A Basket Currency for the EAC: Possible Advantages and Issues By Paul R. Masson, Monetary Union Advisor, Rwanda, funded by TradeMark East Africa September 24, 2012 I. Introduction Creating a monetary union for the East Africa Community requires extensive institutional preparation as well as convergence among the region s economies. The experience of the euro zone shows the need for putting in place adequate safeguards against excessive fiscal deficits and debt. Despite a long period of institution building and many resources invested in preparing the monetary union, the euro zone currently faces a crisis that threatens its continued existence. Given that the EAC is at a much earlier stage in regional integration than was the European Union at the time of the signing of the Maastricht Treaty, it is unlikely that the EAC could create a full-fledged currency union that was effective in creating a zone of monetary stability in much less than a decade. Given the long lead time, there may be some interest in creating a regional currency that would circulate alongside national currencies while providing some of the benefits of a common currency. In what follows, a scheme is described for introducing a new currency in the form of notes and coin, whose value would be defined in terms of a basket of the five EAC currencies. Introducing such a regional currency could hasten the process to monetary union, as it could be a precursor to the single EAC currency and serve as testing ground for it. In the meantime, it could serve as means of payment for cross-border trade and payments, would familiarize the public with the benefits of monetary integration, and would encourage coordination of EAC monetary policies. In the sections that follow, the method for introducing the currency into the regional economy is first described, its potential advantages are discussed, followed by a section considering some of the pitfalls of introducing a common currency in this fashion. A final section suggests how to move forward with such a scheme. II. The mechanics of its introduction A full monetary union necessarily involves a regional central bank with responsibility for monetary policy, and a single currency that circulates freely within the zone. Since all countries would borrow in that currency, countries incurring excessive debts would imperil the monetary 1
policy and solvency of the whole region. The regional central bank would need to be given the independence to be free of pressures to provide monetary financing, backed up by strong regional institutions that prevented fiscal policies from incurring excessive deficits. A monetary union with inadequate safeguards in this regard would risk producing a weak currency and high inflation, as well as leading to fiscal crises. However, a common currency that circulates alongside existing national currencies need not produce these perverse incentives nor require such exacting institutional safeguards provided it does not create additional liquidity. A way of ensuring that no liquidity is created is to give the task of issuing the regional currency to a currency board that is obliged to back its issuance of the new currency (let us call it the EACU) by its holdings of the existing national currencies. Thus, an increase in liquidity in EACU would be offset by a decline in national money supplies. Like the IMF s Special Drawing Right (SDR) and the European Currency Unit (ECU), the EACU would be a basket currency, composed of a certain number of Kenyan, Tanzanian, and Ugandan shillings, and of Burundi and Rwandan francs. However, unlike those other basket currencies, the EACU would take a tangible form, and EACU notes and coin would circulate. At any given time, the EACU s value (say against any of the local currencies) would be determined by the exchange rates of its five component currencies. The public would not be obliged to hold the new currency: the exchange of their existing national moneys into EACU would be done on a voluntary basis with perhaps some restrictions on the amounts exchanged. Thus, the public s gradual acceptance of the new currency would provide a test of the ultimate monetary union project. A. An example of an EACU basket For purposes of illustration, let us use GDP shares to calculate the weights of the five national currencies in the East African Community s currency basket. The following table reproduces the calculation of the number of units of each of the currencies in the EACU basket by Adam et al. 1, and uses 2010 GDP figures and currency values for December 31, 2010. By construction, the exchange rate between the dollar and EACU on December 31, 2010, is exactly 1.000, so the EACU exchange rates for that day are identical to the respective dollar exchange rates. Thus, if someone wanted to trade Rwandan francs for EACU on that day, he or she would have to provide 594 francs to acquire each EACU. Introducing the EACU in this fashion would not require exchange rates to be fixed among the five EAC currencies; instead, it is assumed that exchange rates would fluctuate, as they do now. Consequently, the EACU s value would reflect the exchange rates among them, and hence would vary from day to day. 1 Christopher Adam, Pantaleo Kessy, Camillus Kombe, and Stephen O Connell, Exchange Rate Arrangements in the Transition to East African Monetary Union, International Growth Centre, London, April 2012. 2
