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Money Markets

Lessons missed in the case for EAC monetary union

East Africa Community leaders Zanzibar President Amani Abedi Karume, President Mwai Kibaki of Kenya, Paul Kagame of Rwanda (EAC chairman) and  Pierre Nkurunziza of Burundi after the official opening of 2nd EAC investment Forum in Nairobi in July, 2009. Photo/ANTHONY KAMAU
East Africa Community leaders Zanzibar President Amani Abedi Karume, President Mwai Kibaki of Kenya, Paul Kagame of Rwanda (EAC chairman) and Pierre Nkurunziza of Burundi after the official opening of 2nd EAC investment Forum in Nairobi in July, 2009. Photo/ANTHONY KAMAU 

An East African Safari: We hear the EAC is bracing for a monetary union from March 2012; that if the European Union did it with the euro and a one-size-fits-all monetary policy, well who are we?
A market of 127 million people flaunts a combined gross domestic product (GDP) of $73 billion set to grow with recent oil and gas discoveries. The case for a currency area and the East African Central Bank (EACB) seems tightly sealed. Why do I see a risk and cracks?

Are the conditions right to surrender sovereignty in monetary policy (the exchange rate in particular) even where members face country-specific shocks? True, the classic benefits are substantial: cheaper transactions, safe cross-border investments, capture of a quantity known as seignorage.

Yet, to avoid ditching EAC’s vehicle into a gully, take driving lessons, please. A good start is the European Union, its unfolding euro-crisis.

Lessons in good driving: It proves the deepest questions come from financial sector preparedness. Markets demand credible domestic macro-policies to move capital among member countries. When financial risks escalate, markets dig deeper potholes on the road, starving credit to some members even if there is enough savings to go around in the union.

Yet financial markets are weak and savings is scarce in deficits-ridden EAC. Ignore the facts of imbalances and the markets will punish even booming currency areas. The system wobbles especially when not backed by another key ingredient.

The latter is the grease oiling winners in currency areas – UK and US. As if this lacuna is not enough, in the euro’s case, rival currency areas wait in the wings to wage currency wars.

The Fed’s vow to keep US interest rates near zero to 2013, for example, confirms a prolonged devaluation of the US dollar, adding fuel into the euro’s bonfire of troubles.

Two main indicators gauge the health of a county’s balance sheet that financial markets watch closely: aggregate domestic savings and investments. These are catch-all identities in national accounts that rope in financial health of the government, the private sector and external transactions. Excessive divergence of investments from savings cannot persist before the markets spoil the party.

Running on empty

For decades, integrating Africa has pursued trade benefits while aspiring to merge international finance with the potential of regionally co-ordinated macro-policies. But the twin headaches of matching domestic policies with regional objectives on one hand and achieving credible savings/investment balances that minimise financial risks are underplayed.

The EAC – having died in 1977 then reincarnated to promise a monetary union – raises questions, but rarely on the imbalances. The Bujumbura Summit at the end of November 2011 revealed that political leaders are more optimistic about the federation than citizens. The technocrats, again, were not reading the fuel gauge of regional capital markets!

A laughable paradox of the experiment is the role of the European Central Bank (ECB).

In the midst of drip-feeding the euro on its deathbed, it commissioned the study that the EAC hopes to use to steer ahead with monetary union. Its raft of EAC indicators to be harmonised misses the point on political will and collective commitments on savings/investment balances.

It underplays the rudimentary capital market of EAC’s financial sectors dominated by banks for moving savings and borrowing. The indicators, GDP growth rates, inflation and budgetary deficit face critical measurement and comparability problems across EAC borders.

Take the matatu industry. Up to the moment when the next vehicle crushes on the roads killing dozens, the authorities waffle.

They take bribes while pleading that swashbuckling touts should keep the noise down, careful driving, safety belts, (bring back the Michuki rules), more courtesy towards other drivers. Of course, the accident still occurs. And it kills.

Now, a raft of east African and external technocrats seems to be in the driver’s seat. They talk little to the passengers about the fuel gauge flashing red. Yet they bully a speedy impractical route in the traffic, hell-bent on getting to destination: monetary union.

