The determinants of real exchange rate in the West African monetary zone (WAMZ)

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AFRICAN INSTITUTE FOR ECONOMIC DEVELOPMENTAND PLANNING INSTITUT AFRICAIN DE DEVELOPPEMENT ECONOMIQUE ET DE PLANIFICATION

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THE

DETERMINANTS

OF

REAL

EXCHANGE RATE

IN

WEST AFRICAN MONETARY ^NE (WAMZJ

By

Lansana DABOH

Submitted inpartial fulfilment oftherequirements forthe award of Master ofArts Degree

in EconomicPolicy and Management atthe African Institute for economic Development

and Planning(IDEP)

Supervisor: Professor Aloysius Ajab AMIN

April 2009

At _H I _I ^& I

UNITED

NATIONS

AFRICAN INSTITUTE

FOR ECONOMIC DEVELOPMENT AND PLANNING

IDEP

•

• This-is to certify that

Lansana DABOH

Identification N°080710

has successfully defended the M.A. thesis ^entitled

THE

DETERMINANTS

OF REAL

EXCHANGE

RATE

IN THE WAMZ

Approved by the Thesis Committee:

s#

^JUT

Aloysius Ajab AMIN

Director a.i./

Chfel^/ailiing

Divisiofil \ 21

ff

³

\^t-\

Medou DIAKHATE

Dipo BUSARI

Aloysius A. AMIN.

V-v—- _//_A£& /_{-S /}

,,/ANHOUIDI

Chairmi

Coordinator of UN System / UNDP ResidentRepresentative

W/

A/... MT'I.AA

DEDICATION

To my late mom, Boh Fantaand my sickold dad, Alhaji Abdulai; you both believe in^me

since when I was alad. And _{to my}wife, Isatu andkid daughters, Bejou and Batulie; I did

this foryou, you are myinspiration.

ACKNOWLEDGEMENT

Bismilahi Rahmani Raheem, Alhamdulilahi Rabil Alamin. This is another milestone for

me in the academia and praise is to the glorious one, that after going through thick and thin, I stand out tall and proud. After 18 months of wallowing in academic torture and depression ofbeing away from home, today what I experience is victoryand emotional

wholeness.

My invaluable appreciation ^{goes to} the Central Bank of Sierra Leone forhaving granted

me the opportunity to further my career through the Masters programme in Economic Planning and Management at the United Nations African Institute for Economic Development and Planning (UNIDEP). Furthermore I am grateful to the Government of Senegal for makingmystayin thecountryamemorableone.

I am specifically indebted to my supervisor, Professor Aloysius A. Amin (the Deputy

Director and Head of the Training Division) for the intriguing, brainstorming, thoughtful

and provocative ideas that he shared with me in a bid to produce an excellent piece of

work and improve the quality of the study. Special thanks also go to all my lecturers for having played avital role innurturing andmodeling me into anAfricanpartisanwith the

burden ofmaking Africaabetter continent.

Itake the honor to appreciate the MA coordinator, Dr. Dipo T. Busari and the entire staff

of UNIDEP for guiding me throughout this period and for being ^a source of encouragement in and around UNIDEP. My sincere thanks go to the interpretation

section that not only helpedme understand thecourse, but made it interesting and worth pursing. Iamproud ofyou forhavingdonea challengingbut remarkable task diligently.

Ithank God for the family he has blessed mewith. No words can describe the ^ever-sure,

enormous support and heartening encouragement from my sister, Chernor Amie and

brothers(Karamoh, Foday Musa and Abdul Karim). Though physically absent, you were

present in every detail ofmy stay in Senegal. Your calls, yourwords ofencouragement made a heavy work lighter. Furthermore I extend my sincere gratitude to Dr. Robert

DaudaKorsu forremindingmethat "Yes Icanbe" if I purposedto.

Thisstudy would nothave been a successhaditnotbeen for the relations and friends that

I have been honored to meet. First I appreciate the 'Sy family' at Blanche, especially

Mama Fatmata (Ofofi) and children, Abdul Rahman, Aminata and Tejan Sy, who made

my stay a memorable one. I salute the 2007/09 MA class; Adamu, Aruna, Asmau, Dieynaba, Jacqueline, Jollam, Kwesi, Lamin, Mamoudou and Sayi for the togetherness

we shared both in difficult and easy periods. I am especially indebted to Alie, Angella, MillyandMolai for standing with^meas Iundertook this study.

