Is SACU Ready for a Monetary Union?

Introduction

As regional economic communities (RECs) strive to deepen their level of integration, an increasing number are considering forming a monetary union. [1] Of the 14 RECs that existed in 2001, nine have expressed the objective of attaining a full economic union (monetary and fiscal integration).[2] In Latin America the Mercosur countries, [3] the Andean Community[4] and the Central American Common Market countries[5] have held informal discussions on their monetary union ambitions. Similar intentions have been voiced within the Caribbean Community (CARICOM)[6] for a Caribbean single currency and a proposed ‘Amero’ or NAFTA dollar in North America,[7] while the Association of Southeast Asian Nations (ASEAN) has conducted a feasibility study on a common ASEAN currency. After a trial period of several years, in 2010 the Gulf Cooperation Council launched a new plan for a currency area, to be called the Gulf dinar.[8] Of course, the European Monetary Union (EMU) has always been a prime example of reference for monetary unions, given its unprecedented scope and success.

In the Southern African context, the Southern African Development Community (SADC)[9] has established a framework for outlining procedures and milestones that need to be realised for achieving the necessary macroeconomic convergence for a unified Common Monetary Area (CMA). This form of monetary union is already active in the Southern African Customs Union (SACU), which maintains national currencies but has a unified monetary policy that is pegged to a regional anchor currency.

Studies have been conducted on the benefits of a monetary union and the use of currency areas in Africa, but little work has been done on the readiness of SACU for a monetary union, assuming it decided to upgrade the CMA. The paper seeks to contribute to filling that knowledge gap by identifying challenges or hurdles SACU may face in moving towards a monetary union. Key to this is the question of convergence. Monetary unions limit the capacity of individual states to manage their own financial affairs by centralising monetary policy, and as such a union without convergence can give rise to inappropriate policies and expose countries to damaging idiosyncratic shocks.

The paper begins with a review of the CMA theoretical framework, and a practising example of this in the form of SACU. It then analyses the possible costs and benefits that a monetary union could offer compared with a CMA. The question of the state of convergence between member states will be identified as a key determinant of the benefits of a monetary union, with this fact demonstrated by comparative case studies of EMU and the African Financial Community (CFA). The paper examines the level of convergence within SACU, and therefore its preparedness for a monetary union, before offering its final conclusions and policy recommendations.

Common Monetary Area Framework

The perceived need to fast-track regional integration has motivated a proliferation of RECs. Although RECs help to facilitate integration, they also set limits on the extent of integration. Just as free trade agreements often maintain selective barriers to trade, monetary arrangements often stop short of a full currency union. In the case of SACU, the point of compromise is the freely transferrable, pegged-currency regime of a CMA. There is increasing economic debate on the benefits and costs of such an arrangement. In a CMA, there exists a de facto or anchor currency that is accepted as a medium of exchange within the monetary area. This anchor currency is accompanied by rules that govern a CMA’s operations, such as limiting the mandate of local central banks within a CMA (notably the financing of fiscal deficits through monetary expansion, so-called quantitative easing); maintaining sound macroeconomic performance; and uniform guidelines for prospective and existing members. Other rules relate to the governance of inflation rates – both current and expected – and keeping a CMA’s internal exchange rates within the margins of the de facto currency. [10] Debates continue about the possibility of extending these rules to regulate deficits and debt, and on how to vary deficit ceilings along the business cycle.[11] Decision making under a CMA is therefore constrained by both the rules and reliance on the anchor currency. Although there are often mechanisms to promote consultation among member states, a central bank or currency board, in particular the central bank of the member state with the anchor currency, becomes the primary decision-making organ.

Box 1: Key decision-making processes and functionalities of a CMA

• Small CMA member countries have a right to issue national currencies through their respective central banks. Currencies of CMA member countries and the anchor currency are the only legal tender for the respective member countries.

• Central banks of CMA member states are required to maintain foreign reserves at least equal to their total local currencies in circulation.

