i FEASIBILITY STUDY OF A SINGLE CURRENCY FOR WEST AFRICAN MONETARY ZONE BY DANIEL AMOAH (10222577) THIS THESIS IS SUBMITTED TO THE UNIVERSITY OF GHANA, LEGON IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF THE MASTER OF PHILOSOPHY (M.PHIL.) ECONOMIC DEGREE JUNE, 2013 University of Ghana http://ugspace.ug.edu.gh ii DECLARATION This is to certify that this thesis is the result of research undertaken by DANIEL AMOAH towards the award of the Master of Philosophy (M.Phil.) Degree in Economics in the Department of Economics, University of Ghana. ……………………… DANIEL AMOAH (10222577) ……………………… DR. AUGUSTINE F. GOCKEL (SUPERVISOR) ……………………….. DR. S.K.K. AKOENA (SUPERVISOR) University of Ghana http://ugspace.ug.edu.gh iii ABSTRACT The formation of a Monetary Union by the West African Monetary Zone has been in pursuance for more than a decade. The WAMZ is made up of six countries in West Africa; The Gambia, Ghana, Guinea, Liberia, Nigeria and Sierra Leone. One significant benefit from using a common currency is the lower costs of transactions; however member countries will lose the ability to use monetary policy to respond to different shocks. The participating countries need to converge or ultimately attain an Optimum Currency Area to mitigate the asymmetric shocks. The WAMZ has a set of Macroeconomics Convergence Criteria to be attained by its member countries before the commencement of the Monetary Union. The study assesses the performance of all the WAMZ countries based on the MCC from 2001 to 2011. The study also uses various theoretical criteria to assess the Optimum Currency Area in the WAMZ. The study further employs the exchange rate variability based on the OCA index to analyze the possibility of currency integration among three of the WAMZ’s countries consisting of The Gambia, Ghana and Nigeria using time series data from 1980 to 2011. The assessment based on the MCC indicates that WAMZ is not ready to form the Monetary Union as of 2011. However, there are some convergences in the primary MCC. The results from the study also indicate that the WAMZ is not an Optimum Currency Area. The OCA index results show that the Nigerian Naira was the most stable currency in the region during the period of analysis. Furthermore, the method confirms that the WAMZ single currency (if it will be established) should start with Nigeria and Ghana, followed by The Gambia. University of Ghana http://ugspace.ug.edu.gh iv DEDICATION This work is dedicated to Honorable Kofi Brako, families, friends and all those who have in diverse ways contributed to the success of this work. University of Ghana http://ugspace.ug.edu.gh v ACKNOWLEDGEMENTS My sincere thanks and praise goes to the Almighty God for His wisdom, knowledge, direction, strength and courage to finish this work successfully. I would like to express my appreciation to my supervisors Dr. Augustine Fritz Gockel and Dr. S.K.K Akoena for their advice, comments and constructive criticisms. Special thanks go to Honorable Kofi Brako, my parent Mr. Kwame Amoah and Madam Doris Opokua, not forgetting my siblings Ellen Frempomaa and Richard Darkwa for their inspiration and motivational force throughout this entire academic period. I wish to especially thank Madam Leona Selormey, Madam Grace Mawuko and Dr. Debrah for their parental care. I am thankful to Mr. Conte Mohammed of West African Monetary Institute for his special assistance. I am grateful to Madam Alberta, Pastor James, Dr. Amaning, Mr. Larvie, Miss Amiteye, Miss Geraldine, Wisdom, Bernard and all M. Phil. 2012/2013 Economics students. University of Ghana http://ugspace.ug.edu.gh vi Table of Contents TITLE PAGE .................................................................................................................................... i ABSTRACT ........................................................................................................................................ iii DEDICATION .................................................................................................................................... iv CHAPTER ONE .................................................................................................................................. 1 INTRODUCTION TO THE STUDY ....................................................................................................... 1 1.0 Background to the Study........................................................................................................ 1 1.0.1 Background of the various Currency Unions in Africa .................................................... 3 1.1: Problem Statement ............................................................................................................... 7 1.2 Research Questions ............................................................................................................... 9 1.3 Objective of the Study ........................................................................................................... 9 1.4 Contributions/Significance of Study .................................................................................... 10 1.6 Organisation of the Study .................................................................................................... 11 CHAPTER TWO ............................................................................................................................... 12 OVERVIEW OF THE WEST AFRICAN MONETARY ZONE .................................................................. 12 2.0 Introduction ......................................................................................................................... 12 2.1 General overview of the WAMZ Countries .......................................................................... 12 2.1.1 Location ......................................................................................................................... 12 2.1.2 Demography .................................................................................................................. 13 2.1.3 Language ....................................................................................................................... 14 2.1.4 Relative Size of the WAMZ economies (share of GDP) .................................................. 15 2.2 The process and status of the West African Monetary Zone .............................................. 15 2.3 Summary .............................................................................................................................. 19 CHAPTER THREE ............................................................................................................................. 20 LITERATURE REVIEW ...................................................................................................................... 20 3.0 Introduction ......................................................................................................................... 20 3.1 Theoretical Literature Review .............................................................................................. 20 3.2.0 The concept of the Optimum Currency Area .................................................................... 21 3.2.1 Various definitions and explanations of the OCA .......................................................... 21 3.2.2 The Costs and Benefits of Using a Common Currency .................................................. 23 3.2.3 Some Conditions for assessing an Optimum Currency Area ......................................... 25 3.3 Macroeconomic Convergence ............................................................................................. 29 University of Ghana http://ugspace.ug.edu.gh vii 3.4 The Optimum Currency Area Theory ................................................................................... 31 3.5.0 Empirical Literature Review .............................................................................................. 32 3.5.1 Various forms of assessing the Optimum Currency Area ................................................. 32 3.5.2 The Optimum Currency Area Index ................................................................................... 35 3.5.3 Macroeconomic Convergence .......................................................................................... 36 3.6 Summary .............................................................................................................................. 43 CHAPTER FOUR .............................................................................................................................. 44 METHODOLOGY ............................................................................................................................. 44 4.0: Introduction ........................................................................................................................ 44 4.1.0 Macroeconomics Convergence Criteria Approach ........................................................... 45 4.1.1 The Standard Convergence Criteria .................................................................................. 45 4.1.2 The Real Convergence Approach ...................................................................................... 46 4.2.0 Other traditional OCA criteria ........................................................................................... 48 4.2.1 Degree of Openness and Intra-regional Trade .............................................................. 49 4.2.2 Product Diversification .................................................................................................. 49 4.2.3 Political Will and Public Support ................................................................................... 50 4.3.0 The OCA Index Approach .................................................................................................. 50 4.3.1 Proxy for each of the Variable ....................................................................................... 52 4.3.2 Justification for using USA as a peg Country ................................................................. 53 4.3.3 Justification for using Ghana as a peg Country............................................................. 54 4.3.4 A Priori Expectation ....................................................................................................... 54 4.4 Data and Source ................................................................................................................... 55 4.5 Model Estimation ................................................................................................................. 55 4.5.1 Series Unit Root Test ..................................................................................................... 55 4.5.2 Augmented Dickey Fuller (ADF) Test ............................................................................. 56 4.5.2 Robust Regression ......................................................................................................... 57 4.6 Summary .............................................................................................................................. 58 CHAPTER FIVE ................................................................................................................................ 59 ECONOMETRIC ESTIMATION AND DISCUSSIONS OF THE RESULTS ............................................... 59 5.0 Introduction ......................................................................................................................... 59 5.1 Nominal Convergence Criteria ............................................................................................. 