bank; higher than desirable inflation frequently results. However, Barro and Gordon (1983) argue that even independent central banks may face incentives to create excessive inflation. They add that, if a central bank uses an expansionary monetary policy to attempt to correct a distortion in the economy, causing excessive unemployment, but the private sector correctly anticipates the central bank s actions, unemployment would fail to improve while inflation would rise. 86

17 According to the IMF country report (2000) on the five East African economies, all national central banks are constitutionally independent of the fiscal authorities, except the National Bank of Burundi. Burundi s government has initiated a programme of economic reform with the aid of the IMF, and one of the reforms focuses on the statute of the central bank and its autonomy from the fiscal authority. Making national banks more independent is important, since they will continue to exist and have some influence on monetary policy during the transition period preceding the creation of a supranational central bank. The latter will, in principle, provide a constraint on national central banks, making it easier for the monetary authorities to resist pressures to finance any particular government s fiscal deficit. Going in the other direction, however, member states in a monetary union may encourage governments to allow fiscal positions to get out of hand, either with the expectation that they will be bailed out, or because the costs, in terms of higher interest rates or an over appreciated exchange rate, will be shared by other countries in the union, and not internalised in the high deficit country. To avoid this, the EMU has imposed strict rules to prevent monetary financing or bailouts of governments and an elaborate procedure to prevent excessive government deficits (Masson and Pattillo, 2000). Guillaume and Stasavage (2000) consider in some detail the experience of commitment to financial stability. They argue that monetary unions can effectively provide that commitment, but only if they satisfy three conditions: (1) any exit from the union must be made costly by the loss of the other benefits of regional integration or of assistance from industrialised countries; (2) government structures must be designed to enforce monetary rules; (3) attempts by one country to break the rules of the union must be actively opposed by other governments in the union. Thus, the East African countries will be more likely to build a successful and durable monetary union if the latter is accompanied by parallel linkages and agreements that make exit costly. It will require also both carefully drafted formal rules on monetary financing and the 87

18 experience of peer pressure to ensure de facto monetary and fiscal discipline Convergence criteria towards monetary union in East Africa A high degree of economic and monetary integration requires a common currency that in turn requires macro-economic policy convergence, as shown by the European Union and the introduction of the Euro. Following the example of the above-mentioned union, convergence criteria are important for countries with different economic environments to be able to integrate and form a monetary union. To ensure the viability of any future economic union for a region, macroeconomic convergence should be achieved first. This section will examine the economic indicators similar to those used in the EMU and apply them in the context of the five East African countries current economic environment. These include gross domestic product (GDP), inflation, debt and budget deficit. 88

19 Table 5.5. Selected economic indicators of East African countries Average annual% Years Growth Kenya Population (million) 31.3 GNI per capita (US $) 360 Real GDP 9,422 9,617 9,773 9,900 9,884 9,993 10, (US $ million) Consumer price index (Index 1995 = 100) Interest rate in %*** Budget deficit to GDP in % * External debt 6,931 6,603 6,881 6,487 6,295 5,833 6,031 **6,449 (US $ million) Tanzania Population (million) 35.2 GNI per capita (US $) 290 Real GDP 5,495 5,688 5,899 6,104 6,419 6,784 7, (US $ million) Consumer price index (Index 1995 = 100) Interest rate in %*** Budget deficit to GDP in % * External debt 7,370 7,181 7,653 8,049 7,386 6,676 7,244 **7,383 (US $ million) Uganda Population (million) 24.6 GNI per capita (US $) 240 Real GDP 6,278 6,576 6,944 7,466 7,728 8,086 8, (US $ million) Consumer price index (Index 1995 = 100) Interest rate in %*** Budget deficit to GDP in % * External debt 3,677 3,878 3,912 3,492 3,494 3,733 4,100 **3,735 (US $ million) Rwanda Population (million) 8.2 GNI per capita (US $) 210 Real GDP 1,458 1,660 1,807 1,944 2,061 2,199 2, (US $ million) Consumer price index (Index 1995 = 100) Interest rate in %*** Budget deficit to GDP in % * External debt 1,043 1,111 1,226 1,293 1,271 1,283 1,435 **1,211 (US $ million) Burundi Population (million) 7.1 GNI per capita (US $) 100 Real GDP , (US $million) Consumer price index (Index 1995 = 100) Interest rate in %*** Budget deficit to GDP in % * External debt (US $ million) 1,127 1,066 1,119 1,131 1,100 1,065 1,204 **1,122 Source: World Bank, African Development Indicators, * External debt excluding grants ** Annual average ***Nominal interest rate 89

