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Feasibility and Implication of East African Community Monetary Union

Article by E.P Bagumhe, 2013

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This paper , seeks to employ the Bayoumi and Eichengreen’s (1997) OCA Index methodology as a framework of analysis to examine this objective of EAC. The paper will proceed by providing a brief historical background of monetary and economic arrangements in East African Community. Part two of this paper will review both the theoretical and empirical literature with a view of the theoretical prediction towards the OCA. The specific objective of this paper is to answer four policy questions; Will individual countries increase their welfare when they abolish their national Currency and adopt some currency of a wider area, what is the ideal arrangement of forming regional currency blocs before reaching a complete monetary integration? Thirdly, what is the similarity of output movements of the EAC partner’s states? Fourthly, Does the EAC Partner states meet the convergence criteria as proposed by OCA theory.






DISCUSSION PAPER:




Feasibility and implication of the East African Community Monetary Union:


An Application of Optimal Currency Area Index Methodology










Paper to be presented at the fourth International Conference on Development


Policy, to be held on 14
th
to 15


th
August 2013 at National College of Tourism










Elias Peter Bagumhe


Tel +255765921192


Email: peterbagumhe75@yahoo.co.uk














ii










Table of Contents


1.0 INTRODUCTION .................................................................................................................................. 3


1.3 The Optimum Currency Area Theory ..................................................................................................... 5


1.1 Advantage and Disadvantage of Monetary Union .......................................................................... 10


2.0 Methodology ......................................................................................................................................... 12


2.1 Model Description ................................................................................................................................ 13


3.0 Convergence of Macroeconomic variable of in EAC ........................................................................... 15


3.1 Correlation of Inflation Rate for EAC Countries from 2000 to 2010 ................................................... 15


3.3 Real GDP Growth rate .......................................................................................................................... 17


3.5 Exchange rate ........................................................................................................................................ 20


4.0 Findings and Interpretation of Optima currency area index ................................................................ 22


4.2 Research Findings ................................................................................................................................. 22


4.3 Interpretation ......................................................................................................................................... 23


4.3 Conclusions and Recommendation....................................................................................................... 24


REFERENCES ........................................................................................................................................... 27






1.0 INTRODUCTION


The push towards greater integration within the regional trading blocs has shifted into


high gear in recent years. After the birth of the Euro in 1999, interest in economic and


monetary integration has increased and several regional blocks around the world have been


assessing the possibility of establishing common markets and monetary unions. In the East


African Community (EAC), the desire for and the thinking on monetary union have strongly


been influenced by experiences of Europe‟s integration and the eventual introduction of the


euro. The year 2013 marks the thirteenth anniversary of the Euro, which has rapidly


established itself as an enduring symbol of a harmonious economic integration. This


experience and the resulting success of the Euro have served as a role model and


development that can be replicated in the East Africa Community, and reap the benefits of a


single regional currency, encapsulated in the special contribution it makes to the reduction of


transaction costs on trade and investment.


The envisaged single currency is not only motivated by its benefit, but it is also a medium


term goal which is stipulated in the East African Community treaty of 1999. The revival of


the East African Community (EAC) in 1999 brought to the fore, besides the old idea of a


political federation in East Africa, the possibility of reintroducing a common currency in the


region. The EAC has now concluded the protocol for the establishment of the East African


Community Monetary Union (EAC-MU), awaiting signatures of the Head of Sates scheduled


on November this Year. On top of that, ten years has been defined as a roadmap for the


macroeconomic convergence as the necessary milestone for the proper functioning of the


monetary union and as the pre-requisite for the optimal currency area.




At the heart of this aspiration within the EAC, there is a concern that, the Euro should now be


recognized as an experiment that has failed. The failure which has come just after over a


dozen years since the euro was introduced in 1999. Some scholars are of the view that, the


failure of Euro is not an accident or the result of bureaucratic management, but rather the


inevitable consequence of imposing a single currency on a very heterogeneous group of


countries. The adverse economic consequences of the Euro included the sovereign debt crises


in several European Countries, the fragile condition of major European Banks, a high level of




4




unemployment across the Euro zone, and the large trade deficits that now plague most Euro


zone Countries. Even within the East African Community, there is a growing concern that not


enough litmus test has been done to determine the feasibility of the Monetary Union in the


region.


This paper examines the feasibility and implication of the EAC Monetary Union to Partner


States economies; hence it is albeit important to trace the origin of this integration process.


The East African community (EAC) is the regional intergovernmental organization of the


Republics of Kenya, Uganda, the United Republic of Tanzania, the Republic of Rwanda, and


the Republic of Burundi whose headquarters are in Arusha, Tanzania. The Treaty that came


into effect in 2000 guides the EAC. According to Article 5 of the EAC Treaty, the EAC


Partner States shall undertake to establish among themselves a Custom union, a Common


Market, and subsequently a monetary union and ultimately Political Federation. In this


regard, the Protocol for the establishment of the EAC custom Union was signed in 1999,


followed by the Common Market Protocol in 2009, and the protocol for the establishment of


the EAC Monetary union is expected to be signed in November 2013.


