,
ECONOMIC AND SOCIAL COUNCIL
ECONOMIC COMMISSION FOR AFRICA Meeting of the Intergovernaental
Gfoup of Experts to the Fourth Session of the Conference of African Ministers of Finance Adclis Ababa, Ethiopia
13-15 December 1991
ECONOMIC COMMISSION FOR AFRICA 'l'be Fourth session of the
Conference of African Ministers of Finance Adclis Ababa, Ethiopia 17-18 December 1991
ANTICIPATED IMPACT OF NEW DEVELOPMENTS IN THE EUROPEAN MONETARY SYSTEM ON MONETARY AND FINANCIAL
ARRANGEIIBIfI.'S IN SELECTED AFRICAN COUJI'l'RIES
TABLE OF CONTENTS
I. INTRODUCTION 1
II. BACKGROUND ON THE EUROPEAN MONETARY SYSTEM 2-6 III. HISTORICAL BACKGROUND ON MONETARY AND FINANCIAL
ARRANGEMENTS IN SELECTED AFRICAN COUNTRIES 7-10 IV. THE EUROPEAN MONETARY SYSTEM AND MONETARY
POLICY IN AFRICA 11-17
V. THE EUROPEAN MONETARY SYSTEM AND FINANCIAL
RESOURCE FLOWS TO AFRICA 18-19
VI. AFRICA'S EXTERNAL DEBT SITUATION AND ANTICIPATED
CHANGES IN EMS EXCHANGE RATE MANAGEMENT 20-21
VII. CONCLUSIONS 22
the impact of the envisaged establishment of a monetary union in the European Economic Community (EEC), on monetary and financial arrangements of African countries. This study, therefore, attempts to examine the anticipated impact these new developments in the European Monetary System (EMS) could have on monetary and financial arrangements in Anglophone Africa. The other two studies will evaluate and analyze the impact these developments are likely to have on the "CFA Franc Zone", and on "non-CFA Franc Zone"
French-speaking Africa.
2. Chapter two describes briefly the events leading to the formation of the EMS and reviews some of the potential challenges and opportunities its completion will present. Chapter three surveys the historical background of monetary and financial arrengements in African countries during the colonial period and their subsequent disintegration. It then proceeds to review their evolution in the aftermath of political independence. Chapter four analyses current monetary policy in African countries and the potential impact that recent developments in the EMS could have in the conduct of monetary policy in the former. Chapter five explores the extent to which African financial institutions may find reduced access to resource flows and financial markets in the EEC. Chapter six analyses the effects on African debt of different levels of appreciation of the European Currency unit (ECU) following monetary union in the EEC. Finally, chapter seven summarizes the conclusions of the report.
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II. BACKGROUND OJ' THE EUROPEAN MO!IBTARY SYSTEM
3. In October 1962, the EEC Commission submitted to the Council of the Commission a set of proposals for increasing consultations and co-ordination on monetary and economic policies within the community, with a view to eventually establishing a monetary and economic union. However, it was not until the early 1970s that concerted efforts towards greater monetary and financial integration in the EEC started. The Werner Report of October 8, 1970 laid down a programme for the establishment by stages of an
"economic and monetary union" by the year 1980. 1/ According to this report, the envisaged monetary and economic union was expected to have, a single Community currency (or a rigid fixing of exchange rates of member countries); complete liberalisation of all capital movement wi thin the area; a common central banking system; and centralized responsibility for decision making on economic policy matters within the EEC and accountable to the European Parliament.
4. Following from the Werner Report, the European Economic community subsequently adopted a number of measures designed to promote monetary and financial integration. These included, the establishment of the "snake" in 1972, whereby it was agreed that exchange rates of certain currencies of the EEC would vary among each other within a narrow band; the creation of the European Monetary Co-operation Fund (EMCF) in 1973; and the adoption of a decision by the EEC Council regarding the need for convergence of policies within the community.
5. The move towards economic and monetary union in the Community was reinforced in 1979 with the creation of the European Monetary system (EMS) and the European Currency unit (ECU). The EMS was created with the stated objective of establishing a "zone of monetary stability" with both an external and internal dimension.
Its three other objectives were, to create a zone of internal and external monetary stability (involving both low inflation and stable exchange rates); to provide a framework for improved economic policy co-operation between member states, leading to more
1/ Report to the Council and the COmmission on the Realisation by Stages of Economic and Monetary Union in the Community. Supplement to Bulletin 11, 1970 of the European Communities, the Werner Group, under the chairmanship of Pierre Werner, Luxembourg, October 8, 1970.
convergence in economic performance, as well as increased growth and employment; and to help foster global monetary stability through common policies vis-a-vis third currencies and by spreading the impact of external shocks among all participant currencies.A!
6. In launching the EMS, the European Council declared that the ECU would be at the centre of the EMS. It would be used as the numeric of the exchange rate mechanism; to denominate operations in the intervention and credit mechanisms; and to serve as a reserve asset and means of settlement for EMS central banks. Since coming into operation the ECU has gained considerable popularity in financial markets as one of the denominators for financial transactions.
7. However, the use of the ECU for invoicing and settlements of commercial transactions has remained limited. The ECU, at present, lacks most of the characteristics of a real currency. In other words, the official ECU is still basically a credit instrument and its use severely limited. Its supply also depends on temporary foreign exchange swap operations of member central banks with the European Monetary Co-operation Fund (EMCF). On the other hand, the private ECU has its own life with no apparent link to the official ECU.
B. A monetary union constitutes a currency area in which policies are managed jointly with a view to attaining common macro-economic objectives. At least three conditions are necessary for a monetary union to attain its objectives: assurance of total and irreversible convertibility of currencies; complete liberalization of capital transactions and full integration of banking and other financial markets; and elimination of margins of fluctuations and the irrevocable locking of exchange rate parities. It is a combination of these conditions that usually define a single currency area.