ABSTRACT

The study seeks to investigate the determinants of both the actual and equilibrium real exchange ^rate (RER) and to obtain ^amodel-based equilibrium RER and characterise the

nature of RER misalignment in the West African Monetary Zone. In order to address

these objectives, annual aggregate data from 1970to 2006 were usedto estimate amodel of RER, which was developed by taking into consideration the interactions among

exchange rate, monetary and fiscal variables. Based on time-series characteristics of the data, an error-correction model is formulatedto estimate the determinants of RER. The ERER model was also estimatedby the application of OLS. The Elodrick-Prescott filter method was used to arrive at the equilibrium exchange rates and hence the RER misalignment. The results for the four countries' models confirmed the significance of variables like the terms of trade, openness, government expenditure, investment as a share of GDP, GDP growth rate, capital flows, domestic credits, nominal and RER (lagged) in line with Edwards' (1989) model, butnotin ^one singlecountrymodel. Terms

oftrade, Openness, government expenditure and investment variables were significant in

all four countries either in the short or long run models. Variables such as GDP growth

rate, capital flows, domestic credits, nominal and RER (lagged) are either significant in only one, two or three countries. The speed of adjustment of the RER ^to equilibrium

ranges fromone yearin the Gambia to four years in Nigeria. What stands clear is thatall the countries RER were found to be misaligned, and the incidence ^was very high in the

fixed exchange rate regime than the managed float regime. The study however,

recommends that policies such ^as monetary, fiscal and as well as commercial should targetthe tradable sector. Also the current floatingexchange rateregime be sustained and improved on.

RESUME

Cette étude cherche à investiguer les déterminants du taux d'échange réel (TER) et du

taux d'échange d'équilibre réel (TEER) et à obtenir un TER d'équilibre basé sur un modèleet à caractériser lanature de défautd'alignementdu TER dans laZone Monétaire

Ouest africaine. Pour traiter de ces objectifs, des données globales annuelles allant de

1970 à 2006 étaient utilisées pour estimer un petit modèle macroéconomique, qui a été développé en tenant compte des interactions entre le taux d'échange et les politiques

monétaires et budgétaires. Dans l'estimation d'une équation unique des dynamiques à

court terme d'une variable, la méthode des moindres carrées ordinaires (MCO) est utilisée _pour arriver au modèle à correction d'erreur. Le modèle TEER a été également

estimé_par l'application de la méthode MCO. La méthode du filtre Hodrick-Prescottaété utilisée _pour arriver aux taux d'échange d'équilibre et partant, au défaut d'alignement

TER. Les résultats pour les modèles des quatre pays ont confirmé la signification de

toutes les variables conformément au modèle d'Edwards (1989), mais pas dans un modèle d'un paysunique. Lestermes de l'échange, l'ouverture, les dépenses publiques et l'investissement en tant qu'une part des variables du PIB étaient significatifs dans tous les quatre pays soit dans les modèles à long terme soit dans les modèles à court terme.

Les autres variables ne sont significatives que pour un, deux ou trois pays. La vitesse d'ajustement du TER en ce qui concerne son rétablissement à l'équilibre va d'un an en Gambie à quatre ans au Nigéria. Ce qui reste clair est que les TER de tous les pays se sont présentés mal alignés, et la fréquence était très élevée dans le régime de taux d'échange fixe comparé au régime flottant géré et contrôlé. Cependant, l'étude

recommande _que des politiques telles que monétaires, budgétaires et commerciales,

doivent cibler le secteur des biens commercialisables. En plus, le régime du taux d'échange flottant actuel devrait êtresoutenu etamélioré.

EXECUTIVE SUMMARY

Economists have argued that exchangerate is ^animportant variable in an openeconomy.

The mainreason beingthat the exchange rateinfluences otherprices (wages, interestrate and the general price level) and the allocation ofresources (between the tradable and the

non-tradable sectors of the economy). Slow growth ofoutput, price stability (low and

stable inflation rate) and poor external sector performance have been characteristics of

many developing countries since the early 1980s, though some others had developed

these undesirable features before the 1980s. Good external sector performance does not only have virtuous effects on the attainment of economic growth and price stability butit

also forms avirtuous cycle with them.

Drawing from this, the attainment of healthy external sector has been critical to both national central banks and the International Monetary Fund. The adjustment of real exchange rate through nominal exchange rate devaluations/depreciations, changes in exchange rate regime and demand management policies (fiscal and monetary policies)

have been common in the attempts at resolving weak external sector performance in

many developing countries. However, the external ^sector performance of most of the developing economies, particularly in sub-Saharan Africa, including WAMZ member

state is still weak and this coexists with slow growth ofoutput and non-achievement of

the price stability objective. In order to have a profound arrest of the problem in a

particular economy, itis imperativetoallow the data^toprovide theempirical reality.

In the lightof these considerations the study seeks to examine the following issues in the

WAMZ. (i) To investigate the determinants of boththe actual (short-run) and equilibrium (long-run) real exchange rates, (ii) To obtain a model-based equilibrium real exchange

rate and characterise the natureof real exchange rate misalignment from the early 1970s

to2006.

In orderto address these objectives, annual aggregatedata from 1970 to 2006 wereused

to estimate a model ofRER taking into consideration the interactions among exchange rate, monetary and fiscal variables. The Ordinary Least Squares (OLS) was used to estimate the short-rundynamics, witherrorcorrection consideration. The equilibrium real exchangerate model was also estimatedby the application ofOLS. The equilibrium real exchangerates from the early 1970sto 2006were also derived. This involvedtwo stages in which in the first stage, the sustainable values of the determinants of the equilibrium

real exchangerate were obtained by applyingthe Hodrick-Prescott filter to the historical values of these fundamentals. In the second stage, these sustainable values were substituted into the estimated equilibrium real exchange rate model to compute the equilibrium real exchange rate. The real exchange rate misalignment was consequently computed given the values of the computedequilibrium real exchangerate and the actual

real exchangerateseries.