Despite the fact that the EAC custom union was signed in year 2005. It is a custom union


with Common external tariff and zero tariffs charged for the movement of goods, but without


a single custom territory. Currently, efforts are underway to establish the EAC single


Customs territory with a single customs authority. On top of that, the Common Market


Protocol, which was signed in year 2009, has not well pronounced on the ground. When fully


implemented the four freedoms will be realized including free movement of people and


capital, which are critical for full realization of Common Market and for Monetary Union


among others. The Process of establishing the EAMU is on progress in line with the Summit


directive of signing the EAMU Protocol by the end of 2013.


This paper therefore, seeks to employ the Bayoumi and Eichengreen‟s (1997) OCA Index


methodology as a framework of analysis to examine this objective of EAC, with particular


reference to the branch of economic theory that has become known as Optimal Currency


Area (OCA). The paper will proceed by providing a brief historical background of monetary


and economic arrangements in East African Community. Part two of this paper will


extensively review both the theoretical and empirical literature with a view of understanding


the theoretical prediction towards the OCA. The main objective of this paper is to




5




operationalize the theory of OCA in EAC, by constructing an OCA index based on a


particular empirical specification that summaries country readiness for Monetary Union. The


specific objective of this paper is to answer four policy questions; first, Will individual


countries increase their welfare when they abolish their national Currency and adopt some


currency of a wider area, second what is the ideal arrangement of forming regional currency


blocs before reaching a complete monetary integration? Thirdly, what is the similarity of


output movements of the EAC partner‟s states? Fourthly, Does the EAC Partner states meet


the convergence criteria as proposed by OCA theory.


1.3 The Optimum Currency Area Theory


The main questions which East African Countries need to pose and make a systematic


analysis include, Will individual countries increase their welfare when they abolish their


national Currency and adopt some currency of a wider area?.When should the process of


monetary integration stop? And, Should there be one currency for just five countries of the


present EAC, or for the whole of African Continent? This problem leads us into an analysis


of what constitute an optimum currency area. Robert Mundell first put the Optimum


Currency Area theory forward in 1961 as an examination of how countries engaged in cross


border trade could benefit from being part of a monetary union. Literature defines an


optimum currency area in a number of ways; generally, in order for the country or region to


qualify for the establishment of the monetary union it (the region) must be an optima


currency area. This theory has remained a workhorse of analyzing the feasibility of a


monetary union since the seminal work of Mundell (1961), Mckinnon (1963) and kenen


(1969).


According to Mundell (1961), an optimum currency area is a region, which is economically


preferable to have a single official currency rather than multiple official currencies.
1
This


theory put more emphasis on asymmetric shocks, labour mobility and the transactions value


of a single currency. Additional theories in this area have been developed from the seminal


work of Mundell (1961) and related to the generalised concept of an “Optimal Currency


Area” (OCA). Mundell‟s (1961) work was further supplemented by important offerings from


McKinnon (1963) and Kenen (1969).



1
Carbaugh R.J., International Economics 10


th
Edition, 2005, U.S.A.




6




According to Mundell (1961), if a negative asymmetric demand shock hits one of the


members of an optimum currency area, the labour will move from this country to other


member countries. With high labour mobility, the labour migration between member


countries will equalize wages as well as labour demand and supply in all member countries.


As a result, a common monetary or fiscal policy can be used to stimulate the economies of all


member countries. Hence, migration is a channel through which adjustment to asymmetric


shocks can take place, and flexible exchange rates between the member countries are no


longer necessary for restoring fundamental balances.
2


In the ideal scenario discussed in Mundell (1961), countries in monetary union enjoy two


major competitive efficiencies: wage flexibility and labour mobility. This allows economies


to re-equilibrate almost automatically to offset the effects of asymmetric shocks. For


example, if a rise in one country‟s exports boosted aggregate demand at the expense of


another exports, the two economies AD curve would shift to the opposite directions. The


equilibrium could be restored if workers in the depressed economy lowered their wage


claims, allowing a downward shift of aggregate supply curve hence raising the equilibrium


employment back to what it was previously. Additionally, the subsequently lowered price


level in country B means that its exports become more competitive relative to country A,


leading to a downward shift in the latter‟s AD curve (with regards to domestically produced


goods) restoring its initial position. Similarly, with full labour mobility, the unemployment


workers in country B would be able to find work in Country A. This re-equilibrates both


economies as the current account surplus created in the booming economy via the saving of


its citizens is offset by the expenditure of the new migrant workers. Conversely, the country


with the smaller relative export base would not reduce their spending by an amount equal to


the loss in the exports as social security mechanism like unemployment benefits would mean


that their income would remain high enough for them to consume more than they otherwise


would have, creating a current account deficit. However, since the workers are expected to


have emigrated immediately upon dismissal, no unemployment benefits would be paid out,


meaning that aggregate consumption remained commensurate with the drop in the exports


eliminating the deficit.



