Can East Africa Adopt One Currency? A Generalized - Purchasing Power Parity Analysis

Abstract

The East African Community (EAC) is actively pursuing the formation of a monetary union by 2023. The EAC is located in the eastern part of Africa and is made up of six neighbouring countries namely; Burundi, South Sudan, Rwanda, Kenya, Uganda and Tanzania. The countries have so far made considerable progress towards monetary integration with the establishment of a customs union in 2005 and a common market in 2010. The EAC Monetary Union (EAMU) protocol lays the groundwork for the monetary union through the macroeconomic convergence criteria (MCC) targets which the EAC members states have to attain before the launch of the EAC monetary union. This thesis investigates the suitability of the EAC as a currency area by assessing the performance of the EAC countries based on the MCC for the period 2007-2015. This study also uses the Generalized Purchasing Power Parity (GPPP) model to assess the optimality of a currency area in the community. The GPPP model postulates that cointegration of real exchange rates in a group of countries implies the countries constitute a currency area. Two sets of bilateral exchange rates for the EAC partner countries were computed. The first set comprised bilateral exchange rates between the EAC member states with the US dollar for the time period 2000(Q1)- 2015 (Q4). Kenya was the base country in the second set of bilateral exchange rates for the time period 2011 (M1)- 2015 (M12). The study found some convergence in the MCC which implies a potential for the EAC economies to converge even further. The assessment based on GPPP theory established a long run relationship in both sets of bilateral exchange rates hence qualifying the EAC to be a currency area. The study concluded that a monetary union is feasible in the EAC region but calls for strict harmonization and implementations of measures so as to encourage strong macroeconomic convergence which will foster a conducive environment for a stable monetary union to thrive in this region.