Opalo

Kennedy Opalo

Econ 325: Economies of Developing Countries1.

Prof. Una Osili

Economic Integration and Monetary Unions in Africa:

Hurdles and Possibilities

Introduction:

Sub-Saharan Africa2 (hereafter Africa) continues to lag behind other regions of the

world in terms of economic growth and development. Over the years, a lot of ink has

been spilled in trying to explain this fact. Explanations put forward by various

scholars, to mention a few, have included the region’s inappropriate development

strategies that are dependent on inward-looking policies meant to capture rents

rather than foster growth (Thomson and Thomson, 2000; Dollar, 1992; Cleaver,

1985); external obstacles to trade, especially with regard to policy choices of the

Global North , such as the much maligned agricultural policies of the European

Union and the United States of America (Amjadi et al., 1996); undemocratic

governance that has produced kleptocratic dictators and caused civil strife which

has diverted valuable resources from the development agenda to war efforts

(Collier, 2007; Masson and Patillo, 2005); bad geography (rugged terrain and lack of

access to the sea) that renders transport costs, a vital component of trade,

prohibitively high (Sachs, 1998); the legacy of colonialism that created unsuitable

1
This paper was originally presented as a fifteen page paper in a class on the economies of
developing countries. I have since had to incorporate new material and expand some of the
arguments presented for the purposes of submitting it as a sample paper.
2
Sub-Saharan Africa comprises of countries on the continent of Africa South of the Sahara
desert. This grouping excludes countries from North Africa like Morocco, Tunisia, Libya, Egypt
and Algeria.
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path-dependencies with regard to trade and institutional structures (Nunn, 2007;

Young, 2004); or simply bad leadership3 (Achebe, 1985).

Naturally, none of the explanations provided can singly explain Africa’s

underdevelopment. Each only provides a partial answer as to why the region has

lagged behind others like the Pacific Rim4 which took a meteoric rise towards

becoming developed economies in the 1980s. Most, if not all, of the existing

explanations for Africa’s underdevelopment have been state-centric. They have

mostly implied that solutions lie within the boundaries of the individual countries, if

only these countries’ governments can get their act together. While this might be

true, there is a need to look for alternative solutions that are not state-centric,

especially in light of the increasing rate of globalization. The increasing

interconnectedness of nations through commerce, not just in the regions with

developed economies, but even in Africa necessitates the search for solutions that

look beyond national borders. It is for this reason that this paper provides an

analysis of two complementary approaches to tackling Africa’s underdevelopment:

monetary unions and economic integration in the different regions of the continent.

Through a survey of the existing literature on economic integration and monetary

unions, this paper explores the viability of these two approaches in the African

situation in an attempt to spur economic growth.

3
Chinua Achebe’s famous 1985 book criticized the Nigerian political leadership. The same
criticism can be leveled against other leaders on the continent of Africa.
4
It is interesting to note that when most African states gained their independence from
Western Europe in the 1960s, some African countries were at the same level of economic
development as many East Asian countries. To illustrate this point, in 1975 the GDP in Africa
and Asia was US $ 713 and US $ 309 respectively. In 2004, these figures were US $ 1,842
and US $ 5,331 respectively. This fact is important in dispelling the argument that Asia had a
head-start in the development trajectory. See the Japan Bank for International Cooperation
Institute paper on “Experience in Infrastructure Construction in East Asia and Sub-Saharan
Africa:Implications for Infrastructure Aid in Africa.” (2008).

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Hereafter, this paper is divided into four sections. The first section provides a survey

of the conditions in Africa that make it a particularly suitable region for

implementing monetary unions and economic integration. The second section looks

at economic integration, focusing on the existing literature on the subject, economic

theory and how these apply to the African condition. The third section looks at

monetary unions, again focusing on the existing literature and economic theory

behind it and how it applies to Africa. The fourth section illuminates on some of the

challenges that might hinder successful implementation of the ideas put forth in this

paper. Lastly the conclusion recapitulates the main points presented in this paper

and offers suggestions for further research in this area of Development Economics.

Background:

Most African states have neither been strong militarily nor had isolationist

nationalism. This can be attributed to the processes that created them and their

existing eclectic ethnic mix. Unlike older Westphalian5 nation-states, many of these

countries did not have to fight for and to maintain their territories since their borders

were arbitrarily drawn by 19th century European powers6. The result was that these

states did not have the incentives to promote economic activities that generated

revenue or foster institutions that would sustain them as independent nation-states

as was the case with states founded through wars of conquest (Tilly, 1990). This

guarantee of territorial integrity after independence, later cemented by the current

international regime may explain why most African states lack the ability to project

power throughout all of their territories (Herbst, 2000). The Delta region in Nigeria,

5
This is a reference to the treaty of Westphalia (in actual sense the treaties of Osnabruck and
Muster) of 1648 that is credited by most Political Scientists as having marked the beginning
of the nation state as we know it – with clearly defined borders and legally unchallengeable
sovereignty.
6
The partitioning of Africa took place in 1884-85 in Berlin, Germany in an attempt to
peacefully divide territories in Africa among the imperial European powers at the time.
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the Eastern provinces of the Democratic Republic of Congo, Eastern Chad, among

others, all serve to confirm this theory. Ethnic diversity has also been a cause of the

weakness of African states. First exploited by colonizers to divide and rule their

colonies, ethnicity has since then been used by post-independence leaders to

antagonize different regions of the same countries (Apollos, 2001). In light of these

factors, it is evident that, historically, Africa lacks a brand of nationalism that would

jeopardize attempts to institute economic integration and monetary unions across

the continent, especially in the case where such integration did not affect the

political power dynamics of participating countries.