• There are no restrictions on the transfer of funds, except for liquidity requirements for financial institutions.

• CMA member states are free to invest in the dominant country’s capital and monetary markets through specified securities.

• There are exchange control regulations that govern the issuing and receipt of gold and foreign exchange by authorised dealers in the CMA.

• The dominant country compensates the smaller countries for their forgone seigniorage, given that the smaller countries’ currencies are not legal tender in the wider CMA.

• There is a commission with equal representation from CMA member states consisting of technocrats and monetary authorities. The commission holds regular consultative meetings to discuss and reconcile member states’ monetary and foreign-exchange policy interests.

• Besides the commission, there is a tribunal that arbitrates disputes arising from CMA implementation.

Source: Authors’ compilation.

Interest rates of smaller countries often follow that of the anchor country’s, regardless of prevailing economic conditions, in an effort to eliminate currency mismatching.[12]

Common Monetary Area in SACU

In the case of the SACU CMA, the South African rand acts as the anchor currency, and the policies of the South African Reserve Bank (SARB) are widely influential among the CMA states of Namibia, Lesotho and Swaziland. Botswana is the only member of SACU to stand outside the CMA, instead managing its currency based on a basket of currencies, of which the South African rand holds an approximate 60% weighting. In response to a changing regional political, economic and social environment, SACU and CMA members have signed new agreements and amended old ones, as presented in Table 1.

Table 1: CMA and SACU: Major events in history

Period

Monetary agreements

Customs union

Pre-1960

Informal monetary union. Following the establishment of SARB in 1921, the South African pound became the common currency.

Arrangement became effective in 1910.

1960s

Countries became independent (except Namibia). The rand replaced the pound in 1961.

A new agreement, outlining the revenue-sharing formula, was reached on 11 December 1969.

It stipulated that the shares of the smaller members were determined based on the revenue-sharing formula, with the residual allocated to South Africa.

1974–75

South Africa, Botswana, Lesotho and Swaziland signed the Rand Monetary Area (RMA) treaty on 5 December 1974. Swaziland set up its own monetary authority and introduced its national currency, the lilangeni, pegged at par to the rand. Botswana opted to withdraw from the RMA in 1975.

 

1980

Lesotho established its own central bank and issued its national currency, the loti, at a one-to-one rate to the rand, in January 1980.

 

1986

South Africa, Lesotho and Swaziland signed the CMA Trilateral Agreement in April 1986, replacing the RMA.

 

Period

Monetary agreements

Customs union

1989

The CMA was amended to remove exchange restrictions arising from the limitations on conversion of balances upon termination of the agreement or withdrawal of one party.

 

1992–

Namibia became independent in 1990.

 

1993

The Multilateral Agreement replaced

the Trilateral Agreement when Namibia

joined the CMA in 1992. It issued its

national currency, the Namibian dollar,

in 1993.

2003

After 17 years of interruption, Swaziland re-authorised the use of the rand as legal tender alongside the lilangeni in the country.

Revised SACU Agreements and the formation of a new revenue-sharing formula with a development component.

Source: Adopted and updated from Wang JY et al., ‘The Common Monetary Area in Southern Africa: Shocks, adjustment, and policy challenges’, IMF Working Paper, WP/07/158, 2007, http://www.imf. org/external/pubs/ft/wp/2007/wp07158.pdf.

All SACU and CMA states are also members of SADC, and the future of the CMA is largely contingent on the evolving monetary integration of the larger grouping. The SADC Regional Indicative Strategic Development Plan sets out a target to realise a SADC monetary union by 2016 and a common currency by 2018. This seems ambitious, given the frameworks and institutions that are required for a monetary area operation.