59 5.1.1 Inflation ......................................................................................................................... 61 University of Ghana http://ugspace.ug.edu.gh viii 5.1.2 Central Bank Financing of Fiscal Deficit ........................................................................ 64 5.1.3 Fiscal Balance/GDP ....................................................................................................... 66 5.1.4 Gross External Reserve .................................................................................................. 68 5.2 Secondary Macroeconomics Convergence Criteria ............................................................. 70 5.3 Assessment of the Optimum Currency Area of the WAMZ. ................................................ 84 5.3.1 Co-movement of economic activity (Business Cycle Synchronization) .......................... 84 5.3.2 The Level and Sectorial Composition of Output ............................................................ 86 5.3.3 Product Diversification .................................................................................................. 89 5.3.4 Trade openness and Intra- regional trade .................................................................... 89 5.3.6 Political Will and Public Support ................................................................................... 93 5.4 Optimum Currency Area Index ............................................................................................ 93 5.4.1 Results of Stationarity Test ........................................................................................... 93 5.4.2 Regression analysis ....................................................................................................... 97 5.4.3 Diagnostic tests ........................................................................................................... 101 5.4.4 The OCA index results .................................................................................................. 102 5.5 Conclusion .......................................................................................................................... 104 CHAPTER SIX ................................................................................................................................. 108 SUMMARY, CONCLUSION AND RECOMMENDATIONS ................................................................ 108 6.0 Introduction ....................................................................................................................... 108 6.1 Summary and Conclusion .................................................................................................. 108 6.2 Policy Recommendations ................................................................................................... 110 REFERENCES ................................................................................................................................. 113 APPENDIX 1 .................................................................................................................................. 120 GRAPHES SHOWING THE MCC FOR THE WAMZ .......................................................................... 120 APPENDIX 2 .................................................................................................................................. 125 STUDY DATA SET USED FOR MMC ANALYSIS ............................................................................... 125 University of Ghana http://ugspace.ug.edu.gh ix LIST OF TABLES Table 1.1: Regional Economic Communities and Currency Union Membership………...4 Table 1.2 Stages toward African Economic Integration...............................................…...5 Table 2.0: Some selected statistics of the WAMZ countries…………………………..……15 Table 2.1: The Banjul Action Plan……………………………………………………....17 Table 5.0: Primary Macroeconomics Convergence Criteria and their set Targets……....60 Table 5.1: Secondary Macroeconomics Convergence Criteria and their set Targets........60 Table 5.2: Mean and Standard Deviation of inflation for the WAMZ……………..........63 Table 5.3: Mean and SD of Central Bank Financing of Fiscal Deficit for the WAMZ….65 Table 5.4: Mean and SD of Fiscal balance/GDP for the WAMZ...……..……….………67 Table 5.5: mean and SD of Gross External Reserves for the WAMZ…………………...69 Table 5.6: The status of primary macroeconomics convergence criteria in 2011……….77 Table 5.7: The status of Secondary macroeconomics convergence criteria in 2011…….78 Table 5.8: The summary of the Classical WAMZ primary MMC before 2012…………80 Table 5.9: The WAMZ Secondary MCC before 2012…………………….………….....82 Table 5.10 Business cycle synchronization……………………………………………...85 Table 5.13: Augmented Dickey-Fuller Unit Root Test.....................................................94 Table 5.14: Gambia-US robust regression………………………………………….........97 Table 5.15: Ghana-US Robust regression………………………………………………..98 Table 5.16: Nigeria-US Robust regression………………………………………………98 Table 5.17: Gambia-Ghana Robust regression…………………………………………100 Table 5.18: Nigeria-Ghana Robust regression………………………………………....100 University of Ghana http://ugspace.ug.edu.gh x Table 5.19: F-Statistic test……………………………………………………………...102 Table 5.20: Average OCA indices of WAMZs currencies (against US dollar)……….103 Table 5.21: Average OCA indices of WAMZs currencies (against US dollar)….........104 LIST OF FIGURES Figure 1.0: A geographical map of Economic Community of West African States…....13 Figure 3.0: The stages to the formation of the European Monetary Union………..…….38 Figure 5.10: Sectorial Composition of output for Ghana…………………..…………………….87 Figure 5.11: Sectorial Composition of output for Nigeria………………………………………..87 Figure 5.12: Sectorial Composition of output for Guinea……………..…………………………88 Figure 5.13: Sectorial Composition of output for The Gambia…………………………………..88 Figure 5.4: Sectorial Composition of output for Sierra Leone…………………………………...88 Figure 5.15: Sectorial Composition of output for Liberia………………………………….…….88 Figure 5.16: Trade as a percentage of GDP in the WAMZ……………………………...90 Figure 5.17: Percentage Contribution of WAMZ & Non-WAMZ to Total Export in the ECOWAS (2001-2009)…………………………………………………………………91 University of Ghana http://ugspace.ug.edu.gh xi LIST OF ABBREVIATIONS AMU Arab Monetary Union ASEAN Association of South East Asian Nations AU African Union BAP Banjul Action Plan CIA Central Intelligence Agency COMESA Common Market for Eastern and Southern Africa CPI Consumer Price Index ECCAS Economic Community of Central African States ECOWAS Economic Community of West African States ECB European Central Bank ESCB European System of Central Bank EMS European Monetary System EMU European Monetary Union FDI Foreign Direct Investment GDP Gross Domestic Product GMM Generalized Method of Moment HIPC Heavily Indebted poor Countries IFS International Financial Statistics IMF International Monetary Fund MCC Macroeconomics Convergence Criteria SADC South African development Community SD Standard Deviation SITC Standard International Trade Classification University of Ghana http://ugspace.ug.edu.gh xii OAU Organization of African Union OCA Optimum Currency Area OPEC Organisation of Petroleum Export countries REC Regional Economic Communities USA United States of America VAR Vector Auto Regression WACB West African Central Bank WAEMU West African Economic and Monetary Union WAMI West African Monetary Institute WAMZ West African Monetary Zone WDI World Development Indicator University of Ghana http://ugspace.ug.edu.gh 1 CHAPTER ONE INTRODUCTION TO THE STUDY 1.0 Background to the Study In spite of the high level of globalization, international trade, financial liberalization as well as the increasing economic integration of the world as a whole, there is still a wide range of currencies circulating in the world’s economic monetary system. The International Monetary Fund with 188 member countries has more than 150 currencies. As Mundell (1961) writes: “If some spaceship captain came down from outer space and looked at the way international monetary relations are conducted, I am sure she would be very surprised….and wonder why more than one currency was needed to conduct international trade and payments in a world that aspired to a high degree of free trade”. A single currency is not new, especially in Europe as well as in other groups of African countries. For instance, the Eurozone uses the Euro as its regional currency; African Financial Community (CFA) Franc (now linked to Euro) is used by some francophone countries in Africa, Rand by the Common Monetary Area (CMA), among others. The idea of a single or a common currency is based on the theory of an Optimum Currency Area (OCA) originally developed by Mundell (1961) and extended by Mckninnon (1963). The theory establishes certain criteria that member countries willing University of Ghana http://ugspace.ug.edu.gh 2 to form a Monetary Union have to attain. When member countries are able to attain such criteria, it increases the economic gain for that region (member countries) to share a common currency. An introduction of a common currency is meant to promote trade among the member countries. The member countries can only benefit from a common currency when their region can be defined as an Optimum Currency Area. In order for member countries to benefit from a Monetary Union, they should meet some criteria (i.e. flexibility of price and wages, intra-regional factor mobility, openness to trade, product diversification, and fiscal integration (Masson and Taylor, 1993) which can help to mitigate asymmetric shock. Asymmetric shock occurs when an economic supply or demand shock is different from one region to another. For example, assuming Ghana is experiencing excess demand (under production) and Nigeria is also experiencing excess supply (unemployment) in the same period, these countries are said to be experiencing asymmetric shock. Asymmetric shock makes it difficult for the Monetary Union’s Central Bank to conduct monetary policy that can solve such economic problems for both countries at the same time. A currency area with a single currency means that there is only one Central Bank that manages monetary policy in the region. This means that each member country will lose her monetary policy sovereignty. This is one of the main costs of using a common currency, a subjugation of national policy (monetary policy) to a supranational authority. University of Ghana http://ugspace.ug.edu.gh 3 1.0.1 Background of the various Currency Unions in Africa The unification of Africa in both monetary and political terms has been one of the objectives of the Organization of African Union (OAU) since its inception in 1963. According to Dr. Kwame Nkrumah (1963), “the first step toward our cohesive economy could be a unified monetary zone, with initially, an agreed common parity for our currency”. It is also believed that monetary union is an intermediate step towards the formation of a political union. Various steps have been taken towards the creation of a single currency in Africa under the Organization of African Union and currently the African Union (AU). In August 2003, the Association of African Central Bank Governors agreed to work towards achieving a single currency and a common Central Bank by the year 2021. The AU’s main strategy is to establish a systematic monetary union in five existing regional economic communities. These communities are the Arab Monetary Union (AMU), Common Market for Eastern and Southern Africa (COMESA), Economic Community of Central African States (ECCAS), Economic