Lessons from the Euro debt crisis Part IV

As was pointed out in the previous article, the East African Community (EAC) does not meet one of the principal criteria for Optimum Currency Area-Plus (OCA-P) that is; high degree of economic interdependence (trade integration) and openness. And although this may be achieved in the medium term, a monetary union would be void if trade integration is less than optimum. A common currency in low levels of trade integration only serves to create imbalances and economic disequilibrium among Partner States as it will lead to negative productivity among ‘weaker’ states, and higher rates of unemployment, which would retard growth among the same states. However, a paramount condition for an OCA-P is macroeconomic convergence. The concern over macroeconomic convergence is premised on the fact that, asymmetries of shocks, macroeconomic performance, and policies may negate a common monetary policy. According to OAC-P model on which monetary unions world over benchmarked their roadmap to a common currency, macroeconomic convergence is not only a precondition for a currency union, but also a permanent criteria for such a union to be successful. The main macroeconomic convergence fundamentals include low levels of inflation, low interest rates, sustenance of low levels of public debt deficit, debt ratios below agreed limits which do not bring imbalances in the economy and finally, stable exchange rates. For instance, inflation differentials within member states signal differentials in the conduct of economic policies, which would be a serious problem in a currency union. It is assumed that, low inflation rates should reduce long-term interest rates and by extension stimulate sustained economic growth and competitiveness through price flexibility. Nonetheless, inflation is a common economic fundamental among low income countries, especially under high growth episodes. Under these high growth episodes, demand for credit is high and so is demand for goods and services and this only worsens inflation. Given that all EAC countries are in their developmental states, it is expected that, inflation rates will not be low. Growth and inflation have a correlative relationship and it is only the intervention of monetary authorities, mainly the central bank that tames inflation under these conditions. Once economies reach a developed state, inflation rates lowers, and so is their growth rates. Until inflation have converged to low levels, currency union does not make economic sense. Also countries envisaging a monetary union, must maintain budgets which are close to balance or in surplus. During the down turn, they must nevertheless keep budget deficits below the conventional level accepted as a healthy economic fundamental i.e below 3 per cent of their GDP.Yet budget deficits incurred to finance growth is presumed prudent in as long as GDP posted generates sufficient cash flows to offset the deficit. Since EAC member countries have different levels of economic development, capacities and priorities that translate into different levels of interest and thus readiness for economic integration. Monetary integration implies less control over national monetary as well as fiscal policy to stimulate the economy, and this stifle attainment of intended growth targets enshrined in various member countries development plans/visions. Convergence of macroeconomic fundamentals as pointed above, requires a long history of monetary discipline among member states, which is not the case for a number of EAC partner states, going by all macroeconomic indicators, which are so erratic that, they are indicative of serious monetary indiscipline.Unfortunately, monetary indiscipline is driven by political elite, in most cases for the sake of their personal interests rather than national interests. This stifles the real economic sectors. Therefore, drawing from European Monetary Union (EMU) which imposed restrictions on inflation, long-term interest rates, exchange rate stability, budget deficits and public debt, EAC has set criteria (2011-2015) that includes: overall budget deficit-GDP ratio of not more than 5 per cent excluding grants, and 2 per cent including grants, annual inflation not exceeding 5 per cent, six months import cover, maintenance of market-based interest rates, sustained real GDP growth of 7 per cent, debt sustainability, domestic savings-GDP- ratio of at least 20 per cent, and maintenance of sustainable level of current account deficit excluding grants. Nevertheless, as much as the monetary union project is a political project, criteria set are even more political and unrealistic to meet, at least in the period (road map) specified by EAC.For instance, real GDP growth of 7 per cent and domestic savings growth of 20 per cent are influenced by prudent policies designed and implemented with vigour, and not attained by political rhetoric nor controlled by the governments. Moreover, it is rather odd to set budget deficit with/without grants, since the amount of foreign aid received by EAC governments affects the difference. And although the criteria set is 6 per cent excluding grants, and 3 per cent including grants, in general, a number of member states of EAC receive large amounts of foreign aid too large for achieving the target deficit excluding grants. These cash flows are necessary for achieving developmental targets and given the stages of development of EAC member states which require the same, limiting these at this stage of development is rather counter-productive. Even then, the current the euro crisis exposed political misjudgments that over-ridded economic realities especially with regard to monetary as well as fiscal discipline of some of the euro zone members. These mistakes in the euro project has now cost the entire projects billions of Euros in sunk costs, but the highest cost is the future of the project which many euro-skeptics economists are now imputing.Even with the political misjudgment in the euro project, it took 40 years of serious testing of monetary as well as fiscal discipline before a monetary union was launched. The roadmap for EAC common currency might be longer than it currently seems to be. For instance according to the International Monetary Fund (IMF), Rwanda is expected to receive grants of 10 per cent to GDP until 2015 to finance her development agenda. It is thus in our interest as a country to change this criteria by removing or downgrading the deficit that excludes grants. In addition, the volatility in foreign exchange rate regimes among EAC States has been so high that, expecting a stable exchange rate regime in the short-run is academic. Volatilities between EAC currencies ranged between 9 and 35 per cent with an average of 15 per cent over the last five years. And, there are signs that this may be the case in the medium term. Expecting EAC member States to meet convergence of nominal exchange rates in the roadmap is a political intent utmost. Furthermore, the issue low interest rates of 5 per cent for all EAC is antithesis of the present reality in all EAC member states, a criteria that remains another political intent void of reality for some time to come. In EAC, interest rates range from as ‘low’ as 16 per cent and as high as 32 per cent. Also expecting these to fall to 5 per cent is a political wish. The other criteria is achieving inflation rates of below 5 per cent across board. The reality is, for the last five years, inflation rates have hit ceilings with some EAC countries posting inflation rates of up to 32 per cent with Rwanda recording the lowest rate at 5 per cent for Rwanda (as an exception).But this points out to an earlier observation of monetary indiscipline among some EAC member states, indiscipline that is close to a culture. The issue of monetary convergence for EAC remains a political intent and as such, EAC is not compliant to OCA-Plus, and therefore not an optimum currency area. In all, EAC member states fail to satisfy two major principals, OCA-Plus criteria, that is Trade Integration (High degree of economic interdependency and openness) as pointed out in Part III of these series. Two, the Monetary Convergence in the short run. This as argued in the previous article requires rethinking of the existing road map to monetary union if we are to avoid mistakes in the euro zone.

Insight

Lessons from the Euro debt crisis Part IV