The table also presents the exchange rates for June 30, 2012. Now, dollar and EACU exchange rates are no longer identical, because the currency basket has depreciated by a little more than 5 percent against the dollar since the end of 2010: the EACU is now worth only $0.94292. As a result, though all five currencies have depreciated against the dollar, the Rwanda and Burundi francs and the Kenyan shilling have appreciated against the EACU, while the Tanzanian and Ugandan shillings have depreciated. Now, it would cost only 577 Rwandan francs to acquire an EACU. Table 1. An EAC Currency Unit share of EAC GDP dollar No. of currency dollar EACU country in 2010 Exchange rates units in basket Exchange rates Exchange rates (Dec. 31, 2010) (June 30, 2012) (June 30, 2012) Burundi 2.05 1232.50 25.266 1435.55 1353.61 Kenya 39.9 80.75 32.219 84.23 79.43 Rwanda 7.15 594.45 42.503 612.43 577.47 Tanzania 29.29 1455.15 426.213 1568.91 1479.37 Uganda 21.61 2308.30 498.824 2472.36 2331.25 source: Adam et al., table 2, and author's calculations. The following chart gives a longer perspective on fluctuations of the Rwandan franc and the EACU against the dollar. It can be seen that, by chance, the EACU and RWF have depreciated by about the same amount against the dollar since 2001. The EACU exhibits somewhat greater month-to-month volatility than the franc, because Rwanda s managed float dampens some of the fluctuations in the EACU that reflect the greater flexibility of its other components, in particular the Kenyan shilling. 3
2001M1 2001M7 2002M1 2002M7 2003M1 2003M7 2004M1 2004M7 2005M1 2005M7 2006M1 2006M7 2007M1 2007M7 2008M1 2008M7 2009M1 2009M7 2010M1 2010M7 2011M1 2011M7 2012M1 EAC currency/$, Dec. 2010=1 Chart 1. Exchange Rates of the EACU and RWF against the USD 1.4 1.2 1 0.8 0.6 0.4 0.2 0 EACU Rwandan franc In fact, the month-to-month fluctuations of the exchange rate against the dollar are lower for the RWF than for any of the other four currencies: its standard deviation is the lowest of the five, and hence lower than that of the EACU itself. However, the EACU is less volatile than any of the other currencies, partly because some of the fluctuations of national currencies are in opposite directions and offset each other. Table 2. Standard deviations of monthly percent changes in USD exchange rates, 2001M2-2012M6 Burundi Kenya Rwanda Tanzania Uganda EACU 2.83% 2.52% 0.57% 2.03% 2.81% 1.63% B. Exchange of national currencies for the EACU would be done on a voluntary basis A community institution in the form of a currency board, or monetary institute (let us call it the EAMI) would be charged with issuing EACU notes and coin in exchange for EAC national currencies tendered by the public. It would not be a central bank, since it would not operate its own monetary policy nor have any discretion over the composition of its assets or liabilities. Instead, it would be tasked with doing the exchange of national currencies into and out of EACU, at a rate of exchange dictated by the value of the currency basket. The costs of doing the transactions with the public (e.g., bid-ask spreads or commissions) would be decided jointly by EAC countries, and should be set low enough that the public was encouraged to acquire the new currency. 4
C. The EAMI would not create new liquidity It would hold national currencies as backing for its issuance of EACU, so it would sterilize the liquidity in national currency that was exchanged into EACU. Thus, the EAMI s balance sheet would look as follows: Assets Liabilities Holdings of: Burundi francs Money supply in EACU Kenyan shillings Net worth Rwandan francs Tanzanian shillings Ugandan shillings Other assets It is important to note that the EAMI would not be perfectly hedged. Its assets would be given by the decisions of the public in each of the five EAC countries to tender their national currency for EACU, while its liabilities in EACU would correspond to the proportions (by value) of the five currencies in the EACU basket. At the time they were exchanged into EACU, the national currencies tendered would equal the value of the EACU acquired, but exchange rates could change subsequently, generating a capital gain or loss for the EAMI. Consequently, it would have to have a capital buffer, indicated above as net worth. Initially, the EAMI could be given a certain amount of capital as a buffer. This would appear on its balance sheet as positive asset holdings of other assets. We will assume that it is given the equivalent of 10 EACU at the beginning of the day of December 31, 2010, when it begins operations: Initial Assets and Liabilities (values in EACU) 0 Burundi francs Money supply in EACU=0 0 Kenyan shillings Net worth=10 0 Rwandan francs 0 Tanzanian shillings 0 Ugandan shillings Other assets=10 Suppose now that the residents of each of the five countries collectively decide to acquire 10 EACUs of the new currency, using their national currencies to do so. From Table 1, they would need to tender 12,325 Burundi francs, 807.5 Kenyan shillings, 5,944.5 RWF, 14,551.5 Tanzanian shillings, and 23,083 Ugandan shillings to do so. So now the balance sheet of the EAMI looks like the following: 5