20 Gross Domestic Product (GDP) GDP is the sum of value added by all resident producers plus any product taxes (less subsidies) not included in the valuation of output. It is therefore an indication of the economic activity and development in a country. As can be seen from table 5.5, countries in East Africa are at various stages of economic development. Kenya is the largest economy in the region, following by Uganda and Tanzania. Previous studies (including that by the World Bank, 2000) on the economic situation in East Africa have suggested that Kenya has benefited to the greatest extent from the existence of the common market in East Africa in earlier Hence the higher rate of GDP, resulting in the substitution of Kenyan manufactured goods for those produced outside East Africa, has led to the other countries incurring international trade deficit. According to the same studies, the absence of cooperation in East African countries and the failure of the EAC allow foreign investors to play off one government against another in order to extract concessions regarding taxes, and labour regulations. These multinational corporations then negotiate the best subsidies, that reduce their obligation to assist national development. The removal of exchange controls within the region will most probably increase this competitive negotiation. Guillaume and Stasavage (2000) have demonstrated the above argument by showing that the performance of Tanzania and Uganda deteriorated considerably after the Eastern African Currency Board (EACB) ceased functioning in

21 Table 5.6. Economic performance in the EACB Changes ingross Inflati on Budget deficit national investment GDP growth claims on (% of GDP) government (% of GDP) (%) (% of GDP) Period EACB average Kenya Tanzania Uganda Sub-Sahara Source: IMF,International Financial Statistics. Note: Sub-Saharan Africa excludes CFA and RMA. Within the region, Kenya s economy is better developed, with a real GDP of US $10 billion in Although the industrial sector is still small (compares to that of South Africa or Egypt), it is a growing source of East African exports. The horticultural and tourism industries are growing, becoming two of the country s most important sources of foreign exchange. With a real GDP of US $ 8.8 billion, Uganda is one of Africa s examples of robust economic growth during the nineties, due to the implementation of economic reforms. In 2001, the country enjoyed foreign direct investment totalling US $ 144,7 million. Tanzania, Rwanda, and Burundi have progressed steadily since the implementation of macro-economic stabilisation and structural reform programmes in the mid-nineties. But the political violence and the war in Rwanda and Burundi have severely diminished the economic growth of these two countries Inflation According to Guillaume and Stasavage (2000), there is some evidence that the relatively good inflation performance of Tanzania and Uganda during resulted from the enforcement of the EACB s limits on lending to governments, backed up by a Kenyan veto of any increases in fiduciary limits which it saw as unwarranted. 91

22 A country that experiences a higher inflation rate, for example, in East Africa, Tanzania with 19.3% in 2001, than another country, for example, in the same region, Uganda with 9.5% in 2001, needs to depreciate its currency against the currency with lower inflation. If this does not occur, unbalanced bilateral trade results. Following the above example, the imports from Uganda will appear increasingly competitive compared with Tanzania s domestic goods, whose costs will have been driven up by the domestic inflation. The same applies to the uncompetitive Tanzanian exports to Uganda. Therefore, any low-inflation country has no incentive to join a monetary union with any high-inflation countries, because there is a strong probability that it will end up with more inflation, without any gains in terms of unemployment. Thus, if countries in East Africa want to form a monetary union, there is only one way in which a low-inflation country will join the proposed union: monetary authorities must insist on having a central bank that attaches more importance to price stability than all national central banks do today Debt Table 5.7. Debt to GDP ratio in 2002 Country Debt to GDP ratio in % Concessional Non-concessional Kenya 36 2 Uganda 59 4 Tanzania 61 4 Rwanda 75 0 Burundi Source: World Bank, African Development Indicators, All five countries in East Africa have a debt to GDP ratio of more than 30 per cent, with Burundi experiencing a very high ratio of 148 per cent, due essentially to the political violence and the war. 92

