A quarterly magazine of the IMF

March 2001, Volume 38, Number 1

Six of the 15 members of the Economic Community of West African States (ECOWAS)—The Gambia, Ghana, Guinea, Liberia, Nigeria, and Sierra Leone—have launched an ambitious initiative to set up a second monetary union and common currency in West Africa, alongside the 52-year-old, 8-member West African Economic and Monetary Union (WAEMU).

The six countries have pledged to adopt a common currency by January 2003 and to work toward merging their planned monetary union with the WAEMU by January 2004. In the Accra Declaration on a Second Monetary Zone, they committed themselves to restructuring their economies to meet stringent convergence criteria ahead of the introduction of a single currency: single-digit inflation by the end of 2000 and an inflation rate of no more than 5 percent by 2003; gross foreign currency reserves to cover at least three months' worth of imports by the end of 2000 and six months' worth by the end of 2003; central bank financing of the budget deficit limited to 10 percent of the previous year's tax revenue; and a maximum budget deficit-to-GDP ratio of 5 percent by the end of 2000 and 4 percent by the end of 2003.

Institutional arrangements have already been put in place—at both the regional and the national levels—to oversee the process. National ministers of finance, trade and commerce, foreign affairs, and integration, together with central bank governors, sit on the ECOWAS Convergence Council, which is empowered to carry out multilateral surveillance of national economic policies. A technical committee made up largely of top economists from the national central banks and government ministries will work out the structure and regulatory framework for a common central bank for the six countries. In early 2001, ECOWAS unveiled the West African Monetary Institute in Accra, a transitional institution that will pave the way for a common central bank expected to be functioning by the end of 2002.

Q: The goal of regional integration including monetary union dates back to the early days of ECOWAS. What distinguishes this monetary union initiative from previous efforts?

Asante: There are greater and more specific commitments on the part of the six countries driving the initiative. They have seen how the CFA franc zone operates and are aware of the benefits of a common currency. Faced with increasing globalization and the rise of regional blocs, they must act quickly on monetary union and other economic integration aims.

What is important is that the initiative came from the countries themselves. Two countries—Ghana and Nigeria—approached the ECOWAS Secretariat for advice on how best to move toward the goal of a common currency. ECOWAS is merely facilitating the process.

Masson: The strong political will to proceed with monetary integration on the part of the two most important countries concerned—Ghana and Nigeria—seems to be the main distinguishing characteristic. During my conversations with civil servants in Abuja and Accra, I've been impressed with their commitment to make it happen. A lot remains to be done, in terms of designing a monetary union, achieving the convergence criteria, and putting in place a regional central bank. But it's certainly off to a start with a greater degree of commitment than some of ECOWAS's earlier monetary union plans.

Q: What are the potential benefits of an expanded monetary union in West Africa?

Asante: To the extent that monetary union would succeed in taming inflation and stabilizing exchange rates in the six countries, it should produce a more stable environment for businesses, which, as a result, would feel enough confidence in the economy to plan ahead and to invest. With the risk of macroeconomic instability greatly reduced, the union's members would be free to focus on growing their economies. Financial stability would also help reduce the risk of capital flight and make the countries more attractive to foreign investors. And by facilitating trade and other payments transactions, a currency union would help create a single market for ECOWAS. Foreign exchange savings would accrue from the use of a single currency in intraregional transactions. Moreover, a single currency would reduce the speculative cross-border transactions now common in West Africa's currencies.

A key objective of the accelerated monetary union initiative is to enhance the overall integration effort of ECOWAS. We believe that this particular program will facilitate the free movement of people and free trade in the area. Since most of the nine currencies currently in use in the ECOWAS region are not convertible, businesses have had to use currencies like the dollar and the French franc. We hope that the planned common convertible currency will eliminate the use of third currencies in trade and other business transactions within ECOWAS. And the common currency will be a major symbol of regional integration.

Masson: Hopefully, one of the outcomes of monetary union would be greater trade between union members and greater regional integration more broadly. And increased cooperation among the countries clearly would enhance the region's influence on the world economy. But whether—and the extent to which—the proposed monetary union will actually deliver these favorable outcomes is an important and difficult question.