Assets and Liabilities at end 2010 (values in EACU) 12,325 Burundi francs=10 EACU Money supply in EACU=50 807.5 Kenyan shillings=10 EACU Net worth=10 5,944.5 Rwandan francs =10 EACU 14,551.5 Tanzanian shillings=10 EACU 23,083 Ugandan shillings=10 EACU Other assets=10 Suppose that there are no further conversions into or out of EACU. Then at end June, 2012, the EAMI s asset holdings would have been subject to valuation effects (see Table 1) that led to the following balance sheet: Assets and Liabilities at mid 2012 (values in EACU) 12,325 Burundi francs=9.11 EACU Money supply in EACU=50 807.5 Kenyan shillings=10.17 EACU Net worth=9.3 5944.5 Rwandan francs =10.29 EACU 14551.5 Tanzanian shillings=9.84 EACU 23083 Ugandan shillings=9.90 EACU Other assets=10 Thus, because the proportions of currency holdings do not correspond to their relative shares in the EACU basket, the EAMI is exposed to currency fluctuations and in this case makes a small loss on its holdings and this leads to a decline in net worth. However, the valuation changes on other assets have been ignored, as if they were held in EACU denominated assets, which is unlikely. If, instead, these were held in USD, then their appreciation (see Table 1) would roughly offset the small loss on EAC currencies: $10 of dollar assets would now be worth 10.6 EACU so the net effect on net worth would be a decline of only 0.1. Of course these calculations are only meant to be illustrative; more extreme mismatch scenarios are certainly possible. D. To be attractive, the EACU should have legal tender status, at least for cross-border trade and tourism The main advantage of the EACU with respect to national currencies would be to save on the costs of making cross-border transactions within the EAC. Hence, it could be particularly useful for those purchasing goods from another country or travelling within the EAC, provided that the EACU were generally accepted. If in widespread use, it would eliminate the need to convert between national currencies, and it could substitute for the dollar in some transactions. In time, it might also serve as a vehicle for cross-border investment. A currency becomes more useful the more it is used it is subject to network externalities. This means that unless others are willing to accept it, the new currency will not be viewed as serving the purpose of means of payment. Thus, governments need to take measures to 6
stimulate its initial use. These measures should include making the currency legal tender in the five EAC countries, and conducting a sensitization campaign to encourage the use of the new currency. Making the currency legal tender would mean that it would have to be accepted in settling amounts owed though legal tender status could be limited to particular uses, e.g. tourism and cross-border trade. A campaign to inform the public of the advantages of the new currency would help stimulate its use and make it generally acceptable. E. The EAMI should be paid interest on its holdings of national currencies An interest rate that could be linked to the market interest rate on government bonds of a specific maturity would be paid by the issuing central banks on the EAMI s holdings of each of the national currencies. This would have two purposes. First, the interest paid would provide the EAMI with income to cover its operating costs and to compensate it for the risk of currency fluctuations. Second, by forcing national central banks to pay interest, thus forgoing seigniorage (i.e., interest-free borrowing) when the public traded in their money for EACU, it would provide an incentive for countries to run disciplined monetary policies. A country whose currency depreciated continually against the others would be more likely to see it converted into EACU, which would hold its value better. This would mean that interest payments to the EAMI would increase, which would in time likely lead the central bank to take measures to limit the depreciation of its currency. III. Advantages of introducing the EACU basket currency A. It could be done without much of the institutional preparation necessary for full monetary union The safeguards embodied in a currency board (full backing of liabilities by its holdings of national currencies, albeit with some exchange rate risk) do not require additional surveillance over fiscal policies, nor would the EAMI need the expertise of a full regional central bank. The EAMI would not undertake monetary policy operations, but just passively exchange EACU for national currencies. Its assets would consist of holdings of national currencies, so its operations would be simple and its staff could be kept small. B. It would save on the cost of transacting across EAC borders and on holdings of dollars (or other international currency) As noted above, if the EACU were in widespread use it would deliver many of the benefits of a monetary union, in terms of lower costs of making transactions across borders. By avoiding having to acquire dollars (or other international currency) for some of these transactions, it would in effect transfer seigniorage away from the US Federal Reserve to the EAMI. 7
C. It would involve the public in the transition to monetary union by providing a visible symbol of regional integration A long delay in implementing the planned monetary union might discredit that project. A regional currency could be an important symbol of the commitment to monetary union, and make the public familiar with the idea of a regional currency. It would help to develop public support for regional integration. D. It would tend to discipline national monetary policies Countries whose currencies exhibited trend depreciation against the others would be more likely to be converted into EACU. Since that country s central bank would then have to pay interest on those holdings to the EAMI, it would lose seigniorage. This would provide some incentive to limit depreciation by tightening monetary policy. Thus, monetary policies would tend to converge, even without explicit coordination among central banks. Coordination could of