Seminar Paper, 2011
19 Pages, Grade: B bzw. 1.7
1.2 Problem definition and research questions
1.3 Background knowledge: The advantages of a common currency
1.4 Background knowledge: The disadvantage of a common currency union
1.5 Common currency union and development
2.1 Optimum currency union
2.2 Economic shocks
2.3 Spill over effects
2.4 Currency adjustments to cope with economic performance
2.5 Development traps
This paper deals with the question whether a common currency is beneficial for the African Union. In order to assess this question, potential problems will be analysed and highlighted. The topic of a common currency becomes important in terms of economic growth that can facilitate sustainable development.
The African Monetary Union is an economic and monetary union. The plan to introduce a common currency is based on the Abuja Treaty that was signed on 3.6.1991 in Abuja, Nigeria. In this treaty it was decided to set up an African Economic Community, an African Central Bank and an African Economic Community with a single currency by around 2020 (Masson, Milkiewicz, 2003). Up to today most countries have not signed this proposal as some decided to form their own currency unions, some want to delay the starting date and some are already using currencies from other countries.
The paper will start looking at the advantages and disadvantages of a common currency and putting it into context with sustainable development. Here it can be highlighted that a successful and stable common currency can foster economic growth and therefore result in higher sustainable development.
Further on, the paper looks into the theories of an Optimum Currency Area, Economic shocks, Spillover effects, currency adjustments and development traps.
In order to analyze these theories the analysis part is looking into these using inflation rate data, GNI per capita and trade pattern provided by the IMF, the World Bank and UNECA, while contrasting it with the difficulties due to the development traps.
In the end, it becomes apparent that the African Union has to pay attention to their fundamental problems first (conflicts, uneven wealth distribution, low intra-African trade, low diversification in the economy, bad governance, etc) in order to implement a successful common currency. As these problems would pose a severe threat on the new currency as due to spillover effects, problems might be spread over the common exchange rate from one country to another. This would endanger sustainable development and therefore threaten the welfare of the continent.
This term paper looks at the planned common currency in the African Union. It will put development issues in the context of the optimum currency area in order to find out in how far a common currency is beneficial for the African continent.
The African Monetary Union is an economic and monetary union, which looks to introduce a currency similar to the euro. The agreement, which builds the fundament for the plan, is the Abuja Treaty, which was signed on 3.6.1991 in Abuja, Nigeria (Masson, Milkiewicz, 2003). The treaty includes setting up an African Economic Community, an African Central Bank and an African Economic Community with a single currency by around 2020 (Masson, Milkiewicz, 2003). By now most countries have not signed the contract, some countries have formed their own currency unions (for example East Africa), some are calling for a currency at a later day and some are using currencies from other countries, as for example the South African Rand is currency in several African countries. At the moment it is still a hypothetical plan, it is not clear if it will become reality in the near future. But it provides us with an important insight. It seems like the African countries want to change something on their economic situation and might have seen that they were left out of the gains globalization has to offer.
Collier (2008) states that a reason for the bottom billion to have missed the chances the globalization are the missing export diversification, no private capital inflows and even a private capital outflow, high investment risk and high brain drain (Collier 2008).
These causes show that a stable economic environment foster development. Therefore this paper seeks to clarify it.
The focus of the paper is on whether implementing a common currency for the African Union would be beneficial for the member states. In order to assess this question factors that need to be fulfilled in order to implement a common currency will be assessed, as will the difficulties that exist which must be solved in order for the common currency to succeed, especially in the case of the African countries. The analysis is likely to lead to answers regarding the feasibility of the plan and also to highlight potential problems.
There are some advantages that a common currency has. It provides higher currency stability as a currency used in a larger zone is more credible, less speculation is expected and exporter can project future markets better (BBC, 1997). These advantages might even lead to a greater potential for growth (BBC, 1997). This thesis is supported by Frankel (1999) who suggests that countries being subject to many internal disturbances are more like to want to peg its currency. A common currency is then a stricter currency peg, which is supposed to stabilize the currency (Frankel, 1999). Having a stable currency might suggest more investment and more jobs (BBC, 1997) as more capital is attracted either domestically or from abroad. The business world itself has not only the advantage of having a more stable currency but also has less transaction costs when buying or selling to a neighboring country (BBC, 1997). Furthermore it does not have to hedge to insure themselves against currency fluctuations (BBC, 1997).
The advantages of implementing a common currency might be outweigh by the disadvantages due to the different nature of the participating countries. The huge differences in economic performance might lead to a race to the bottom (BBC, 1997), which leads to high unemployment in some parts and low in others. As a common currency is managed by one central bank it prohibits the national states to devalue their currency and if that’s not done the country might go into a recession, which will damage the economy even more (BBC, 1997), as seen at the moment in the Euro zone in which Greece and some other countries are struggling economic-wise. The same happens as the central bank is not only managing the value of the currency but also the inflation rate which will be set for the union as a whole and not for every individual state, so some member states will have difficulties with having too high inflation rates while others will suffer from too low inflation rates (BBC, 1997). Given that strong countries will have to co-operate with weak countries, the trade-offs might be huge and therefore result in not only advantages but also especially economic disadvantages, which are even able to for example result in higher unemployment. In order to introduce a new currency, introduction costs will appear, costs that are due to changing the currency, prices etc (BBC, 1997). In the long run, the last point will disappear as one hope that the advantages of having a common currency will even out the disadvantages.