A number ofimportant resultswereobtained. Among these are improvement in the TOT significantly depreciates the RER of Gambia in both the short and long run and only in

the short run of Nigeria and Sierra Leone (lagged), as the substitution or price effect outweighsthe income effect oftheimprovedTOT. The result conforms tothe findings of

Baffes et. al. (1997) for Burkina Faso and Cote d'Ivoire and Aliyu (2007) for Nigeria.

Thechange in TOT, however, have significant negative effectsonthe real exchangerates in the short ^run for Ghana, and both the short and long run for Sierra Leone, which

indicates that the income effect is muchgreaterthan theprice effect. It is however, in line

with the findings of Edwards (1989) for twelve developing countries and Aliyu (2007)

forNigeria. The degree ofopenness is significant and has it expected negative sign only

in the shortrun equation of Sierra Leonein it lagged form and in the longrun equation of Nigeria showing an appreciation. The result is supported by the findings of Edwards (1989) for twelve developing countries and Morrissey et. al. (2005) for Ghana. It is however, significant but not having it expected sign in the short run for the Gambia, Nigeria and Sierra Leone equations as well ^as the long ^run in the Ghana equation. The

result is in line with the findings of Mkenda (2001) for Zambia and Mtonga (2006) for

South Africa.

An increase in GEX registered significance depreciation of RER in both the short and long run equations of Ghana and the long run equation of the Gambia. The result conforms to that of the findings of Mkenda (2001) for Zambia and Simwaka (2004) for

Malawi and South Africa. Increased GEX, however, shows an appreciation in both the

short andlongrun RER equations of Nigeria andthe longrun of SierraLeone. The result

is in line with that of Edwards (1989) for twelve developing countries and Aliyu (2007)

for Nigeria. An increase in IGDP significantly appreciates the RER of Gambia and Nigeria in the short ^run and that of Ghana in the long run. The result confirms the findings of Ghura and Grennes (1993) for SSA and Baffeset. al. (1997) for Burkina Faso

and Cote d'Ivoire. It however, found to be depreciating the RER in the long run for Nigeria and Sierra Leone. This is in line with the findings of Edwards (1989) for twelve developing countries andHyderand Mahboob (2006) for Pakistan.

The growth rate of real GDP which is used as a proxy for Technological progress and productivity gain to capture the Ricardo-Balassa effect on the equilibrium RER is

confirmed in the Ghana andNigeria short run RER equations and found to be significant causing an appreciation of the RER. The result is in conformity with the findings of

Ghura and Grennes (1993) for SSA and Alper and Saglam (2002) for Turkey. It is however,significantbuthavingapositive sign, whichdepictadepreciationof the RER in

the short run equation of Ghana (lagged) and the long run equation of Sierra Leone. The results confirm the findings of Edwards (1989) for twelve developing countries and Morrissey et. al. (2005) for Ghana. Capital inflow which was proxy for Exchange and Capital control is found to be significant without it expected sign in the short^run model ofNigeria and the long runmodels ofGhana and SierraLeone. This result is in linewith the findingsofAlper and Saglam (2002) forTurkey and Simwaka(2004) forMalawi and

South Africa. Domestic credit a proxy used for Macroeconomic policy is found to be significant with it expected sign only in the RER equation for Ghana both in it current and previous period. The result confirms the findings of Edwards (1989) for twelve developing countries and Simwaka(2004) for Malawi and South Africa. Domestic credit

was however, foundtobe insignificant inthe Gambia,Nigeriaand SierraLeone.

Nominal exchange rate is also significant with it expected positive sign in the RER equations of Ghana andNigeria (current and previous). The result confirms the findings

of Edwards (1989) and Aliyu (2007) for Nigeria. The nominal exchange rate was found

not being significant in the Gambia and Sierra Leone. However, the lag of the RER is significant and positive in the Gambia and Sierra Leone equations. The result confirms

the findings of Simwaka (2004) for Malawi and South Africa. The error correction terms for all for models are significant at one per cent. The coefficients ^are less than one and have their negativesigns. The speed ofadjustment showed that ittakes about 1.1 and 1.3

years respectively for the RER of the Gambia and Ghana to return to equilibrium. Also,

the speed of adjustment showed that ittakes about 4.1 and 1.5 years respectively forthe

RERofNigeria andSierra Leonetoreturn to equilibrium.

The findings of the study reveal some lessons for policy consideration. Terms of trade improvement in the Gambia and Nigeria lead to depreciation of the actual real exchange

rate. This implies the authorities should promote policies to lower prices of import, resulting to a dominated substitution effect. The authorities in Ghana and Sierra Leone should however redirect theirpoliciesto that of there Gambian andNigerian counterpart.