It may seem impracticable to call for economic and monetary union on a continent

that is largely devoid of modern communication and transportation infrastructure -

vital aspects of economic growth and development. For instance, Africa as a region

has the lowest landline telephone density in the world (Jerome, 1999). The continent

has witnessed marked under-investment and mismanagement of its road, rail and

port systems over the past few decades (Pedersen, 2001). Adding to Africa’s

transportation woes is the fact that most of the rivers that run through the continent

are not navigable due to rapids and waterfalls. But this is not the entire picture. The

same Pedersen paper notes that there is a surprisingly high private interest in

investing in railways and other transport infrastructure to facilitate the existing

minimal intra-African trade. Pedersen also points out the fact that there is increasing

regionalization of the continent around hub-ports and hub airports – in Nairobi,

Abidjan and Johannesburg – which can be seen as pointers to the idea of regional

economies around certain growth poles. In addition, free market policies adopted by

a few countries in the 1990s have gone a long way in bringing much needed

efficiency and expansion in Africa’s ports, in addition to reducing corruption

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(Pedersen, 2001). Africa’s lack of robust infrastructure may even prove to be a plus.

Economic and monetary integration will inevitably necessitate the construction of

new transport and communication links. The non-existence of such links may prove

advantageous in that it will help reduce switching costs and associated losses.

The above arguments highlight the viability of economic and monetary integration in

Africa. But perhaps a better case for this approach to development on the continent

can be made using the population argument. In his famous book, Guns, Germs and

Steel, Jared Diamond cited Africa’s low population density as a reason behind the

continent's failure evolve nation-states with hard borders and lasting Weberian

rational-legal institutions comparable to those that developed in regions with higher

population densities (Diamond, 1997). Other scholars have cited this same reason

for Africa’s failure to be part of the green revolution that spurred economic growth in

more densely populated Asia (Johnson et al., 2003). Relating population density to

innovation in agriculture, Boserup found that, high population densities are highly

correlated with more intensive forms of farming – a case of necessity being the

mother of invention. Her work also illustrated that a high population density

stimulated European development of “special handicrafts and manufactured goods”

(Boserup, 1981).Yet another advantage of a high population density is the simple

fact that two heads are better than one. A bigger population is more diverse and

thus, due to competition and shear numbers, has a higher probability of producing

individuals with innovative ideas (Kremer, 1993).

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Figure (i)

Source: Ray, Debraj: Population growth and economic development.

Looking at figure 1 and assuming that the rate of population growth is consistent

with this graph and diminishes over time, as the population grows so will the rate of

technical innovation and income – as suggested by Kremer and Boserup. This results

in a long-run situation where technological progress outpaces population growth

leading to an increase in per capita income (Debraj, 1998). This analysis seems to fit

the African condition. This vast continent is sparsely populated with millions who,

able to own small pieces of land, eke out a living through subsistence agriculture.
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The abundance of land in Africa obviates the need for intensive agricultural

production and limits technological progress. The other problem related to low

population densities is a lack of sufficient markets to support local industries. So in

the African case, not only do industries not emerge because of a lack of innovation –

a la Kremer – but also due to a lack of large-enough markets to support these

industries. The demographic problem discussed here can be tackled by opening up

Africa’s borders – through economic integration – in order to facilitate free

movement of people and goods. This will create opportunities for people to move to

areas with economic resources thereby benefiting from the advantages of

agglomeration (Venables, 2007) thus promoting economic development and

allowing for efficient allocation of resources across regions.

There is, however, a negative side to the demographic argument. Population growth

eats away at economic development. The rapid population growth in most African

countries due to increased health care coverage and nutrition ended up drowning all

the economic achievements of the 60s and 70s. To illustrate this point, between

1965 and 1980, the per capita GNP Africa grew by 3% but declined by 0.4% between

1980 and 1990. During these two periods the rate of population growth grew from

2.8% to 3% (Ohadike, 1996). Since 1980, population growth has on average

outstripped economic growth, thus putting a strain on the continent’s infrastructure

and contributing to the deterioration of provision of services such as healthcare and

education. A high population growth rate also increases a country’s dependency

ratio thereby reducing its savings rate. This has a direct negative effect on economic

development because a low savings rate implies reduced investments (Debraj,

1998). While appreciating the negative effects of population growth, it still holds

that sparsely populated areas do not provide the suitable ingredients needed to spur

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economic growth. Even with a population growth rate of zero, Africa still needs a

great amount of economic integration in order to increase trade and the mobility of

factors of production, the latter which causes a rational and efficient allocation of

the same factors.