The empirical literature, while not definitive, does suggest some increase in trade among monetary union members. Andrew Rose, Professor of International Trade at the University of California Berkeley, estimates that a currency union increases trade by a factor of three relative to what it otherwise would have been, but I don't believe that this particular monetary union would lead to such a large increase in trade. An examination of past and current monetary unions reveals a wide variety of experiences. For instance, trade is still quite modest within WAEMU, a currency union based on the CFA franc, and is even more modest among the six countries in the Central African Economic and Monetary Community, which also uses the CFA franc.

Countries that already had tight trade links would benefit more from a monetary union, because transactions costs would be reduced and exchange rate fluctuations eliminated. For ECOWAS members as a group, however, trade with each other accounts for only slightly more than 10 percent of total exports and imports. Of course, the official statistics do not incorporate informal trade, which is thought to be considerable. Taking informal trade into account could boost trade within ECOWAS by several percentage points.

I do think efforts toward monetary union could be an important part of a wide-ranging approach to regional initiatives for integration that include lowering trade barriers, putting in place a common trade policy, and improving transportation links. By improving political cooperation, it could hopefully build on initiatives to reduce regional conflicts.

Q: What are the potential costs associated with the monetary union?

Asante: The single most obvious cost associated with the new monetary union is the participants' loss of national sovereignty in the use of monetary instruments, such as the exchange rate and the interest rate. There would be gains at the regional level, however, since the participant countries would decide collectively on monetary policy. We expect monetary management at the regional level, with the national central banks coming under a single regional umbrella, to result in better and more efficient use of available resources. Given the propensity over the years for monetary mismanagement in West Africa, the cost associated with the loss of national monetary instruments would not really amount to much. So, in a way, the potential cost is more imaginary than real.

Masson: There is a possibility that ECOWAS won't make enough progress in the other areas of regional integration to make it in the interests of each of the countries involved in monetary union to honor its commitments. The danger is that the monetary union might not last if it is not supported by other policies and institutional arrangements and by a feeling of solidarity among the participants. And a breakdown of the monetary union could, in turn, deter or even roll back regional integration in other areas.

Another potential cost is related to the susceptibility of these economies to different shocks. Economies linked by a monetary union must have the same monetary policy, which is not necessarily appropriate in the face of very different shocks. The larger and more asymmetric the shocks, the greater the costs of a fixed exchange rate. A major source of shocks, especially for countries that export primary commodities, is the terms of trade. Large, asymmetric terms of trade shocks are less likely among monetary union members that have diversified economies with similar structures. Unfortunately, these six countries fall short on both criteria. For example, Nigeria is different from its neighbors—all net oil importers—in being a large oil producer; hence, changes in world oil prices would affect their economies differently.

Over time, however, a monetary union's member economies may become more similar in the ways in which they respond to external shocks. In some sense, the structures of member economies adapt and become more flexible as a matter of course if a monetary union remains in place for some time. But the economic policy goals of the member countries must be similar enough in the first place to make the monetary union durable.

Q: Mr. Asante, does ECOWAS envisage any particular measures for coping with the adjustment costs associated with asymmetric shocks?

Asante: It is worth noting that the 12 members of the European Economic and Monetary Union also experience different kinds of shocks. Monetary union members can respond using fiscal, price, and wage policies. I prefer to view the differences in West Africa's economies as a plus, rather than as an obstacle. The differences mean that they would be less likely to experience adverse external shocks at the same time, which could enhance the stability of the arrangement. For example, the factors that influence oil prices will be totally different from the factors that influence cocoa or gold prices. We believe that if, for example, Ghana, a major cocoa exporter, experiences a terms of trade shock, then Nigeria, as a major oil exporter, would be able to come to Ghana's aid. This is the beauty of the proposed arrangement, in the sense that these economies would be able to support one another.

ECOWAS members plan to set up a regional stabilization and cooperation fund as a buffer to temporary shocks and adverse balance of payments situations. The fund—slated to begin operating once 75 percent of its proposed initial capital of $50 million has been raised—will be based in the same building in Accra as the West African Monetary Institute but will operate as an independent institution. No country will be allowed to borrow more than 25 percent of the fund's total proposed resources of $100 million. And a country that wishes to draw on fund resources would be obliged to submit an application showing that it has prepared a program for addressing its temporary adjustment problems.