Perhaps the most important condition for any monetary union is manifest by the decisive step of locking exchange rates
irrevocably.
9. The EEC has to a large extent fulfilled the first two stages.
However, the last stage (i. e. the irrevocable interlocking of exchange rates) has yet to be attained. This requires national currencies to become increasingly close substitutes of each other and their interest rates to converge. Furthermore, the adoption of A! David Flokerts-Landau and Donald J. Mathieson, ~he European Monetary System in the context of the Integration of European Financial Markets, International Monetary Fund, Washington D.C., October 1989.
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a single currency could naturally become a further development towards the creation of a monetary union. Should the Community decide to eliminate the margins of fluctuation and agree to the irrevocable locking of exchange rate parities, then there will be a need for common monetary policy which would be carried out through new operating procedures, including the possibility of establishing a common central bank.
10. The creation of t.he EMS by the Community was a logical consequence of a grOWl.ng integration of goods and financial markets. The expectation is that by 1992, conditions resembling those of an internal market will be created, implying more freedom of movement of goods and services and greater circulation of money and freedom in capital transactions.
11. The EMS agreement did not map out the entire route to
"monetary union." What it did was to envisage the evolution of the system into the European Monetary Fund (EMF) as an essential second phase and major advance of monetary co-operation and convergence. However, in recent years and springing from the revived momentum of European integration created by the single European Act, a number of proposals and idea.s have emerged for reforming the EMS.
12. In 1985, a package of measures was adopted in order to strengthen the EMS. For instance, "the Internal Market Programme", and "the signing of the Single European Act". The latter set out a time-table and method for creating a unified economic area in which persons, goods, services and capital would move freely. It also introduced four major changes in the communi ty' s strategy for economic and monetary integration: i) simplified requirements for harmonizing national law to the essential standards and called for systematic adoption of mutual recognition of national norms and regulations; ii) established a faster and more efficient deciSion-making process by extending the scope of qualified majority vote; iii) gave the European Parliament a greater role in the legislative process; and iv) re-affirmed the need to strengthen the Community's economic and social cohesion.
13. Considerable progress has also been achieved in the implementation of the "Internal Market programme," which is designed to liberalize the movement of capital flows in the community. By July 1990, eight member countries of the EEC had fully liberalized capital movements and others were expected to follow after a transitional period.
14. The reduction in average inflation in the member countries of the EMS has been accompanied by a remarkable reduction in inflation differentials. Furthermore, co-ordination of monetary policies in the EMS has meant a significant narrowing of interest rate differentials among the currencies of the EEC member states. The
act of irreversible interlocking of exchange rates of their currencies could lead to a further narrowing of interest rate differentials. The introduction of a common currency promisses to el iminate most transaction costs and eventually result in the convergence of nominal interest rates. Interest rates will then have an identical risk premium, one that will stem from uncertainty between the European community and external currencies and not from uncertainties among EEC currencies. All things being equal, one would assume that the process of capital liberalisation should give rise to lower interest rates in the EMS as further gains are made in resource mobilisation and financial intermediation. However, others argue that an attempt to achieve full capital liberalisation at too quick a pace could give rise to significant increases in interest rates or additional foreign borrowing by some EEC governments. 1/
15. Admittedly, the Internal Market Programme will pose challenges to member countries of the community. In particular, since it will reduce room for independent policy manoeuvre by individual members of the community and will amplify the cross-border effects of developments originating in each member country. Consequently, there will be a need for community policies in support of a broadly balanced development in the region, greater convergence of economic performance, and more intensive and effective policy co-ordination.
These developments are evidence enough that each country will be less and less shielded from developments elsewhere in the community.
16. However, economic and monetary union in the EEC would imply more than an Internal Market Programme. It entails, major steps being taken in all areas of economic policy, such as: a particular role being assigned to common policies aimed at developing a more balanced economic structure within the community; and the adoption of permanently fixed exchange rates. The latter would remove the
1/ George Reynolds, Irish View on Capital Liberalisation and Strengthening of the European Monetary System, Speech before the Committee on Economic and Monetary Affairs and Industrial Policy of the European Parliament, Brussels, 31st May, 1988.
E/ECA/TRADE/91/29 Page 6
exchange rate as an instrument of adjustment from the melllher countries' set of economic tools. Consequently, economic illlhalances among melllher countries would have to be corrected by policies affecting the structure of their economies and costs of production, if major regional disparities in output and employment are to be avoided.
17. The attainment of an "internal market" in the EEC in 1992 implies, in the monetary and financial area, the elimination of all remaining restrictions on the full mobility of capital and the complete freedom for households, firms and financial intermediaries in the melllher states to demand and supply financial services. At present, short-term capital is not yet wholly transferable within the EEC and the national markets for financial services are not fully open. However, the implementation of the programme of the internal market in the EEC could result in the full liberalization of the capital and money markets in the region.
18. The European Council confirmed at its meeting in June 1988 its commitment to the objective of economic and monetary union and on the need to propose concrete stages leading towards the progressive realization of an economic and monetary union. The Treaty of Rome
(which established the European Economic Community), as amended by the Single European Act of 1985, provides the legal foundations for many of the necessary steps towards economic integration in Europe.
However, this does not suffice for the creation of an economic and monetary union. Economic and monetary union in Europe will require a change of the Treaty of Rome and consequent changes in national legislation. Furthermore, it would require a single monetary policy and responsibility for the formulation of this policy to be vested in one decision-making body, possibly a single central bank.