A case can also be made for the approach to developing Africa suggested in this

paper based on studies of how borders impact trade. With increasing globalization,

many people have come to take borders for granted. The truth, however, is that

borders still matter, especially when it comes to trade. A study by John McCallum

found evidence to suggest that borders actually reduce trade volumes, ceteris

paribus (McCallum, 1995). The subject of the study was the US-Canadian border and

how it impacted trade between the two nations. The results indicated that the mere

existence of a border had a significant effect on trade patterns in the border regions

of both countries. Given the good infrastructure between these two countries, it is

reasonable to assume that “border induced” trade barriers would even be more

acute in areas where they have been reinforced by poor or sometimes non-existent

infrastructure, like is the case in Africa. Going by these findings, it is reasonable to

assume that by opening up African borders would promote a growth in the volume of

intra-continental trade, which currently stands at a paltry 10%7.

A key ingredient of economic growth in Africa, like in most other regions, will be

foreign direct investment (FDI). However, comparing historical FDI figures for both

Africa and South East Asia, it becomes apparent that there is an “adverse regional

effect” that makes Africa receive less FDI than other similarly underdeveloped

regions, even after controlling for all other observable differences (Asiedu, 2002).

This difference in FDI levels can only be attributed to the negative image the region

7
This is according to the IMF’s quarterly magazine, Development & Finance, December 2006
issue.
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has come to acquire over the last three decades due to its reputation for violent

conflicts and political mismanagement. This off-putting image can be shed off by

creating economic and monetary unions. Such unions would reduce the instances of

economic mismanagement and foster the formation of reputable institutions that

are essential to economic growth and stability (Pevehouse, 2002).

It is not just economics that necessitate economic integration in Africa; a political

argument can be made for the same - in line with the liberal democratic peace

arguments of International Relations theorists8. Trade promotes peace, among other

associated benefits as strong institutions and proper governance. This is especially

vital in violence-prone regions of Africa like the Great Lakes region and the Horn. To

quote Montesquieu9, the “natural effect of commerce is to lead to peace.” Increasing

interconnectedness of African nations and peoples through trade will help eliminate

ethnic animosities that have fuelled numerous bloody conflicts throughout the

continent.

Economic Integration:

Looking at the Development Economics literature, it appears that if Africa is to

develop through export orientation - the way the Asian tigers did - it will have to

wait until there is a large enough differential in the cost of factors of production

between the region and the new emerging markets of South East Asia and the BRICS

(Brazil, Russia, India and China). It is only then that the international market will shift

its gaze towards Africa which will then still have cheap labor and less restrictive

8
This is a reference to the Kantian democratic peace theory which posits that democratic
nations do not go to war with each other. An extension of this is the neoliberal idea of
“Complex Interdependence” advanced by Robert Keohane and Joseph Nye. Complex
interdependence suggests that when countries are economically integrated through trade
and by being partners in international institutions like the UN, they rarely go to war with each
other because going to war with each other would lead to severe losses due to the disruption
of trade links. For more information see “Power and Interdependence” by Robert Keohane
and Joseph Nye (2001).
9
Charles de Secondat, Baron de Montesquieu in “Spirit of the Laws” published in 1748.
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labor laws to facilitate a relocation of industrial production from the Pacific Rim in

the same way that the shift occurred from Western Europe and the Western Off-

shoots10 (Collier, 2007). Obviously, the region can ill-afford to sit and wait for this

eventuality. There is an urgent need for Africa, as a region, to boost its position in

the world trade arena by being both inward and outward looking. Development

Economics literature also point to the fact that sustainable economic growth

necessarily requires industrial development, which shifts factors of production from

low-level productivity areas to high-level productivity areas11. If Africa is to develop a

robust industrial sector, it is imperative that it does this with a view of selling

primarily to a domestic market since the global market is currently saturated by the

above mentioned emerging market nations. This can only be done through economic

integration, since, as mentioned above, many African countries lack the big

populations needed to support a robust industrial sector.

The theory:

Economic integration theory suggests that integration affects participating

economies through two main channels: The scale-effect channel and the factor-

reallocation channel (Bretschger and Steger, 2004). Scale-effects have to do with

the benefits that accrue to a region after the expansion of markets and

establishment of linkages between similar or complementary firms. Factor-

reallocation on the other hand deals with the idea that in an integrated free market

economy the market allocates capital efficiently – across sectors and/or

geographical locations. Economic integration therefore increases opportunities for

increased efficiency in factor-reallocation and thus ought to positively influence the

10
Western Off-shoots here refers to the United States, Canada, Australia and New Zealand.
11
The United Nations World Economic and Social Survey, 2006. Oct. 27th 2008
<http://www.un.org/esa/policy/wess/wess2006files/chap2.pdf>
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rate of economic growth. While the scale effect may have an unambiguously

positive effect, factor-reallocation effects are ambiguous.

