EFFECT OF MACROECONOMIC CONVERGENCE ON EXCHANGE RATE VOLATILITY IN QUEST FOR THE EAST AFRICAN MONETARY UNION (2000- 2016)

ABSTRACT 
Attaining a monetary union is an ambition for most African regional economic communities (RECs). So far, the formation of a monetary union in the East African Community (EAC) has remained elusive. Macroeconomic convergence is critical for EAC members to achieve a level of harmonization required for establishing a stable and sustainable monetary union. The EAC partner States therefore established set targets for macroeconomic convergence, with an aim to eliminate exchange rate variability within the bloc. Where countries are able to eliminate or reduce exchange rate adjustments to maintain external balance, the costs of a monetary union reduces, thus the more suitable it is for such a region to form a monetary union. However, empirical studies undertaken indicate that the rate of convergence of the member states economies to the set targets has been very slow, resulting in high exchange rate variability within the region. It is against this background that this study was carried out to determine the effect of convergence in macroeconomic variables on exchange rate volatility, of five East African community (EAC) countries; Kenya, Uganda, Tanzania, Burundi, and Rwanda. The research was carried out in order establish whether macroeconomic convergence in EAC reduces exchange rate volatility within the region in readiness for a stable and sustainable monetary union. The macroeconomic variables focused by this study were: nominal GDP growth rates, budget deficit/GDP, national savings/GDP, and inflation rate. These are the four variables that the region has identified as being major in influencing their economies. Secondary data obtained from World Bank, EAC member countries National Bureau of Statistics, International Monetary Fund (IMF), and World Development Indicator (WDI) Report of the World Bank was used. The study was guided by the Optimum Currency Area (OCA) theory. A panel data analysis was used over the period 2000-2016. Sigma (standard deviation) was used in the study to establish convergence of variables and volatility of exchange. Levin-Lin-Chu test for panel unit root was employed to test for data stationarity and it was found that real exchange rate, nominal GDP growth rate, and inflation rate were stationary. Budget deficit and national savings were non-stationary, they were differenced once and they became stationary. The study results showed that all the explanatory variables had a significant and a negative effect on exchange rate volatility. This means that convergence in nominal GDP growth rate, budget deficit, savings and inflation rates among the EAC countries reduces exchange rate variability within the region.

CHAPTER ONE 
INTRODUCTION 
Background to the Study 
Monetary integration is a process whereby two or more countries come together and subject themselves to a single monetary authority or central bank which is responsible for the issuance of legal tender currency and formulates financial policies on behalf of member countries (Guillaume and Starage, 2000). It involves harmonization of exchange rates among different countries which existed before they integrated. On the other hand, countries that accept the occurrence of monetary integration process or arrangement are said to be in a monetary union. 

According to Alper (2015), there are three forms of monetary unions; (1) an informal exchange rate union – consists of separate currencies of the member countries whose parities are fixed but only within margins that can be adjusted; (2) a formal exchange rate union – countries use separate currencies but rates fluctuating within narrow or zero margins, and a strong degree of coordination among the central banks; and (3) a full monetary union – which involves use of a single currency and central bank among member countries. Countries willing to form a monetary union start with informal union, then formal and finally to full monetary union. EAC countries are at the formal stage where they are moving towards maintaining zero or narrow margin in exchange rate volatility. 

Advantages of a monetary union for member states include reduced cost of transaction in trade, price transparency and increased efficiency (Mongeli, 2008). However, the major disadvantage for member states who agree to form a monetary union is the loss to a certain degree of sovereignty (De Grauwe, 2010). Hence, forming a monetary union implies that member countries must give up the right to set their own independent policies which they consider as conducive for their domestic alone, and must be bound to agree with a common policy that is suitable for member states (Mongeli, 2008). 

As Regional Economic Communities (RECs) in the world strive to deepen their level of integration, an increasing number are considering forming a monetary union. According to Collier (2007), out of the fourteen RECs that existed in 2001, nine have expressed the objective of attaining full economic union (monetary and fiscal integration). In Latin America, the Mercosur countries, the Andean Community, and the Central American Common Market countries have held informal discussions on their monetary union ambitions. Similar intentions have been voiced within the Caribbean Community (CARICOM) for a Caribbean Single Currency, while the Association of South-East Asia Nations (ASEAN) has conducted a feasibility study on a common ASEAN currency. 