19. In su~~ary, the EMS has yet to fulfill fully its mandate for three main reasons: (a) not all melllhers of the European Economic Community (EEC) are melllhers of the European Monetary System (EMS);
(b) lack of sufficient convergence of fiscal policies as reflected in large and persistent budget deficits; and (c) transition to the second stage of EMS and the establishment of the European Monetary Fund has not been accomplished.
III. HISTORICAl. BACltGlWUND ON KOllETAIlY AlII) FINANCIAL ARRAJiGEKBJiTS IN sEx.BCTED AFRICAN COUNTRIBS
20. The post-independence period witnessed disintegration and monetary disharmony in most of the former British possessions as many of these new states attempted to achieve economic self- sufficiency and modernization.!! Nonetheless, these developments rolled back the clock on efforts at regional economic and monetary integration which had taken place in various parts of Africa during the pre-independence period.
21. Before the advent of independence most of the British colonies and territories in Africa belonged to a monetary co-operation arrangement of one form or another. The most notable of these were, the west African Currency Board: the Rand Monetary Area: the East African Currency Board; the Southern Rhodesia Currency Board, and the Central African Currency Board. The West African Currency Board was established in 1913 to serve British colonies and territories in that region. ~
22. Most of the British currency boards were established with a view to act as automatic money changers providing 100 percent Pound Sterling cover for their currencies, and were not allowed to pursue independent monetary, credit or balance of payments policies.
Furthermore, Currency Boards did not have discretionary powers over monetary policy. The East African Currency Board came into existence in 1919 and was mandated to put out of circulation various currencies which were circulating in East Africa and replacing them with the "East African Shilling," whose quantity was determined on the basis of automatic redemption against the Pound sterling.
23. A common currency system also existed during the Federation of Southern Rhodesia (now Zimbabwe), Northern Rhodesia (Zambia) and Nyasaland (Malawi). The Southern Rhodesia Currency Board was established in 1939 and it was subsequently replaced by the Central
!! Preferential Trade Area for Eastern and Southern African states, The Monetary Harmonization Programme of the Preferential Trade Area for Eastern and Southern Af:rican States, Report of a Technical Study Group, Lusaka, Zambia, 15 August 1990.
~ For more on African currency Boards, see: J.B. Jones, The West African Currency Board 1912-1962; and J.W. Kratz, "The East African Currency Board," IMF Staff papers, July 1, 1966, pp. 240-241.
EjECAjTRADEj91j29 Page 8
African currency Board in 1954.§j An enabling Act (the currency and Coinage Act) was passed by the government of the Federation of Rhodesia and Nyasaland to provide for legal tender and to authorize expenditure in preparation for the establishment of a central bank in the area. The Bank of Rhodesia and Nyasaland, established in 1956, was to serve as a central bank for the Federation and accordingly, replaced the Central African Currency Board.
24. Efforts at economic and monetary integration in Africa are therefore not new and have been used in various forms during the colonial era. The best known experiment at economic integration was the East African Community, which grouped together Kenya, Tanzania and Uganda. These countries agreed to co-operate in developing various sectors of their economies, as was evidenced in the creation of the East African Development Bank. However, the East African community, like other efforts at integration, also crumbled following the attainment of independence by the three members of the Community. The colonial era provided for monetary harmonization and integration for groups of countries in the English-speaking countries of Africa through the creation of Currency Boards.
25. The Report of a Technical study Group on Monetary Harmonization Programme in the PTA states indicates that in the immediate post independence period the African financial system was relatively liberal. However, this changed as African countries experienced serious balance-of-payments problems. The Report states:
"the use of the exchange rate and fiscal and monetary policies as instruments for curing balance-of-payments problems does not appear to have been given much thought in the immediate post independence period by any of the countries. The resort to exchange control and payment restrictions (in subsequent years) at the exclusion of the use of fiscal and monetary policy tools, therefore, resulted in a multiplicity of
diverse, inconvertible currencies and exchange regimes which are not compatible with intra-regional trade expansion and integration." 1/
§j See C.T. Mwalwanda, Balance of payments Management in Malawi, 1966-1976, Ph.D. Dissertation, University of Toronto, Canada, 1979, pp. 27-30.
1/ PTA, Monetary Harmonization Programme of the Preferential Trade Area for Eastern and Southern African States, Report of a Technical Study Group, Lusaka, Zambia, 15 August 1990, pp. 1.3.
26. The Report further states that the PTA region, among economic integration regions in Africa, has perhaps, the most diversified systems of exchange regimes and is also the one in which some of the most restrictive trade and exchange policy regimes persist.
This diversity of trade and exchange policy regimes constitute a ,major handicap in the effort to promote economic integration. As most of the Anglophone countries of Africa belong to the Eastern and Southern African Preferential Trade Area this observation is important to note.
27. Political independence was followed by the establishment of individual central banks in most African countries. However, national currencies that were created after independence were initially tied to the currencies of the countries of the former colonial rulers and were generally freely convertible in the initial stages into other currencies. For Anglophone Africa this meant that most of their currencies were tied to the Pound Sterling in the immediate post-independence period. These arrangements were reinforced by the Sterling Area Agreements. Accordingly, exchange control regulations were often similar.
28. Similarly, a number of financial institutions currently operating in Africa were or are still subsidiaries of institutions existing in the former metropolitan powers. Thus, capital liberalization in the EEC and the latter's opening up to Eastern Europe and the soviet Union will mean greater competition for resources likely to adversely affect a great number of African economies. The possibility exists that international banks based in the EEC may shift their financial services from Anglophone African countries to the EEC market and Eastern Europe. It is worth nothing that in Anglophone Africa, the EEC based international commercial banks include Barclays Bank D.C.O., standard Chartered Bank and others which have extensive operations
in Africa, either as subsidiaries or as partners with other local shareholders and it is not possible to predict their future plans in the face of these developments.