course proceed in a number of areas anyway, including perhaps a mechanism for limiting exchange rate fluctuations. IV. Possible issues and how to address them A. Allowing the public to freely exchange between national currencies and EACU might encourage currency speculation and produce instability If individuals and firms could easily move out of national currencies into EACU, this might encourage speculation and interfere with monetary policies of EAC countries. It is already the case that the public can acquire dollars and use them as a store of value, at generally low transactions costs, without there being evidence that this is a major problem 2. Any residual concerns could be addressed by putting sand in the wheels that is, not making it too easy to move currencies in an out of the EACU with a short holding period. The cost of converting into and out of EACU would have to be set with an eye both to covering costs of the EAMI and to make speculation less attractive, while at the same time not discouraging use of the new currency. There could also be limits in the amounts that could be exchanged at any given time. B. The EAMI could be subject to risk of insolvency, since the currency composition of its assets would not necessarily match those of its liability (the EACU basket) The risk arises because the public s tender of national currencies determines the EAMI s asset holdings, and it is likely that more of the weaker national currencies would be tendered than of the stronger currencies. The exposure of the EAMI could be minimized by providing an adequate interest rate on its currency holdings (a rate that reflects different rates of depreciation, which 2 Dollarization is most prevalent in Tanzania, and has been a cause for concern there. See Dollarization in Tanzania: Empirical Evidence and Cross-Country Experience, IGC Working Paper, London, 2011. 8
the market rate should do), giving it a capital buffer, and perhaps by limiting the amounts it would convert (see A. above). Holding some foreign currency assets could provide a hedge against large depreciations of EAC currencies (see II. C above). C. The EACU might not catch on The EACU could be made attractive by making it legal tender and by allowing people to exchange into and out of national currencies at a low cost (or narrow spread between the exchange rate when buying or selling). A public awareness campaign should also be planned in preparation of the launch of the EACU and subsequently. The daily rate of exchange of national currencies into EACU should be publicized by national central banks as well as the EAMI, in order to inform people of its value. If despite these efforts the currency still did not catch on, then perhaps the objective of a single currency should be reconsidered. D. The EACU might become too popular, and shrink national money supplies drastically While this seems less of a risk than C, if it materialized, it might then force an early move to monetary union. It is unlikely in any case to occur before several years had elapsed years that would have allowed some of the institutional preparation discussed above, as well as giving the EAMI some experience, helping to prepare it to become the regional central bank. E. The EACU would complicate liquidity management and national monetary policies If the EACU were legal tender and came to be used widely, it might make sense to start calculating the money supply in each country to include both the national currency and the EACU circulating in the country (to the extent that this could be determined), as this would give a better idea of domestic liquidity. But increasing use of the EACU would naturally lead to thinking of a coordinated regional monetary policy, rather than national monetary policies. V. Practical issues and possible next steps A. The proposal should be carefully examined by monetary experts, including the IMF While the idea is based on two well-tried concepts, namely a basket currency (like the European Union s ECU and the IMF s SDR) and a currency board, it has some unique aspects. In particular the physical introduction of notes and coin for a basket currency is untried; and the backing of the new regional currency by national currencies (not by dollars or euros) is also novel. Ways would need to be found to limit the risks of monetary instability resulting from currency competition. It would be desirable to give all aspects of the proposal adequate scrutiny before proceeding. 9
B. How should it be reflected in the EAC s monetary union protocol? It would not necessarily have to form a part of the protocol, since even though it would be intended to pave the way for monetary union it could proceed independently of it. However, it might be desirable for the protocol to provide for the establishment of the EAMI, both as a currency board to put into circulation the EACU and as the precursor for the EAC central bank. The protocol could also specifically allow for the possibility that the EACU would eventually replace national currencies, that is, become an independent currency managed by the EAC central bank rather than a basket currency. C. How quickly could the new currency be introduced? Some changes to national legislation would be required to make the new currency legal tender, and the EAMI would have to be set up and its capital paid in. A public awareness campaign would have to be planned and put in place. In practice, these preparations would probably take a few years but considerably fewer than would be needed to achieve full monetary union. 10