How to Create a Successful Monetary Union in West Africa (Part II)
Yesterday we argued in this column that the six countries which will form the West African Monetary Zone - The Gambia, Ghana, Guinea, Liberia, Nigeria and Sierra Leone - have had poor records with central banking. Consequently, this history casts doubt on the success of any West African Central Bank. Indeed, these countries cannot escape their histories by simply creating a larger institution.
But let's assume that the slate is clean and the member countries simply concentrate on meeting their European Monetary Union-style convergence criteria. These criteria include:
· A floor on foreign exchange reserves of at least three months of imports by 2000 and six months by 2003;
· A ceiling on central bank financing of budget deficits to 10% of the previous year's tax revenue;
· A limit of the annual inflation rate to a single digit in 2000 and 5% by 2003; and
· A restriction of the budget deficit to GDP ratio of no more than 5% in 2000 and 4% by 2002.
The most problematic of these criteria is the floor placed underneath net foreign assets. Absent a strong inflow of foreign investment, a grant of foreign exchange from the government, or a nearly miraculous increase in exports, it is unclear how the central banks will augment their foreign exchange reserves. While foreign currency holdings may increase seasonally, those seasonal increases will be drawn down again as the season's proceeds are used to pay for imports, providing no net gain. The central banks could address this by making exports of foreign exchange illegal, but this would violate contracts and earn the banks little credibility.
Alternatively, the central banks could sell their domestic currencies on the open market to buy foreign currency. This would put downward pressure on the exchange rate and upward pressure on inflation, compromising the inflation target included in the convergence criteria.
And all of this doesn't even take into account the impossibility of simultaneously pursuing a domestic monetary policy of "disinflation" (that is, lowering inflation rates) while managing fixed exchange rates vis-à-vis the other countries within the zone. The dual pursuit of a monetary policy and an exchange rate policy amounts to a pegged exchange rate regime, much like those that have failed West African countries in the past, and, more recently, countries like Thailand, Indonesia, Russia, Brazil, and Turkey.
Does all this mean that a successful West African Monetary Zone is impossible? Fortunately, the answer is no. The member states can still achieve their admirable goals by establishing a West African Central Bank that would operate on a currency board rule. The new West African currency would be backed 100 percent by a reserve (also called an "anchor") currency such as the euro, and would be convertible on demand into the reserve currency at a fixed exchange rate. The currency board would not have a monetary policy, would not finance government deficits, and would not regulate banks or act as a lender of last resort. Inflation, as measured by traditional consumer price indices, would converge to US levels, as would interest rates. By pursuing an exchange rate policy without having a domestic monetary policy, a currency board constitutes a fixed exchange rate regime, distinguishing it from the traditionally problematic pegged exchange rate regimes.
Most importantly, a currency board would secure for West Africa one of the principal functions of money - a stable and clearly defined unit of account by which all forms of labor can be measured. Western Africa's policy makers should realize that it is not "price stability", as it is traditionally defined that they should be interested in, but rather the "law of one price" that should concern them most. The monetary authority would follow the law of one price by maintaining the price of the new currency in terms of the anchor currency. Doing so would provide a unit of account around which the regional economy could freely arrange prices of goods and services. By aiming at a stable unit of account, any monetary disruptions to the general price level would be avoided, securing price stability. This unit of account function of money has the effect of increasing the level of equality in a society, as the government is unable to manipulate the value of its currency in favor of one class of citizens over another.
To emphasize principle, each day, under a currency board regime, the balance sheet of assets and liabilities should be presented to the public, so that the citizenry, consumers and producers are aware of the soundness of the backing of the local currency. This would increase trust, an asset in any economy, and dispel any suspicions of manipulation on the part of the currency board.
And to guard against a deterioration of the anchor currency - as measured by a leading indicator such as gold - a model currency board law could contain a rule that contains very specific terms for switching to a new anchor currency. For example, if the dollar price of gold were to increase or decrease significantly, and remain at that level for over a year, the law would allow for a switch to another currency as a new anchor. The new reserve currency would, of course, have to perform better than the old, along the same criteria, in order to assume and maintain the anchor currency position.
Four West African states - Ghana, Nigeria, Sierra Leone and The Gambia - were part of a West African Currency Board from 1913 until the establishment of their respective central banks. The Currency Board preserved a fixed link to the pound sterling through two World Wars and the Great Depression. During this time inflation was low and growth was high. As just one example, per capita GDP in Ghana doubled from 1913 to 1960, an annual growth rate of roughly 1.5%.
Why did these countries leave the currency board? Principally for two reasons: first, the influence of nationalist arguments made by Africans heavily influenced by socialist and communist teachings and rhetoric - which were easily accepted by those who despaired of inadequate access to credit; and second, the victory of the theoretical argument advanced by the International Monetary Fund and some independent economists that central banks represented the ultimate monetary regime.
But central banks, since the independence era, have certainly not improved things where the access to capital and credit argument is concerned. Nominal lending rates are now, for example, as high as 56 percent in Ghana, compared to the 12.5 percent mortgage rate that prevailed in the early 1950s. Unsubsidized long-term lending in local currency at fixed rates, available during the currency board era, is no longer available. Consequently, the cost of financial capital is higher today than it was in the colonial era. As for the double hurdle of crony capitalist and race - oriented discriminatory practices that many Africans point to as barriers to access to credit, a currency board regime could help to overcome the existence of such, by its delegation of credit creation to members of civil society, specifically, merchant and investment banks, credit and savings associations, and even micro-lending institutions. These entities could more than adequately develop liquidity for the regional economy as these institutions intermediate savings and generate credit through the issuance of shares and/or subordinated debt instruments.
Both West Africans and international investors could freely create, own and operate such institutions with success and profits, addressing skepticism that only foreign financial capitalists would benefit from credit creation. And if property rights issues can be peacefully resolved (in a leading West African nation like Nigeria, for example) financial intermediation could become a very lucrative undertaking in West Africa, as titles to land and other assets could serve as collateral for bank loans.
Currency boards have a strong record in general, and in West Africa in particular. By operating on a currency board rule, the West African Central Bank could create a strong regional currency that would satisfy its goals of achieving price stability and providing a foundation for growth. Without a currency board rule, the West African Central Bank has little chance of accomplishing either goal.
Matthew Sekerke is Research Associate at the Institute for Applied Economics and the Study of Business Enterprise at the Johns Hopkins University. He can be contacted at firstname.lastname@example.org. Cedric Muhammad is President of Black Electorate Communications and can be contacted at email@example.com.
Matthew Sekerke and Cedric Muhammad
Tuesday, February 19, 2002