29. Following the attainment of independence by most African countries, efforts at economic and monetary integration have intensified. A number of clearing and payments arrangements have been established. In East Africa, the PTA Clearing and Payments House has been established in addition to the PTA Trade and Development Bank. In Central Africa, the Central African Clearing House (CACH) was created in 1979 and in West Africa, the West African Clearing (WACH) in 1975.
30. Monetary and financial integration efforts are more successful in West Africa since the establishment in 1982 of the West African
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Monetary Union (WAMU). studies have shown that five of the seven states which have recorded statistically significant positive intra-African trade growth are members of WAMU. Furthermore, it would appear that members of WAMU have achieved much more stable long-term growth than their neighbours.
31. Recently, the Economic community for West African states (ECOWAS) group decided to create a monetary union by the year 1994.
Similarly, the PTA sub-region has in principle agreed to implement a programme of monetary harmonisation leading to a monetary union.
The present ideas of monetary harmonization and union in Africa derive not only from general awareness of regional unification efforts in other continents but also from some of the problems faced by the public in their attempt to freely integrate the markets for goods, capital and labour in the region. Accordingly,
it is anticipated that as integration efforts in other continents intensify, Anglophone Africa's efforts at economic and monetary integration will also intensify.
IV. TilE EUROPEAN MONETARY SYSTEK AND KONETARY POLICY IN AFRICA
32. The main focus of this section of the paper is an examination of the likely implications the new developments in the European Monetary System could have on the conduct of monetary policy in Africa. In particular on exchange rate management, determination of interest rates and the effectiveness of instruments of monetary policy.
(a) Exchange Rate arrangements countries
in .~lJglQphone African 33. Exchange arrangements in
twenty Anglophone African countries (see Chart 1) range from a single currency peg to an independently floating exchange rate system. About 15 of the 20 countries surveyed were either pegged to a single currency or a "composite of currencies". At the end of 1987, seven (Ethiopia, Liberia, Sierra Leone, somalia, sudan, uganda, and Zambia) of the twenty countries covered by the study were pegged to the United states dollar, six (Botswana, Kenya, Malawi, Mauritius, Seychelles, and Tanzania) to a composite of currencies and two (Leshoto, and swaziland) to other types of currency peg. Of the remaining five Anglophone countries, Egypt has a managed floating arrangement and the Gambia, Ghana, Nigeria, and
CHART 1
fEATURES Of EXCHANGE RATE DETERMINATION IN ANGLOPHONE AFRICAN COUNTRIES. 1987
Other Gun 2
Mane-geo Floetm\i 1
CIJP.PENCY ?EG
Zimbabwe are under independent floating arrangements. Muzorewa study's (1990) of exchange rate arrangements for 40 African
countries established that at the end of 1989, nearly 38 (or 78 percent) were either pegged to a.single currency or a composite of
E/ECA/TRADE/91/29 Page 12
currencies and only 11 (or 22 percent) had adopted more flexible exchange arrangements.
HI
34. As stated before, greater monetary and financial integration in the European Economic Community will invariably lead to total and irreversible convertibility of the European currencies of the EEC and elimination of margins of fluctuations as well as irrevocable locking of exchange rate parities. The question is:
how will these developments impinge on exchange rate arrangements of Anglophone African countries?
35. In order to p.roperly respond to the above question i t is essential to exam~ne the existing exchange rate regimes in Anglophone Africa and then evaluate how these are likely to be affected by the new developments in the EMS. We begin first by examining the impact new developments in the EMS could have on those African countries currently pegged to the united States dollar. For these countries, the decision of whether to stay pegged to the US dollar or change will depend on at least the following two factors. Firstly, whether the "composite European currency" gains prominence as a "reserve currency" equal to or greater in its share in international transactions with the united states dollar. Secondly, whether the share of trade of these African countries with the EEC countries as well as the main currency in which external transactions of the country concerned are conducted will be either positively or negatively changed.
Accordingly, the seven African countries currently pegged to the US dollar could end up deciding to alter their exchange rate arrangements in response to developments in the EMS.
36. For Anglophone African countries currently pegged to a
"currency basket" new developments could significantly alter the stability and relevancy of their existing exchange rate regimes.
Assuming eight currencies are in the currency basket of a given Anglophone African country (the U.S. dollar, Japanese Yen, Pound Sterling, German Mark, French Franc, Italian Lira and Dutch Guilder), the irreversible interlocking of exchange rates of the EEC currencies will mean that all the eight in the basket will for all intent and purposes have become a "single currency" • Accordingly, the country which had hitherto eight currencies in its currency basket will now have only three currencies, the U.S.
dollar, the Japanese Yen and a composite currency of the EEC currencies (call i t the ECU). The stability in exchange rates which may have been offered by the adoption of a basket with eight
HI
Basil C. Muzorewa, The Proposed African Monetary Fund: An Immediate Necessity?, African Development Bank, January 1990.currencies may be substantially different from that offered by the three currencies.
37. Furthermore, the adoption of a Common market in the EEC in 1992 could result in a significant shift in trade shares of African countries with the EEC. Should this situation develop, then the trade-weights used in the calculation of a currency basket could be altered significantly as the European market is eroded for some African countries. African countries will therefore need to evaluate how such a development could significantly alter existing exchange rate arrangements and their appropriateness.
3a. For the five countries currently on a "float.ing" exchange rate regime, these developments will have minimal influence on their exchange rate arrangements. Nonetheless, the ability to retain this system of exchange rate regimes will also depend on whether the European market is to them a significant market and whether the adoption of a Common Market in the EEC in 1992 will erode that market. Whether independent floating is maintained in these countries will depend on the ability of these countries to earn adequate foreign exchange to support the current exchange rate system.