23 According to Zuma (2002), it is estimated that Africa for the next fifty years will be paying off its debt to the first world countries and their private institutions. In that case, resources for development of education, health and infrastructure will not be available. In the fall of 1996, the World Bank and the IMF proposed the Heavily Indebted Poor Countries (HIPC) initiative in order to reduce the external debt of the world s poorest, most heavily indebted countries. All the East African countries are part of the initiative. Under the enhanced framework of the HIPC, the benefits of exports and central government revenue will accrue fully to the country, allowing for greater investment in poverty reduction strategies (World Bank, 2003). Certain prerequisites would need to be enforced to ensure that relief is constructive for both the lenders and the borrowers. Countries would also need to qualify for this debt relief; the danger is that these countries will not take active measures to reduce this debt, but will rather rely on the sympathy of the industrialised world. Following the EMU convergence criteria on the debt to GDP ratio target of 60 per cent, applying them to the five East African countries, except Rwanda and Burundi, the remaining countries do qualify to form a monetary union. However, Rwanda is within shouting distance of the target. The high ratio in Burundi can be attributed to the war that affects the country. Compared to the situation prevailing in the EU one year before the launching of the Euro, only three countries out of fourteen, namely France, Luxembourg and Finland, successfully reached their target. This represented only 21 per cent of the countries in the region Budget deficit Guillaume and Stasavage (2000) state that the relatively good fiscal performance of Tanzania and Uganda in the former EAC resulted from the EACB s limits on lending to government. The Tanzanian government was forced to scale back certain investments (IMF, 1963) and the 93

24 Ugandan government found itself in periodic borrowing difficulties with the EACB. After the failure of the EAC in 1966, the Ugandan government modified the statute of the central bank to suit the government s increased demands regarding both current and capital expenditures. In Tanzania, increased domestic financing of the socialist economic development programme was made possible by nationalising the banking sector and by grouping of existing commercial banks within the National Bank of Commerce (NBC). Credit extended to the public sector by the state-owned NBC by 245 per cent in real terms during (Stasavage, 2000). There were some obstacles to Tanzania s and Uganda s exit from the EACB. Tanzania hoped to extract concessions from Kenya in the form of subsidies or, at a minimum, through the allocation of rights to produce certain industrial products in exchange for maintaining free trade. Members of Uganda s government also hoped that economic federation with Kenya might provide access to more development finance. The problem for the sustainability of the EACB was that Kenya was ultimately not willing to agree to these sorts of regional subsidies (Stasavage, 2000). Table 5.8. Government deficit/surplus to GDP ( per cent to GDP) Countries Kenya Uganda Tanzania Rwanda Burundi Source: World Bank, African Development Indicators, various issues. During the years 1997 to 2002, all five countries in East Africa experienced a budget deficit, as shown in Table 5.8. Kenya and Tanzania had a favourable budget position in 1999, consecutive to grants received by their governments of 1.2% and 13.7% to GDP respectively. 94

25 Budget deficits are seen to be chronic in Africa in general and in East African states particularly. This structural budget problem may only be solved by reducing government expenditures or by relatively slower growth. Compared to the EU criteria two years before the launch of the Euro, except for Greece the remaining countries were within the shouting distance of 3 per cent limit target budget deficit to GDP. As said previously, 60 per cent of debt to GDP limit was difficult to realise for most European countries. Belgium and Italy, both now European Union members, were both over twice the limit. Applying the criteria of 3 per cent limit target to the five East Africa states, all qualified in 2001, but only Kenya and Burundi were within the limit in Obviously, both debt and budget deficits will more easily continue once monetary union occurs Payment system in East Africa The payment system is a vital link between the financial system and the real sector of an economy. Sustainable economic growth requires a wellfunctioning, efficient and reliable clearing and payments system to lubricate local and international business transactions, by providing liquidity in the financial system. The payment instrument in the five East African countries is predominantly cash. The predominance of cash for transaction purposes increases the volume of currency in circulation and high-powered money, which renders monetary control difficult, in some cases impossible. In this respect, the five countries in East Africa seek to foster the stability of the financial system by ensuring the integrity of the payment system. To that end, their central banks are presently engaged in strengthening the legal and regulatory framework necessary for the soundness and international/regional compatibility of the payment system. In 1998, the East African National Payment System Harmonisation Committee (Kenya, Tanzania, and Uganda) was formed 95

