Copenhagen Business School Copenhagen, 15 May 2019 An Optimal East African Monetary Union? Optimum Currency Area Theory and Policy Recommendations for a Sustainable Monetary Union submitted by Florian Preis (115684) Dominik Michael Thomas Rappe (115701) supervised by Professor Svend Erik Hougaard Jensen Master’s Thesis, MSc in Advanced Economics and Finance Department of Economics Pages: 119 Characters: 268,346 Acknowledgements Throughout the process of working on this thesis, we have received a great deal of support for which we are truly grateful. First and foremost, we want to thank our supervisor Professor Svend Erik Hougaard Jensen for his patient guidance, readiness to give invaluable advice, and fuelling our interest in the topic. Professor Lisbeth La Cour was able to offer proficient guidance related to the methodology of our econometric models. Her expertise and willingness to help are much appreciated. We want to further extent our sincere gratitude to Dr. Pantaleo Joseph Kessy, who significantly contributed to the relevance of this thesis by sharing insightful resources and perspectives. In addition, we want to thank Dr. Richard Kiplangat Siele for his local judgement and understanding of the topic. We truly enjoyed speaking to our interview partners. Furthermore, we want to thank the reviewers for their thoughtful comments and suggestions. Last but not least, we are grateful for our friends at Copenhagen Business School, who made this Master’s programme a delightful journey. Finally, we would like to thank our families, in particular our parents, for their everlasting support. Copenhagen Business School Copenhagen, May 2019 Florian Preis Dominik Michael Thomas Rappe i Abstract This thesis examines the feasibility of the proposed East African Community Monetary Union. First, a framework is built by outlining the integration initiative in the region and synthesising the various strands of traditional and modern Optimum Currency Area theory. Alongside a descriptive evaluation of convergence and Optimum Currency Area criteria, the comprehensive analysis is centred around two models assessing the symmetry of shocks and synchronisation of business cycles. Contributions are made by updating the time horizon of underlying data as well as including the latest member of the East African Community, South Sudan, and potential candidates for future enlargements where data was available. Overall, little evidence is found in favour of a monetary union mainly due to the prevalence of asymmetric shocks, structural differences, and limited convergence. However, as the results suggest core-periphery patterns, a perspective is offered in the form of two-speed East Africa where the single currency is first introduced by Kenya, Tanzania, and Uganda and later expanded. The derived policy recommendations are split into two parts: crucial preparatory actions in the short-term, and far-reaching measures to complete the Monetary Union to ultimately decrease the fragility in the long-run. JEL Classification – E32, E42, F15, F33, F45, O55 Keywords – East African Community, Economic and Monetary Integration, Macroeconomic Convergence, Monetary Union, Optimum Currency Area, Policy Coordination Author Contact Information – fl[email protected], [email protected] ii Contents Contents 1 Introduction 1 2 The East African Community 3 2.1 History of the EAC . .4 2.2 Governance and Economic Integration . .6 2.2.1 Customs Union . .8 2.2.2 Common Market . .8 2.2.3 Monetary Union . .9 2.2.4 Political Federation . 10 2.3 Challenges with the Current Agenda . 11 2.4 General Characteristics of EAC . 11 2.5 Potential Candidates for EAC Enlargement . 13 3 The Concept of Monetary Union 16 3.1 Definition of Currency Area and Currency Union . 16 3.2 Institutional Integration . 16 3.3 Costs and Benefits of Monetary Unification . 17 4 Theory of Optimum Currency Areas 20 4.1 Traditional OCA Theory . 21 4.1.1 Factor Mobility . 21 4.1.2 Price and Wage Flexibility . 22 4.1.3 Fiscal Integration and Risk-sharing Mechanisms . 23 4.1.4 Degree of Openness . 24 4.1.5 Diversification in Production and Consumption . 25 4.1.6 Additional Considerations . 27 4.2 Modern OCA Theory . 29 4.2.1 Symmetry and Nature of Shocks . 29 4.2.2 Endogeneity versus Specialisation Hypothesis . 31 4.2.3 Credibility and Effectiveness of Monetary Policy . 34 4.2.4 Additional Considerations . 