39. What will worry some African countries most, beyond 1992, is whether the irreversible interlocking of exchange rates of the European Monetary system will alter significantly their existing systems of exchange rate arrangements to warrant changes in their pegging systems. The monetary authorities of these countries will need to undertake studies and simulate possible developments in 1992 and, accordingly advise their respective governments as to the appropriate course of action that needs to be taken.
(b) Interest Rate Determination in Anglophone African countries
40. Another important element of the new developments in the EMS could be their impact on the determination of interest rates in the African countries in general and Anglophone countries in particular. The debate on interest rate policy in developing countries has dealt with a Variety of issues. Not least of all, the relation between financial intermediation and economic growth, the sensitivity of the volume of savings to changes in real interest rates, and the relation between investment and interest rate. The process of financial liberalization in developing countries, including Africa, has shifted the emphasis away from investigating the effects of freeing interest rates to examining how interest rates are in fact determined in developing COUntries,
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once the domestic financial market has been liberalized.2/ There is cumulative evidence to suggest that the high and volatile world interest rates in recent years have at least partially been transmitted into developing countries, suggesting further that interest rates in developing countries are affected by both
"foreign factors" and "domestic monetary conditions".
41. The financial system in most Anglophone African countries can be described as underdeveloped and rather limited. It is typicallY composed of a small number of deposit banks, a few specialized banks, a development bank, few savings institutions, and a postal savings bank. The African financial markets are characteristically public sector institutions, since the state is their major borrower, often accounting for more than fifty percent of the total credit extended by the domestic banking system. A further striking feature of Anglophone African financial systems is the importance of the central bank as a primary source of funds to the economy. In a number of African countries, more than half of the credits provided by the banking system are ultimately extended by the central bank, either directly or indirectly through advances or rediscounts to deposit money banks. Important to note also is that in most of these countries the informal financial sector plays a significant complement role to the organized financial markets.
Traditional money-lenders provide financial services to the rural areas and to some segments of the urban population who do not have access to the organized financial system. For sometime the financial system was primarily oligopolistic as government intervention in the financial markets of most African countries was rather extensive.
42. In this regard, perhaps we need recall that for a number of years most Anglophone African countries considered low interest rates to be inducive to investment and accordingly "financial repression" was widespread. Furthermore, deliberate decisions to maintain low and stable interest rates were often perceived as a countervailing policy designed to ameliorate the perceived baneful effects of the very high interest rates prevailing in the "informal financial sector" or unorganized credit market. However I in recent years a marked shift in policy has occurred in most African countries towards "financial liberalization" and maintenance of
"positive" real interest rates as a deliberate policy for mobilizing an efficient allocation of resources. Accordingly, an analysis of the possible effects the EMS could have on interest rate policy will be conducted within the framework of the 2/ Sebastian Edwards and Mohsin s. Khan, Interest Rate Determination in Developing Countries. A conceptual framework, IMF Staff Papers, Vol. 32, No.3, September, 1985.
transition that is taking place in most African countries towards greater financial liberalization.
43. Recently Anglophone African countries have moved rapidly towards "financial liberalisation, It including freeing of the determination of interest rates. However, due to the lack of developed capital and money markets, the determination of nominal interest rates is still the domain of deposit money banks and the central bank. The parameters for the determination of nominal interest rates often consist of foreign factors as well as the domestic monetary environment. The desire to maintain "positive"
real interest rates has meant that nominal rates have had to be adjusted periodically to equal or exceed the prevailing annual rate of inflation. Nonetheless, domestic interest rates in some African countries have also reflected deposit and lending rates prevailing in major capital and money markets.
44. The opening up of the financial sector has meant that both domestic and external factors come to bear on the process of determination of interest rates. This process will be significantly different under alternative degrees of openness of the capital account of the balance of payments. In the case of a fully open capital account some form of interest arbitrage exists;
thus domestic interest rates depend. on world interest rates, expected devaluation, and some risk factors. Accordingly, as Anglophone Africa moves towards greater financial liberalization, in tandem with capital liberalization in the European Economic Community, foreign factors will increasingly come to bear on the determination of interest rates in the region.
45. How do external factors impinge on interest rates prevailing in African countries, and particularly in Anglophone Africa?
Firstly, African financial institutions borrow from international financial institutions to supply their clients with seasonal financing, often in the form of exports pre financing and pre-export processing. The amount outstanding of such borrowing by the financial institutions of the twenty countries identified above (excluding monetary authorities) totalled about US$29.l billion at the end of 1989. In order not to make losses, the financial institutions borrowing abroad inevitably have to ensure that they also lend at interest rates equal to or above those prevailing in international financial markets. Secondly, a number of Anglophone African countries have programmes with the International Monetary FUnd and the World Bank (Structural Adjustment Programmes).
Execution of such programmes often includes implementing certain economic and financial policies, and adjUstment of real and nominal interest rates are usually part and parcel of the policy package.
To the extent that recommended adjustments take into account
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movements in international interest rates and developments in domestic monetary aggregates and inflation rates, external developments will indeed enter into the determination of domestic interest rates in African countries.
46. A further examination of nominal and real interest rates in the twenty Anglophone African countries covered by this study reveals two facts. Firstly, for low inflation countries (Botswana, Kenya, Lesotho, Malawi, Mauritius, Swaziland and Zimbabwe) nominal interest rates after 1985 appear to have moved in line with international interest rates as reflected in the London Interbank Offer Rates (LIBOR). Accordingly, nominal interest rates in these countries appear to partially reflect developments in international interest rates. This situation could be a result of domestic rates responding to international rates through external short-term borrowing or through the IMF requests to these states to periodically adjust domestic rates to reflect both domestic and external monetary factors. Secondly, for high-inflation countries, movements in nominal interest rates appear to mainly reflect developments in domestic monetary and inflationary factors. For these countries (Sierra Leone, Somalia, Sudan, Tanzania, Uganda, and Zambia), real interest rates are extensively negative. If nominal interest rates are adjusted in these countries, in order to achieve positive interest rates, this could result in very sharp increases in such rates. Accordingly, a two-pronged appears necessary combining dual efforts aimed at reducing the inflation rate while, at the same time, periodically increasing nominal interest rates. This is the approach which appears to be pursued in such countries as Ghana, Uganda and Tanzania.