This is because with an expansion of markets (a case of the scale effect), production

capacity can be increased or reduced depending on the demand thereby limiting

any losses when shifts are necessitated by market conditions. Production factors on

the other hand are not as flexible. Once a plant has been moved to a new location it

is not easy to relocate because of a change in the market condition. Furthermore, it

is hard to anticipate all the factors that might be in play in determining whether

such a reallocation of factors of production will be profitable or not. Therefore the

net effect of integration remains a coin toss. The available literature on trade growth

after integration offer mixed results. Edwards (1998), Badinger (2005) and Dollar

(1992) find a positive net effect in their studies of economic integration. A case

study of the EU-block by Hendekson et al. (1997) also found significant positive

effects. Another study of the EU-block by Frankel and Wei (1993) found that joining

the block in 1980 would have increased a member country’s volume of intra-

regional trade by 68%. However, Vanhoudt (1999) found the net effect to be

negative. Yet others studies have found the effect to remain ambiguous (Bretschger

and Steger, 2004). The ambiguity of the economic integration theory can be

dispelled by a look at international trade studies. Here, the findings illustrate that, in

general, trade benefits all those involved – in terms of transferring technology,

enhancing efficiency and promoting growth (Irwin, 2005). Same studies show that

regional trade is particularly important in accelerating reforms of domestic policies

that distort prices and inhibit trade thus further opening up countries to wider

multilateral trade (Burfisher et al., 2001). It light of these findings, it hard to imagine

that economic integration would have net negative effects

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Relating economic integration theory to Africa:

Applying the economic theory to the African context, it is reasonable to speculate

that scale effects will be unambiguously positive. Because of sparse populations and

uneven distribution of natural resources, not every African country can support a

vibrant industrial base. But as integrated economic regions, various parts of the

continent can support industries by exploiting their comparative advantages in

relation to other regions and the scale effects of having bigger markets. Economic

integration would allow for free flow of capital that would shift resources from region

to region depending on need and efficiency concerns. It would also provide bigger

and more diverse markets for whatever industries that emerge thereafter. The

development of an industrial base in Africa is of paramount importance. As already

mentioned above, technological progress is the main engine of growth and such

growth can only be attained and sustained through industrialization.

No region of the world has managed to achieve a state of sustainable economic

development without having a homegrown industrial sector. Individual African

countries, with the exception of a populous few like Nigeria and South Africa, will not

be able to achieve this on their own – hence the need for the creation of regional

economic units. Furthermore, the historical dependence of African economies on

commodity exports has proven to be a failed strategy. Over the last three decades,

African commodity exporters had been victim to fluctuations in global commodity

prices which have had adverse effects on their economies. A case in point is

Zambia. After the Copper boom and burst of the 70s, the country suddenly found

itself unable to finance projects and an expanded government from the boom years

(Bevan, 1993). The adverse effect of this kind of “export instability” on economic

growth has been well documented (MacBean, 1966). It is imperative therefore that

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Africa places its bets, with regard to economic development, on local industries and

markets that are relatively decoupled from the global markets to protect its

economies from adverse global shocks.

At this point it is necessary to look at where the region stands in global trade

activity. Africa has about 12% of the world population but accounted for only 2%

percent of world trade in 2005; down from about 5% in 1970 (see figure ii below).

This sharply contrasts with Asia whose share has increased from about 5% to over

20% with the same period. It is also important to note that the decline in African

exports has not been matched by significant increases in intra-continental trade

which still stands at a paltry 10% as of 2006 (IMF, 2006). Although unrecorded intra-

continental trade exists (Akello-Ogutu, 1997) and despite the encouraging evidence

of growth of recorded trade (McCormick and Pedersen, 1999), there is still a pressing

need to significantly increase trade activities both within the continent of Africa and

with the rest of the world. The latter will be difficult, especially in line of East Asia’s

domination of the global light manufactures export market. But the former can be

achieved through economic integration. Such integration would open up the region

to business opportunities that exist throughout the continent. A good illustration of

this is the fact that retail sales in Kenya have grown by over 64% in the last four

years alone.12 This suggests that there is still a huge untapped market that can be

exploited for economic gains if resource mobility was enhanced in the region

through economic integration.