35 4.3 Limitations and Concluding Remarks . 36 5 Empirical Literature Review 37 5.1 G-PPP Approaches . 37 5.2 VAR and Other Symmetry of Shocks Approaches . 38 5.3 GMM and Other Convergence Approaches . 42 5.4 Alternative Approaches . 44 5.5 Concluding Remarks . 46 6 East Africa in Light of Convergence Criteria 47 6.1 Ceiling on Headline Inflation . 48 6.2 Ceiling on Fiscal Deficit . 50 6.3 Ceiling on Gross Public Debt . 53 iii Contents 6.4 Reserve Cover . 54 6.5 Concluding Remarks . 56 7 East Africa in Light of Traditional OCA Theory 58 7.1 Labour Mobility . 58 7.2 Price and Wage Flexibility . 61 7.3 Degree of Openness . 64 7.4 Diversification of Production and Consumption . 66 7.5 Financial Market Integration . 69 8 East Africa in Light of Modern OCA Theory 72 8.1 Symmetry of Shocks . 72 8.1.1 Methodology . 72 8.1.2 Data . 76 8.1.3 Results and Interpretation . 78 8.1.4 Concluding Remarks . 84 8.2 Business Cycle Synchronisation . 84 8.2.1 Methodology . 84 8.2.2 Results and Interpretation . 86 8.2.3 Concluding Remarks . 88 8.3 Endogeneity versus Specialisation . 89 8.4 Credibility of Monetary Policy . 95 9 Policy Recommendations 97 9.1 Short-term Focus of EAC Efforts . 97 9.2 The Case for Two-speed East Africa . 99 9.3 Completing the Monetary Union . 101 9.3.1 Fragility of Incomplete Monetary Unions . 101 9.3.2 Lessons from other Monetary Unions . 102 9.3.3 Towards a Complete East African Monetary Union . 104 10 Conclusion 110 References 112 Appendix 128 A1 Figures . 128 A2 Tables . 131 A3 Interview Transcripts . 145 A3.1 Interview 1: Pantaleo Kessy . 145 A3.2 Interview 2: Pantaleo Kessy . 149 A3.3 Interview 3: Richard Siele . 154 iv List of Figures List of Figures 2.1 Four Pillars of Integration in the EAC . .7 4.1 Nature of Shocks . 30 4.2 Endogeneity Hypothesis . 32 6.1 Headline Inflation of EAMU Candidates (in percent, 2008–2018) . 49 6.2 Fiscal Balance, incl. Grants of EAMU Candidates (in percent of GDP, 2008–2018) 51 6.3 Gross Public Debt of EAMU Candidates (in percent of GDP, 2008–2018) . 53 6.4 Reserve Cover of EAMU Candidates (in months of imports, 2008–2017) . 55 7.1 Migration Trends in East Africa (in thousands, 2000–2017) . 59 7.2 Migration Patterns in East Africa (in percent, 2017) . 59 7.3 Employment Share per Sector in East Africa (2017) . 68 7.4 Value Added to GDP by Sector in East Africa (2017) . 69 7.5 Debt and Equity Market Performance in East Africa (2005–2018) . 70 7.6 Cumulative Net FDI Activity per Capita in East Africa (in US dollar, 2001–2017) 71 8.1 Aggregate Demand and Supply Model . 72 8.2 Demand and Supply Shocks in East Africa (1997–2017) . 78 8.3 Correlation of Demand and Supply Shocks with Anchor Kenya . 80 8.4 Impulse Response Functions for Output . 81 8.5 Impulse Response Functions for Prices . 82 8.6 Business Cycles in East Africa (1995–2017) . 86 A1.1 Map of the East African Region . 128 A1.2 Specialisation Hypothesis . 128 A1.3 Cyclical Components in East Africa (1995–2017) . 129 A1.4 Trend and Cyclical Components in East Africa (1995–2017) . 130 v List of Tables List of Tables 7.1 Flexibility of Wage Determination in East Africa (2007–2017) . 63 7.2 Degree of Openness in East Africa (in percent, 1999–2017) . 64 7.3 Diversification of Exports in East Africa (2013–2017) . 66 8.1 Descriptive Statistics of East African Country Data (in percent, 1995–2017) . 77 8.2 Correlations of Demand Shocks . 79 8.3 Correlations of Supply Shocks . 79 8.4 Correlation of Permanent Component of GDP in East Africa (1995–2017) . 87 8.5 Correlation of Cyclical Component of GDP in East Africa (1995–2017) . 87 A2.1 General Characteristics of EAMU Candidates . 131 A2.2 Overview of Empirical Literature Review . 132 A2.3 Headline Inflation of EAMU Candidates (in percent, 2008–2018) . 133 A2.4 Fiscal Balance, incl. grants of EAMU Candidates (in percent of GDP, 2008–2018)133 A2.5 Fiscal Balance, excl. grants of EAMU Candidates (in percent of GDP, 2008–2018)133 A2.6 Gross Public Debt of EAMU Candidates (in percent of GDP, 2008–2018) . 134 A2.7 Reserve Cover of EAMU Candidates (in months of imports, 2008–2018) . 134 A2.8 Bilateral Estimates of Migration Stocks in East Africa (2017) . 135 A2.9 Degree of Openness in Selected European Countries (in percent, 1990–2017) . 136 A2.10 Diversification of Exports in selected European Countries (1997–1999) . 136 A2.11 Main Products of Export in East Africa (2017) . ..