2
McKay J., et.al, Regional Economic Integration In a Global Framework, 2004, European Central Bank.




7




Since neither of the above conditions exist to any considerable degree in practice, particularly


in the developing economies of East Africa, it would be difficult to solve the asymmetric


shock problem of OCA in a monetary union. Since the booming economy no longer has a


sovereign currency that it can allow to appreciate relative to the depressed economy to restore


equilibrium, it must choose between lowering inflation and reducing the current account


surplus. Lowering inflation would involve contractinary fiscal and/ structural policy, which


would harm the growth prospects and cut into spending while increasing the current account


surplus further. Conversely, spending the current account surplus would feed in to higher


price levels.


As Kenen (1969) observes further, a more diversified economy is more suitable for a


currency union than a less diversified one. If an economy is more diversified in the goods it


produces, it can forgo the need to frequently change its nominal exchange rate in case of an


external shock. This is because an economy producing a wider variety of products would also


export a wider variety. In that case, if a fall in the demand occurred for some of its products,


the effect of such a shock would not create a large fall in employment. However, if an


economy is less diversified, a shock that can affect one sector would necessarily have a


bigger effect on the economy. Moreover, in a more diversified economy, if independent


shocks affect each of the products, the law of averages would ensure that the economy


remains stable. This is more so if sufficient occupational mobility exists to re-absorb labour


and capital, which are rendered idle by the shocks.


If prices and wages are flexible between and among the regions, the need of using the


exchange rate for adjustment is diminished. This is because the transition toward adjustment


between regions is not likely to be associated with unemployment in one region and inflation


in another.


As Bayoumi and Ostry (1995); Jonung and Sjöholm (1998) maintain, countries that have


similar industrial structures are more suitable candidates for a currency area because they are


affected in a similar way by sector specific shocks. Such a situation negates the need for


undertaking a unilateral adjustment in the exchange rate in response to terms of trade shocks.


Countries may have different industrial structures but if they exhibit a high co-variation in


their economic activities, they will still be candidates for a currency union because it would




8




imply that they are likely to experience similar economic shocks. This reduces the


significance of exchange rate policy autonomy for making necessary adjustments (Bayoumi


and Ostry, 1995; Jonung and Sjöholm, 1998).


As Jonung and Sjöholm (1998) argue, if countries are to be good candidates for a currency


union, the patterns of inflation should be similar as this can make the convergence in inflation


rates easier once they belong to a currency area. If countries have different inflation rates, this


would imply that they are different in the way they conduct their economic policies, and also


that their economic structures is different.


In a nutshell, what might be termed as traditional OCA theory and which have be judged


from the main factors that the theory highlights should be considered when planning


monetary integration between two or more countries. According to this theory, the critical


factors in determining an optimum currency area include the following:


 Asymmetry of Shocks. Relating to other points summarized here, increased asymmetry of


shocks increases the cost of giving up the dual adjustment mechanisms of exchange rate


movements and interest rate changes. However, these costs can be reduced as shall be


summarised below.


 Factor Mobility. Increased movement of factors within the area reduces the inflation-


unemployment trade-off that would otherwise be eliminated through adjustments in the


exchange rates or interest rates.


 Price and Wage Flexibility. Increased flexibility of nominal prices and wages reduces the


need for exchange rate adjustment to restore external balance, reducing the loss created


by a move to monetary integration.


 Size and Openness of Countries. Increased openness, relating the proportion of non-


tradable to tradable goods in the economy, increases the variation of the domestic price


under flexible exchange rates, reducing liquidity and the possibility for money illusion.


Clearly, smaller economies, having less diversified structures and higher external reliance


are necessarily more open.


 Source of Shocks. The preceding argument holds, unless the exchange rate is adjusting to


shocks of an external nature. Where this occurs, exchange rate flexibility is said to


“insulate” the domestic economy from foreign instability.




9




 Product Diversification. Increased diversification, particularly in the tradable sector


reduces the effect of negative asymmetric shocks through offsetting positive changes in


other industries.


 Production Structures. Similar production structures between economies reduce the


likelihood of asymmetric shocks, reducing the need for exchange and interest rate


movements and thus reducing the loss from losing such instruments.


 Inflation Convergence. Reduces the need for exchange rate movements that would be


unavailable under monetary integration.


 Fiscal Integration. Not discussed explicitly here, increases in fiscal integration may be


able to smooth out the effects of asymmetric shocks through fiscal transfers.


Clearly, as Tavlas (1993) points out in his summary of traditional OCA characteristics, what


becomes increasingly obvious in the European Union is that political factors are also


important in determining the formation and success of a single currency area. However, for


the purposes of this literature review, the researcher will confide himself to economic


factors
3
.


Given that the costs of undergoing monetary integration consist of losing the ability to adjust


to asymmetric shocks through exchange rate movements (or adjustments given a more rigid


but none-the-less flexible exchange rate system) or interest rate movements, much of the


early literature seems focused on the reduction of losses rather than a discussion of benefits.


The above characteristics relate largely to the effectiveness of exchange rates and the


possibility for adjustment through alternative means. Thus, the reduction of losses seems to


have been the main area of concern during the early development of OCA theory. The


benefits were assumed implicitly: reductions in transactions costs and exchange rate


uncertainty, increased liquidity and trade, economies of scale concerning currency reserves,


and the general notion that monetary integration should improve allocative efficiency. New


OCA theory, using theoretical developments from various economic branches, both reduced


the two main costs of monetary integration and highlighted other important benefits to be


gained.