26 with a view to coordinate and harmonise payment system developments within the region. The overall objective of the East African Payment System is to promote a sound regional payment system in order to further economic integration within the East African region Payment system in Tanzania The payment system in Tanzania is rudimentary, with a high level of the money supply being tied up in the payment system. The phenomenon has led to large amounts of money not being involved in the production of goods and services. The Bank of Tanzania, in collaboration with the banking system, has initiated the National Payment Systems (NPS) Development Project, which aims at developing the current payment systems into a modern and efficient payment system. The NPS vision is to have in place an efficient customer centred payment system by the year As the existing payments are mainly cash based, most transactions and payments are effected outside the banking system. This has resulted in a huge amount of currency in circulation, thus increasing transaction costs due to immobility and the costs of printing and distribution. According to the Bank of Tanzania (1999), financial deepening (M2/GDP) has stood at about 30 per cent during the 1990 s, with cash accounting for roughly 40 per cent of the total bank payments, followed by cheques, estimated to account for about 80 per cent of all commercial bank paper based payments in the country (the informal sector not included). Banking coverage of the population, per branch, is poor with a total of 14 banks in existence. The largest commercial bank controls about 60 per cent of the country s deposit money and handles approximately 80 per cent of the total volume of cheques. Daily intra-bank cheque volume was estimated to be items in Before January 2002, interbank clearing was manual, with netting at the end of the day, for settlement via clearing accounts held at the central 96

27 bank. Interbank clearing in the cities, within the clearing houses latitudes, is done in three days with a maximum of 28 days for remote clearing. Some banks use SWIFT mainly for transferring international funds. While SWIFT transfer can take up to three days before the beneficiary s account is credited, other means such as telegraphic transfers can take weeks before the Tanzania shilling cover is provided, even after payment has been cleared. In the quest to achieve efficiency in the processing of payments and settlements, the Bank of Tanzania has implemented the Electronic Clearing House System to facilitate interbank electronic debit clearing. Indeed, members of the Clearing House have installed the Magnetic Ink Character Recognition (MICR) equipment for processing paper encoded payment instruments. This aims at reducing the number of fraudulent items passing through the banking system by providing electronic images of instruments passing through the MICR system. Changes from the old system include reduction of the number of days taken to clear instruments, from five days and thirty days within the locality of clearing houses and inter-regional clearing to two days and seven days respectively Payment system in Kenya The Central Bank of Kenya (CBK), aware of the numerous benefits of an efficient payment system, especially in its role in the effective implementation of monetary policy operations and financial stability, is jointly collaborating with the Kenya Bankers Association in coordinating the modernisation and reform programme of the payment system in Kenya. Kenya is rich in type and sophistication of its financial institutions, and in the depth of its financial assets compared to most Sub-Saharan African countries (IMF report, 1999). The financial system of Kenya comprises one central bank, 48 commercial banks, 40 forex bureaus, 13 97

28 non-bank financial institutions and two mortgage finance companies. There is also a large number of non-bank financial institutions, a segment comprising four building societies, 37 insurance companies, 57 hire-purchase companies, and some 2670 savings and cooperatives credit societies. Cash is the most important form of payment because it is readily accepted, has no need for authorisation and provides instant value. The cheque is the main paper based mode of payment, accounting for 48 per cent of non-cash payments. In the year 2000, the average daily volume of cheques cleared through the Nairobi Clearing House amounted to 1,127,090 cheques or Kshs 10.1 billion. Kenya is currently on a two-day clearing period for high value payments (Kshs 10 million and above) and a three-day clearing period for low value payments. The use of payment cards has taken a significant leap within Kenya s non-cash payment instruments segment: credit cards, debit cards, and pre-paid cards. The credit card is the most common on this category, although debit cards are taking root very fast. Only 20 out of 48 banks are members of the SWIFT. The central bank is encouraging banks to use SWIFT for high value payments. Since membership is costly, the central bank is encouraging non-swift banks to utilise a secured SWIFTderivative (bureau), called the African Commerce Exchange (ACE) Facility, which supplies the full range of SWIFT services at a lower cost. The CBK provides clearing and settlement services on a net multilateral arrangement at the Nairobi Clearing House (NCH), which is domiciled at the central bank. The modernisation and reform process within the economy of Kenya is being spearheaded by the National Payment System Operations Committee at the central bank, and on a regional basis, there is the East African Payment System Harmonisation Committee as showed above. The clearing and settlement arrangements are undertaken by bank representatives and cheques are physically exchanged and data computed to produce settlement figures by a.m. local time. The second 98