The results also have implication for commercial policies in the WAMZ. The governments should encourage trade liberalization measures since these policies depreciate the actual and equilibrium real exchange rates, thus improving competitivenessto internationaltrade.

Fiscal authorities in Nigeria and Sierra Leone should redirect expenditure to tradables

like there counterparts in the Gambia and Ghana whose authorities should continue to encourage the greater part of government expenditure on tradables as it lead to

depreciation of the real exchangerate. Tothe extent that increase in the investment share of GDPappreciates the equilibriumreal exchange ratein the Gambia, Ghana andNigeria (short run), implyingthat investmenttakes placemorein thenon-tradable goods sector, it

is recommended that the government increases investment in the tradable sector just as there counterparts in Nigeria (long run) and Sierra Leone and they should implement policies thatencourageprivate sectorinvestment in this sector sothat theequilibrium real exchangeratecan depreciatewith increase ininvestment.

Unlike Nigeria, The governments of Ghana and Sierra Leone should promote policies

that would lead to growth in the economy through total factor productivity (Solow- residual) ^as improvementin the growthrate of RGDP depreciatesthe real exchangerate.

The authorities in Ghana should enhance the use of domestic credit for monetarypolicy

purposes. Nominal exchangerate depreciation leads to real exchangerate depreciation in

Ghana and Nigeria. Depreciation of the RER in the previous period also lead to

depreciation in the current period in the Gambia and Sierra Leone. This suggests that the monetary authorities in the WAMZ can use exchange rate management to check misalignment. The study also has implication for the exchange rate regime in the

WAMZ. To the extent that the period of the fixed exchange ^rate regime had higher real exchange rate misalignment than the periodof the managed floating exchange regime, it

is recommended that thecurrent floating exchangerateregimebe sustained.

TABLE OF CONTENT

Pages

DEDICATION I

ACKNOWLEDGEMENT _II

ABSTRACT _Ill

RESUME _IV

EXECUTIVE SUMMARY _V

LIST OFTABLES, FIGURESAND ANNEXES X

LIST OF ABBREVIATIONS ANDACRONYMS _XI

CHAPTER ONE: BACKGROUND 1

1.1 Introduction ₁

1.2 Statementofthe problem 2

1.3 Objectives of thestudy 4

1.4 Justificationfor theresearch 4

1.5 Organisationof thestudy 5

CHAPTER TWO:MACROECONOMIC PERFORMANCEAND POLICIES IN THE WAMZ 6

2.1 Introduction 6

2.2 Macroeconomicperformanceandpoliciesin theGambia 7 2.3 Macroeconomicperformanceandpoliciesin Ghana 11 2.4 MacroeconomicperformanceandpoliciesinNigeria 16 2.5 MacroeconomicperformanceandpoliciesinSierra Leone 21

CHAPTER THREE:LITERATUREREVIEW 27

3.1 introduction 27

3.2 theoretical reviewon thedeterminantof realexchange rate 27 3.2.1 Definitionsandmeasurementsof realexchangerate 27

3.2.2 Measurementsof equilibriumrealexchangerate 29

3.3 Empiricalevidenceon thedeterminants ofreal exchange rate 32 CHAPTER FOUR:METHODOLOGYANDANALYSIS OF EMPIRICAL RESULTS 36

4.1 introduction 36

4.2 Methodology ₃₆

4.2.1 Theoreticalframework 36

4.2.2 Specificationof theempirical model 41

4.2.3 DataSources, Variabledefinitionandmeasurement 45 4.3 EstimationProceduresandTimeseries properties ofthevariables^... 47

4.3.1 Testsforstationarity ofvariables 47

4.3.2 Cointegrationtests 48

4.3.3 Estimation issues 49

4.3.4 Themodel-basedequilibriumrealexchangerate 55

4.4 RealexchangerateMisalignment 58

4.4.1 Misalignmentin theGambia RER Model 58

4.4.2 Misalignmentin theGhana RER Model. 59

4.4.3 MisalignmentinNigeriaRER Model 59

4.4.4 MisalignmentinSierra Leone RER Model 60

CHAPTER FIVE: SUMMARY,CONCLUSIONAND LESSONS FORPOLICY 5.1 Summaryandconclusion

5.2 Lessonsforpolicy

5.3 suggestions forfutureresearch REFERENCES

ANNEXES

LIST OF TABLES, FIGURES AND ANNEXES

Pages

Figure 1.1: CFA franc^zone andnonWAEMU countries 3

Table 2.1: Key Macroeconomicvariables 6

Figure 2.1: GDP Growth Rates and Inflation in the Gambia 8

Figure 2.2: NominalExchangeRates inthe Gambia(dalasisperUS dollar) 10

Figure 2.3: GDP Growth ^Rates and Inflationin Ghana 12

Figure2.4: Nominal ExchangeRates inGhana(cedisperUSdollar) 15 Figure2.5: GDP Growth Rates and Inflation inNigeria 17 Figure2.6: Nominal ExchangeRates inNigeria (nairasperUS dollar) 20 Figure2.7: GDP Growth Rates and Inflation inSierra Leone 23