Mind you, this fund is intended as a regional initiative to offer assistance to the smaller economies in the short to medium term. Problems could arise if Nigeria faced external shocks over a prolonged period because the other economies might not be able to support the large Nigerian economy. We have not yet addressed this issue. I think that Nigeria will be the biggest contributor to the fund but will probably never draw on the fund's resources.

Planned labor market reforms in the converging economies—to help people move across industries and national borders where necessary to find jobs—would make markets more flexible, cushioning the effects of shocks.

Q: Mr. Masson, do you think that ECOWAS's planned regional fund and measures to facilitate labor mobility could reduce adjustment costs in the face of asymmetric shocks?

Masson: They would certainly help. For such a fund to work, however, each member must be strongly committed to helping its neighbors. With planned resources of $100 million maximum, the fund is intended to be modest. It is recognized that the fund would not be able to significantly cushion shocks for a very large economy like Nigeria, although it might provide significant cushioning for some of the smaller economies. But in the event of a persistent, large shock, it wouldn't make a major difference even for the smaller economies.

I think regional labor mobility could become an important factor in cushioning shocks that affect the economies differently. Although hard data are difficult to obtain, mobility is likely to be high between some of the countries, following traditional migratory and trading patterns that cut across national boundaries. ECOWAS has facilitated mobility by eliminating visa requirements, but citizens of one country seeking to establish residency in another still seem to encounter administrative difficulties. In practice, there is some resistance to labor mobility, and in a few countries there has been a backlash against large-scale immigration from neighboring countries. So, I think there are limits to the extent to which regional labor mobility could cushion shocks.

Q: There has been some speculation about how difficult it would be for these economies to meet the macroeconomic convergence criteria and form an economic and monetary union, especially within the envisaged time frame. Can you comment on that?

Asante: We know that countries will have to make a special effort, especially in the area of inflation, to meet the convergence criteria. While some countries will meet the targets on time and others might not, with a determined effort the countries can converge their economies. Some of the countries have already cut inflation by more than half in just one year: in Nigeria, for example, inflation fell from about 70 percent to 30 percent in one year and continues to decline.

An assessment of the six economies vis-à-vis the convergence criteria was discussed at an ECOWAS Convergence Council meeting in November 2000. The assessment revealed that The Gambia had met all four criteria by the end of 1999; Nigeria had met three, Guinea had met two, and Ghana and Sierra Leone had met one.

This assessment took into account qualitative as well as quantitative factors. Some countries failed to achieve the criteria because of external factors: sharp declines in prices of commodities such as cocoa and gold during 1999 affected exporting countries like Ghana. As both cocoa and gold prices dipped while oil prices increased, Ghana's terms of trade deteriorated significantly. In spite of that, most of the countries—apart from Sierra Leone, which is in the throes of a civil war—managed to maintain satisfactory growth rates during the assessment period. So most of the countries are moving in the right direction. Although we haven't yet carried out an official assessment for 2000, we are optimistic that the data will show an improvement over 1999. The final assessment will be carried out by the end of 2002.

Masson: A key question is whether monetary union should come at the beginning or at the end of regional integration. In the European Union, many other forms of integration preceded monetary union; it was argued that these would be necessary to make monetary union work. In ECOWAS, the intention seems to be to try to push forward these other integration agendas in parallel with monetary union. The ECOWAS timetable for monetary union is quite tight, and it's unrealistic to think that all of the various aspects of regional integration could be put in place that quickly.

Since having common economic policy goals is important to the success of a monetary union, I think there is an important role for the convergence criteria. The extent to which these countries work to meet the criteria will show the extent of their commitment to common economic objectives and monetary union. I think that's one reason why meeting the convergence criteria should be a prerequisite for joining the monetary union; countries that are unable to meet the criteria should be excluded.

Given the position of some of the countries now, relative to the convergence criteria, it seems unlikely that all six of them will qualify for monetary union by 2003. But there seems to be a strong desire, principally on the part of Ghana and Nigeria, to proceed by that date. This raises questions about the role of the convergence criteria. Some of the countries with serious economic and political problems would not be able to make sufficient progress to meet the convergence criteria and hence should not be allowed—by the stated procedures and goals of the ECOWAS countries themselves—to participate in the monetary union. One would imagine that some later entry date would be possible for those countries if they continued to work toward economic convergence.