Community of West African States (ECOWAS) and the Southern African Development Community (SADC) members (Adams 2005). Table 1.1 shows the various Regional Economic Communities and Currency Union and their member countries. University of Ghana http://ugspace.ug.edu.gh 4 Table 1.1: Regional Economic Communities and Currency Union Membership Regional Economic Community Membership Arab Monetary Union (AMU) Algeria, Libya, Mauritania, Morocco, Tunisia Common Market for the Eastern and Southern Africa (COMESA) Angola, Burundi, Comoros, Democratic Republic of Congo, Djibouti, Egypt, Eritrea, Ethiopia, Kenya, Madagascar, Malawi, Mauritius, Namibia, Rwanda, Seychelles, Sudan, Swaziland, Uganda, Zambia, Zimbabwe Economic Community of Central African States (ECCAS) Burundi, Cameroon, Central African Republic, Chad, Democratic Republic of Congo, Republic of Congo, Equatorial Guinea, Gabon, Rwanda, Sao Tome and Principle Economic Community of West African States (ECOWAS) Benin, Burkina Faso, Cape Verde, Cote d’Ivoire, the Gambia, Ghana, Guinea, Guinea- Bissau, Liberia, Mali, Niger, Nigeria, Senegal, Sierra Leone, Togo Southern African Development Community (SADC) Angola, Botswana, Democratic Republic of Congo, Lesotho, Malawi, Mauritius, Mozambique, Namibia, Seychelles, South Africa, Tanzania, Zambia, Zimbabwe Source: www.africa-union.org Each of these regions is supposed to individually achieve a common currency after which they can integrate to create a common currency for the whole African continent. One of the problems facing the African Regional Economic Community (REC) integration is the inclusion of some countries in more than one regional group (Angola, Botswana, Burundi, Democratic Republic of Congo, Malawi, Mauritius, Namibia, Seychelles, Swaziland, Rwanda, Zambia and Zimbabwe are all members of more than one REC). Different regional groups have created different timetables or stages and policies (such as intra and inter trade policies) towards the creation of a common University of Ghana http://ugspace.ug.edu.gh 5 currency (Adams 2005). This means that member countries in the multiple regional groups will complicate and confuse the harmonization process. It will be effective if each individual country belongs to only one regional group to avoid duplication and confusion. The stages toward the integration of African Economic Union as outlined in the Abuja Treaty in 1991 can be seen in the Table 1.2. Table 1.2 Stages toward African Economic Integration 1. Strengthening of existing RECs and establishment of RECs where necessary (not to take more than five years). 2. Stabilisation of tariff and non-tariff barriers, customs duties and internal taxes within each REC and the strengthening of sectorial integration, particularly in the areas of trade, agriculture, finance, transport and communications, industry and energy. Harmonisation of the activities of the RECs (not to take more than eight years). 3. Establishment of free trade and customs union areas at the level of RECs with the associated harmonisation of tariff and non-tariff barriers (expected to take ten years). 4. Co-ordination and harmonisation of tariff and non-tariff systems among RECs with the movement towards a continental customs union (to take two years). 5. Establishment of an African common market and the adoption of common policies (to take four years) including the free movement of peoples. 6. Integration of economic, political, social and cultural sectors towards a single African market and a Pan-African economic and monetary union. The setting up of a single African Central Bank, single Pan-African Currency and the election of the Pan-African Parliament (to take no more than five years). Source: http://www.dfa.gov.za/foreign/Multilateral/africa/treaties/aec.htm The Economic Community of West African States (ECOWAS) was formed in 1975 with the main objective of creating an Economic and Monetary Union for promoting economic growth and development in the West African sub-region with 16 countries. West Africa alone uses nine different currencies and most of which are inconvertible. The CFA Franc University of Ghana http://ugspace.ug.edu.gh 6 is used in Benin, Burkina Faso, Guinea–Bissau, Cote d’Ivoire, Mali, Niger, Senegal and Togo; the Ghana Cedi for Ghana; the Dalasi for The Gambia; the Dollar in Liberia; the Leone in Sierra Leone; the Guinea Franc in Guinea; the Escudo in Cape Verde; the Ouguiya in Mauritania; and the Naira for Nigeria. The difference in currencies among the West African countries and the difficulty in converting the currencies make the cost of transaction very high hence lowering trade in the region. As with most economic regional groups in Africa, one of the main objectives of ECOWAS is to create a Currency Union. Currently, there are two monetary regions in ECOWAS. On the 10 th January, 1994 some countries within the West African sub-region founded the first monetary union called the West African Economic and Monetary Union (WAEMU) which was based on a pre-existing West African Monetary Union of CFA Franc (now at a fixed parity to the Euro). Currently, the union is made up of eight member countries which are Benin, Burkina Faso, Guinea–Bissau, Cote d’Ivoire, Mali, Niger, Senegal and Togo. All the member countries in the union are French speaking countries and the union is headquartered at Ouagadougou, the capital city of Burkina Faso. On 20 th April 2000, the Heads of State and Governments of The Gambia, Ghana, Guinea, Nigeria and Sierra Leone within the ECOWAS regional integration signed a declaration in Accra on the creation of a second monetary zone. In December 2001 the Heads of States and governments of these member countries officially launched the West African Monetary Zone (WAMZ) at Bamako. The West African Monetary Institute (WAMI) was also established with the task of setting up a West Africa Central Bank (WACB) and the University of Ghana http://ugspace.ug.edu.gh 7 introduction of a common currency to be named ECO. In 2007, Liberia also joined the West African Monetary Zone. According to Masson and Pattillo (2004), there are two main reasons for the enthusiasm for African monetary union and hence that of WAMZ, “first, it is clear that the Euro’s successful launch has stimulated interest in Monetary Unions in other regions….., African Monetary Union has been motivated by the desire to counteract perceived economic and political weakness”. However, it is uncertain whether the European Monetary Union has been successful or their member countries have become stronger economically than before as the union continues to experience series of financial crisis in recent times. There is the need for the WAMZ to learn from the European Monetary Union (EMU) so as not to repeat the mistakes made by the EMU in this recent time. 1.1: Problem Statement The West African Monetary Zone, since its inception in 2001 has failed on several occasions to introduce the common currency (ECO) in the region. The launching of the union has suffered three postponements following the inadequate status of the macroeconomic convergence criteria. December 1, 2009 was the last set date for the launching but was not done since none of the countries could meet the set Macroeconomics Convergence Criteria targets. As of 2011, the state of readiness of the WAMZ countries for the Monetary Union using the Macroeconomics Convergence Criteria is not certain. University of Ghana http://ugspace.ug.edu.gh 8 The Macroeconomics Convergence Criteria (MCC) adopted from the European Monetary Union (Maastricht Convergence criteria) is one of the ways of assessing countries with respect to the formation of a monetary union. The MCC is a “nominal convergence” rather than a “real convergence”. According to Onwioduokit (2002), the nominal convergence deals with the convergence of the development of costs and prices and their underlying determinants, while the real convergence is of working conditions and living standards and the convergence of economic institutions or structures. The convergence of these nominal economic indicators does not necessarily mean that their real economic structures are also converging. Again, apart from the real economic convergence which is a necessary condition for the formation of a monetary union, there are other conditions proposed by the traditional Optimum Currency Area (OCA) theorists. The traditional OCA theory which has dominated the academic literature on common currency and Monetary Union has proposed series of characteristics that make a region or an area qualify for the formation of a Monetary Union. For a successful, lasting and a sustainable adoption of a single currency, some of the criteria proposed under the OCA must be taken into account. The WAMZ with her main objective of using a single currency among her member countries has not been really tested on this economic ground. From the principal economic point of view, the OCA is the highest stage of monetary integration process. However, no existing Monetary Union has attained all the criteria of the Optimum Currency Area before the adoption of a common currency. Among member countries forming a Monetary Union, some countries if integrated might near the OCA than others. Usually, these countries are supposed to start the Monetary Union formation University of Ghana http://ugspace.ug.edu.gh 9 before others join as to when they are ready. There has not been any empirical evidence on which countries in the WAMZ are more integrated based on the OCA criteria. Also, the countries which are likely to benefit more from the monetary union are still unknown. 1.2 Research Questions The following research questions are paramount to the study 1. Is West African Monetary Zone ready to adopt the use of a common currency based on the Macroeconomic Convergence criteria? 2. Is West African Monetary Zone an Optimum Currency Area? 3. If the WAMZ wants to start the formation of the Monetary Union now, which of the countries should begin? 4. Which countries will benefit the most when the common currency is adopted in the West African Monetary Zone? 1.3 Objective of the Study The study will be carried out with the aim of achieving the objectives stated in this section. This study investigates empirically, the feasibility of forming a Monetary Union in the West African Monetary Zone. This study will specifically seek to 1. Examine the state of the preparedness of the WAMZ’s member countries as at 2011, using the Macroeconomics Convergence Criteria. In particular, to assess the University of Ghana http://ugspace.ug.edu.gh 10 WAMZ’s member countries based on the set MCC targets and also examine whether empirical investigation points to the gradual convergence of these macroeconomic indicators. 2. Empirically examine the Optimum Currency Area of the WAMZ. In, particular the study investigates whether the WAMZ meets some of the conditions under the traditional Optimum Currency Area. 3. Compute the OCA index to evaluate the stability of each member country’s currency in order to determine which countries can benefit the most from the Monetary Union. This evaluation is also to determine which countries can start the formation of the WAMZ monetary union. 