Figure2.8: NominalExchange Ratesin SierraLeone(leonesperUS dollar) 26

Table 4.1: CointegrationTest results fromJohansen'sMaximum Likelihood Approach 48

Table 4.2: The Error Correction Models of RER ₅₀

Table 4.3: TheLong-Run Models of RER 54

Figure4.2: Real ExchangerateMisalignment in the Gambia 58

Figure4.4: Real ExchangerateMisalignmentin Nigeria 60

Figure4.5: RealExchange rate Misalignment in SierraLeone 60 Annex 1: Results of the Test forStationarity using DickeyFuller (ADF (0)), Augmented

DickeyFuller (ADF (1&2)) andPhillips Perron (PP (Bartlett Kernel)) for the

Gambia 69

Annex 2: Results of the Test for Stationarity using DickeyFuller (ADF (0)), Augmented DickeyFuller (ADF (1&2))and PhillipsPerron (PP (Bartlett Kernel)) for Ghana.. 69 Annex 3: Results of the Test for Stationarity using DickeyFuller (ADF(0)),Augmented

DickeyFuller (ADF(1&2)) andPhillips Perron (PP (Bartlett Kernel)) for Nigeria 70

Annex 4: Results of the Test forStationarity using DickeyFuller (ADF (0)), Augmented DickeyFuller (ADF (1&2)) andPhillips Perron (PP (Bartlett Kernel)) for Sierra

Leone 70

Annex 5: TheJohansen cointegrationtestresult of the Gambiamodel 71 Annex 6: TheJohansencointegrationtestresult of the Ghanamodel 72 Annex 7: The Johansencointegrationtestresult of theNigeria model 73 Annex 8: TheJohansencointegration^test result of the Sierraleonemodel 74 Annex 9: ParsimoniousECM of the RER of the Gambia and diagnostictestresults 75 Annex 10: ECM of the RER of Ghana anddiagnostictestresults 76 Annex 11: ECM of the RER ofNigeriaand diagnostic^testresults 77 Annex 12: ECM of the RER of Sierra Leone and diagnostic testresults 78 Annex 13: Real ExchangerateMisalignmentinthe Gambia 79

Annex 14: RealExchangerateMisalignment in Ghana 80

Annex 15: RealExchangerateMisalignment inNigeria 81 Annex 16: RealExchange rateMisalignment in Sierra Leone 82

Annex 17: Datasources and description 83

Annex 18: Major trading (Export) Partners intheWAMZ 84

LIST OF ABBREVIATIONS AND ACRONYMS

ADF: Augmented Dickey-Fuller

AFEM: Autonomous Foreign ExchangeMarket

ARER: ActualRealExchange Rate

BDC: Bureaude Change

BoG: Bankof Ghana

BSL: Bank ofSierra Leone

CA: CurrentAccount

CAEMC: Central African Economic andMonetaryCommunity

CAPFLO: Capital Inflow

CBN: Central Bank ofNigeria

CBG: CentralBank of the Gambia CPI: ConsumerPriceIndex DAS: Dutch auctionSystem

DC: Domestic Credit

DF: Dickey-Fuller

ECM: ErrorCorrectionModel

ECOWAS: EconomicCommunity of West African States

ERER: Equilibrium ExchangeRate

ERP: EconomicRecoveryProgramme

FDI: Foreign Direct Investment

FEM: Foreign Exchange Market

FINSAP: Financial SectorAdjustment Programme

GDP: GrossDomestic Product GEX: GovernmentExpenditure

HP: Hodrick- Prescott

IFEM: Inter- bankForeign Exchange Market

IGDP: Investmentratio toReal GrossDomestic Product IMF: InternationalMonetaryFund

KA: Capital Account

MERA: ModifiedExchangeRateArrangement

MP: MonetaryPolicy

NER: NominalExchange Rate

OLS: Ordinary LeastSquares

OPEN: Openness

PP: Phillips-Perron

PPP: PurchasingPowerParity

PSBR: Public SectorBorrowingRequirement

PSD: Programme forSustainedDevelopment

RER: Real Exchange Rate

RERMIS: RealExchange RateMisalignment

RGDP: Real GrossDomestic Product SAP: StructuralAdjustment Programme

SDR: SpecialDrawing Right

SFEM: Second- TierForeignExchangeMarket

SSA: Sub- SaharaAfrica T-Bill: Treasurybill

TOT: Termsof Trade

UK: United Kingdom

US: United States

VAR: VectorAuto-regression

WAEMU: WestAfricanEconomic andMonetaryUnion

WAMZ: WestAfricanMonetaryZone

WDAS: Wholesale Dutchauction System

CHAPTERONE BACKGROUND

1.1 Introduction

In sub-Saharan Africa, the growing overvalued exchange rate

that started in the early

1980s has also contributed to the poor performance on the current account

balance of

most of these countries (Ghura and Grennes, 1993),

thereby aggravating the

poor performanceonthebalance ofpayments

of these economies.

Economists have argued that exchangerateis an

important variable in

an open economy.