A merger of the second monetary zone with the WAEMU is a much more distant prospect. I think it will take a number of years. The non-WAEMU monetary union would have to be successful to make a merger attractive for the WAEMU. For the two monetary unions to be on an equal footing, the new monetary zone would have to prove its ability to provide price stability, as the WAEMU has. I think that is going to take some time—after all, even the European Central Bank has had to fight to establish its credibility as a new institution.

Q: Mr. Asante, do the plans call for the creation of an entirely new currency or the adoption of an existing one?

Asante: For practical reasons, a totally new currency will have to be created from scratch. I don't think any of the currencies in the region qualifies to be the common currency.

The West African Monetary Institute will lay the groundwork for the common central bank for the second monetary zone. A rudimentary common central bank—to be known as the West African Central Bank—is slated to be in existence by the end of 2002. The existing national central banks of the participating countries will be under its direction and control. As its executing agencies, they will be responsible for implementing, at the national level, policies agreed at the regional level. Current plans provide for a board of directors comprising the management of the common central bank and the governors of the national central banks. Central bank statutes adopted in December 2000 prohibit direct lending by the bank to national governments.

We envisage two regional central banks operating in West Africa: WAEMU's existing Banque Centrale des Etats de l'Afrique de l'Ouest (BCEAO) and the West African Central Bank. Details of the relationship between the two banks have not yet been worked out, but they should have equal standing. The plan is eventually to merge them, but this would not happen until 2004, at the earliest.

Q: Mr. Masson, what are your views on ECOWAS's plans to set up a new regional central bank for the second monetary zone participants first, to be merged with WAEMU's long-standing regional central bank, the BCEAO, a few years later?

Masson: In my view, this is not the ideal option. The question of whether it makes sense to create new institutions that would disappear shortly thereafter was among the issues that my colleagues in the African Department and I discussed on our recent trip to Abuja and Accra. We suggested that ECOWAS might consider an institutional arrangement whereby the existing central banks cooperate among themselves without creating a new supranational central bank at an early stage of the monetary union, when it might be preferable to aim for a form of monetary cooperation that I would term an "informal exchange rate union," to distinguish it from a full monetary union. This suggestion wasn't received with much interest—mainly because, if I understand correctly, creating a new institution helps to symbolize achieving the goal of regional integration. But, having created a new central bank, the task of then combining it with the BCEAO would not be simple because essentially there would be two rival central banks. Leaving both institutions in place would be wasteful in terms of human resources and actual financial resources, while eliminating either one of them might be divisive.

Q: Mr. Asante, what external exchange rate policy is envisaged? Do the monetary union plans call for an internal nominal target/ anchor for monetary policy?

Asante: The West African Monetary Institute must work out the technical details associated with an external exchange rate policy before a decision is taken.

In terms of an internal nominal anchor for monetary policy, one of the common central bank's objectives will be to maintain price stability—defined as an inflation rate of 5 percent or less.

Q: Mr. Masson, what do you consider to be the pros and cons of the various external exchange rate policy options?

Masson: A peg to the euro would go furthest toward giving the second monetary zone a stable nominal exchange rate relative to neighboring countries and its main trading partners in Europe. And a euro peg would probably facilitate any later merger with WAEMU: if the two monetary zones had essentially the same peg, there would be no need to change from one exchange rate policy to another.

One could ask whether a euro peg would be ideal, however. Because commodity exporters might benefit from a degree of flexibility in their exchange rate, a currency peg might not be desirable. A currency basket—such as the SDR—including both the euro and the dollar and perhaps the yen would be an alternative with somewhat more flexibility that would provide some insurance against large movements of the dollar vis-à-vis the euro. I think this decision needs to be taken on economic grounds—based on the extent to which trade is denominated in euros or dollars—but also possibly with an eye to how the eventual merger of the second monetary zone with the West African CFA zone would occur and, ultimately, what the exchange rate policy of the combined ECOWAS monetary union would be. But these stages may be far enough in the future that more immediate concerns will dominate.

See also Paul Masson and Catherine Pattillo, 2001, Monetary Union in West Africa (ECOWAS), IMF Occasional Paper No. 204 (Washington: International Monetary Fund).

R.D. Asante is head of the Money and Payments Division of the ECOWAS Secretariat. Paul Robert Masson is a Senior Advisor in the IMF's Research Department.