1.4 Contributions/Significance of Study The study will contribute to the existing literature on the adoption of a common currency in the West African Monetary Zone. Limited researches have been done on the feasibility of a common currency in the WAMZ relative to that of the EMU. The study uses a multi-criteria approach to assess the feasibility of a Monetary Union for the WAMZ. By so doing, it will increase the awareness of member countries about their progression level in achieving the Monetary Union. As far as the methodology is concerned, the study introduces new approaches to the study of assessing the feasibility of common currency in WAMZ. A few studies have been undertaken to theoretically and empirically investigate the feasibility of a common currency in WAMZ. Most researches focus solely on the use of the Macroeconomics University of Ghana http://ugspace.ug.edu.gh 11 Convergence Criteria with disregard to the other conditions proposed by the OCA theorists. This study closes this gap in common currency and monetary literature on WAMZ by empirically investigating the various ways of accessing an Optimum Currency Area. Africa with its intention of creating a single currency has proposed a gradual convergence through a sub-regional Monetary Integration. Already there are existing regional monetary zones in Africa including the Common Monetary Area (CMA) and the Economic Community for Central African States (ECCAS) and among others. The findings from the study can be useful to other Regional Economics Communities in Africa. 1.6 Organisation of the Study This study is divided into six chapters. The rest of the work is organized as follows. Chapter two looked at the overview of the West African Monetary zone. Chapter three presents a review of theoretical and empirical literature on common currency and monetary union. The methodology adopted by the study is covered in chapter four. Chapter five contains the estimations and its interpretations, analysis and evaluations, and discussions of the results. Chapter six provides a summary of the whole study and draws out policy recommendations. University of Ghana http://ugspace.ug.edu.gh 12 CHAPTER TWO OVERVIEW OF THE WEST AFRICAN MONETARY ZONE 2.0 Introduction The formation of a monetary union is meant to promote trade and economic growth among the participating countries. However, factors such as geographical location, language, demography, country size, etc. of member countries have a key role to play. This chapter presents an overview of some geographic features and also the process of West African Monetary Union. 2.1 General overview of the WAMZ Countries 2.1.1 Location The member countries of the West African Monetary Zone are located in the western part of Africa (the second largest of the seven continents on Earth). The six member countries (Gambia, Ghana, Guinea, Liberia, Nigeria and Sierra Leone) are bounded by the Atlantic Ocean in the south. Apart from the boundary connection among Guinea, Liberia and Sierra Leone, the rest of the countries in the WAMZ do not share any border with any of the member participating countries. This shows that the OCA for WAMZ will be more of economic than geographic area. The zone covers an area of about 1,603,307 km 2 , with Nigeria being the largest (923,768 km 2 ) and Gambia the smallest (11,295 km 2 ). One problem is that, the WAMZ is not geographically bounded as compared to the WAEMU. Below is the geography map of Economic Community of West African States. University of Ghana http://ugspace.ug.edu.gh 13 Figure 1.0: A geographical map of Economic Community of West African States Source: www.wikipedia.com Most of the WAMZ countries as shown in figure 1.0 are not geographically bounded. There the mobility of factors (labour and capital) among the WAMZ member countries is less likely to be flexible relatively to that of the West African Economic and Monetary Union. 2.1.2 Demography Demographically, the West African Monetary Zone (WAMZ) has a numerical strength in West Africa. From the World Development Indicator, the member countries in the WAMZ have a total population of about 216.3929 million under the review period. Nigeria is the most populated country in Africa and seventh in the world. Ghana is the University of Ghana http://ugspace.ug.edu.gh 14 second populated country in the zone with a population of about 24 million. The least populated country in the zone is Gambia with less than two million people. The density of WAMZ is about 14 persons per square kilometer. This gives an indication that the size of the WAMZ market is large enough to promote trade. 2.1.3 Language A common language is known to be one of the factors which promote bilateral trade. There are so many indigenous languages spoken in the member countries of the West African Monetary Zone (WAMZ) which roughly correspond to the ethnic groups in the region. Examples of these local languages include; Hausa, Yoruba and Ibo in Nigeria; Akan, Mole-Dagbon and Ewe in Ghana; Peuhl and Malinke in Guinea; Mandinka, Wolof and Fulani in Gambia; Kpelle and Bassa in Liberia; and Temme and Krio in Sierra Leone. But the official languages used by the WAMZ are the English and French. Five of the WAMZ member countries (Gambia, Ghana, Liberia, Nigeria and Sierra Leone) use English as their official language, while the remaining country (Guinea) uses French. Though the English language dominates in the zone, both French and English can be translated to one another easily. This shows that, the language barrier in the zone is not so high enough to reduce intraregional trade in the WAMZ. The Pidgin English language is also common in countries like Nigeria, Ghana and Liberia and is largely spoken by both illiterates and literates. University of Ghana http://ugspace.ug.edu.gh 15 Table 2.0 Some selected statistics of the WAMZ countries Country Area Popula- tion GDP GDP growth GDP per capita Unemp Rate Agric- ulture Indus try Trade Bal. Ext. debt 1000 Km 2 Million Currency $ Annual % Currency % % of Labor % of GDP % of GDP Million $ % of GDP Gambia 10.4 1.7822 3.496 b. 3.3 505.8 NA 24.5 17.4 -119.1 Ghana 235.5 24.233 75.66b 14.4 1570.10 11 25.6 25.9 -3.675 38.2 Guinea 245.9 10.884 11.5b 1.9 497.9 NA 12.9 47.8 -1.215 2.99 Liberia 111.4 3.8878 2.432b 8.2 374.3 85 76.9 5.4 -754.3 Nigeria 923.8 170.12 414b 7.4 1501.70 21 31.1 43 8.686 17.8 Sierra L. 71.7 5.4859 6.41b 6 374 51.7 22 -1.153 80.8 Sources: Word Development Indicators, 2011 2.1.4 Relative Size of the WAMZ economies (share of GDP) The dominant economy in the WAMZ is Nigeria, with over 81 percent of the zones’ GDP. The next largest economy is Ghana with 14 percent of the zones’ GDP. Liberia is the lowest economy constituting 0.4 percent of the GDP. The statistics shows that Nigeria is likely to have a major influence in the economy of the West African Monetary Union if established. 2.2 The process and status of the West African Monetary Zone In the year 2000, the Heads of State and Government of ECOWAS approved the formation of a second sub-regional zone of economic and currency integration in West Africa. In 2001, five West African countries (Gambia, Guinea, Ghana, Nigeria and Sierra Leone) signed an agreement creating the WAMZ and establishing its operational University of Ghana http://ugspace.ug.edu.gh 16 secretariat, the West African Monetary Institute (WAMI), in Accra. On 16 th January 2010, Liberia also joined the zone. Initially, the target date for the launch of a new common currency for the WAMZ countries was set at January 2003; this was subsequently extended to July 2005 and furthermore to December 2009. The action plan identified for each aspect of the program: the objectives, components, activities, time frame for completion and the responsibilities for implementation are captured in the Banjul Action Plan. The core activities in the Banjul Action Plan and the time frame specified is shown in table 2.1. University of Ghana http://ugspace.ug.edu.gh 17 Table 2.1: The Banjul Action Plan Source: WAMI 2004 Banjul Action Plan - Benchmarks Programme Minimum Requirements Expected Completion Date 1 Macroeconomic Convergence Attainment of all 4 Primary Criteria March-09 2 Creation of a Customs Union Compliance with ETLS & CET December-08 3 Development of a Zonal Payments & Settlement Establishment of RTGS in The Gambia, July-07 System for Cross-border Transactions Guinea and Sierra Leone 4 Statistical Harmonization & Database Development i. National Accounts: adopt SNA 93 2009 ii. CPI: (a) adopt COICOP December-06 (b) National coverage December-08 (c) Zone-wide harmonized index December-08 iii. Common Macroeconomic database 2007 i.e. Monetary aggregates Zonal GDP Zonal Fiscal indicators Zonal External sector indicators 5 Financial Sector Integration Enact legal instruments to ensure the following: i. Full Capital Account Liberalization December-07 ii. Cross Listing of Stocks December-06 iii. Regional Currency Convertibility December-06 Harmonization of Banking Supervision January-06 (Compliance with BCPs) 6 Ratification & Incorporation into National Law of the WAMZ Agreement December-08 WAMZ Legal Instruments WACB Statute December-08 WAMZ Secretariat December-08 WAFSA Statute December-05 Banking Statute December-05 Non-Bank Financial Institutions Statute December-08 Growth & Convergence January-08 Harmonization of Financial & Company Laws December-08 7 Activation of WAMZ Institutions WACB: Building & facilities July 2009 WAFSA WAMZ Secretariat SCF: Retrieval of Outstanding Contributions December-08 8 Sensitization Step wise approach in consonance with Action Plan On-going 9 Preparation Towards the Introduction of the Eco i. Currency design 2008 ii. Vetting by member countries 2008 iii. Introduction of Eco December 1, 2009 10 Programme for Promoting Regional Development i. West African Gas Pipeline On-going and Integration ii. West African Highway Project On-going iii. Energy Power Pool On-going iv. Electricity Grid Interconnectivity On-going v. Improvement in Air, Transportation, Railways & On-going Maritime transportation in the ECOWAS On-going University of Ghana http://ugspace.ug.edu.gh 18 It was announced that the date for the commencement of the common currency has been extended again to 2016. Despite these several postponements, these ambitious goals reflect the determination of the WAMZ countries to achieve their monetary union. The WAMZ agreement provided for the establishment of an institution called the West African Monetary Institute (WAMI). The main principle of WAMI is to carry out functions leading to the establishment of the West Africa Central Bank (WACB) with the following objectives: i. Undertake all the preparations necessary for the take-off of the West African Central Bank (WACB); ii. Monitor and assess compliance with the convergence criteria; iii. Adopt price stability as its central objective and strengthen the coordination of monetary policies in order to achieve that objective: iv. Make the necessary preparations for the conduct of a common monetary policy; v. Make preparations for the issue of a common currency; and vi. Supervise the development of an Exchange Rate Mechanism and a West African Monetary Unit for settlements in the Zone. The WAMI annually gives report on the progress of each of the WAMZ participating countries towards the monetary unification. University of Ghana http://ugspace.ug.edu.gh 19 2.3 Summary This chapter looked at various geographical and some economic features of the WAMZ participating countries and discusses the impacts of these factors on the formation of the WAMZ’s monetary union. Also this chapter looked at the process and the status of the WAMZ. There are indications that systematic steps have been put in place for the formation of the WAMZ monetary union. University of Ghana http://ugspace.ug.edu.gh 20 CHAPTER THREE LITERATURE REVIEW 3.0 Introduction This chapter examines the theoretical and empirical issues in the literature on common currency and monetary union. This chapter will also form the basis for the fashioning of the regression model in the next chapter. 