Figure (ii): Shares of Asia and Africa in world merchandise trade, 1990 -0013

Asia

12
East African Business Week, Monday 18th June, 2007.
13
The African figures on this graph include North Africa, which is not part of the region
commonly referred to as Sub-Saharan Africa. Source: World Trade Organization, 2001.
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Africa

Monetary Union:

Monetary union in Africa can be carried out in either one of two ways. The first

option would be to have a single currency for the entire region with one independent

central bank in charge of monetary policy. The second option would be to have

regional blocks of currency unions like the existing CFA Zones. Possible regions

would be West Africa, Central Africa, East Africa and Southern Africa. As is explained

below, the latter option is better than the former. West and Central Africa have a

head start because of the existing France backed CFA zones. Southern Africa

(Lesotho, Namibia, Swaziland and South Africa) also has a Common Monetary Area

(CMA) which is essentially a formal exchange rate union but with separate

currencies, with rates fluctuating within narrow or zero margins and a strong degree

of coordination between central banks. The participating countries’ currencies are

linked one to one to the South African Rand (Mason and Patillo, 2005). An expansion

of these three existing unions and in the case of East Africa a creation of a new

union is what this paper proposes.

Finance is the engine of growth. The centrality of finance in economic development

is, by most accounts, undisputable. Although some scholars maintain that it is

economic growth that leads to the development of complex financial institutions

that efficiently allocate capital (Lucas, 1988), the majority believe that the arrow of

causality run in the opposite direction (Schumpeter, 1912; Goldsmith, 1969; Miller,

1998). The bottom line, however, is that regardless of one’s belief, the importance of

the financial sector in resource allocation is indubitable. An efficient financial sector

removes market distortions, allowing for savings and investment rates that are

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conducive to economic development (Demirguc-Kunt, Asli, 2006). Because of the

degree of importance of the financial sector, it is important that it is run with high

integrity and with regard to free-market ideals (Friedman, 1964). The integrity of any

country’s financial sector can only be maintained in the presence of strong

institutions devoid of political manipulations (Calvo and Mishkin, 2003).

In the case of Africa, the integrity of its financial institutions has been wanting.

Economic mismanagement and rent seeking activities have, many a time, led to the

adoption of policies that distort the market thus causing macroeconomic instability.

The historical overvaluation of African currencies is legendary (Ghura and Grennes,

1993). Decades of poor governance have stunted institutional development, with

grave consequences for African economies (Chabal, 2002). Repeated attempts at

reforms have been met with little enthusiasm and have largely failed (Van de Walle,

2001). Perhaps a way of instituting reform would be to take the power to effect

monetary policy and regulate the different countries’ financial sectors away from

individual governments and give it to regional central banks staffed with credible,

apolitical experts. This can be implemented via a currency union, in the model of the

European Union’s euro-zone. Having such currency unions would bring about much

needed macroeconomic stability in the four regions of Africa and create confidence

in the same economies. Regulation of the financial sectors would also be entrusted

to these central banks in order to de-politicize the regional financial sectors and

harmonize regional capital markets.

The whole idea behind such unions would be to promote trade and accompanying

economic development – and there is evidence to suggest that this indeed would be

the case (Vickers, 2000). Vickers notes that although monetary unions do not

necessarily promote growth, they serve to ensure price stability – much needed to

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tame Africa’s runaway inflation. Furthermore, such unions instill fiscal discipline

since individual governments cannot monetize deficits like they are wont to do when

they control the mint. Other studies by Rose (2000) and Glick and Rose (2002) have

also found that controlling for all factors (such as proximity, trade arrangements,

among others) countries that use a single currency have an increased volume of

trade compared to those that have their own sovereign currencies. So at the

minimum, currency unions in Africa would guarantee sanity in the formulation and

implementation of monetary policies and regulation of the financial sector. Beyond

that, and with the right ingredients in place, there is potential for an increase in

trade volume and a realization of the associated benefits of more efficient financial

markets.

The theory:

There is no unified theory of optimum currency areas. There are different theories

that try to explain the conditions under which such arrangements can succeed and

when they cannot. Based on a survey of the available literature on this subject, two

types of criteria emerge for determining the success or failure of currency areas into

two groups as displayed in table (i).

Table (i): Criteria for an optimum currency area

Country specific criteria Region - Specific criteria

High flexibility in wages and prices High mobility of production factors

High degree of product diversification Similar industrial structures

High co-variation in economic activity

Similar cultural and economic factors

Similar economic policy preferences

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Source: Tavlas (1993) and Bayoumi and Eichengreen (1997)

The country specific criteria evaluate the state of an individual country’s economy

and how it would be affected by joining a currency union. Flexibility in wages and

prices is important because after a country concedes the ability to use monetary

tools to offset shocks to its economy, such shocks can only be offset by adjustments

in the prices of goods and labor (Friedman, 1964). Rigid labor laws and/or sticky

prices are therefore inimical to success after a country joins a currency area. A high

degree of product diversification is also important for hedging purposes. A country

that is asymmetrically dependent on one industry or commodity would suffer

greater consequences from external shocks once it joins a currency union more than

it would if it had a diverse basket of products.

Region-specific criteria deal with the currency area as a whole and the factors that

may increase the chances of success of such a union. High mobility of production

factors is essential because it guarantees efficient use of these factors. In other

words it guarantees that capital and labor move to areas where they are most

needed and would be used the most efficiently. Similarity in industrial structures

ensures uniformity and standardization. This is most essential when one considers

infrastructure designs such as railway gauges, electricity grid, among other things.