In the best case the common currency union increases trade within the member states, this would make the African Union members more independent from other countries and therefore more sustainable development might happen. Furthermore a more stable currency contributes to more investments and then more jobs (BBC, 1997). Due to high unemployment rates in African countries, that might be a huge benefit, promoting sustainable development as well. But a common currency has dangers for development as well. As the question has to be solved what would happen to countries going into a deep recession due to a common currency and might this not decrease but foster unemployment and weak economic performance. This case can be observed at the example of Greece. Considering that the Euro countries are far more similar than the African states, a common currency might even have more severe effects.
The theory of the optimum currency area determines an area of countries for which it is beneficial to enter into the agreement on having a common currency. The area is “a region that is neither so small and open that it would be better off pegging its currency to a neighbor, nor so large that it would be better off splitting into sub regions with different currencies (Frankel, 1999, page 14).
There are five characteristics that are important to be fulfilled. The first one is that in optimum currency areas people should move easily (Baldwin, Wyplosz, 2006). This implies that people don’t have barriers on their moving behavior and that they are also willing to move around for job or study purposes. This way the labor force would always be where it is needed. The second characteristic is that countries forming an optimum currency area should have widely diversified production and exports as well having a similar structure to the other countries in the union (Baldwin, Wyplosz, 2006). This is important, as widely diversified countries are more self-sustainable and therefore less dependent on other countries or on one specific industry. This decreases their likelihood of suffering under an economic shock. The next characteristic targets open trade so that “countries which are very open to trade and trade heavily with each other form an optimum currency area” (Baldwin, Wyplosz, 2006). This refers to the economic interdependence and that it makes most sense for countries to have a common currency if they are very integrated into each other’s trade. This way firms don’t have to deal with exchange rate risks etc. Furthermore it implies that countries should not only be willing to trade but also perform it. The next point refers to compensation to each other if an adverse shock hits a country (Baldwin, Wyplosz, 2006). This shows that if one country suffers from a shock the other ones have to be willing to compensate this country. An example for this would be the situation in the EU at the moment, as strong countries have to pay for the failing weak countries. A crisis like this is likely to happen in the African Union as well and it shows that compensation of weak states is not only important for the weak state itself but also for the strong ones which might otherwise for example suffer from a value loss of the currency if one country is not able to perform well. This aspect goes hand in hand with the last characteristic of an optimum currency area as it says that “when the common monetary policy gives rise to conflicts of national interests, the countries that form a currency area need to accept the costs in the name of a common destiny” (Baldwin, Wyplosz, 2006).
These characteristics are important to be kept in mind when further down trying to assess the effect of a common currency union for the African countries.
Economic shocks can hit an economy at any time. There are three kinds of shocks that might happen in a common currency union. The symmetric shock is a shock that affects all countries in the same way. Asymmetric shocks are shocks that just affect one country. While a symmetric shock with adverse effects is a shock that affects all countries in different ways, some are affected positively, some negatively (Baldwin, Wyplosz, 2008). For example a raise in oil price which affects oil-producing countries in a positive way and oil-importing countries in a negative way. These shocks have to be handled in common currency unions and might be a reason for higher costs as mentioned in the part about the optimum currency union.
Spillover effects can be characterized as the consequences actions and policies have for another country and not only for the own one. It is possible that these are positive but it might turn out negatively as well (Baldwin, Wyplosz, 2006). As in a common currency area the monetary policy is not in national hand anymore, policies and other events are likely to have effects on neighboring countries (Baldwin, Wyplosz, 2006). An important spillover effects if the effect of heavy borrowing. If one government is borrowing far too much, it is likely that the interest rate is increasing, as there is only one currency and only one interest rate, it will increase the interest rate for the whole monetary union. A higher interest rate attracts more capital inflows, leading to an appreciation of the currency. This way the currency might get too strong for some countries, making it almost impossible to for example export goods, as the prices increase due to the high exchange rate (Baldwin, Wyplosz, 2006).
Exchange rate regimes are important for the economy as it has an influence on the economic performance. There are two extreme exchange rate regimes that is 1) the fixed exchange rate, which means that the exchange rate does not change due to economic changes and 2) there is a freely floating regime that means that the exchange rate is changing constantly due to economic changes. This includes a currency appreciation if the economy is doing well; currency appreciation means that the currency is getting stronger and more expensive compared to other currencies. Currency depreciation is the opposite; it means that the currency is getting cheaper compared to other currencies (Baldwin, Wyplosz, 2006). There are two regimes in between which are leaning either against the more stable fixed exchange rate or the more changing floating exchange rate. The exchange rate can be influenced by the central bank and therefore the central bank has a huge influence on the economic performance of a country. If the currency has a high value it suggest that capital flows out and a low currency value suggest capital inflow. If the central bank uses its power in the right way it can adjust the exchange rate to the actual economic situation and this way high unemployment and negative economic growth can be avoided. Here it is important to keep in mind that as the monetary union does not have national central banks anymore, the regional central bank will adjust the exchange rate to the area as a whole. Individual negative growth and high unemployment might not be able to be avoided. Especially when asymmetric shocks occur which would require different monetary policies in the differently affected countries, this causes problems. Monetary policies that benefit one country might harm another (Madura, Fox 2007).
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