3
Tavlas (1993) suggests Mintz (1970) and Cohen (1993) as insightful readings on the political aspects of


monetary and economic integration.




10




Bayoumi and Eichengreen (1980) supplement the traditional OCA theory by suggesting what


it has came to be known the New OCA theory. The new theory produces very little academic


literature concerning OCA theory, but provides important theoretical developments in other


areas of economics. The broad ranging nature of work contributing to “New” OCA theory


necessitates some elements of separation which include: The Monetarist Critique, the


disputed role of the exchange rate, Credibility, time consistency and policy rules, and


endogeneity of OCA criteria.


1.1 Advantage and Disadvantage of Monetary Union


The advantage and disadvantage of joining a monetary union may arise at the micro or macro


level. Although these advantages accrue mostly at the microeconomic level, Monetary union


is a deeper stage of integration; hence, it leads into a gain in economic efficiency emanating


from two sources: first is the fact that Common Currency can eliminate transactions costs that


are incurred when converting currencies; second a common currency can help to eliminate


the risks from uncertainty in the movement of the exchange rates (De Grauwe 2000).


Likewise, common currency tends to provide potential for reinforcing the discipline and


credibility of monetary policy (Jacob, 1997). Additionally, it may potentially make


businesses and investments as well as movements of people and capital within the bloc much


easier.


The other side of the coin is that Common Currency tends to create loss of independence over


monetary and exchange rate policy. When a country relinquishes the exchange rate as an


instrument, it loses a mechanism for protecting itself from economic shocks. This cost would


be less severe if the shock affects all the members of the currency union. But if the shocks


affect the members differently due to for example different industrial structures, then a


common policy might not be appropriate; in which case the inability to use the exchange rate


to make the needed adjustments could result into greater volatility in output and employment.


As Dispasquier and Jacob (1997) observe, the disadvantage of a common monetary and


exchange rate policy might be reduced if prices and wages are flexible and if labour is


sufficiently mobile. The flexibility of prices and wages and the mobility of labour allow


adjustment to a shock to occur more promptly. The above disadvantages of a common


currency may be tricky in the event of financial and economic crisis; thus, the feasibility of


Monetary Union in the EAC needs further research.




11




As evident from the experience of the European Monetary Union (EMU), forming a


monetary union is a complicated project, and there is a non-negligible risk of failure. It is


therefore necessary to ensure that the pre-conditions for forming the EAMU are adequate.


This entails making sure that economic, political, and institutional requirements are in place,


since the benefits are likely to be less visible than the short term costs. Despite the


importance of this initiative and the steps already taken by the EAC, and whereas the political


will continue to gain momentum, there is concern that not enough empirical economic


research has been done on this issue.




12




2.0 Methodology


There are several key methodologies for testing OCA criteria on a broad scale. There are also


multitude possibilities of testing the individual hypotheses postulated in the literature. Indeed,


Mongelli (2002) is “struck by the very high number and diversity of studies making reference


to the OCA theory”. Other authors have employed Macroeconomic modelling to determine


an optimal policy strategy. However, it is the paper by Harris (1991) which paved the way for


the use of simulation exercises in assessing the trade impact of varying degrees of economic


integration. Accordingly, Harris (Ibid) uses several different economic simulations to assess


the medium and long run impacts of the US-Canada Free Trade Arrangement. Recently,


adopted by Debrun, Masson and Patillo (2002), with specific reference to Africa, this


methodology involves the adoption of several key assumptions in the construction of an


appropriate economic model. These assumptions are with regards to the supply function of


the economy as well as government budget and objective functions. Importantly, the Debrun-


Masson-Patillo (DMP) Model identifies not only the asymmetry of shocks but also the


asymmetry of political distortions affecting fiscal policy. Therefore, the Central Bank‟s


preferences represent a weighted average of all members of the currency union, depending on


the economic size. The economic model is then calibrated according to empirical evidence


and simulations were run to determine the costs and benefits of monetary union. Masson and


Patillo (2005) relate this model directly to Africa thus, the model seems relevant to this


discussion; however the development of such a value laden modelling process is both non-


trivial and overly complicated for the purposes of this study.


The Generalized purchasing power parity analysis has also been employed whereby co-


integration analysis has been employed to assess the level of similarity in the movements of


the real exchange rate (in terms of a Generalized Purchasing Power Parity) relative to a


central dominant country. This method was developed by Enders and Hurn (1994) and


assesses the extent to which a group of countries exhibit integration of their real exchange


rates. Real exchange rates, which are assumed dependent on economic fundamentals, are able


to show the similarity of economies and therefore their suitability for monetary union.