Perhaps the most important ingredient for success in a currency area is the need for

covariance in economic activity. Countries experiencing different business cycles

and which experience different types of shocks ill-fit in a currency union. This is so

because it makes it hard for the affected countries to uniformly implement the

necessary monetary adjustments that might be needed to offset any shocks that

may affect the economy (Chamie, De Serres and Lalonde, 1994). This is the reason

for this paper’s recommendation that currency unions in Africa be implemented

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along regional lines. Similarity in culture and economic factors is important because

of the significance of the interplay between culture and economic outcomes. Using

proxies for culture – like religion, structure of social relations, among others - various

studies conducted in areas as diverse as Economics and Anthropology have since

discovered that there is a correlation between culture and economic outcomes of

any given people (Guiso and Zingales, 2006; Stulz and Williamson, 2002). Similarity

in economic policy preferences is an obvious requirement in a currency union.

Participating countries must commit to agreed levels of government deficit and ways

of financing those deficits, among other things.

Relating the optimum currency area theories to Africa:

Applying the above criteria to the African situation reveals various challenges. To

begin with, the labour market in Africa is not flexible. This is illustrated by the higher

than normal wages in the formal sector, despite the fact that the countries in this

region usually have high unemployment rates (Kingdon, Sandefur and Teal, 2006).

This condition, according to optimal currency area theory, makes the region

unsuitable for a currency union since it makes it harder for states to correct

disequilibria due to country-specific shocks after ceding foreign exchange rate

adjustment as a policy tool (Monga 1997). On the diversification criterion, Africa also

scores poorly. The region’s economies have largely remained dependent on the

primary production industries of agriculture and mining. That said, it is important to

note that this theoretical criterion considers differential levels of diversification. This

means that what matters is relative diversification; how country A is diversified

relative to other countries around it. In a union with only a few highly diversified

countries, the less diversified countries would suffer as the more developed

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economies establish monopolies over entire sectors of the economy. But the African

situation is not like this. Nearly all the economies in the region have the same levels

of diversification and so would all benefit from a currency union, as predicted by the

theoretical assumptions stated above.

Judging by Africa’s history, the region-specific criteria are going to be the hardest to

meet because of their dependence on political will. However, there is hope for

positive outcomes in the newly created African Union. The charter of the Union has

revolutionary ideas concerning economic and cultural integration of the continent.

Gaddafi’s empty rhetoric of a United States of Africa aside, the region should

consider quick implementation of the trade and labor mobility proposals in its

constitutive act14. This would remove most of the barriers to free movement of

factors of production across borders thereby reducing the effects of any asymmetric

shocks within the currency unions. Once such openness to trade and production

factor mobility is in place there will then be a need to harmonize economic policies

in the various regions that form the unions.

The African currency unions would not find it difficult meeting the criterion for

similar industrial structures. As stated above, most of Africa’s economies are

extractive and in the beginning stages development. States forming the currency

unions would therefore simply have to harmonize their development agenda in order

to ensure an outcome with relatively similar industrial structures. Because of their

underdeveloped and extractive nature, the economies of Africa have had a

significant degree of co-variation, depending on global commodity prices. This

situation would persist even during integration and thus obviate the need for

autonomous exchange rate adjustments because shocks would be similar across the

board. On the need for similar cultures and economic factors, the regions, although
14
The African Union Constitutive Act: http://www.au2002.gov.za/docs/key_oau/au_act.htm
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diverse in their own unique ways, still have a great amount of resemblance in terms

of cultural practices and economic activities – mainly revolving around subsistence

farming and animal husbandry. Therefore, transforming the regions’ economies

while at the same time maintaining these similarities, under currency unions, should

not pose any serious difficulties.

The last union-specific requirement, being political, will pose greater challenges.

African countries are not known for their excellent policy preferences. Policy

preferences in the region tend to depend on domestic political contingencies rather

than sound economic principles (Dollar and Easterly, 1999). The solution to this

problem would have to be political – leaders realizing that printing money for

elections and/or artificially inflating currency prices are not good for long term

growth and development. Furthermore, countries with different histories of inflation

will find it hard to converge to the regional desired rate without bold policy

measures (Jonung and Sjoholm, 1999). As already pointed out, there is no reason to

completely rule out the possibility of African leaders cooperating in this respect,

especially in light of the new treaty of the African Union. Currency unions would

implicitly force member states to adopt similar policies thus reducing chances of

manipulation of monetary policy by individual countries for political ends.