Even if this timeframe was feasible, there remains uncertainty as to whether the benefits of deeper monetary integration outweigh the costs. Linking a local currency to an anchor currency can improve macroeconomic stability as opposed to operating under a flexible exchange rate. Under a flexible exchange rate regime, commodity prices often become unstable, and can in turn create disturbances in smaller SADC economies, particularly if their currencies are depreciating; thereby resulting in general price-level volatility. However, although a CMA would have a better capacity to cope with these disturbances, [13] it would have less capacity to deal with the idiosyncratic shocks and development challenges that might only occur in certain member states, which would have lost their capacity to tailor monetary policy to their needs through the centralisation of monetary control. Individual countries could face the effects of differentiated external shocks due to differences in their production, consumption and expenditure patterns; market characteristics (monopolistic/competitive); and level of openness, among others. Asymmetric shocks could cause havoc to individual economies under independent currencies. Box 2 summarises the costs and benefits of a monetary union.

Box 2: Benefits and costs of a common currency

Benefits

• Ties domestic inflation to partner’s inflation or targeted currency area inflation rate – establishes an anchor for monetary policy and imports credibility.

• Decreases transaction costs.

• Improves microeconomic efficiency by increasing price transparency between partners.

• Eliminates costs associated with exchange rate uncertainty vis-à-vis partner countries – eg hedging.

• Can reduce the risk premium on interest rates in the home country – currency and inflation risk.

• Can be a catalyst for further economic integration – endogeneities.

• Protects against domestic lobbies promoting exchange-rate manipulation.

• Reduces risk of speculative attack on home country currency.

Costs

• Loss of ability to maintain an independent monetary policy.

• Loss of exchange rate adjustment flexibility to terms of trade, and other shocks.

• Shocks to partner countries can be transmitted to home country.

• Loss of national sovereignty.

• Weakened accountability of policy makers to national citizenry.

• Loss of seigniorage (under dollarisation).

• One-off changeover costs.

Source: Adopted from Hunt C, A Fresh Look at the Merits of a Currency Union, Reserve Bank of New Zealand: Bulletin, 68, 4, 2005, external pagehttp://www.rbnz.govt.nz/research/bulletin/2002_2006/2005dec68_4 hunt.pdfcall_made.

The trade-off between greater stability and more domestically appropriate policies is particularly important in the case of a region as diverse as SADC, particularly if monetary control remains largely in the hands of South Africa. The size and influence of the country and the sophistication of SARB, means that South Africa would in all likelihood remain very influential. However, the South African economy is very different to those of the region, facing different types of shocks and development challenges, and thus possibly requiring a different monetary policy.

SADC’s Committee on Central Bank Governance adopted initiatives that need attention, as it marches towards the desired monetary integration (see Table 1). However, the predominance of South Africa’s economy and its advanced financial system compared with other SADC member states – as well as the majority of these countries’ dependence on foreign aid – raises the question of whether there is a place for the CMA under the SADC ambitions of monetary integration, when this would imply a revised framework or an expanded CMA.[14] It remains to be seen if resource-rich countries such as Angola, Zambia and the Democratic Republic of Congo (DRC); countries with high per capita income such as Mauritius, Mozambique and Seychelles; and countries experiencing fiscal pressure such as Swaziland and Malawi, would be willing to peg their currency to the rand. Zimbabwe’s continued use of multiple currencies aimed at restoring confidence in the country’s monetary system suggests that its joining the CMA remains unfeasible in the foreseeable future.

One of the greatest threats to a monetary union is therefore the existence of large structural differences between member states, which can give rise to the type of idiosyncratic shocks and challenges that a regional monetary policy is not equipped to handle. However, given the requisite level of convergence between economic fundamentals, monetary unions can avoid this problem and be better equipped to tackle common challenges. To demonstrate the role of convergence in the success of monetary unions, the paper will now turn to case studies of the EMU and the CFA.

