Usefulness of the article: This article examines the prospects offered by the new monetary agreement signed between France and the countries of the West African Monetary Union. In particular, it discusses the economic policies that this new agreement promotes for the countries in this monetary zone, assesses the advantages and disadvantages of the agreement, and discusses issues related to credit constraints and foreign exchange reserve management.
Abstract:
- Currency is not a factor of production and is therefore unlikely to stimulate long-term economic growth.
- Fixed parity with the euro has advantages and disadvantages: it guarantees the effectiveness of fiscal policies but theoretically renders monetary policy ineffective, and it promotes economic ties between African countries and the euro zone. However, it can be problematic in the event of euro appreciation against other currencies.
- Switching to a flexible exchange rate regime in order to take full advantage of monetary policy does not necessarily guarantee an increase in lending to the economy, as this is closely linked to the level of risk perceived by commercial banks.
- The removal of the requirement to hold foreign exchange reserves certainly gives countries more flexibility in managing these reserves, but is unlikely to have any economic impact.
Recent news is marked by the ratification on December 10, 2020, by the French National Assembly of a monetary cooperation agreement between France and the states of the West African Monetary Union (WAMU). This agreement replaces the agreements of December 4, 1973, governing the management of the CFA franc and enshrines the transition to the ECO, a brand new currency. In essence, the name of the currency is changing, the obligation to centralize foreign exchange reserves in the French public treasury’s operating account is being abolished, and France is confirming its withdrawal from the monetary zone’s governing bodies.
Nevertheless, the fixed parity between the new currency and the euro remains, as does the guarantee of unlimited convertibility provided by France. In addition, as specified in Article 8 of the new cooperation agreement, France will have the option, on an exceptional basis, to appoint a representative to the monetary policy committee of the BCEAO (Central Bank of West African States) with voting rights in the event of a crisis. It is legitimate to ask whether this new agreement, and more generally this new currency, is likely to support the economies of the countries concerned.
To answer this question, we must first clarify that currency is not a factor of production. Standard economic models establish that it is neutral, meaning that it is not likely to stimulate long-term economic growth. The latter depends on technological progress and the growth of factors of production such as labor and capital. Nevertheless, in times of economic crisis, monetary policy can, under certain conditions, be an effective tool for combating recessions and stimulating short-term economic growth. That said, the fixed parity with the euro and the high mobility of capital between the ECO zone and the euro zone render this tool ineffective.
1) Both the new and old agreements favor the use of fiscal policy to address economic conditions
1.1) Effectiveness of monetary policy under a fixed exchange rate regime
Indeed, as suggested by Mundell and Fleming’s incompatibility triangle, it is not possible to apply an independent monetary policy in the presence of a fixed exchange rate regime with perfect capital mobility, as the latter would prove ineffective.
An increase in the money supply, for example, would immediately result in downward pressure on interest rates, a significant outflow of capital due to its perfect mobility, an overall deficit balance, and therefore downward pressure on the nominal exchange rate. This would call for endogenous monetary contraction by the central bank to maintain parity.
This policy would therefore be ineffective because it would not be able to generate the hoped-for short-term growth. The new monetary cooperation agreement, which is still based on the principle of fixed parity, would therefore not allow WAEMU countries to benefit from monetary policy in the event of a crisis. However, these countries could still rely on fiscal policies which, unlike monetary policy, are more effective under a fixed exchange rate regime with high capital mobility.
1.2) Effectiveness of fiscal policy under a fixed exchange rate regime
In economic theory, an expansionary fiscal policy financed by borrowing, for example, would have a direct positive effect on GDP due to an increase in aggregate demand, an increase or upward pressure on interest rates (depending on the degree of capital mobility) due to increased demand for loanable funds, which would theoretically result in capital inflows and an improvement in the overall balance.
This improvement in the overall balance would imply upward pressure on the nominal exchange rate, which would call for endogenous monetary expansion by the central bank to maintain parity. The fixed exchange rate regime between the ECO zone and the EURO zone therefore conditions the economic policies of the African countries concerned, just as a flexible exchange rate regime would condition them just as much[1]. It is not obvious at first glance to determine which exchange rate regime would have been preferable. Studying the advantages and disadvantages of this fixed exchange rate regime in more detail can provide us with a preliminary answer.
2) Maintaining a fixed parity with the euro has advantages and disadvantages
2.1) Advantages of fixed parity with the euro
Firstly, it should be noted that fixed parity between the ECO and the euro will enable exporters and importers in both zones, as was already the case with the CFA franc, to protect themselves against exchange rate risk, which should in principle promote financial and trade flows. The guarantee of unlimited convertibility granted by France, which accompanies this parity, is also a significant assurance for investors regarding the security of their investments and profits in the face of the risk of a currency crisis.
Secondly, it should also be noted that pegging to the euro will continue to ensure good price stability. According to the Banque de France’s 2019 report on the Franc Zone, the average inflation rate was 1.6%, compared to 8.5% in sub-Saharan Africa as a whole. If price stability for economies that are supposed to be in a phase of economic catch-up were a good thing, we could conclude that pegging to the euro is an excellent choice for the new ECO currency. However, we believe that this is not so obvious.