Themain reasonbeing that the exchangerate influences

other prices (wages, interest

rate

and the generalprice level) and the allocation

of

resources

(between the tradable and the

non-tradable sectors of the economy). Moreover, the exchange rate

is affected by

macroeconomic policies. It has also been

argued that the exchange

rate

policies of the

high performing East Asian

countries, which contributed

to

low volatility of real

exchange rate and avoided real exchange rate

misalignment (overvaluation),

were

major

factors _among their success, especially their healthy export

performance (Elbadawi and

Soto, 1997). Hence exchange rate policies play

crucial role in the growth and

developmentprocess ofaneconomy.

The International Monetary System under the Bretton

Woods

era

(1944-1971)

was

such

thatthe exchangerates werepegged and capital control^was

high, making capital account

less important than the current account. Thus, the

international finance literature

was

concerned with the conditions under which the current account disequilibrium could be

eliminated. Since the collapse of the Bretton Woods system (and

the adoption of the

floating exchange rate regime) in 1973 the exchange rates

have been highly volatile in

both developed and developing countries and in most

developing countries, nominal

exchange rate depreciation has been sustained without

reflection

on

their real exchange

rates. Thishasbrought the issueof real exchangerate determination

into

the

forefront.

1.2 Statementof theproblem

The desire to evolve a common currency for the ECOWAS sub region

has been in the

offing since the birth of the regional integration body.

This

was

considered expedient

given the fact that there exist in the sub region one

of the oldest monetary union

- WAEMU. This informed the setting up of the second West

African Monetary Zone

(WAMZ),proposedfornon- WAEMU, as a

prelude and "fast-track" approach to ultimate

unification andadoption ofacommon ECOWAS currency.

Thekey elements of the fast-trackapproach

require the need for these countries

topursue

both monetary and fiscal policies that

could lead

to

macroeconomic

convergence.

Therefore, monetary policies which yield

undesirable effects and which

meant non¬

compliancewithconvergence criteria tendedtodim

the

prospects

of adoption of

common monetary policies and currency. Elowever, it is

argued that relative

monetary

policies

ineffectiveness can be an alternative test to macroeconomic convergence criteria for determiningthetakeoff ofthe WAMZ. Indeed, the argument

is that these countries could

adopttheunionization strategyofFranco-phone West

African Monetary Union, which

as

a group of countries became an optimal currency area expost,

without

recourse

to

ex

anteconditionality (Cobham and Robson(1993); Guilaumont, et.

al. (1988); Masson and

Pattillo (2001)).

Theperformance of the external sectorof WAMZ

member countries has been

poor

since

the 1980s. The _poor external sector performance coexists

with high

rate

of inflation and

lowgrowth ofoutput. Moreover, despite the increasein real GDP

growth and decrease in

the rate ofinflation in 2001-2005, external sector performance as measured by external

balance on goods and services and net foreign assets is worse than

it

^was

in the 1970s

through the 1990s.

Moreover, the substitution of the fixed exchange rate regime with the

managed floating

exchange rate regime in the mid 1980s and 1990s ^was

done

^on

the basis that external

sector performance would improve by reducing

real exchange

rate

misalignment.

However, thecountries stillexperiencespoorexternal sectorperformance.

Figure 1.1: CFA franczoneand ^nonWAEMU

countries

CAEMC Cameroon Chad

Congo

Central Afr. Rep Equat. Guinea

Gabon

WAEMU Benin

Burkina Faso Cote d'Ivoire Guinea-Bissau Mali

Niger Senegal Togo

Gambia Ghana Guinea

Nigeria

Sierra Leone WAMZ

Liberia CFA franczone

ECOWAS

CapeVerde

Forappropriatemacroeconomic management,

the research questions that therefore follow

from these observations are: What is the effect of the nominal exchange rate on the real exchangerate (which is the conventional measure

of the competitiveness of the

economy

to international trade)? What macroeconomic factors are there, apart

from the nominal

exchange rate that explains the behaviour ofthe real

exchange rate? Has the (managed)

floating exchange rate regime been associated with less

misalignment of the real

exchangerate than the fixed exchange rateregime? An

understanding of these issues

can give necessary inputs to policy makers in resolving the

problem of misalignment and

making appropriateexchangeratemanagement

policies.

1.3 Objectivesofthestudy

The overall objective of the study is to

investigate the determinants of the real exchange

rate andmeasureits misalignment in the WAMZ.

Thespecificobjectives areto:

(i) investigate the determinants of theactual (short-run)

real exchange

rates (ii) investigate the determinants of the

equilibrium (long-run) real exchange

rates

1.4 Justificationfor theresearch

Despite the nominal devaluations of the domestic currency

before 1990, adoption of the

managed floating exchange rate regime in the mid-80s to

1990 and the continuous

depreciation of the nominal exchange rate in the

managed floating exchange

rate

regime,

external sector performance of the WAMZ region have been poor. It

is therefore

importantto investigate the role of the nominal exchangerate in

the determination of the

competitiveness (the real exchange rate) of these

economies, determine whether other

factorsarebehind the determination ofcompetitiveness of the economies to

international

trade and ascertain the effects of real exchangerate ^on external sectorperformance. This

would provide inputs for policy makers in addressing the issue of external sector development.