47. How then will new developments in the EMS affect the determination of interest rates in Anglophone Africa? As already stated, a possibility exists for two alternative scenarios. On the one hand, greater monetary co-operation in the EMS, leading up to the creation of a single currency, could result in a significant narrowing down of interest rate differentials in the EMS and therefore a fall in interest rates in the EMS. This could have a positive effect on nominal interest rates in Anglophone Africa.
A fall in interest rates could reduce interest payments on Africa's external debt as well as reduce the cost of borrowing from European banks. On the other hand, it is important to take note that full capital liberalisation at a rapid pace could give rise to significant increases in interest rates or additional borrowing requirements by some EEC governments. This development could exacerbate the debt problems of Anglophone Africa and raise significantly the cost of their external debt. Which of these two developments is likely to occur (i.e. an increase or a fall in interest rates in the EMS after 1992), is indeed difficult to forecast. It may, however, suffice to take note that both
possibilities exist. Anglophone African countries will need to be conscious of the possible adverse effects which could arise.
(c) ~nduct of Monetary Policy in Anglophone Africa
48. The efficacy of monetary policy in developing countries in general and in African countries in particular, has been a subject of extensive debate for some time. The debate has centred not only on the effectiveness of monetary instruments in affecting monetary aggregates but more importantly on whether monetary policy in these countries is capable of influencing the main macro- economic variables of output, prices and employment.
49. Anglophone Africa's financial system still remains rudimentary, despite the significant developments that have taken place since independence. Accordingly, capital and money markets are underdeveloped, which in turn tends to reduce the efficacy of monetary policy. Traditional monetary instruments used in developed countries (i.e. open market operations, changes in discount rates, and influencing "free reserves" of the banking system) are not that effective in developeing countries. In the past, African monetary authorities in the bid to control monetary policy have relied on a number of instruments such as a combining of target growth rates for the money supply, domestic credit controls, changes in central bank discount rate, exchange controls, and moral suasion.
50. Needless to say, and in view of the practice of "basket currencies, It full integration of the European Community capital markets will have deep implications for domestic monetary policy, eXChange-rate policy and fiscal policy in the Anglophone countries.
Accordingly, full liberalization of capital markets will impose a choice on a target and the loss of a policy instrument (i.e. it will have to be achieved at the sacrifice of independent monetary policy among EEC countries). The burden of national adjustment to economic shocks will under this environment fall more and more on fiscal policy.
51. The problem is to answer how these developments affect the conduct of monetary policy in Anglophone Africa? Clearly for the African countries whose financial systems are relatively open, new developments in the EMS will have spill-over effects on the conduct of monetary policy, particularly for those African countries with significant foreign liabilities to EEC financial institutions. For those countries with a significantly underdeveloped financial system, the effects are likely to be peripheral.
E/ECA/TRADE/91/29 Page 18
V. THB OS :AND PIHl\lJCIAL RESOURCB PLOWS TO URIeA
52. The extent to which Anglophone financial institutions may find reduced access to financial markets of the EEC will depend on various factors. Among some of the most important are the extent to which capital liberalization in the EMS will result in expanded investment opportunities within the EEC, the degree to which the adoption of market-oriented reforms in Eastern Europe and the Soviet Union will induce financial resource flows from the EEC to those regions, and the impact the new developments are likely to have on financing of government budget deficits in the EEC itself and therefore, on foreign aid commitments.
53. The attainment of an economic and monetary union (EMU) in the EEC will invariably mean a commitment to an exchange-rate target (expressed in irrevocably interlocked exchange rates) and sacrifice of independent monetary policy among EEC countries. An Economic and Monetary Union will eliminate monetary financing of budgets and hidden tax collections through regulation of banking reserves (seigniorage). As a result, financing of public-sector borrowing will occur primarily through capital markets at non-privileged rates. Furthermore, it will not be possible to resort to surprise inflation through devaluation of public debt (inflationary financing of the budget deficit).
54. The need for convergence of policies in the EEC will further put a lid on public deficits of EEC member countries in order to avoid unsound public policies that could jeopardise monetary stability in the zone and the Community's external balance. This will impose limits on national public deficits. These constraints on budget policies of EEC member states could add to those stemming from the removal of tax frontiers and interest-rate competition and from the adjustment necessary for (especially for high-inflation EEC countries) nominal convergence with low-inflation countries.
101 Whilst these moves will be of benefit to the EEC as stated by Costa, yet they are bound to have an adverse effect on aid flows from EEC countries to Africa as the zone goes through its adjustment process.
55. The rapid developments of the last two years point to a more difficult period for the African continent in terms of resource flows as demand for international savings is expected to exceed supply. Furthermore, there is a chorus of voices in the EEC to 1Q/ Carlos Costa, EMU: The Benefits outweigh the Costs, European Affairs, pp. 22-27.
provide some form of associate membership to some Eastern Europe countries and even the Baltic states. Whether Africa in general, and Anglophone Africa in particular, will be able to compete effectively for resources with EEC's new friends, in spite of Lome IV convention, remains to be seen.