This paper has confined to broader based studies which have been used in the past to


conclude for or against membership within a monetary union. The key methodologies which


become evident in the literature are detailed in the application of the OCA index which is




13




employed in this study, and the correlation and co-integration test of the convergence


criteria‟s is identified in the Optimum currency area theory. Bayoumi and Eichengreen


(1997) construct an “OCA Index” on the basis of the following equation:


jiijijjiij
SIZETRADEDISSIMyySDeSD 4321 )()(   …….(1)


Where subscripts i and j denote the two countries in the pair and the variables are defined as:


SD(eij), which is the standard deviation of the change in the logarithm of the end-year


bilateral exchange rate between countries i and j; The expectation here is that, the estimation


of change rate volatility should decline over time as the result of fiscal and macroeconomic


policy coordination and provide a yard stick to measure the suitability of the OCA. SD(∆yi-


∆yj) is the standard deviation of the difference in the logarithm of real output between the


country pair; DISSIMij is the sum of the absolute differences in the shares of agricultural,


Mineral and manufacturing trade in a total merchandize trade; TRADEij is the average value


of bilateral trade, weighted by GDP, between countries i and j; SIZEij is the mean of the


logarithm of the real GDPs of the country pair.


2.1 Model Description


This model relates the variability of the nominal exchange rate with several independent


variables associated with OCA theory as noted above the main assumption of the model is


that, it relates the variability of the nominal exchange rate with several independent variables


associated with OCA theory as follows: the differences in the output disturbances and


dissimilarity of commodity compositions of the exports to capture asymmetry of shocks and


therefore the costs of monetary union;


In our model output disturbances(SD(∆yi-∆yj)) is measured as the standard deviation of the


change in the log of relative output in the two countries. Thus for countries in which business


cycle are symmetric and national outputs move together the value of this measure will be


small. We also add the dissimilarity of the commodity composition of the export of the two


countries (DISSIMij ) as the second proxy for the symmetric of shocks. The assumption here


is that Industrial specific shocks will be more symmetric when two countries have revealed


comparative advantage in the same export sector.





14




Trade linkages was measured using bilateral trade data, measuring the average value of trade


(both imports and exports) between any two pair of countries, scalled by GDP of the two


Countries


TRADEij = TiGDPi + TjGDPj


GDPi + GDPj


Ti stands for the exports of country i to country j; GDPi stands for the real GDP of country i;


Tj stands for the exports of country j to country i; GDPj stands for the real GDP of country j.


Where bilateral trade is high, the variability of nominal exchange rates between those two


countries is expected to be low. The benefit of the more stable currency is measured by


including the arithmetic average of the log of real GDP of the two countries in the country


pairs.


SIZEij = log GDPi + log GDPj 2


Bayoumi and Eichengreen (1997) anticipate this to be positively related to exchange rate


variability, to reflect the concept that smaller countries will benefit more from the stability of


a single currency area.


Variables were taken as averages over successive 10 year sample periods from 2001 to 2010;


the regressions were estimated and assessed for continuity with the theory. Given intuitively


consistent results, the most significant estimation period was used to predict bilateral values


for the dependant variable within a pre-existing REC.


These predicted values are termed the “OCA Index”. Where the index is relatively low, OCA


characteristics predict a low level of bilateral exchange rate variability and therefore a high


suitability for monetary integration. This was conducted for the five regional blocs already


appearing in the East Africa Community to assess their current levels of convergence.


Equation one above is estimated and then compared against a base or a “centre” country,


which is in line with Bayoumi and Eichengreen‟s (1997) assessment of EMU is Germany (In


this a centre country is the most performing country in the region) over a number of different


time periods hence in our case this country will be Kenya. We then compared the movement


of the dependant variable, the so-called OCA index, over time, using forecasts to project into


the




15




3.0 Convergence of Macroeconomic variable of in EAC


The theory of OCA focuses on the characteristics, which make stable exchange rates and


monetary unification more or less desirable. The most important factors are, asymmetrical


disturbances to output, Trade linkages, the usefulness of Money for transactions, the mobility


of labour and the extent of automatic stabilizers. Moreover, the OCA stresses the need to


have labour market flexibility and labour mobility, and labour mobility as an important


requirement for successful monetary union. According to this theory, if these conditions are


satisfied, there is no need to wait for more than ten years to for countries to enter into


monetary union (Frankel and Rose, 1997). An important question to be posed at this point is,


why then did the designer of the monetary union stresses so much on the macroeconomic


convergence, while the theory stresses on the microeconomic conditions. This part will


descriptively assess some of these factors within the EAC and examine the likely hood of


convergence.


3.1 Correlation of Inflation Rate for EAC Countries from 2000 to 2010


The Maastricht Treaty of 1991, made a historical transformation in the European Union, the


treaty went well even beyond the purely monetary affairs. Two strategies were envisaged, the


strategy towards the monetary union was a gradual process extending over the period of


many years, and second the entry into the union was made conditional on satisfying


convergence criteria. One of the criteria set was inflation rate to be not more than 1.5


percent. Regarding the envisaged EAC-MU, the study conducted by the European Central


Bank recommended not more than 5 and 8 percent of core and headline inflation rate


respectively as one of the precursors for any Partner State to be eligible to enter the EAC-


MU. The current situation within the EAC depicts a very high divergence among the EAC


Partners states. According to the EAC facts and figures (2012), Uganda has the highest


inflation rate within the region of about 18.7 percent, followed by Kenya 14 percent ,


Tanzania has 12.7 percent and Burundi has 9.6 percent. Arguably, even the proposed


roadmap towards EAC-MU, which is to be realized in ten years from the day of signature i.e.