European Monetary Union (EMU) has always been a prime example of reference of monetary unions, given its unprecedented scope and success. According to Klein (1998), political support for EMU among leaders of Europe has been very strong which kept the prospects for EMU alive. Countries joining EMU had to strictly adhere to convergence in macroeconomic variables outlined in the Maastricht treaty. Proper mechanisms and adequate resources have been provided for effective planning, coordination, implementation, and monitoring of the union (Gramlich, 2016). Therefore, though EMU has had its own challenges, the above are lessons that RECS in Africa can learn from. 

Macroeconomic Convergence and Monetary Integration in Africa 
Monetary integration in Africa has been intense over the decades since independence (Tsikata, 2014). Initiatives of monetary integration among the African RECs has been increased by the creation of the Euro zone in January 1999 and the January 2002 introduction of Euro notes and coins to replace the German deutche mark, French franc, Italian lira, and other currencies of the twelve member countries (Zhang, 2012). 

According to Robson (1987), poor macroeconomic performance experience in Sub-Saharan African countries have been a major hindrance to a successful monetary integration for the blocs and a subject of great concern over the past three decades. The African countries as a group share some similarities in terms of growth and macroeconomic management. Since the 1980s, they have experienced declining growth, fiscal and trade deficits, and large external debts. While there are several causes of poor macroeconomic performance, main ones include; excessive budget deficits and printing of money to finance fiscal deficits leading to high inflation, low degree of product diversification, deficits in balance of payments and debt crises. 

According to Collier (2007), there are two main justifications as to why macroeconomic convergence is needed for any successful monetary union of the blocs. First, domestic fiscal policies can cause negative spillover effects on other members of the union. For example, excessive government deficits in one country may cause inflationary pressures on the common currency that could negatively impact other countries as well. Second, a moral hazard arises in a monetary union as countries become able to borrow unsustainably with the hope that other members of the union or a regional central bank would bail them out in case of a debt crises. 

South Africa has been exploring monetary integration in the context of South African Development Community (SADC) to build on the long-standing but more restricted South African Cooperative Union (SACU) and the Common Market Area (CMA) (Talvas, 2008). Though the main focus of SADC is on trade and structural policies, some consideration is also being given to expanding CMA centered on the rand, which formerly included Lesotho, South Africa, and Swaziland to include other SADC countries (Talvas, 2008). Macroeconomic convergence in SADC region is guided following criteria and bench marks that have been specified by a Committee of Central Bank Governors which focus on key essential requirements for macroeconomic convergence. However, there have been significant disparities in macroeconomic performance among SADC member states, coupled with civil conflicts and drought in some parts of the region. Thus, full monetary union among SADC countries may take several years before its establishment (Maruping, 2005). 

In West Africa, Economic Community of West African States (ECOWAS) was formed in 1975 with a vision to create a single regional economic space having a single market and single currency to accelerate social economic development and global competitiveness (Olakunle, 2015). Proposed date of the realization of a single currency was 2000, but later revised to 2005, 2009, and then 2020. A set of macroeconomic convergence criteria which member countries are expected to observe prior to the emergence of the monetary union have been set. But the absence of any progress on the mentioned initiatives led to a subset of ECOWAS countries to propose a second monetary zone, in addition to the existing Common Franc Area (CFA) zone in West Africa, known as West African Economic Monetary Union (WAEMU). This was a fast track to the creation of the unified West African Monetary Zone (WAMZ) by 2005. WAMZ would be subsequently merged with WAEMU to achieve the goal of a single West African currency (Sanusi, 2013). 

A wider project (which includes Kenya and Uganda but not Tanzania) is a monetary union among the Common Market for East and Southern Africa (COMESA) countries. This regional grouping also partly overlaps with SADC, exhibiting the overlapping regional commitments that prevail in Africa and often lead to inaction and contention (McCarthy, 2015). As is the case for SADC, differences in macroeconomic stability, fiscal discipline, and financial development among COMESA countries are great, making it unlikely that such a project is achievable as currently envisioned. Moreover, South Africa is not a member, hence COMESA may not benefit from the track record of monetary stability of South African‟s Reserve Bank (Maruping, 2005). 