While most of the arguments presented here in relating of the optimum currency

areas theory to the African condition have not been backed up by raw data, it is

fairly reasonable to assume that the findings on the ground would not grossly

contradict the conclusions made in the preceding paragraphs. Indeed, there is

empirical evidence from CFA Franc zones in central and West Africa that suggests

that with the proper institutions in place the proposals presented in this paper can

work. For instance, the CFA Franc Zones have had historically lower inflation rates

20
 Opalo

compared to the rest of the continent due to policy restrictions imposed on member

states by virtue of being in the two currency unions (Honohan, 1990). The rest of

Africa can learn from the existent weaknesses of these two currency zones - which

have mainly been adverse incentives and a great amount of moral hazard caused by

weak central banks and France’s guarantee to back the CFA Franc (Fuouda and

Stasavage, 2000). Building on the strengths of the CFA zones, new currency unions

should be created with an express commitment to support strong institutions and

economically sound monetary policies.

Potential Challenges:

The advantages of economic integration far outweigh any disadvantages that may

result from coupling of economies or trade diversion (Burfisher, et al., 2001). Free

trade benefits all those engaging in it. It allows for the transfer of technology, labor

and capital mobility and increases competition leading to greater efficiency. African

leaders ought to place a premium on potential for continental economic expansion

and growth. As has been noted above, sustained economic development is only

attainable if a country or economic region has an industrial base and potential for

technological advancement. Reliance on the export of raw materials will not only fail

at promoting economic growth, it is also bad for the development of transparent

government and reliable institutions (Karl, 1997; Sachs and Warner, 1995; Shafer,

1994). Africa’s economic development, just like that of the Asian tigers, will be

heavily dependent on foreign direct investment (FDI). There is evidenceto suggest

that economic integration attracts FDI more than stand alone economies, even in

advanced regions of the world (Brenton, Di Mauro and Lucke, 1999). Economic

integration will not only help the region shed some of its bad image, but will also

help it attract much needed investment to create jobs and develop industry. But FDI

21
 Opalo

alone will not do the trick. The continent has to boost local investment and savings

rates. It is estimated that the amount of capital flight from the continent between

the years 1970 – 1996 was a whooping US $ 176 billion (Ndikumana and Boyce,

2002). Couple this with the fact that as of 2002 there were over 100,000 African

millionaires worth over US $ 600 billion15 and it becomes clear that it is possible for

domestic investment to play a role in getting the continent of Africa out of the

economic ditch that it finds itself in right now.

The biggest challenge will be how to implement the currency unions. First of all, this

paper proposes that there be four unions – Southern Africa, East Africa, Central

Africa and West Africa. The idea of having a monetary union raises serious questions

about monetary policy and adjustment to shocks. Optimality of currencies, even

within individual states cannot be taken for granted. Different regions have different

economic structures and may experience different shocks (Mundell, 1961).

Furthermore, labor and capital mobility is not guaranteed, even within borders.

These challenges get even more amplified when one considers entire regions of a

continent as big as Africa. The counterpoint to this challenge is that the reduction in

transaction costs and liquidity security provided by the use of a single currency

within a country or within regions far outweighs the disadvantages of being in a

single currency area. To add to this is the fact that less developed countries, in light

of the large size of their informal economies usually have more labor and price

flexibility than official figures that only capture formal employment may suggest

(Calvo and Mishkin, 2003). The bottom line is that there can never be objective

optimality of a single currency, even within nation states. It is all a question of

weighing the pros and cons. In the African case, the advantages of having currency

unions, as argued here, would outweigh the disadvantages.

15
African Business (London), Sept. 2004, p. 8.
22
 Opalo

The other disadvantage of being in an optimum currency area is the fact that

individual countries would lose their powers to use monetary policy to offset nominal

or real shocks on their economies. In the African case, the lack of this policy option

might actually be a good thing. The need for monetary policy flexibility assumes

that governments choose to use exchange rate policy as an instrument only when

warranted by economic concerns (Eichengreen, 1994). However, empirical evidence,

mostly from Africa, has shown that political instability greatly increases the

likelihood of abuse of this policy instrument (Klein and Marion, 1994). Because of

this, it would overall be beneficial for the countries in the region to cede control of

their monetary policy to an independent and reputable regional central bank in a

currency union (Fouda and Stasavage, 2000) than to leave this tool in the hands of

politicians.

It goes without mention that institutional strength is vital to the success of currency

unions. Africa’s institutional weaknesses may hinder the establishment of robust

financial institutions to accommodate the levels of economic and monetary

integration advocated for in this paper. Indeed, some might even argue that the

choice of having a currency union should be secondary to the development of sound

financial institutions that have credibility to guarantee to stability of a country’s

financial sector (Calvo and Mishkin, 2003). To counter this challenge, it is important

to note that being in a currency union offers institutional stability or a bias towards

institutional stability because of potential for stricter oversight by players with a lot

of power and leverage – nation states. Being international institutions, the central

bank in the currency unions would be less susceptible to political manipulation

compared to individual states’ central banks.