November, 2013, is somewhat unrealistic.







16




Table 1, Correlation of Inflation Rate for EAC Countries from 2000 to 2010


KE TZ RW BU UG


KE 1.00


TZ 0.15 1.00


RW 0.32 0.44 1.00


BU 0.14 0.27 0.08 1.00


UG 0.19 0.70 0.63 0.42 1.00


Source: EAC Fact and Figure 2012


Table 1 above suggest that it will take a very long time for the EAC countries to converge in


terms of inflation pressure, since the correlation coefficient of the four countries, namely


Uganda, Tanzania, Kenya, Rwanda and Burundi is very low with the exceptional of Rwanda.


This divergence of the correlation coefficient for the EAC inflation rate will increase the need


for Nominal exchange rate adjustment. Since the similarities of inflation rates between


Countries will ensure the stability of terms of trade and encourage current account


transactions, and trade to be in equilibrium. Hence reduces the needs for nominal exchange


rate adjustment.


3.2 Correlation of M2/GDP for EAC Countries from 2005 to 2010


The ratio of broad money, relative to National income (M2/GDP ratio) is a popular proxy


measure for determining the depth of financial markets in developing countries. The measure


provides a means by which the degree of monetization in the economy can be determined.


Additionally, M2/GDP measures the overall size of the financial intermediary sector and it is


strongly correlated with both the level and rate of change of the real GDP per capital.


Although this measure may not enable us to assess accurately a country‟s financial


development, it is the only indicator which is readily available in the monetary survey in the


IMF statistics especially for developing Countries (Lynch, 1996). The effectiveness of


monetary union depends also on the level of development of financial market for the country


in question.







17










Table 2 Correlation of M2/GDP for EAC Countries from 2006 to 2011


KE TZ BU RW UG


KE 1.00


TZ 0.33 1.00


BU 0.71 0.69 1.00


RW 0.85 0.77 0.82 1.00


UG 0.88 0.55 0.60 0.90 1.00


Source: EAC Fact and Figure, 2012


Table 3 below indicates a high degree of monetization for Burundi, Rwanda, Uganda, and


Kenya, while Tanzania depicts a low level of monetized economy. However, the overall


results also suggest that there has been a considerable convergence in the size of financial


intermediary sectors for most of the EAC countries, which suggest the possibility of a well


functioning of the envisaged EAC monetary union


3.3 Real GDP Growth rate


The growth rate of the countries wishing to form a monetary Union is another important


factor to be considered. The pattern of the growth rate of the countries is also used as a


yardstick to encourage or discourage countries to against forming a monetary union. If


countries have a very big divergence in their real growth rate, forming a monetary union is


not a sound decision. Since the central insight of the theory of optimum, currency area is that


countries or regions that experience a high divergence in the output and employment growth


need a lot of flexibility in their labour markets, if they want to benefit from the monetary


union, and if they wish to avoid major adjustment problems. The large the degree of real


divergence the greater is the need for flexibility in the labour market to make a smooth


functioning monetary union. Hence, these factors need to be taken into consideration within


the EAC; the pattern of growth for EAC countries has a substantial difference when




18




compared with the original EU-15 that adopted the Euro. The EAC Countries include Kenya


- ,a developing country with a substantial base of Industrial growth, and Burundi, which is


one of the poorest in all development indicators with a very weak base of Industrial growth.


Table 3, Real GDP Growth Correlation from 2000 To 2010


KE TZ RW BU UG


KE 1.00


TZ 0.38 1.00


UG 0.37 0.52 1.00


RW -0.11 0.11 0.28 1.00


BU 0.16 0.48 -0.02 0.31 1.00


Source: EAC Fact and Figure, 2012


Literature reveals that, the fastest-growing Country would suffer in a monetary union with


slower growing countries because the imports, of the fastest-growing Country, which are


unconstrained with trade barriers, would increase faster than its exports, leaving it with a


mounting current account deficit. Table 3 above suggest that the envisaged EAC-MU might


work best if it starts by including only the countries with at least reasonable correlation rate in


their real GDP growth rate, and these are Kenya, Uganda, and Tanzania. A reasonable


correlation would mean a fair degree of convergence. Likewise, the closer the correlation


coefficient of their real GDP growth rate would mean that, roughly equal measure of business


cycle synchronization can possibly be adopted.


3.4 EAC Partner States Openness indexes for the Period 2000 to 2010


De Grauwe (2000) maintains that there is a relationship between the benefit of a monetary


union and openness of a Country. He emphasizes that welfare gains of monetary union are


likely to increase with the degree of openness of an economy. The trick is that the elimination


of the transaction costs will weigh more heavily in the countries where firms and consumers


buy and sell a large fraction of goods and services in the foreign countries. This may


happened because the consumer and the firms in these countries are more subject to decision


errors because they face large foreign markets with different currencies. Hence, eliminating




19




these risks will lead to a large welfare gain in small and open economies than in large and


relatively closed countries.