Macroeconomic Convergence and Monetary Integration in East African 
The East African Community (EAC), which was established in 1967, formerly comprised three countries; Kenya, Uganda and Tanzania. According to Kuteesa (2014), the three countries shared a long history like free trade area among themselves, establishment of custom union in 1919, formation of the East African high commission in 1948, and establishment of customs collection centre in 1990. The EAC collapsed in 1977 but was officially revived on 7th July 2000 (Kibua, 2007). 

Rwanda and Burundi, which were previously regarded as part of central African bloc, joined the EAC in 2007 mainly for economic and political reasons. Both countries were struggling to emerge from years of civil war since 1993 and they needed to rebuild their shattered economies. They hoped to benefit from an EAC custom union which would ensure free circulation of goods and a reduction of tariffs among the five member countries. The move also allowed the countries to join a planned political federation, including a common market for the region. However, the countries feared the competition they would face especially from the largest economy, Kenya (Kibua, 2007). 

Objectives of EAC are to develop policies and programs aimed at widening and deepening cooperation among member states in economic, social, cultural and political fields (EAC, 2005). 

Member states resolved to establish a custom union among themselves, a common market, and subsequently a monetary union and ultimately a political federation to strengthen and enhance harmonious, equitable and sustained economic development. This collaboration of efforts has so far yielded a custom union launched in 2005 and a common market established in 2010 (Muthui, 2016). Recent negotiations have sought to elevate the REC to a monetary union with the introduction of a single currency by 2015. EAC member states agreed to go through a process of monetary policy harmoniously with a view to achieve macroeconomic convergence. To assess this objective, a number of convergence criteria were set to guide the member countries and to help move the bloc into a monetary union (EAC, 2005). 

However, success of EAC agenda has been hindered especially by the political situations in the member countries. The single-party dominance which is apparently deepening in the parliaments of both Tanzania and Uganda is unattractive to Kenyans (Kibua, 2007). The ethnic politics in Kenya is regarded with some horror in Tanzania. Rwanda‟s distinct political culture and leadership committed to building a developed state is a great lesson that the other EAC countries can learn from. Diversity of the political systems of the member states will make monetary integration difficult (Kibua, 2007). 

Burundi, one of the poorest nations in the world, is struggling to emerge from a 12-year ethnic- based civil war (Kuteesa, 2014). Since independence in 1962, it has been plagued by tension between the dominant Tutsi minorities and the Hutu majority. In 2015, the country was plunged into its worst crises since the end of a civil war in 2005, when Mr. Nkurunziza‟s ultimately successful bid for re-election to a third term sparked protests by opposition supporters who said the move was unconstitutional (Kuteesa, 2014). This has led to long and intense political instability which significantly affected the country‟s economic prospects. The country‟s economy is dominated by subsistence agriculture, and over half of the population lives below the poverty line. This has led to poor performance in macroeconomic variables in the country compared other EAC member countries, though the country is slowly recovering from the recession after 2015 (Muthui, 2016). 

The task of forming a monetary union in EAC started early, but proceeded slowly. Thus, in 2001, the EAC Development Strategy for 2006-2010 (EAC, 2005) decided to fast track its establishment and aimed it for 2012. The intention was to sign a protocol to establish the East African Monetary Union (EAMU) in 2012, which was finally signed in 2013, while actual implementation, though planned to be completed by 2015, is now expected to take several years. As evident from the experience of European Monetary Union (EMU), forming a monetary union is a complicated process, and therefore it is necessary to ensure that the pre-conditions for forming the EAMU are adequate (Alper, 2015). 

In pursuing this fast tracking process, key legal framework for macroeconomic convergence criteria were adopted by partner states in 2007 as part of preparation of monetary integration. Thus, the East African countries have set bench mark criteria: sustained growth, price stability, sustainable fiscal and current account deficits and external debts (EAC, 2005). They are set for three different stages and divided into primary and secondary criteria in the first two stages, followed by introduction of a single currency at the last stage as shown in Table 1.1:

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