E/ECA/TRADE/91/29 Page 20
VI. AFRICAN EXTERNAL DEBT SITUATION AND ANTICIPATED
CHANGES IN 1!!K8 EXCHANGE RATE KAHAGEXEHT
56. As stated earlier, under an economic and monetary union there would be total and irreversible convertibility of Community currencies at fixed rates, or more probably a single Community currency. It is possible to assume that a common European currency (ECU) would initially appreciate against currencies outside the European Monetary system, especially the united States dollar and the Japanese yen. An assumption which is based on the belief that the ECU may gain ground as a reserve currency, and a currency for international transactions. We can simulate the impact of an appreciation of a common European currency (against currencies outside the EMS), ranging from 5 to 15 percent, might have on the external debt of African countries. The exercise is purely illustrative. (see Tables I, 2, and 3)
57. A number of African countries debt is not only owed to countries of the EEC but significantly denominated in currencies of the EEC (Pound Sterling, Deutchemark, French Franc, Italian Lira etc.) and the ECU. Accordingly I the creation of a common European currency unit will have an impact on the debt outstanding of African countries. At a simplistic level we have assumed that fifty percent of the debt outstanding at the end of 1988 of the twenty countries covered by this study is denominated in EEC currencies (approximated by the ECU). This amount is equivalent to US$64.1 billion and converted into ECU at exchange rates prevaling at the end of 1991, amounts to nearly 55.2 billion.
58. On the assumption that the European currency unit (ECU) appreciates by nearly 5 percent against major currencies outside the EMS after 1992, the ECU-denominated debt of the tweny African countries would in us dollar terms increase and total debt outstanding of these countries would rise purely due exchange rate variations from U8$128.3 billion to US$131.5 billion (or 2.5 percent). Similarly, an appreciation of the ECU by 10 percent would increase the debt stock from US$128.3 billion to US$134.7 billion (5 percent). A 15 percent appreciation would result in a rise in the debt outstanding of these countries of 7.5 percent, from US$128.3 billion to US$137.9 billion (see Tables 1,2, and 3), Thus purely on the basis of exchange rates of the ECU vis-a-vis exchange rates of major currencies outside the EMS I Africa' s external debt burden could be aggravated by developments in the EMS.
59. This simple example demonstrates that through the creation of a common currency in the EEC, if it resulted in an initial appreciation of the BCU, the debt burden of African countries could be aggravated. At a national level, the analysis would have to be conducted in greater detail. It would have to involve analy~ing
the currencies in which a country's debt is denominated and the currencies in which it is serviced, the amount of interest changes on such debt, and the percentage of the debt which is denominated in BEC currencies and the European currency unit.
E/ECA/TRADE/91/29 Page 22
VII, CONCLUSIONS
60. Some conclussions can be drawn with respect to the effects on the economies of Anglophone countries as a result of the process of achieving greater integration of the European Monetary system.
First, it is safe to assume that a common European CUrrency would be at least as good or even stronger than individual currencies of the EEC. In this respect, it could provide an alternative to other convertible currencies and as a reserve currency. Second, as the completion of an internal market is achieved, each country will be less and less shielded from developments elsewhere in the community. Nonetheless, a number of obstacles still exist in the process of achieving an EMS. For instance, not all EEC states are members of the EMS and therefore the effects can not be predicted in totality as the situation may change in the long run.
Similarly, the fiscal policies of EEC members need to converge even closer for them to decide how to deal with third parties.
Finally, a European Monetary Fund has not yet been established.
It is difficult to pass judgement on how it will accomodate the current non-CFA zone African countries as oppossed to those in the CFA zone.
61. However, what can not be disproved 1s the fact that the above developments in the European Monetary System will have an impact on most African economies irrespect of their present status.
Developments in the EMS will affect Anglophone African countries in the determination of exchange rate regimes, the debt service capacity through its effects on interest rates, the conduct of monetary policy and the flow of international capital.
62. consequently, and given the rapid developments taking place in the EEC, and other regions of the world, Africa should also attempt to proceed in tandem with efforts at market and monetary integration rather than merely reacting to developments in the EEC's market and monetary integration process.