Also, good exportperformance is essential for sustained economic growth and to

obtain

good export performance, the competitiveness of exports to international trade must

be

established. Thisrequires thereal exchange rate tobe atits right value orto bevery

close

to its right value (its equilibrium value). Hence, knowledge of the

determinants of the

actual and equilibrium real exchange rates is essential. Such

knowledge provides

informationon the determinants ofreal exchange ratemisalignment, since

real exchange

ratemisalignment is thegap betweentheequilibriumand

actual real exchange rates. This

enablespolicy makers to realign the real exchange rate

in

an

effort

to

strengthen external

sectorperformance.

This study seeks to improve on the existing literatureby

recognising the linkages

among

fiscalpolicy, monetarypolicy andexchangerate

policy, and therefore estimating

a

model

that captures these linkages, with the

view of determining the real exchange rate in the

WAMZ region. Also most studies have been

focusing either

on

the actual (short-run)

or

the equilibrium (long-run) real exchange rate,

however, this study seeks

to

examine both

and see what hold for these economies. Thirdly, the analysis to be presented here

is

unique in that you can hardly find published

work

on

the above topic in the selected

countries. Finally, such a studycanraise issuesrelevant for

policy makers in the region.

1.5 Organisationof the study

The organization of the rest of the thesis is given

in what follows. A review of

macroeconomic performance and Policies in the WAMZ

is done in chapter

two.

This

includes discussion on the macroeconomic trends, monetary policy, fiscal policy and exchange rate policy. Chapter three is the literature review. It

discusses both the

theoretical andempirical literature on the determinants of the

real exchange

rate.

This is

done in ordertoaddress theoverallobjective of the study fromtheperspective

of existing

theories and previous empirical works. It also enables us to

objectives of the studyis discussed. The specifications of the equation of the model, the

estimation procedure and the results of the estimated equation of the model, their interpretations, and simulation exercises are discussed. Chapter five is a

presentation of

the summary, conclusion and lessons for policy. Suggestions for future

research

^are

also

presented in this chapter.

in the literature.

Chapter four is thetheoretical framework andmethodology findings. Here, the theoretical foundation for the empirics

CHAPTERTWO

MACROECONOMIC PERFORMANCE AND POLICIES IN THE WAMZ

2.1 Introduction

A review of the macroeconomic performance of the WAMZ,

with

respect to

inflation,

growth of real output and external sector performance,

is undertaken in this chapter.

Trends in the demand management policies (monetary and fiscal

policies)

as

well

as exchangeratepolicyin the WAMZ arealso

reviewed here.

Table 2.1: KeyMacroeconomicvariables

GDP Growth X/GDP M/GDP CAB/GDP Budget ^Inflation

Growth rate of (annual (annual ^Bal./GDP

rate PerCapita ^{% %}

GDP change) change

Gambia 1984 3.4 -0.7 1.7 3.7 -19.3 -15.5 22.1

1994 4.1 1.0 2.7 1.3 -5.0 -3.1 4.0

2003 6.7 4.3 9.3 10.7 -5.7 -4.7 17.0

2004 8.3 6.2 5.4 7.2 -5.8 -3.6 14.8

Ghana 1984 4.7 1.8 9.3 7.7 -4.8 -3.1 39.7

194 4.4 2.3 6.0 6.6 -4.9 -11.5 24.9

2003 5.2 3.3 2.7 7.7 1.6 ^-2.8 26.7

2004 5.2 3.3 3.8 11.3 1.2 -1.1 10.8

Nigeria ^{1984 5.0 2.0 3.9 -3.2 -3.8 — 39.6}

1994 3.4 0.8 1.6 8.8 -6.8 1.9 57.0

2003 10.7 8.0 31.9 11.6 -2.4 -1.3 14.0

2004 6.0 3.5 3.1 2.3 4.8 7.4 15.0

Sierra Leone

1984 -1.7 -3.9 -0.6 0.8 -4.7 ^— 66.7

1994 3.0 0.9 ^{-- --} -5.8 -5.9 24.2

2003 9.2 7.1 ^{-- —} -7.6 -6.8 7.5

2004 7.4 5.4 ^{— —} -4.8 -3.5 14.2

Source: Calculatedfrom World Bank Africa Site 2006

Macroeconomic performance of sub-Sahara African

(SSA) countries in the 1980s

was weak, emanating mainly from inappropriate domestic

policies though external factors

have also been identified to have played a role. The economic performance

for

most

of

these economies was worse in the 1990s than in the 1980s. The poor economic performance of SSAsince the 1980sholds for theWAMZ

region

as

well.