3.1 Theoretical Literature Review Evidence shows that economic integration promotes convergence among trading countries. Economic integration which includes monetary integration is expected to boost transaction and increase trade benefits. However, the differences in economic structures, financial liberalization, and trading systems restrain effective economic integration. Also the variations in exchange rate systems among countries constrain the monetary unification among countries. One of the conditions to be fulfilled by the member countries before currency integration is the attainment of an Optimum Currency Area (YUceol, 2006). The main aim of economic integration is to promote trade and productivity among the member countries. Yuceol (2006) is of the view that the key element to fulfilling effective Economic integration (Monetary Union) is the attainment of an Optimum Currency Area by the member countries. He also proposed a flexible exchange regime among the member countries in a Monetary Union. University of Ghana http://ugspace.ug.edu.gh 21 “The OCA theory is back. Once dismissed as a "dead-end problem" with little practical significance…the issue has been resuscitated and re-thought” George Tavlas (1993) 3.2.0 The concept of the Optimum Currency Area This section elaborates on various aspect of the optimum currency area such as its definitions and explanations, costs and benefits and conditional factors. 3.2.1 Various definitions and explanations of the OCA Theory of Optimum Currency Area (OCA) was originally propounded by Mundell (1961). In his article ‘A theory of Optimum Currency Area’, he defines OCA as an area with internal factor mobility and external factor immobility. That is, when there is a free movement of capital and labour in a particular region, that region could be termed as Optimum Currency Area. The factor mobility includes both the interregional and inter- industrial movements. Mundell’s (1961) concept of an Optimum Currency Area with respect to internal factor mobility can be described as the best option (free trade, with perfect competition ), perhaps in the ideal world. However, in the real world, a clear situation will be the absence of trade barriers. His other criteria of the OCA regarding external factor immobility (where factors of production cannot easily move from one OCA region to another), might not favour international trade in the real world. However, Mundell’s (1961) concept of OCA can be likened to a situation where the whole world integrate economically and use a common currency. University of Ghana http://ugspace.ug.edu.gh 22 After Mundell’s article in 1961which set out the foundation of the optimum currency Area, other researchers such as McKinnon (1963) and Kenen (1969) have explored the issue of OCA concerning the degree of openness and product diversification respectively. Most of these researchers focus on the exogenous factors of the OCA. Many studies have followed suit. For example, Bayoumi (1994) provides a formalization of Mundell’s analysis in a multi-region, general– equilibrium model. Recently, Alesina and Barro (2002) extended Mundell’s analysis and among others. Grubel (1970) defines a currency area as ‘a territory with one or several currencies whose relative values are fixed permanently but whose common external value is determined in markets free from official intervention’. According to him, two separate nations wishing to form a currency area under a flexible exchange rate regime have to surrender some sovereignty in terms of fiscal and monetary policies to the regional central bank (supra- nation agency). Grubel’s (1970) concept on Currency Area describes another degree of economic integration (Fiscal and Monetary Union). Under this condition, member countries have to surrender their fiscal and monetary policy tools to a supra-regional Central Bank or Fiscal Authority. Grubel is not concerned with whether member countries maintain their own currency or use a common currency. The key issue is the fixed exchange rate among the member countries in the union. Kenen (1997) also defines a currency area as ‘a group of countries that undertake to contain their bilateral exchange rates within narrow bands, defined in respect of agreed central rates which they cannot change unilaterally’. According to him, a currency area is University of Ghana http://ugspace.ug.edu.gh 23 different from a monetary union. Under the currency area, member country retains its own currency managed by the nation’s central bank. The country has sovereignty over her fiscal and monetary policies and also chooses which exchange rate regime she wants to operate. But with the monetary union, there is one central bank and monetary policy for all member countries. This means that under the monetary union, the member countries lose their monetary sovereignty to a supra-nation agency. In Kenen’s (1997) view, member countries do not have to surrender their fiscal and monetary policies to another authority under the currency union. Again, what is important is the fixed exchange rate among the member countries. A Monetary Union from both Mundell (1961) and Grubel (1970) point of view involve member countries surrendering their monetary tool to a supra regional Central Bank, however Kenen (1997) argues differently. Generally, all these authors are not concerned about whether the member countries maintain their own currencies or use a common currency in the Monetary Union. What is important is the fixed exchange rate among the member countries. 3.2.2 The Costs and Benefits of Using a Common Currency The fundamental literature on the OCA focuses on two basic issues; the costs and benefits of adopting a common currency and the criteria member countries forming a Monetary Union need to consider. In this section, the study considers the costs and benefit of using a common currency. University of Ghana http://ugspace.ug.edu.gh 24 According to Talvas (1993), a common currency promotes economic efficiency through a reduction of transaction cost incurred during currency convertibility. From his argument, in a situation where member countries in a Monetary Union maintain their own currencies such benefit cannot be realized. This is because there will be an opportunity cost (time) in converting currencies even though the exchange rate among member countries is fixed. Emerson (1992) also raised another benefit which involves the reduction of foreign exchange risk and of substantial changes in relative price. Since exchange rate is fixed among member countries, there is a reduction in exchange rate risk during intra-regional trade. However, Emerson’s (1992) view on the reduction in exchange rate risk can only be realized when member countries in Monetary Union trade among themselves. In a situation where member countries in a Monetary Union trade more with external countries such exchange rate risk will still be experienced. Most of the arguments on the benefits of using a common currency to the member countries seem to depend on the degree of intra-regional trade in the Monetary Union. A Monetary Union becomes beneficial to member countries when there is a high degree of Intra-regional trade. Therefore one key factor a country needs to consider before joining a Monetary Union is the degree of trade among the member countries. Masson and Pattilo’s (2004) also summarized Mundell’s idea on the costs and benefits of an Optimum Currency Area. From the summary, a common currency can save on various types of transaction costs, but a country abandoning its own currency gives up the ability to use national monetary policy to respond to asymmetric shocks. Also from the same University of Ghana http://ugspace.ug.edu.gh 25 angle, Baldwin and Wyplosz (2006) wrote that one of the key costs involved in the formation of a common currency is the loss of monetary and exchange rate instrument in the presence of asymmetric shocks among member countries. The arguments on the costs of using common currency seem to dwell on the loss of monetary policy and exchange rate adjustment instruments. The loss of monetary policies and exchange rate instrument however become problematic when the currency area experiences asymmetric shock. There is therefore the need for member countries forming a Monetary Union to put in measures to mitigate asymmetric shocks. In addition to the views on cost of joining a Monetary Union is the monetary contribution made by the member countries during the Monetary Union formation process. Such monetary contribution may be for the construction of various Institutions (such as regional Central Bank), development of zonal payments and settlement system, etc. Also, the free trade barrier among the member countries takes way much of the import duties which would have been realized if the members were not in a Monetary Union. 3.2.3 Some Conditions for assessing an Optimum Currency Area In order for a region to be classified as an Optimum Currency Area, that region has to meet some criteria. The cost involved in forming a common currency can be minimized if the member countries fulfill the OCA criteria. Since countries forming a common currency lose their national monetary sovereignty, they may nevertheless be able to adapt to asymmetrical shocks, mainly through degree of product diversification, similarity in University of Ghana http://ugspace.ug.edu.gh 26 industrial structure, fiscal transfers, and political factors. These factors are considered as the features of an OCA. 3.2.3.1 Economic Openness The degree of economic openness among members is also very important. If the degree of openness is very high, more fluctuations in international prices of tradable are likely to be transmitted to the domestic cost of living. According to McKinnon (1963), this will reduce the potential for money and/or exchange rate illusion by wage earners. Also, from Mongelli (2008), economic openness needs to be assessed along several dimensions, including the overall openness of a country to trade with the world; the degree of openness vis-à-vis the countries with which it intends to share a single currency; the share of tradable versus non-tradable goods and services in production and consumption; and the marginal propensity to import. From Mongelli’s (2008) arguments, a country which is opened to trade with the rest of world but not with the member countries in the Monetary Union might not benefit from the union. In another way, if the degree of trade among countries forming a Monetary Union is low then the member countries are not likely to benefit. University of Ghana http://ugspace.ug.edu.gh 27 3.2.3.2 Product Diversification The degree of product diversity among member countries forming a currency union is very crucial. A country which exports highly diversified products is less likely to experience sector specific shock. Therefore, high diversification reduces the need for changes in the term of trade through the nominal exchange rate mechanism and provides ‘insulation’ against a variety of disturbance (kenen, 1969). Kenen’s (1969) argument on product diversification focuses on how export of variety of goods and services by a region could mitigate sector specific shocks. This is because if a country exports a variety of goods and services, a fall in demand of one product, will not affect employment so much. To add to Kenen’s argument, countries in a Monetary Union with high degree of product diversity are also likely to trade among themselves relative to external countries. Such condition can favour balance of payment in the Monetary Zone. However, if the Monetary Union member countries are product diversified in the same sector, intra- regional trade is likely to be low. A favourable condition is when each member country in the Monetary Union is diversified in production in different sectors or sub-sectors. 