Table 4 Correlation of Openness index of EAC Countries from 2000 to 2010




Source: EAC Fact and Figure 2012


Table 4 above, provides a correlation coefficient of openness Index for EAC countries from


2000 to 2010. This index is calculated as the ratio which the country exports and imports to


GDP. The finding indicates that EAC countries have a very low degree of openness,


suggesting that EAC countries are unlikely to enjoy the welfare gain of the envisaged


Monetary union. The low openness index may also suggest that firms and consumers within


the EAC tend to buy and sell a very low fraction of goods and services in foreign countries.


McKinnon (1963), have also observed that the economy of the Country wishing to form a


monetary union should be more open, this makes it easier for the said Countries to enter into


a currency union arrangement in that the nominal exchange rate is already redundant as a


policy instrument.


Moreover, finding from Table 4 has depicted a very high divergence of the Correlation


coefficient among the EAC Countries, suggesting that, small country like Burundi and




20




Rwanda will face more challenges in terms of reaping the benefit of the Monetary Union.


The proposition behind this philosophy is that, small open economy will find it beneficial to


enter into a currency union with her trading partners who are equally open. This argument


have been maintained by Frankel and Rose (1996) that, currency union tend to reduces


transaction costs and exchange rate risk, in which countries would suffered if a flexible


exchange rate were to be maintained against each other. Also, such a currency union would


provide a credible nominal anchor for monetary policy in the individual countries. They


further argue that to the extent that such open economies are integrated in terms of capital


flows, labour mobility, or similar economic behaviour, the need to maintain the exchange rate


as a policy instrument in individual countries becomes of little importance.


3.5 Exchange rate


The optimum currency area between groups of countries means that individual countries


maintain an irrevocably fixed exchange rate among each other. Therefore, an individual


country within the union cannot unilaterally devalue her currency. In fact, with the


introduction of a single currency within a currency area, individual countries completely


surrender their rights of unilaterally altering the exchange rate. For an individual country


therefore, the nominal exchange rate becomes redundant as a policy instrument. Thus the cost


of a monetary union derives from the fact that, when a country relinquishes her national


currency, she also relinquishes an instrument of economic policy. This implies that a nation


joining monetary union will not be able any more to change the price of her currency by


devaluating or revaluations, or to determine the quantity of the national money in circulation.


This cost can be compensated in a monetary union through the reduction of t transaction cost,


and elimination of exchange rate volatility. In due course, countries would benefit from more


trade and investment flows. This benefit will be realized only and if the convergence of the


exchange rate within the union will be possible. Table 5 below provides the correlation


coefficient of EAC Countries from 2000 to 2010.









21




Table 5, Exchange rate correlation from 2000 To 2010


KE TZ RW BU UG


KE 1.00


TZ 0.89 1.00


RW 0.90 0.95 1.00


BU 0.89 0.96 0.97 1.00


UG 0.75 0.79 0.80 0.79 1.00


Source: EAC Fact and Figure 2012


The correlation coefficient of EAC Countries in Table 5 above depicts a very high


correlation of exchange rate of EAC countries for the period from 2000 to 2010, suggesting


that, the elimination of exchange rate volatility in the envisaged EAC – MU will be possible


and hence EAC countries are likely to reap the benefits of monetary union in the form of high


trade and investment inflows. On top of that, stable exchange rate tends to encourage trade,


EAC countries need to optimize this economic advantage by addressing had and soft


impediment to trade.




22




4.0 Findings and Interpretation of Optima currency area index


We begin by testing the stationary of variables specified in our panel output functions by


running unit root tests on the variables.


Table 6: Results of Test for Unit Roots


Unit Root Test


Levin–Lin–Chu Harris–Tzavalis Order


SD(eij) -2.4264** 0.2169*** I(0)


SD(∆yi-∆yj)


-5.1951*** 0.5795*




I(0)


TRADEij -4.3146*** -4.4943*** I(0)


SIZEij


-4.8248*** 0.1129***




I(0)


*and ** significant at 1% and 5% levels respectively


The Levin- Lin- Chu test revealed only SD(eij) being stationary, the rest of the variables were


found to be non stationary. This finding made it necessary for the researcher to difference the


variables and then to conduct a Levin-Lin-Chu unit root test, whereby all the three variables


were stationary at 1% level. The Harris-Tzavalis Test was also conducted to verify the


findings of the Levin-Lin-Chu test. Both of these tests have the null hypothesis that all the


panels contain a unit root.


4.2 Research Findings


Variables were taken as averages over successive 10-year sample periods from 2001to 2010.


After running regression analysis, the researcher was able to obtain the findings as shown in


Table 6.













23




Table 7: Estimation Results


Time Frame 2001 – 2010


Relative GDP Volatility 0.0723
***


(0.2394)


Variability of Output 0.0612
**


(0.0308)


Extent of Bilateral Trade 3.6365
**


(1.8513)


Mean of Country-Pair GDP -0.0142
***


(0.0068)


Number of Observations 60


Standard Error 0.0117


(Robust Standard Errors in parentheses)


*
= significant at 10%


**
= significant at 5%


***
= significant at 1%


4.3 Interpretation


Finding from this study depict that, all the explanatory variables are statistically significant at


5% and 1% level. The coefficient of the GDP volatility is 0.072 significant at one percent


level with a positive sign, This is what we would expect. This suggests that, an increased


divergence in income growth will increase the volatility of bilateral exchange rates. This


finding is contrary to expectation of the optima currency area, which focuses on the


characteristics‟, which make stable exchange rate. Concisely this variable suggests that


monetary unification in EAC is less desirable.