Should a common currency be developed? Well, it could cost east Africans dearly in taxpayers money and dashed hopes. Give them a say on the rules of a better journey than that of the EU. Why might the matatu crush in an accident that is eminently avoidable?

Study the EU again. It integrated, but to cross borders, financial markets looked for details. They perceived and studied new eurozone opportunities largely into two parts. First, above the Alps, the economies are strong. Productivity is high, investment is high and savings high enough to more than meet domestic investment requirements.

This lowers risk premiums to capital markets, moving credit from net saver countries above the Alps to net borrowers throughout EU. The German government today can issue bonds at virtually zero rates. The EU above the Alps was thus always ready for the business of integration.

It benefited from an upsurge in production and employment, revenues and exports to the entire eurozone.

The economic boom brought jobs and prosperity as expected under trade creation in theories of integration.

Second, financiers saw opportunities in southern Europe despite economies that were net borrowers and weaker, especially in Portugal, Italy, Greece and Spain. Wages were low, but investments returns were high despite relatively lower productivity.

Financiers took these opportunities to boost the economies, rating the borrowing risks as low since debt and repayments were anchored on the mighty euro.

Domestic savings/investment imbalances were overlooked since obligations were underpinned by the euro collectively. This permitted years of easy credit, and much higher wage and price growth in southern Europe relative to areas above the Alps.

After the 2008 global financial crisis, banks woke up to the spanner in the wheels: the credibility of domestic policies south of the Alps. After that, it was every country for itself.

Private sector activity retreated, with the deflation relatively deeper in southern economies.

EU governments braced for higher deficits as lower private sector economic activity cut tax revenues and employment. Germany, the creditor king in EU (and main benefactor of integration) played safe due to the risks of financing other members out of trouble.

In the south, investment requirements that exceeded domestic savings were no longer sufficiently guaranteed by the euro.

Suspicions of fiscal indiscipline and measurement errors in fiscal deficits proliferated. Attempts at austerity to resolve the problems looked unconvincing. The wag who coined the word PIGS (Portugal, Italy, Greece and Spain) for the main clutch of southern members needs mouthwash for bad manners. But by then, the party had gone sour, with Greece as the epicentre.

For all the talk of bailouts, IMF, blank cheques and burden-sharing, eurozone banks now charge higher premiums for bonds issued in the southern part of EU. Past loans lose value as bond yields escalate to ‘junk bonds’ status.

Banks that had swung in to finance the boom mostly in private sector lending have closed the taps.

The PIGs pay stiff interest rates while their economies contract. Social unrest is rising. Brussels seems powerless to stop the haemorrhage.

Mistakes
Along comes the ECB, the saviour of EAC. It has made key mistakes, proving how devastating central banks’ mistakes can become.

It pushed for fiscal austerity and higher taxes in the eurozone instead of supporting recovery and a lifeline for the PIGS.

Eventually, when this deflationary stance and calls for policies to shore up confidence in the euro economies failed, by early 2011, ECB tightened monetary policy, raising interest rates even though inflation was low.

This contractionary stance for fiscal and monetary policy in the zone, slashing spending and tightening credit in economies mired in depression, was enough to ditch the euro into a massive pothole.

The problem threatens to spill not just into fiscally-disciplined EU economies, but globally as well.

Nevertheless, the EU has potentials that EAC can only dream of. Its capital markets are well-developed and highly integrated.

Banks account for only about one third of the financial sector, while a vibrant capital market moves credit with bonds and government securities commanding two thirds of the financial sector. EU could survive.

In EAC, the shares are just the reverse.

There’s no creditor king. Uncompetitive banks would command saving and lending and prefer the comforts of Nairobi. Why? With over 10 per cent interest rate spreads, they need not move much capital to secure super-profits and retire to Nairobi’s leafy suburbs.

Moving the surplus of savers to borrowers (if any) would remain a structural problem and a myth until capital markets are developed. Imagine the chaos if a euro scenario of the above proportions hit the EAC?

Dr Wagacha is a consultant at Central Bank of Kenya and Economic Commission for Africa

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