3.2.3.3 Similarity in Industrial Structure Similarity in industrial structure is also one of the factors to be considered when assessing an optimum currency area. Countries become better candidates for a currency union if they have similar industrial structures. This is because such countries will be affected by University of Ghana http://ugspace.ug.edu.gh 28 similar sector specific shock. As a result there will be no need for a member country to unilaterally use exchange rate as an adjustment mechanism in response to terms of trade shock (Mkenda 2001). To add to Mkenda’s (2001) argument on similarity in industrial structure, if the Monetary Union is experiencing similar sectorial specific shock, it will be easier for the regional Central Bank to implement a similar policy for the all whole Union. 3.2.3.4 Political Will and Public Support Political will among leaders is important because belonging to a currency union must involve agreeing to, for example, coordination of policies with members. Political will fosters compliance with joint commitments, sustains cooperation on various economic policies, and encourages more institutional linkages (Mongelli 2008). The issue of a currency union may not be popular among the public domain of member countries; it is up to the political leaders to convince them about the costs and benefits of joining such a monetary union. From Mongelli’s (2008) perspective, the political will and public support of member countries are needed in a Monetary Union. This argument holds because, the Heads of States and Government belonging to a Monetary Union must agree to the coordination of policies among members and also implement them. However, countries forming a Monetary Union should not allow their ‘political will’ to exceed the ‘economic will’. University of Ghana http://ugspace.ug.edu.gh 29 3.3 Macroeconomic Convergence The convergence of member countries forming a monetary union is inspired by the concern that, in the presence of asymmetric shocks, macroeconomics performance, and policies may cause problems for a common monetary policy. However, the concept of convergence can be separated into two, the nominal convergence and real convergence. According to Onwioduokit (2002), the nominal convergence is of price and currency value whereas the real convergence is in terms of per capita incomes, production structures and economic activities. A school of thought argues that since monetary policy would enforce nominal convergence in any case, nominal convergence should not be a precondition for monetary union. However, another school of thought argues that, using nominal convergence as a precondition for monetary union may signal that economic adaptation to the single currency will not involve important challenges nor require substantial changes in the behaviour of households or firms—which may not be true if countries have very different starting points (Masson and Rusuhuzwa, 2012). From the arguments raised above, both schools of thought agree that nominal convergence is a necessary condition for countries adopting a common currency. However, their differences come as to whether the nominal convergence should be a pre-condition or a post condition. Macroeconomic convergence should be seen as both a precondition for monetary union membership and a permanent requirement for its successful operation (Masson, 1996). Therefore both the nominal and the real convergence should be used as a precondition for University of Ghana http://ugspace.ug.edu.gh 30 monetary union. However, in the year 2012, an argument raised by the same author and Rusuhuzwa beg to differ a little. Countries with lower per capita income, on average, have higher rates of inflation, suggesting that a common monetary policy may not be appropriate for rich and poor countries together. However, inflationary rates differential among member countries may be due to better institutions in richer countries, and improving of institutions is one of the anticipated benefit of a monetary union (Masson and Rusuhuzwa, 2012). The first issue raised by these authors with respect to the need for the convergence of per capita income indicates a typical example of real convergence. The convergence of per capita income is meant to bridge the inflationary rate differential among member countries forming a Monetary Union. However, Masson and Rusuhuzwa quickly added that inflationary rate differential among countries could be as a result of institutional factors. In other words, these authors are arguing that the differences in the per capita income among countries should not hinder their Monetary Union formation since similar institutional measures can promote real convergence in the long run. Both Masson (1996) and Masson and Rusuhuzwa, (2012) are of the view that both nominal and real convergence should be a necessary conditions for countries forming a Monetary Union. However, while Masson (1996) considered these convergence criteria as a precondition factor, in the year 2012 he and Rusuhuzwa indicated that these criteria can be considered as a post condition factor. University of Ghana http://ugspace.ug.edu.gh 31 3.4 The Optimum Currency Area Theory Economic literature started to develop a form of OCA theory known as the Endogenous Optimum Currency Area. The traditional OCA theory was basically concerned with the preconditions that would enable a successful Monetary Union. However, Frankel and Rose (1998) argued that many of the prerequisites for the Monetary Union, proposed by the traditional theorists, Endogenous are actually reinforced by the creation of Monetary Union. As Frankel and Rose (1998) wrote, “the examination of historical data gives a misleading picture of a country’s suitability for entry into a Monetary Union, since the OCA criteria are endogenous.” Again they said “the suitability of European countries for EMU cannot be judged on the basis of historical data since the structure of these economies is likely to change dramatically as a result of European Monetary Union (EMU).” This means that waiting for economies to converge before adopting the same currency is one of the ways toward attaining OCA since using a common currency will also force the economies to become an OCA. Another way can be adopting the common currency even if the region is not an Optimum Currency Area. The use of a common currency will promote trade among the members of the Monetary Union; the increase in trade will further enhance economic convergence of those countries. The traditional OCA theorists focused on the exogenous Optimum Currency Area (OCA) concept. These theorists have generally proposed that countries forming a Monetary Union need to converge or attain the OCA criteria before formation. However, Frankel and Rose (1998) have introduced what is called the endogenous Optimum Currency. Under the concept, member countries forming a Monetary Union need not to converge University of Ghana http://ugspace.ug.edu.gh 32 before the formation. The use of a common currency will increase trade, which will further promote economic convergence among the member countries. 3.5.0 Empirical Literature Review In the first part of this chapter, we reviewed theoretical literature on the Optimum Currency Area and Macroeconomic Convergence. This section reviews various empirical approaches that have been used to identify the Optimum Currency Area and the Macroeconomic Convergence and also discusses the literature on the possible endogeneity of the OCA criteria. 3.5.1 Various forms of assessing the Optimum Currency Area This section reviews empirical works, for assessing the suitability of countries forming a Monetary Union under the Optimum Currency Area Criteria proposed by various OCA theorists. 3.5.1.1 Degree of Product Diversification Quenan and Tarija (2008) used the hirschman index for measuring the degree of product diversification among some Latin America countries. The results showed that Brazil was considered to have most diversified structure of export followed by Argentina and finally Mexico. However, no concrete conclusions were made by the author with respect to the University of Ghana http://ugspace.ug.edu.gh 33 degree of product diversity and its implication for the suitability of the countries to form a currency union. 3.5.1.2 Degree of Openness Mongelli (2002) assessed the optimum currency area of the European Monetary Union through the measure of the degree of openness across the euro-zone. Openness measured by the ratio of export plus import of goods and services to GDP is averaged around 46% in the euro-zone, evidencing a favourable condition for the formation of a monetary union. Quenan and Torija in 2008 also evaluated the degree of openness between Argentina and Mexico. The result indicates that the trade between the two countries in 2005 accounted for just 1.6% of the total GDP of these two countries, far lower than the 46% of the same indicator of the euro zone. The result concludes that Mercosur is not an optimum currency area. Rusuhuzwa and Masson (2012) also measured the degree of trade openness for five East African countries by the sum of exports and imports as a percentage of GDP. The result indicates that Kenya is the most open economy in the region followed by Tanzania, Uganda, Rwanda and Burundi. According to the authors the difference in openness may cause asymmetric shock in the region since the countries have exposure to different terms of trade. This means that the degree of openness in the region does not favour monetary unification. University of Ghana http://ugspace.ug.edu.gh 34 3.5.1.3 Similarity of the industry structure Mkenda (2001) used the contribution of the industries to value added to evaluate the extent of similarities in the industry sector of three countries in East Africa. The analysis indicates that the three countries have similar industrial structures, as food products and beverages accounted for the largest of value added in Kenya and Uganda. However, this share was the second largest sector in Tanzania. Further analysis also indicates that the three countries have a dominated agriculture sector with respect to both export income earning and its share to the GDP. This implies that if a shock in the price of one of the crops happens in the world market, the three countries would be affected in the same way. The findings indicate that, the similarity of the industry structure coupled with the nature of agriculture export products does not support a Monetary Unification among the East African countries. 