exchange rate commitments under stress, leading to volatility in exchange rate expectations and possibly to speculative attacks that impose costs during the transition phase and undermine the credibility of union-wide policy.

5. The conversion phase

The defining steps in the consummation of a monetary union are the transfer of monetary policy to a supra-national authority and the conversion of multiple national currencies to a single currency. We focus here on the process of currency conversion, leaving issues of institutional transition to Section 6.

5.1. Establishing a new East African currency

Despite the current travails of the Euro zone, the successful replacement of the individual currencies of its eleven founding members with the euro on 1 January 1999 was acclaimed in all quarters and offers a valuable template for managing the final stages of the transition to monetary union in East Africa. For reasons we discuss below, the conversion phase should be short, ideally around two quarters. It should commence with a major, union-wide announcement of:

1 – A date for the creation of full monetary union.

2 – A commitment by the Partner States to the irrevocable conversion of their national currencies into a new East African currency on that date.

3 – A set of (final, possibly revised) basket weights for the East African Currency Unit (EACU).

4 -- A set of irrevocable central parities between national currencies and the EACU at which conversion to the new currency will occur.

Explicit exchange rate commitments will therefore feature prominently during the conversion phase, regardless of the presence or absence of such commitments during the convergence phase. Partner States will establish a tight internal grid – a set of intra-union cross-rates – by committing to keep their currencies within very narrow bands of a set of central parities against the EACU. The EACU, computed as a weighted basket of the Partner State exchange rates vis à vis an external reference currency (most likely the US dollar), will serve as a unit of account between the Partner States during the conversion phase, and may be established for this purpose considerably earlier, during the convergence phase. At the consummation of union, the EACU will convert at an exchange rate of 1:1 with the new (still to be named) East African currency. The relation of national currencies to the EACU will therefore determine the conversion rates at which basis Partner States’ currencies will be fixed against the new currency. These conversion rates will determine the purchasing power of the new currency in each jurisdiction; it is therefore important that the basis for the computation of conversion parities is transparent and

18 Figure A1.3 Current account and financing EAC Balance of Payments

BDI KEN RWA 0 5 0 1 1 4 0 1 0 5 2 5 0 0 0 0 5 2 - - 5 - 0 0 0 4 1 1 - - -

P 2000 2002 2004 2006 2008 2010 2000 2002 2004 2006 2008 2010 2000 2002 2004 2006 2008 2010

D CA KA FA CA KA FA CA KA FA G EO XF RA EO XF RA EO XF RA f o t

n TZA UGA e 0 c 1 0 r 1 e 5 5 P 0 0 5 5 - - 0 0 1 1 - - 5 5 1 1 - - 2000 2002 2004 2006 2008 2010 2000 2002 2004 2006 2008 2010

CA KA FA CA KA FA EO XF RA EO XF RA

Source: IMF. Debt cancellations purged: BDI 2009, RWA TZA UGA 2006. Key: CA= Current Account (after net transfers); KA = Capital Account, Net; FA = Financial Account, Net; EO = Errors and Omissions; XF = Extraordinary Financing + Use of Fund Credit; RA = Reserve Assets, Net. Note: To maintain scaling, we have purged the accounts of large one-time reductions in government foreign liabilities (in Burundi, an inflow of extraordinary financing reduced government foreign investment liabilities by 71% of GDP in 2009; in Rwanda and Tanzania, respectively, a capital account grant reduced government foreign investment liabilities by 38 and 30 percent of GDP in 2006; and in Uganda, a capital account grant reduced extraordinary financing by 33 percent of GDP in 2006). In each case we removed both sides of the transaction, in order to leave the overall balance of payments identity intact.

48 A second, indirect form of evidence about capital mobility comes from measures that assess the degree to which monetary policy is constrained by short-term capital movements. In Appendix 2 we estimate the dynamic response of foreign exchange markets to changes in monetary policy on a country-by- country basis. These results suggest that there is significant exposure to short-term capital mobility in the EAC, particularly in the larger countries.

In interpreting these varied results, we place weight on the increasing sophistication of interbank markets in the EAC countries, and also on the recent liberalization of capital controls within the EAC itself. While the EAC countries are well short of the trilemma, their scope for maintaining tight exchange rate commitments while simultaneously pursuing domestic monetary policy objectives is limited. This is particularly true for Kenya and Uganda, but as capital movements become freer within the EAC, portfolio capital will be able to move between each member and global markets indirectly, via transit through partners whose capital accounts are more open vis-à-vis the rest of the world. As in the case of a free trade area without a common external tariff, the de facto exposure of each participant to external markets will tend to converge to that of the most open partner.

4. Exchange rate options for the convergence phase

Figure 1 divides the transition period into a convergence phase and a conversion phase. We argue in Section 5 that central banks should be prepared during the latter phase to defend their exchange rates within relatively narrow bands around the announced conversion parities. To reduce the scope for speculative attacks or asymmetric changes in the real exchange rate fundamentals, the conversion phase should be short – perhaps two calendar quarters at most.

The convergence phase, by contrast, is of uncertain duration. Exchange-rate policies for this phase should therefore be consistent with the successful conduct of monetary policy for a potentially extended period. In analyzing the options, we place a particular emphasis on the transparency of alternative arrangements, their suitability for the EAC countries, and how they anchor inflation. We assume that regardless of the option chosen, countries will work during the convergence phase to deepen market integration and harmonize financial market regulations.