2.2 Macroeconomicperformance andpolicies in theGambia

In the 1960s, the Gambia maintained broadly stable macroeconomic

conditions and

experienced modest economic growth. However,

after 1983, economic performance

worsened significantly as a result of adverse terms

of trade shocks and inappropriate

domestic policies. To address this deteriorating

situation, in

June

1985, the

government supported by the Bretton Woods Institutions, began

the implementation of

a set

of

stabilization and structural adjustment programmes called the

Economic

Recovery Programme (ERP) and succeeded in 1990 by the Programme for Sustained

Development

(PSD) which continued the thrust of the current policies, while

incorporating renewed

effortsto spurprivate sectorparticipation.

To encourage a return offoreign exchange proceeds to the banking system

through the

stimulation ofexports, a flexible exchangerate systemwasintroduced in January

1986 in

the form ofan interbank market, replacing the peg of the Gambian dalasi to the British pound sterling. To deepen the foreign exchange market, the Foreign Exchange

Act

was repealed, de facto removing the exchange restrictions on both current

and capital

international transactions, while permitting the establishment of foreign exchange

bureaux in April 1990. The inter-bank foreign exchange market then has functioned smoothly, resulting inaneffective absorption ofthe parallel foreign exchange market and

thevirtual elimination of thepremium orthe spread amongthe exchange ratesprevailing

in thetwomarkets. Underthis floating exchangerateregime, the dalasi depreciated by 57

per cent in nominal effective terms during 1986, but appreciated by 18 per cent byearly

1990 and has remained stable, fluctuating within a narrow range, until late 1989. The depreciation ofthe dalasi then, resultedin higher producer prices of cash^crops.

Figure 2.1: GDP Growth Rates and

Inflation in the Gambia

RGDPg GDPg Growth Rates (Real Vs Nominal

GDP)

Inflation (CPI)

180.00 160.00 140.00 120.00 100.00 80.00 60.00 40.00 20.00 0.00

1970 1973 1976 1979 1982 19851988 1991 19941997 2000 20032006

Calculatedby author fromWorldDevelopmentIndicatorsCD-ROMandInternational Financial

StatisticsCD-ROM 2008

As mentioned earlier, an integral part of the adjustment programme efforts

has been the

pursuit of a restrictive fiscal policy, aimed at

narrowing the budget deficit (excluding

grants) and raising government savings. On the whole,

although special budgetary

provisions for the repayment ofpublic enterprise debts to the

domestic banking

system

and the takeover by government of non-performing bank loans sometimes expanded pubic expenditure during the reform period, the overall budget (excluding

grants)

on commitmentbasis was reduced fromapeak of17 percentof GDP in 1987 to4.0 percent

of GDP in 1991. The improvement inthe fiscal position then, together withthe

available

net inflows of external assistance, have allowed Government to effect a sizable net repayments to the banking system, thereby accommodating

the financial needs of the

private sectorand supporting the anti-inflationary stance ofmonetary

policy. To this end,

contractionary monetary and credit policies ^were

pursued. Consequently, the

effectiveness of financial intermediation was enhanced through the removal of

interest

rate repression in September 1985 and the

introduction of

^an

auction system for the

issuanceof Gambia GovernmentTreasuryBills in July 1986 ^aswell as

the adoption of

an

indirect monetary policy approach in

September

1990.

Since 1986, interest rates have

been maintained through the Open Market Operations at

positive levels in real terms

(measured in relation to

inflation in the previous 12 months) and with appropriate

differential vis-à-vis interest rates abroad, thereby encouraging financial

savings and

proddingthe exchangeratepolicy.

Centralto thecountry's IMF-supported economic^recoveryprogramme

(ERP) initiated in

mid 1980s was to drastically reduce inflationwhich was about

70.0

per cent at

the time,

to move away from the then negative real interest rates to

positive real interest rates.

Thus, the sale of short-term government securitiesin the

form of

Treasury

Bills (T-Bills)

auctionwasalso introduced. Sincethemoneymarket intheGambia was

neither wide

nor deep, with theCentral Bank left with only

this instrument for both liquidity and domestic

debt management purposes. The quantity floated for sale ^was

therefore crucial in

influencing the T-Bill rate and through it, all other

interest

rates

in the country.

Commercial banks deposit and lending rates arehence

linked

to

the T-Bill

rate.

Interest

rates on deposits are regulated bythe floor deposit rate

while the time deposits cannot be

lower thantheT-Bill rate less 5.0_percent. This floorondeposit rates,has however

been

criticized for being responsible for the high nature and

inflexible

structure

of interest

rates in the country. Another reason advanced for the

introduction of the T-Bill besides

limiting Net Credit to Government (through the

public

sector

borrowing requirement-

PSBR), wasthebuilt-up (accumulation) ofofficial externalreserves (or

the foreign

assets

of theCentral Bank.

Eventhoughcommitted to allowing exchange rate to float, the Gambia has

accorded the

accumulation of official foreign ^{reserves a} high priority. After the elimination of

its

external payments arrears at the end of the 1980s, foreign ^reserves were

built

up consistently during the 1990s and reached over 21.0 per cent

of

GDP

in 1998, covering

over 5.0 months ofimports. In principle, under a clean float

fluctuation, the supply and