3.5.1.4 Co- movement in economic activities In order to assess similarities in the movement of economic activities, Mkenda (2001) correlated some economic variables, growth of output and money supply, and nominal interest rate and real interest rate among three East Africans countries. The result shows that growth of output and money supply among Kenya, Tanzania and Uganda is very low and insignificant. The results suggest that the three countries business activities do not move together, implying that they are not suitable to form a currency union. Since these University of Ghana http://ugspace.ug.edu.gh 35 countries business activities does not move together, implementation of similar policies will be difficult by the regional Central bank in the zone. 3.5.2 The Optimum Currency Area Index Skorepa (2011) defines an OCA index as the exchange rate pressure predicted on the basis of a regression of observed exchange rate pressure on a list of OCA indicators. If two countries are an OCA, indicators should imply an OCA index value close to zero. This is because the two economies that are an OCA do not experience any exchange rate pressure. The OCA index was first developed by Bayoumi and Eichgreen (1997), a way of applying the core implications of the Optimum Currency Area to cross country data. This is a way of analyzing what determines nominal exchange rate variability. The OCA index estimated by Bayoumi and Eichengreen (1997) is based on a particular empirical specification that summarizes countries’ readiness for European Monetary Union. The results show European countries divided into three groups: those exhibiting high level of convergence: those with a tendency to converge, and those with little or no convergence. The finding also indicates that France desire for Monetary Unification is driven by political rather than economic consideration. Horvath and Komarek (2003) calculated OCA index for industrial countries to estimate the benefit-cost ratio of adopting a Common Currency. The result corresponded to the University of Ghana http://ugspace.ug.edu.gh 36 estimation of Bayoumi and Eichengreen (1997) and show that the ranking of the economies stable to form a Monetary Union stays the same in the 1980s and in 1990s. Again, Falianty (2006) used a similar method used by Bayoumi and Eichengreen (1997). Her study was based on currency union construction properties and of the calculation of an OCA index for the ASEAN-5 countries. Using both pairwise and multivariate method, the result concluded that Singapore, Malaysia and Thailand are more ready to construct currency union as compared to the other ASEAN-5 countries. Bangake (2008) also measured an OCA index for some selected African countries. Evidence was provided concerning the link between bilateral exchange rate volatility and variables such as, size, trade intensity, sector-specific shock and disturbance to output. The result shows that in the West African Economic and Monetary Union (WAEMU), the OCA index is generally low, reflecting the structural convergence between the countries. Also there is an indication that it will be appropriate for Ghana (non CFA country) to join the WAEMU. Furthermore, a reasonable structural convergence exists among the following countries: Malawi, Zambia and Zimbabwe. This suggests that a monetary union that encompasses these countries would be beneficial. The results have important policy implication for proposed monetary union in Africa. 3.5.3 Macroeconomic Convergence Kiyotaki and Wright in 1989 write, “Assuming Monetary Union is desired, who should be entitled to join? Insofar as the efficient advantages of a common currency are an University of Ghana http://ugspace.ug.edu.gh 37 increasing function of the number of countries adopting it”. It is desirable that all the WAMZ countries participate in the Monetary Union. However admitting a country whose economic structure and performance (monetary and fiscal performance) is entirely different from the rest of the member countries in the Union will destabilize the Monetary Union and make it difficult for the Central Bank to achieve any specific objective especially on inflationary pressure. 3.5.4.1 The European Monetary Union Macroeconomics Convergence In 1985, the European Commission published a white paper on the completion of the Internal Market. This was meant to enhance the free circulation of persons, goods and services, and capital in the European Union. In their 1992 Maastricht Treaty, the Union was to undergo through three phases of transition as shown in figure 3.0. University of Ghana http://ugspace.ug.edu.gh 38 Figure 3.0: The stages to the formation of the European Monetary Union Source: European Central Bank In February 1992, the then European Economic Community under the Maastricht Treaty decided to specify five precondition for member countries participating in the Monetary Union. These conditions were referred to as Maastricht Convergence Criteria (MCC). Member States could only participate in the union if they could show a high degree of lasting convergence confirmed by the fulfillment of four economic criteria (inflation, long-term interest rates, fiscal debt and deficit, and exchange rates). That is, the qualification for an individual EU member state as a member for a single currency is the attainment of the Maastricht Convergence Criteria. 1. Each country's rate of inflation must not exceed 1.5% above the average of the lowest three inflation rates in the EMS; University of Ghana http://ugspace.ug.edu.gh 39 2. Its long-term interest rates must be within 2% of the same three countries chosen for the previous condition; 3. It must have been a member of the narrow band of fluctuation of the ERM for at least two years without realignment; 4. Its budget deficit must not be regarded as 'excessive' by the European Council, with 'excessive' defined to be where deficits are greater than 3% of GDP for reasons other than those of a 'temporary' or 'exceptional' nature; 5. Its national debt must not be 'excessive', defined as where it is above 60% of GDP and is not declining at a 'satisfactory' pace. It can be seen that formation of the European Monetary Union passed through stages from 1985 to 2002 before the commencement. Each of these stages was meant to lay a strong foundation for Monetary Unification and also for improvement of economic convergence. The WAMZ should not only focus on the attainment of the set Macroeconomic Convergence Criteria by her member countries in attaining the set but also on other factors (as per used by the EMU) to create a good foundation for the Monetary Unification. 3.5.4.1 Plausible Economic Logic behind the Maastricht Convergence Criteria Eichengreen (1993) explained the plausible economic logic behind these convergence criteria used by the EMU as follows. University of Ghana http://ugspace.ug.edu.gh 40 The first precondition is that a country's inflation rate should converge to a level not too far above that of the Community's low inflation countries. Specifically, the average rate of CPI inflation over the preceding 12 months must not exceed the inflation rates of the three lowest-inflation member states by more than 1.5 percentage points. The idea behind this condition is from the fact that member states have to run a very similar inflation rate under a monetary union. According to Eichengreen (1993), this result is backed by empirical evidence from the works of Wim Vanhaverbeke (1991) for Germany,that the inflation rates of states joined together in a monetary union can vary by as much as 1.5 percent a year though not persistently in one direction. The second precondition is that nominal exchange rate must be stabilized. Qualifying countries must have maintained their exchange rate within the normal EMS fluctuation band for two years before entering the Monetary Union. This is meant to recognize the effort of the participating government for valuing and defending their exchange rate commitment. Entering a monetary union with several competitive problems may weaken the credibility of a government’s commitment to the monetary union (Eichengreen 1993). Thirdly, a qualifying country's long-term interest rates over the preceding year must have been no more than 2 percentage points above those of the three best performing member states in terms of inflation. If the second precondition is satisfied (i.e. exchange rates are credibly fixed) then interest rate cannot vary significantly except when there is a sovereign risk of default. This precondition can be rationalized if a risk of default is a threat to the monetary union (Eichengreen 1993). University of Ghana http://ugspace.ug.edu.gh 41 The fourth precondition has to do with aligning the fiscal policy in terms of debts and deficit. According to Eichengreen (1993), budget deficits should not exceed 3% of GDP and gross public debts not exceeding 60 per-cent of GDP. The rationale behind these conditions is that if member countries being admitted into the monetary union display inadequate fiscal discipline, the ECB would be forced or compelled to pay the debt of those countries. This can cause inflation for the whole union if the debt is settled through deficit financing (Eichengreen, 1993). The analysis by Eichengreen (1993), indicate that the convergence criteria used by the European Monetary Union has significant economic reasons. Also, the set criteria targets have both theoretical and empirical economic backing, meaning that countries who want to adopt the same approach for monetary integration must set the criteria target based on their economic backgrounds. 3.5.4.3 Plausible Economic Logic behind the MCC for the WAMZ The Macroeconomics Convergence criteria (MCC) adopted by the WAMZ for selecting her members for the Monetary Union is not new, since similar Criteria were used by the European Union (EU). The EU set five MCC to be attained by their member countries. In the case of the WAMZ, ten MCC has been set under two groups, the primary MCC and secondary MCC, perhaps to correct the mistakes made by the EU. What is very clear is that, the set targets of the MCC by the EU are far different from the WAMZ’s set targets. University of Ghana http://ugspace.ug.edu.gh 42 The entire set MCC targets by the European Union are based on both theoretical reasons and empirical evidence. There has not been any strong empirical evidence as to whether the set Macroeconomics Convergence Criteria targets favour all the WAMZ’s member countries. However in the case of inflation, empirical evidence on the economy of Ghana and Nigeria shows that single digit inflation will not negatively affect their economies. A research conducted by Ahortor (2011) et al for WAMI shows that the optimal inflation range for Ghana is 6-12 percent, while the one for Nigeria is 9-14 percent. These findings on optimal inflation range for the two countries suggest that inflation rate below the minimum of the optimal range could be detrimental to growth just as inflation above the range is harmful to growth. The result indicates that monetary policy in Ghana should target inflation within the estimated range of 6-12 percent, while that of Nigeria should set their inflation target within the estimated range of 9-14%. These results also confirm and conclude that both countries (Ghana and Nigeria) can comply with the single digit inflation criterion without any harmful effect on the economy of these countries. Since Nigeria and Ghana form the larger part of the WAMZ, setting single digit inflation as the target might not cause any economic harm to the entire WAMZ. However, it is necessary for research to be conducted on the rest of the WAMZ’s countries to identify whether single digit inflation favours their economy. Also, it is important for research to be conducted on the set targets for the other forms of the MCC to verify its suitability for the WAMZ’s economy. University of Ghana http://ugspace.ug.edu.gh 43 3.6 Summary From the theoretical and empirical literature, it has become clear that countries willing to use a common currency must attain some criteria. The attainment of these criteria optimizes the economic efficiency for that region (those countries) to share a common currency. The ultimate criteria for the formation of a beneficial monetary union are for the region to attain an optimum currency area. However, convergence of some macroeconomic criteria by the participating countries can be the starting point for the commencement of the monetary union. University of Ghana http://ugspace.ug.edu.gh 44 CHAPTER FOUR METHODOLOGY 4.0: Introduction The study tests the feasibility of a common currency in the West African Monetary Zone through a multi-criteria approach. Three approaches are used for this test. The first two approaches are used to test the convergence (nominal and real) of the participating member countries and also the optimum currency area of the WAMZ. These approaches are meant to determine the readiness of the WAMZ in the formation of a monetary union as at 2011 and to assess the optimality of the WAMZ currency area. The third approach is used to calculate an OCA index of the WAMZ in an effort to estimate the benefit-cost ratio of adopting a common currency and to also show the ranking of the economies suitable to form a monetary union. This chapter provides a description of the theoretical and empirical model and the estimation method to achieve its set aims and objectives. It further specifies the choice and justification of the variables used in the model. It also provides a brief description of variables and data type and source. The organization of the chapter is laid out in the following manner. In section 4.1.1and 4.1.2 the concept for the convergence criteria analysis are specified. Arguments for the choice and justification of the variables used in the econometric model for estimating the OCA index are made in section 4.3. Section 4.4 considers the scope and the sources of the data for the study. Finally, in section 4.5, the University of Ghana http://ugspace.ug.edu.gh 45 estimation procedures followed in estimating the econometric OCA index model selected in section 4.3 are elaborated. The chapter ends with a conclusion. 