Should nominal exchange rate commitments – in particular, convergence criteria for intra-union nominal exchange rates – play a central role in the lead-up to monetary union? The complete elimination of intra-union exchange rates is of course the single most obvious consequence of adopting a common currency, and the appropriateness of this commitment plays a central role in the theory of optimal currency areas. In Europe, moreover, where the convergence phase spanned nearly three decades, nominal exchange rate commitments played a prominent role through the entire transition process. The exchange rate mechanism (ERM) specified a grid of bilateral central exchange rates between the potential partners and a set of country-specific bands within which exchange rates were allowed to fluctuate. The central rates could be adjusted by mutual agreement, but for the two years leading to entry countries were not to devalue their central rates, and were to manage their economies so as to remain within a ±2.5% band of the parities without experiencing severe pressure. The central

9 Exchange Rate Arrangements in the Transition to

East African Monetary Union

Christopher S Adam

University of Oxford and IGC

Pantaleo Kessy

Bank of Tanzania and IGC

Camillus Kombe

Bank of Tanzania

Stephen A O’Connell†

Swarthmore College, PA and IGC

February 2012

This paper is the outcome of research collaboration between staff of the Department of Economic Research and Policy at the Bank of Tanzania and the International Growth Centre. The views expressed in this paper are solely those of the authors and do not necessarily reflect the official views of the Bank of Tanzania or its management. All errors are our own.

† Corresponding author ([email protected])

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As of the time of writing, the video had received 57,100 likes and nearly 4,000 comments. Back in February, Dogecoin developers made the controversial decision that Dogecoin's total supply was not capped. Instead, they decided to stick to the original plan and allow an annual inflation rate of 5%. This is achieved from time to time with a 10,000 Dogecoin reward per block. Dogecoin Core 1.8 is currently available, the latest update to the Dogecoin protocol. Dogecoin (DOGE) holders will receive a 10:1 airdrot from DOGET on June 10. willingness of Kenya, Tanzania and Uganda to tolerate sharp nominal depreciation and, in October 2011, to implement a coordinated tightening of monetary policy. The associated movements in external exchange rates have implied large fluctuations in intra-union exchange rates.

The central principle of a hard-currency reserve pool is mutual insurance. Thus, even if each member is obliged to maintain a fixed long-run average contribution to the pool, the fact that shocks to reserves are not perfectly correlated across countries means that the volatility of the overall pool is smaller than the average volatility of shocks to individual members. Figure 6 illustrates the potential for mutual insurance among the EAC countries. We compare the time-varying volatility of reserves for individual countries with the same measure for EAC-wide reserves. For the EAC as a whole, the volatility of reserves is similar to that of South Africa (which is 2/3 larger by GDP). This tends to be considerably lower than the volatility for individual Partner States. The differences are considerably larger for the smaller countries, reflecting both their size and their much smaller degree of exchange rate flexibility. But even for the larger countries, temporary access to a community-wide pool could substantially enhance the scope for short-term intervention.

Insurance schemes are subject to moral hazard, and this concern is particularly strong in the case of a hard-currency reserve pool. The danger is that countries will adopt excessively expansionary monetary policies during the conversion phase, knowing that the costs of exchange rate weakness will be shared with other members. For this reason any hard-currency reserve pool should, in our view, have a graduated interest cost structure that allows nearly-costless drawing in limited amounts but discourages over-use. In any case, of course, the importance of transparency, credibility and speed in handling exchange market pressures during the conversion phase reinforces our earlier argument in favor of the EAMI’s role as a forum for information sharing and coordination across the Partner State central banks.

33 Official rate is Corridor functions as a weighted average of previous day’s trades. determined by volume- crawling peg, previous day’s trades. weighted average of determining daily limits and is used to price off- Official rate is used to buy/sell quotes of 18 on exchange rate market transactions price off-market commercial banks movements. BNR will and for valuation. transactions and for (accounting for around sell/buy at upper/lower valuation. 90% of all forex corridor limits. Formal limits were transactions). placed on daily Market is ‘reasonably Official rate (Average exchange rate competitive’ although Reference Rate) movements when IFEM recently off-shore currently calculated as was established; these financial institutions 5-day moving average are no longer operative have been taking of banks’ transactions although may act as speculative positions with customers and market ‘norm’. against the Uganda BNR intervention rate. Shillings large enough Market perceived to be to move rates. ARR to be replaced by reasonably competitive unified official rate in although coordinated 2011. behaviour by banks – reflecting correlated . demands of customers – can move rates in the short run (e.g. as customers seek Shilling liquidity to meet tax obligations).

Government imports are not financed through IFEM while large private transactions may be handled off market and/or offshore.

Principal sources of Export earnings still Principal sources of Export earnings Strong but predictable Strong but predictable exchange market limited. Aid flows pressure come from dominated by coffee seasonality in export seasonality in cash dominate market capital and services but this accounts for earnings (cash crops crops revenues

57 The International Growth Centre (IGC) aims to promote sustainable growth in developing countries by providing demand-led policy advice based on frontier research.

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