23
 Opalo

Lacking in the arguments presented in this paper are the already existing

preferential trade area arrangements – Economic Community of West African States

(ECOWAS), the East Africa Community (EAC) or the Southern Africa n Development

Community (SADC). This is deliberate because these regional arrangements, as

currently constituted, have not managed to spur significant amounts of trade and

economic development (Geda and Kebret, 2007). Many of the regional economic

agreements unnecessarily overlap, thus creating complications than are needed

when trying to promote free trade (Foroutan and Pritchett, 1993). A case in point is

the SADC. A study found that even though the South African economy is much larger

than of any other country in the Southern African region, it is not big enough to act

as a growth pole for the region (Lewis, Robinson and Thierfelder, 1999). For these

regional arrangements to succeed there is the need for a deliberate attempt to

integrate the participating economies rather than leave this task to market forces.

Another facet of the African development discourse lacking in this paper is the role

of Overseas Development Assistance (ODA). This is deliberate because so far there

is no evidence of significant ODA success in Africa. Since the sixties the continent

has received the equivalent of six Marshall Plans (Taylor, 2005). If ODA were an

essential part of economic development then Africa would be far mode developed

than it currently is. ODA may be helpful in the short term – for financing deficits and

essential programs like healthcare – but in the long run it undermines development

because it encourages a culture of dependency and undermines institutions of

government by making governments accountable to foreign aid givers and not the

populations they govern (Knack, 2004; Bautigam and Knack, 2004; Moss, Petterson

and Van de Walle, 2006). To reiterate the hackneyed phrase, what Africa needs is not

aid but trade. If farm subsidies were scrapped and African farmers allowed to

24
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compete freely prices of basic commodities would go up thus making farming a

viable economic activity for millions of African farmers. An example is cotton, a vital

commodity for the African nation of Mali. If farm subsidies were to be abolished, the

global price of cotton would go up by as much as 20% thus providing much needed

income and foreign reserves for this arid African country (Taylor, 2005). The current

buzz in the “aid industry” is the achievement of the millennium development

goals16. It is not surprising that Africa will not meet these goals (Sachs, McArthur and

Schmidt-Traub, 2005). Development assistance programs, as currently

constituted,cannot promote sustainable growth and development. Instead, they

continue to erode institutional strength and promote dependence, as illustrated

above.

Conclusion:

Africa’s arbitrary borders have oftentimes been blamed for the continent’s troubles

(Herbst, 2001). Adopting economic policies that are blind to these national

boundaries is a way of mitigating the impact of this historical accident. This paper

offers a challenge to the existing idea of statist economic development planning.

Instead there ought to be regional planning. Many of Africa’s countries are

landlocked. Economic development fuelled by trade with the external world and the

rest of Africa in these countries is dependent on the quality of infrastructure in their

neighboring countries (Collier, 2007). This calls for further integration of African

economies in order for the region, as a whole, to have a harmonized development

16
The millennium development goals are a set of targets set by the Millennium Summit at the
UN in 2000 with a target of eliminating a number of problems afflicting the third world by
2015. The goals include: halving global poverty levels and eliminating hunger, providing
education for all children of school-going age, improving gender relations and care for the
girl-child, providing dependable maternal health, combating HIV and AIDS, improving
environmental conditions for sustainable development and lastly, to promote global
partnerships in development. This last commitment requires the governments of the
developed world to give at least 0.7% of their GDP as foreign Aid. For more details see
<http://www.un.org/millenniumgoals/>
25
 Opalo

agenda. To facilitate this integration, the regions of the continent need common

currencies to reduce the cost of transaction and build confidence in their economies

by offering convertible currencies, guarantying sound monetary policies and

enhancing the development of credible financial institutions.

Economists have yet to come up with a general theory of the location of economic

activity. The existing work on growth theory is founded on closed-economy models.

There is a need for a new geographical economics that recognizes the fact that

“dense configurations of economic activity work better than sparse or fragmented

ones” and provides policy prescriptions for the creation of these high density

economic clusters (Venables, 2006). Africa’s challenge is to create poles of growth,

its own silicon valleys and route 128’s17. Evidence suggests that for this to occur it

will need more big cities and population centers. Recent work on the relationship

between population densities and productivity suggests that doubling the size of a

city/population center is associated with a productivity increase of 3 percent to 8

percent (Rosenthal and Strange, 2004). To benefit from the economic advantages of

agglomeration, Africa needs increased labor mobility within and across countries on

the continent. Although the role of a development-oriented industrial policy in

economic growth remains controversial (Rodrik, 2004), Africa needs policies that

encourage both domestic and foreign direct investment in creating a domestic

industrial base. These policies ought to support the development of credible

institutions, low transaction costs, economic factor mobility and convertible

currencies. All these are achievable through having integrated economies and

currency unions in the different regions of the continent. This paper concludes with a

recommendation for further research on economic integration and monetary unions

17
This is a reference to the technology hub in Silicon Valley, California and the Route 128
biotechnology corridor in Massachusetts.
26
 Opalo

in the various regions of the continent of Africa. The dearth of data to support some

of the arguments presented here is because of the little scholarly interest in this

particular area of Development Economics.

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