The Monetary Geography of Africa

Chapter 5. Experiences of Countries in Managing Independent Currencies

What are the individual country experiences with independent currency regimes? We focus in this chapter on those sub-Saharan African nations that are not currently members of a monetary union (either the CFA franc or CMA zone), covering the period from the 1970s to the beginning of the current decade. Countries are grouped into two broad categories: those that have moved to some form of flexible exchange rate system (the majority) and those with continued unilateral pegged (fixed or adjustable) exchange rate regimes. The objective of the chapter’s analysis is twofold. First, and most important, countries currently involved in proposals either to form or join existing monetary unions have to evaluate the potential desirability of such arrangements against the costs and benefits of the alternative, which is continued use of independent currencies, in either flexible or fixed rate systems . Specifically, countries planning to form WAMZ and revitalize the EAC would all be changing from currently flexible rate regimes. Also, a potential COMESA or SADC monetary union would involve new monetary union status for both some currently flexible and some currently pegged rate countries. Second, by highlighting periods or situations during which exchange rate management became a key macroeconomic issue, we draw out some key areas 77 Experiences of Countries in Managing Independent Currencies 5 2284-05_CH05.qxd 10/27/04 11:14 Page 77 78 managing independent currencies or potential fault lines that exchange rate regimes, including monetary unions, would need to be designed or prepared to deal with.1 Note that our flexible and fixed exchange rate groupings use official classifications published by the IMF, which are de jure or based on countries’ selfreporting of their regime. Alternative de facto classifications based on actual behavior (see chapter 2) show that a number of countries officially classified as managed or independent floaters actually behave more like intermediate regimes (very dirty floats or crawling pegs or bands).2 The same is true (where data are available) for the smaller number of official unilateral pegs. Appendix B presents a set of country vignettes in which experiences with flexible exchange rates are assessed. The vignettes highlight periods during which exchange rate policies were a key macroeconomic issue.3 What are the summary lessons we distill relating to the necessary conditions for successful management of independent currencies in Africa? We conclude that underdeveloped financial markets and inadequate fiscal discipline, particularly following external shocks, limit African countries’ ability to successfully operate flexible exchange rate regimes; and that in some cases, “fear of floating”4 appears justified. Often, however, adjustable peg regimes have also not been managed well due to losses of fiscal control and a resistance to devaluations. Preliberalization Regimes Many postindependence governments sought to promote development by establishing import-substitution industries. The primary policy instruments were a protectionist trade regime (restricting imports through increasingly cumbersome systems of tariffs, quotas, exchange controls, and licensing) and state-owned enterprises. At the root of many of the problems during the 1970s and 1980s were high government deficits, financed by money creation, which led to high inflation. In combination with fixed exchange rates that were not adjusted, real exchange rates became increasingly overvalued. Excessive domestic credit creation and the overvalued exchange rates also spilled over into high import demand. 1. The experience of African monetary unions discussed in chapter 4 should also inform understanding of these issues. 2. Alternative classifications are discussed later in this chapter. 3. By focusing on periods when exchange rate management became an important issue or problem, we risk overplaying the downsides of flexible rates relative to their potential benefits. Some additional positive effects are mentioned in the conclusion. 4. Calvo and Reinhart (2002). 2284-05_CH05.qxd 10/27/04 11:14 Page 78 managing independent currencies 79 Devaluations were considered politically dangerous to incumbents, so countries reacted to balance of payments difficulties by tightening exchange and trade restrictions, leading to large parallel premiums for foreign exchange. Asset motives also generated demand for parallel market foreign exchange, as extremely high financial sector taxation, high inflation, and controlled low nominal interest rates reduced the attractiveness of saving in domestic currency. At some point the authorities began to lose control of a vicious circle. Money financed deficits and foreign exchange controls led to an increase of smuggled or misinvoiced goods (both exports and imports), resulting in declining trade tax revenues that further worsened the deficit and started the cycle again.5 The controlled...