Case Studies of Monetary Unions and Convergence

The European Monetary Union

EMU is an umbrella term for the group of policies aimed at converging the economies of all members of the EU in three stages. Both the 17 eurozone states and the 10 noneuro states are EMU members. A member state, however, needs to reach the ‘third EMU stage’ before being able to adopt the euro currency, and as such the ‘third EMU stage’ has also become largely synonymous with the eurozone. The EU is perhaps the best example available of an optimal currency union, and for years the success of the euro epitomised the hypothetical benefits of a monetary union. The euro helped to maintain monetary discipline, keep inflation rates low, and decreased cross-border transaction costs. This was despite the incredible diversity of the EU, incorporating a range of differentsized economies, with different economic structures and facing different development challenges; all operating under a Stability and Growth Pact, which provided insufficient incentives to abide by convergence guidelines.

The 2008 financial crisis provided exactly the kind of shock that centralised monetary control struggles to handle. The crisis hit all of Europe and triggered a common reaction. The European Central Bank (ECB) certainly had a greater capacity to respond than individual nations would have had. However, the crisis affected different European states differently, and although the likes of Germany, France and many Eastern European states had the capacity to cope with the crisis, heavily indebted GIIPS (Greece, Ireland, Italy, Portugal and Spain) countries were threatened with economic collapse. Even within this vulnerable group there were broad differences, with Greece, for example, having a heavily indebted national government, whereas Spain faced a heavily indebted private sector.

There is widespread debate over how countries in crisis should react. Although this point is certainly not settled, one option would certainly be to devalue their currency as a means of reducing debt obligations and improving export performance, with the ensuing decreasing debt loads and increasing growth helping to restore confidence in the solvency of the nation. Whether this would work in the case of the GIIPS countries, or even the most extreme case of Greece, remains a highly contentious question. However, one thing is certain: GIIPS does not have the option of making use of such a strategy because of the EMU. If similar shocks were to hit a more unified Southern African region, the same question of lack of capacity to manage these shocks would arise. This is particularly important in a region that is more crisis prone with far less capacity to provide the type of massive fiscal stimulus that the EMU used to circumvent biting questions about its inability to revalue individual currencies.

The African Financial Community franc zones

The two CFA franc zones pre-date the eurozone by 54 years, having their roots in the colonial era. The CFA zones were created during the French colonisation of North and West Africa, and split between two zones. The West African Economic and Monetary Union (WAEMU) covers Benin, Burkina Faso, Côte d’Ivoire, Senegal, Togo, Mali, Niger and Guinea-Bissau. The Economic and Monetary Community of Central Africa (CEMAC) covers Cameroon, Gabon, the Central African Republic, the Republic of Congo, Equatorial Guinea and Chad. Each area has a central bank, the Central Bank of West African States (BCEAO) and Bank of Central African States (BEAC) respectively, both of which are independent of their member states and which have stringent rules for monetary financing of fiscal deficits. The CFA franc exchange rate is pegged to the euro through a guarantee of convertibility by the French Treasury, with the relationship between the two further managed by requirements on the holding of reserves by the two central banks.

The CFA areas are powerful examples of monetary unions that have shown incredible durability even in a highly unstable region, and which seem to validate many of the benefits of such a union, with the region showing consistently low and stable inflation rates. Although there have been periods of instability during revaluations of the currency by the French Treasury, most noticeably in 1994, the region has remained largely stable. Growth rates are perhaps less convincing, with WAEMU in particular trending below the levels of non-oil gross domestic product (GDP) growth found on the rest of the continent. However, given the instability and complexity of the region, it would be hard to pin this underperformance on the currency area.