The coefficient of the Variability of output is 0.06 significant at five percent level with a


positive sign. The interpretation on this variable is that a positive coefficient tells us that an


increase in the dissimilarities in the structural of the EAC export portfolio would increase




24




exchange rate volatility. The bilateral trade variable is statistically significant at five percent


level with a positive sign but with a very big coefficient of 3.63, the bigger the magnitude of


the coefficient while statistically significant could be explained by the inability of the


institutional efforts within the EAC to increase intra- regional trade and investment. Since


where intra trade is high, the variability of exchange rates between those countries is


expected to be low. However, in the case of EAC regional bloc, the variability of exchange


rate is high which indicates that intra- trade between EAC member states is low.


The Country pair means GDP figures are statistically significant at one percent level, but with


a negative coefficient. This suggests that an increase in the mean GDP would lower exchange


rate volatility. This may be possible because increased mean GDP of Countries suggest


improved institutional reform and macroeconomic stability.


4.3 Conclusions and Recommendation


The finding from this paper revealed that, EAC is not an optimum currency area hence


forming a monetary union is not feasible. The main factors highlighted by paper is that


business cycles are divergent among the EAC member states, and the intra-trade between the


EAC member states is very low, at 11.4 percent when you compared to 70 percent in


European Union and 50 percent in ASEAN. The finding also has depicted that smaller


countries such as Burundi and Rwanda are unlikely to benefit from the stability of a single


currency area.


From the above, finding this paper concludes that: Firstly the EAC monetary union should


start with Kenya, Tanzania, and Uganda, since national output in the three countries tend to


move together as depicted by table 3 of this paper and the likelihood of macroeconomic


convergence for the three countries is feasible.


Secondly, dissimilarities in the structural of the EAC export portfolio is also an area of


concern since it increases Exchange rate volatility. All characteristics applied in the OCA


index methodology to measure the suitability of Optimum currency area has not indicated the


suitability of EAC as an optimal currency area, the benefits already reaped, in terms of


increased trade need to be enhanced. The findings from the correlation coefficient of


macroeconomic variables indicated in Tables 1 to 5, show that there is a very high divergence


in most macroeconomic variables for the EAC economies. This implies that there is a




25




distance that needs to be travelled by EAC in terms of convergence criteria for the feasible


monetary union. In this regard, deliberate efforts should be made to promote convergence of


economic criteria. Although complete monetary unification may never be economically


justified, it represents a good opportunity to promote the harmonization of financial, banking


and political systems, which will increase efficiency and development of East African


countries individually.


Lastly, East Africa countries may present unique circumstances, regarding the application of


Optimum currency area theory as a yardstick for the examination of countries‟ qualifications


for monetary union. This theory was developed and tested in developed countries. Hence, the


possibility that it can work properly in developing country is an empirical question that needs


to be resolved. The theory was mostly developed with the European Union as a backdrop and


as such certain elements disregard the important differences that exist between African and


European countries. This is perhaps the most important research gap that can be identified by


this paper; what is more the research gap requires much more detailed qualitative case study


approach to identify how the existing OCA theory can be adapted to suit East African


monetary union.


The traditional OCA criterion may be less relevant in the EAC, and that decisions based upon


this traditional theory may be misplaced. This clearly warrants further investigation into the


particular economic and social criteria that may influence and affect the outcome of planned


regional and continental integration. The need to streamline the current regional arrangements


so as to avoid duplication of efforts and contradictory policy measures is very important as


EAC enters into the consolidation phase of the integration process.


Further recommendation from the finding of this paper is that, there exist sympathetic


relationship between economic integration and monetary integration. Hence, readiness of


EAC Countries to Monetary union will depend on the extent of the implementation of the


Common Market, as well as enhancement of the intra-EAC trade. The current 11.4 percent of


intra- EAC trade provide some signal that there is a long distance that needs to be travelled


for the proper functioning of the EAC monetary union. Hence, EAC Countries need to


deliberately undertake systematic and painful transition period, balanced against the policy


credibility, to realise the welfare gain of a Monetary Union.




26







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31




ANNEX 1.


TABLE 4: REGRESSION STATISTICS


Regression Statistics


Multiple R 0.365224562


R Square 0.133388981


Adjusted R Square 0.08696339


Standard Error 0.011666606


Observations 60






Table 2: Summary Output




Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0%


Intercept 0.072296819 0.023941694 3.019704 0.003806 0.024335844 0.120257795 0.024335844 0.120257795


SD(ChYi-ChYj) 0.061162434 0.030790425 1.986411 0.05189 -0.0005182 0.122843067 -0.0005182 0.122843067


trade 3.63649E-05 1.85125E-05 1.964339 0.054461 -7.20174E-07 7.345E-05 -7.20174E-07 7.345E-05


Size -0.014234799 0.006772355 -2.1019 0.040073 -0.027801456 -0.000668142 -0.027801456 -0.000668142









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