Country
Botswell&
Egypt
Ethiopia nanf,ia Ghane Kenya
Leshoto Li~ria
Malawj Mauritius
"'igeria Sierra Le<me Somalia Sudan Strleziland Tanlania Uganda Zanbi a Z i I'fi)abwe Touts
'rABLE I
EXTERNAL DEST OUTSTANDING Of SELECTED AfRICAN COUNTRIES AND SIMULATED ~ESUlTS Of AM AP?REC1ATIQH ~N THE
EUROPEA. CURRENCY UNIT «(CU)
External Debt Assl..ne half is feu OertOmtMted ECU Oenani noted Outstanding 85 denominated in debt .t 1991 Debt 8SSlIIIiog 5X end of 1988 fCU currencies Exchange rates eppreciat1C>f"1 of ECU (millions of US $) (m; U ions us S) (millions of SCU) II (mllll"". US I)
499.10 249.55 214.65 262.03
49,970.00 24,985.00 21,490.62 26,234.25
2,978.00 1,489.00 1,280.75 1,563.45
327.00 163.50 140.63 171.68
3,099.00 1,549.50 1,332.79 1,626.98
5,888.00 2,944.00 2,532.26 3,091.20
281.30 140.65 120.98 147.68
1,632.00 816.00 701.88 856.80
1,349.00 671.,.50 580.17 708.23
861.00 430.50 370.29 452.03
30,718.00 15,359.00 13,210.91 16,126.95
727.00 363.50 312.66 381.68
2,035.00 1,017.50 875.19 1,068.38
11,853.00 5,926.50 5,097.63 6,222.83
264.80 132.40 113.88 139.02
4,729.00 2,364.50 <,033.80 2,482.73
1,925.00 962.50 827.89 1,010.63
6,498.00 3,249.00 2,794.60 3,411.45
2,659.00 1,329.50 1,11,3.56 1,395.98
128,293.20 64,146.60 55,175.12 67,353.93
Total Oebt outstarding
End 1992 (millions us $)
511.58 51,219.25 3,052.45 335.18 3,176.48 6,035.20 288.33 1,672 .80 1,382.73 882.53 31,485.95 745,18 2,085.88 12,149.33 271.42 4,847.23 1,913.13 6.660.45 2,7L5.48
131,500.53 1/ Th~ rate used tu eoovt'rt US$ values to fCU is that which prevailed ot'l A!JQust 2, 1991. 1 ECU = 1.626 USS
E/ECA/TRADE/91/29 Page 24
Country
Batswana
£gl'Pt Ethiopia GMbia Ghana Kenya teshoto liberia Matawi Mauritius Nigeria Sierra leone SOOIal i e Sudan
$10181 i land Tanzania Uganda ZOl'ft;ia linDEibW'e
TABLE IT
EXTERNAL DEBT OUTSTANDING OF SELECTED AFRICAN COUNTRIES AND SIMULATED RESULTS OF AN APPRECIATION IN TKE
EUROPEAN CURRENCY UNIT (ECU)
External Debt Assune hal f is fCU Denominated fCU Denomi noted OutsteOOlrlg 8S denominated in debt at 1991 Oebt ass ... i ng 10%
end of 1988 ECU cUf"re:t1Cies Exchange rllte$ apprecjat\on of ECU (ft'l111.ons of US $) (mi II ions US $) (millions of Eeu) 1/ (millions US S)
499.10 249.55 214.65 274.51
49,970.00 24t985~OO 21,490.61 27,=.50
2,978.00 1,489.00 1,280.75 1,637.90
327.00 163.50 140.63 179.85
3,099.00 1,549.50 1,332.79 1,704.45
5,888.00 2,944.00 2,532.26 3,238.40
281.30 140.65 '20.98 154.72
1,632.00 816.00 701.88 897.60
1,349.00 674.50 580.17 741.95
861.00 430.50 370.29 473.55
30,718.00 15,359.CO 13,210.91 16,894.90
727.00 363.50 312.66 399.85
2,035.00 1,017.50 875.19 1,119.2S
11,853.00 5,926.50 5,097.63 6,519.15
264.80 132.40 113.88 145.64
4,729.00 2,364.50 2,033.80 2,600.95
1,925,00 962.50 827.89 1,058.75
6,498.00 3,249.00 2,794.60 3,5T.l.90
2,659.00 1,329.50 1,143.56 ',462.45
Total Debt outstanding
End 1992 (millions US $)
524.06 52,468.50 3,126.90 343.35 3,253.95 6t 182~40
295.37 1,713.60 1,416.45 904.05 32,253.90 763.35 2,136.75 12,445.65 278.04 4,965.45 2,021. 25 6,822.90 2,791.95
~==:====;============~~====~;==~~=====================~=:~====:~===-====~==========~=====~============;=============%===
Totels 128,293.20 64,146.60 55,175.12 70,561.26 1341101.86
1/ The rate used to convert USS values to ECU is that which prevailed on August 2, 1991. 1 ECU = 1.626 USS
C04..l)try
Botswana
Egypt Ethiopia GR18 Ghana
Kenya leshoto liberja Natawi M8Urit ius Nigeria Sierra leone somalia
sOOan Swaziland Tanzania
Uganda Zao'bi a Zirilobwe
7ABLE III
EXTERNAL DEBT OUTSTANDING Of SElEcTED AfRICAN COUNTRIES ANO SIMULATEO RESULTS OF AH APPRECIATION IN THE
EUROPEAN CURRENCY UNIT (ECU)
Extern.a l Debt AsslIIle hal f IS ECU Def'IOOl;lnated Eeu Denominated OUtstanding 8G denominated 1n debt at 1991 Debt assl.IfIing 15%
end of 1988 ECU currenc i es Exchange rates appt"'&C; at i on of fCU (mil tions of us $) (m; II ions US $) (millions of EOU) 1/ (millIons US $)
499.10 249.55 214.65 286.98
49,970.00 24,965.00 21,490.62 28,732.75
2,978.00 1,4&9.00 1,280.7"5 1,712.35
327.00 163.50 140.63 188.03
3,099.00 1,549.50 1,332.79 1,781.93
5,6Il8.00 2,944.00 2,532.26 3,385.60
281.30 140.65 120.98 161.7'1
1,632.00 816.00 701.88 938.40
1,349.00 674.50 580.17 m.67
861.00 430,50 370.29 495.08
30,718.00 15,359.00 13,210.91 17,662.85
n7.00 363.50 312.66 418.03
2,035.00 1,017.50 87"5.19 1,170.12
11,853.00 5,926.50 5,097.63 6,815.4&
264.80 132.40 113.88 152.26
4,729.00 2,36'<.50 2.033.80 2,719.18
1,925.00 %2.50 827.89 1,H16.88
6,498.00 3,249.00 2,794.60 3,736.35
2,659.00 1,329.50 1,143.56 1,528.93
Total Debt ovts t and i ng
End 1992 (millions us $)
536.53 53,717.75 3,201.35 351.53 3,331.43 6,329.60 302.40 1,7"54.40 1,450.18 925.58 33,021.85 781.53 2,187.63 12,741.98 284.66 5.083.68 2.069.38 6,985.35 2,858.43
;;~;;=~:=:;;;~;==~~~:=;;;;;~~====~;;;=;;;~~;;;;;;;;;:~==~=x;;;;====;;~~;:====~;==:======~=:==;=====~========~=~==~~~==;
Totels 128,293.20 64,146.60 55,17"5.12 1'3,768.59 137,915.19
1/ The rate used to convert US$ values to ECU is that which prev81led on August 2, 1991. 1 ECU = 1.626 US$