4.1.0 Macroeconomics Convergence Criteria Approach With the lesson learnt from the Maastricht Convergence Criteria, this section deals with how to evaluate the convergence criteria adopted by the WAMZ and other criteria proposed by the traditional OCA theorists. Some of these macroeconomics convergence criteria are nominal while others are real. 4.1.1 The Standard Convergence Criteria As was the case with the Maastricht experience, the West African Monetary Institute has also set target for these Macroeconomics Convergence Criteria (MCC) to be attained by its member countries before the commencement of the Monetary Union. These Macroeconomics convergence criteria are divided into two groups (the primary MCC and secondary MCC). The primary MCC are the most crucial or important targets. The secondary macroeconomics convergence criteria are intended to facilitate and foster the achievement and sustenance of the primary macroeconomics criteria. These criteria will be used to evaluate the performance of the member countries of the West Africa Monetary Zone over the past decade (2001-2011). Under each of the criterion, all the participating countries are assessed to determine their individual performance over the review period. Also the convergences of these criteria among all the participating University of Ghana http://ugspace.ug.edu.gh 46 countries are assessed by the use of mean, standard deviation and maximum differential in two periods (2001-2005 and 2006-2011). The reductions in the mean and maximum differential (best performing –worst performing country) for the two periods will be an indication of convergence among the WAMZ member countries and vice-versa. 4.1.2 The Real Convergence Approach This is based on the ideas suggested by various OCA theorists that in the presence of asymmetric shock, application of similar macroeconomic policies may be unfavourable for some member countries in a Monetary Union. The situation becomes better when the participating countries converge on a real macroeconomic level. Countries which converge on the real macroeconomic structures are likely to experience symmetric rather than asymmetric shocks. A similar trend was used by Masson and Rusuhuzwa (2012) in assessing Common Currency Area of East African Community. YǘCeol Mualla (2006) and Lee and Saucer (2008) in their separate articles assessed whether UK should join the Euro Zone using a similar approach. The real macroeconomics convergence will be dealt with under the following. 4.1.2.1 Similarities in Economic Structure of the WAMZ Member Countries When countries are similar in terms of sectorial and export structure and per capita incomes, they are less likely to face asymmetric shocks (Masson and Rusuhuzwa, 2012). Similar economic structures among countries will mean those countries are likely University of Ghana http://ugspace.ug.edu.gh 47 experience symmetric shocks or experience the same economic problem. This makes the implementation of monetary policies easier since such policies are meant to solve the same problem across the region. In determining the similarities in economic structure of the WAMZ’s member countries, the following issues are considered. 4.1.2.2 Business Cycle Synchronization (co-movement of economic activity) As a measure of business cycle synchronization in the WAMZ, we compute bilateral correlation coefficient between the cyclical parts of real GDP for each pair of countries over the 1980-1995 and 1996-2011 periods. The correlation coefficient gives the degree of the linear relationship between two series and its values lies between [-1:1] or [- 100%:100%]. It can be seen as a measure of co-movements between two cycles and its absolute values gives the strength of association between the two series. For the business cycle synchronization, the original real GDP series are denominated in the US dollars. The Hodrick-prescott filter is applied to obtain the cyclical of the real GDP (Silva 2009). In a monetary union, the higher the correlations of business cycles or economic activities among member countries, the lower the cost of forgoing an independent monetary policy. It also makes it easy for the Common Central Bank to implement a similar monetary policy across the zone. University of Ghana http://ugspace.ug.edu.gh 48 4.1.2.3 The Level and Sectorial Composition of Output Differences in sectorial output compositions of countries forming a Monetary Union could result in a situation that there will be country specific shocks causing divergence within the area in future. That is, differences in structures could make one country more vulnerable to shocks that do not affect the rest of the member countries; hence such country would react differently to changes in economic situations that in turn affect the entire union (Mkenda 2001). Similarity in output compositional structures of the participating countries will limit the extent of divergences from country-specific shocks, since they are all likely to experience symmetric shocks. Also, it makes responses to such shocks simpler. Under this same category, we are to assess the closeness of the per capita incomes across member countries and again examine the structure of each member countries’ GDP. This will be in terms of contribution by each sector to the GDP of the WAMZ member countries. It is also important to know the composition of exports of member countries. If the member countries rely on different primary commodities for export, there is a likelihood of a high level of asymmetric shocks across the region. 4.2.0 Other traditional OCA criteria These conditions also help to determine whether the WAMZ is an optimum currency area or not. University of Ghana http://ugspace.ug.edu.gh 49 4.2.1 Degree of Openness and Intra-regional Trade McKinnon’s trade openness criterion (1963) relates the trade-off between fixed exchange rates and flexible exchange rates to the intensity of trade relations. There is an indication that an economy that trades with the rest of the world has all the greater interest in having a fixed exchange rate the higher its trade openness rate is (Mongelli 2008). The degree of openness is meant to reduce the cost of trade and the risk of exchange rate uncertainty. The cost of discarding the exchange rate as an instrument used to adjust relative prices decreases as long as trade between the economies of member countries of the currency area is substantial. Countries that are integrated through trade may find it beneficial to adopt a common currency as their respective currencies will probably display similar movements on international markets vis-à-vis the rest of the world (Mongelli 2008). This assessment is attained by computing the sum of export and import as a percentage of the GDP. In terms of the intra-regional trade, the export absorption by the West Africa Monetary Zone from each member country will be measured. As a benchmark, the European Union has an intra-zone trade of about 60%. 4.2.2 Product Diversification Product diversification within the industrial sector is also an important factor favouring the formation of common currency. The more a region is diversified in the goods it produces, the less its need to adjust to external shocks using the nominal exchange rate. Therefore, a more diversified economy is a more suitable candidate for a monetary union University of Ghana http://ugspace.ug.edu.gh 50 than a less diversified one (Kenen, 1969). The analysis on product diversification is assessed on the industry sector level, which is mostly divided in the manufacturing, mining/oil and the construction sector. This is to determine whether the industrial export products among the WAMZ member countries are diversified across the sub-industry sectors. The condition becomes favourable if the product diversification across the WAMZ is high. 4.2.3 Political Will and Public Support Other important factors in the formation of a currency area are the political will and the public support. Member countries in a Monetary Union need to be committed to coordinate policies and to accept a loss of national (monetary) sovereignty. Also it is important for public to support the process toward a Monetary Union (Masson and Rusuhuzwa, 2012. Econometrically, it is very difficult to measure political will and public support. However, assessing the rate at which member countries of the WAMZ are complying with the Banjul Action Plan can give an idea about the political will of the WAMZ participating countries. 4.3.0 The OCA Index Approach Various OCA theorists have proposed different Currency Union indicators. In a situation where a region attains some of the indicators but poor in others, it makes the interpretation of the mixed results very difficult. To avoid this problem an index University of Ghana http://ugspace.ug.edu.gh 51 computed from Optimum Currency Area indicators need to be made. According to Bayoumi and Eichengreen (1997), OCA index can be defined as the prediction value of exchange rate variability, calculated using the ordinary least square (OLS) method. The smaller the OCA index, the more stable the currency. A country with smallest index indicates that her currency is the most stable among others. The model of exchange rate variability was originally developed by Vaubel (1977). He used the model to evaluate OCA on nine countries of the European Community. In addition, OCA index has served as an indicator for measuring the benefit and cost of currency union development. A smaller OCA index indicates greater benefit to a country than its cost, and vice versa. This is because countries with high symmetric shock and trade linkage tend to have stable exchange rate volatility and therefore easy to use a single currency. Hovart (2003) improves the Bayoumi and Eichengreen (1997) model by introducing the following formula: Lij = a0 + a1BCSij + a2FINij + a3DISSIMij +a4INFLij +a5TRADEij + a6SIZEij +a7OPENNESSij + ε, where Lij is the exchange volatility between country i and country j, i.e., the OCA index, BCSij is the business cycles synchronization, FINij is financial growth rate, DISSIMij is the dissimilarity of export commodity structure, INFLij is the inflation differential,