A key component of the longevity of the CFA areas has been the level of convergence between the member states. A study by the Economic Commission for Africa (ECA) shows that the dispersion of the fiscal balance for the CEMAC and WAEMU countries was very low, and that income per capita showed positive, if limited, convergence in both regions.[15] There are major differences in the economic structure of CFA states, most noticeably being that many are oil exporters while others are oil importers, which are largely reliant on cash crops such as cocoa and coffee. This divergence can be incredibly important, since these commodities are exactly the kind that are vulnerable to external shocks and require constant management. The CFA areas are, however, largely successful in managing this – in no small part due to the fortunate historical accident that all oil exporters are grouped into CEMAC, whereas none are in WAEMU. The use of subgroups that take cognisance of the economic structure of member states therefore supplements the fundamental convergence found within the region. There remains major divergence, however, in the wealth of the various countries. The regions include very large and sophisticated economies such as those of Senegal and Côte d’Ivoire, as well as tiny countries such as Guinea-Bissau and extremely economically vulnerable countries like Mali. Mali has a per capita GDP of approximately 6% of Gabon’s, a figure that dwarfs the largest SACU difference, in which Lesotho’s per capita GDP stands at 14% of South Africa’s. Overall, although the CFA area highlights the importance of economic convergence in key areas such as policy and commodity reliance, it also highlights that states at very different stages of development can coexist in a monetary union. Table 2 summarises key features of the monetary unions explored thus far.

Table 2: Main features of selected monetary unions

 

WAEMU

CEMAC

EMU

CMA

Number of countries

8

6

17

4

Single currency

Yes

Yes

Yes

No, but rand is a de facto currency

Common central bank

Yes (BCEAO)

but French Treasury has influence

Yes (BEAC) but French Treasury has influence

Yes (ECB) but national central banks execute monetary policy

No, but SARB has influence

Common pool of reserves

Yes

Yes

Yes

No

Regional surveillance of fiscal policy

Yes

Yes

Yes

No

Free trade area

No

No

Yes

Yes

Common external tariff

Yes

Yes, in principle

Yes

Yes

External current account convertibility

Yes

Yes

Yes

Yes

Degree of capital mobility within the region

Low, in principle free

Low, in principle free

High

High

External exchange rate anchor

Yes, pegged to the euro

Yes, pegged to the euro

No

No

 

Source: Adapted and updated from Wang JY et al., ‘The Common Monetary Area in Southern Africa: Shocks, adjustment, and policy challenges’, IMF Working Paper, WP/07/158, 2007, http://www.imf. org/external/pubs/ft/wp/2007/wp07158.pdf.

Macroeconomic Convergence in the SACU Region

To build a solid and sustainable monetary union, macroeconomic convergence is therefore an important prerequisite. The successful transition of a bloc from a simple REC to a monetary union presupposes that countries fulfill different convergence criteria. At present SACU does not have macroeconomic convergence criteria. In the absence of this, the convergence criteria of SADC can be used for the analysis of their performances. The use of the SADC criteria can be justified by the fact that all SACU members are also members of SADC and therefore they are obliged to respect those criteria. The SADC criteria list progressive targets of inflation, fiscal deficit, national debt, and the holding of reserves. These criteria are presented in Table 3.

Table 3: Macroeconomic convergence criteria

Indicator

Timeline

2008

2012

2018

Inflation

Single digit

5%

3%

Fiscal deficit

< 5%

Between 2% and 4%,

anchored at 3%

Between 2% and 4%,

anchored at 3%

National debt

< 60%

< 60% of GDP

Reserves

3 months of imports of goods and services

Source: Adapted from Mbao FZ, ‘Re-examination of SADC macroeconomic convergance criteria’, Bank of Zambia Working Paper, 2011, http://www.sadcbankers.org/Lists/News%20and%20Publications/ Attachments/148/Re-exam%20of%20MECcriteria%20BoZ.pdf.

The convergence in macroeconomic indicators suggests that monetary and fiscal policies are well co-ordinated. The co-ordination of those policies is a necessary foundation for moving the REC through the various phases of integration towards establishing a monetary union. Figure 1 shows the standard deviations of the different criteria from 2003–11. A low standard deviation suggests a low volatility in a criterion, and therefore indicates a greater convergence of member economies of a REC to a given target.

Figure 1: Dispersion of inflation, fiscal balance, debt and reserves in the SACU monetary union, 2003–11