2.2) Disadvantages of a fixed parity with the euro
In order to maintain the peg to the euro, the monetary authorities of the WAEMU zone, as was already the case with the CFA franc zone, must ensure that the money supply in circulation in the economy does not exceed a certain threshold. This is intended to reduce lending to the economy. For example, according to World Bank data, loans granted by the banking sector to the private sector represented 22% of GDP on average in 2018 in the WAEMU zone, compared with 13% on average in the CEMAC zone[2]. This percentage was 86% in the euro zone and 104% in France. This implies high interest rates in the WAEMU and CEMAC zones, and in fact limits the ability of companies to access sources of financing on favorable terms and to invest, as the financial system is dominated by the banking sector in these countries.
Beyond this aspect, the euro is a strong currency and often experiences periods of appreciation against the US dollar, as has been the case over the past year (the euro gained 10% against the US dollar between January and December 2020). This is likely to affect the export price competitiveness of ECO zone countries. The fixed exchange rate regime with the euro therefore has advantages, but also disadvantages that should not be overlooked. However, this does not imply that abolishing parity with the euro zone or adopting a flexible exchange rate regime would be appropriate solutions.
3) Credit constraints and risk
Returning to credit constraints, it is true that they weigh on the economies of the WAEMU and CEMAC countries. However, by way of comparison, countries such as Ghana and Nigeria, which have more flexible exchange rate regimes, do not necessarily perform better in terms of credit to the economy, with total credit granted by the banking sector to the private sector standing at 11.7% and 10.2% of GDP respectively in these countries in 2018. One of the main reasons for this phenomenon, both in the new ECO zone and in the countries mentioned above, is the level of risk perceived by commercial banks. The latter face a lack of financial, economic, and legal information on borrowers, who are also very rarely able to provide sufficient collateral to borrow at reasonable rates. This forces commercial banks, which paradoxically are often overliquid, to limit the amount of credit they grant.
It is therefore uncertain whether adopting a flexible exchange rate regime for ECO zone countries will enable them to implement a more proactive monetary policy that promotes increased lending to the economy as long as the level of risk perceived by commercial banks remains high.
Similarly, the end of the requirement to centralize at least 50% of foreign exchange reserves with the French Treasury is unlikely to bring about any major changes.
4) Reserve assets
For a long time, a poorly informed opinion considered this obligation to centralize foreign exchange reserves as a problem that prevented the economies of the Franc zone from freely using their foreign exchange reserves to finance infrastructure investments, lending to the economy, and other development projects. The reality is quite different. The constitution of foreign exchange reserves is a mechanism to protect against external shocks and the risk of currency crises. Most of these economies specialize in the export of raw materials and primary products, and their health is often dependent on international prices. When oil or other commodity prices fall, for example, the shock is often very severe for these economies, reducing export revenues, generally leading to a rapid depletion of foreign exchange reserves, and often giving rise to rumors of devaluation.
This is what happened in the CEMAC zone from 2015 to 2016 following the fall in oil prices, with net foreign assets (which include foreign exchange reserves) halving over this period from CFAF 5,466 billion to CFAF 2,254 billion, stabilizing at this level until 2018. However, the WAEMU zone was in better health, with net foreign assets falling much less sharply from 2015 to 2016, from CFAF 5,480 billion to CFAF 4,565 billion, to reach CFAF 6,585 billion in 2018. Nevertheless, net foreign assets represented approximately five months of imports in 2018, according to the UMOA’s December 2018 monetary policy report. This figure is equivalent to the average for sub-Saharan African countries according to World Bank data for 2019 and in line with the golden rule of a minimum of three months’ imports (for foreign exchange reserves) generally applied by central banks.
In addition, foreign assets are intended to be held in particular in the form of secure assets that retain their value over time, such as gold or US Treasury bonds, or in the form of safe international currencies such as the dollar or the euro, in order to meet liquidity, yield, and risk requirements. The requirement to centralize at least 50% of the franc zone’s foreign exchange reserves in French Treasury accounts could be likened to holding French government treasury bills. The removal of this centralization requirement will therefore allow for greater flexibility in the composition of assets held by the WAEMU central bank, but is not intended to fundamentally change the level of reserves held for the reasons mentioned above.
Conclusion
Ultimately, the transition from the CFA franc to the ECO in the WAEMU zone does not substantially change the situation of the countries in this zone. Maintaining a fixed parity with the euro will not allow for greater freedom in the conduct of monetary policy. In any case, monetary policy would prove ineffective in stimulating lending to the economy if a flexible exchange rate regime had been adopted, given the level of risk perceived by credit institutions.
Similarly, the end of the obligation to centralize foreign exchange reserves, although welcome as it is perceived by many as a relic of a bygone era, is not likely to substantially change the exchange rate policy of these countries. The urgent priority for the countries of the WAEMU and CEMAC zones today should be to implement structural reforms capable of improving the functioning of the financial system and enabling the establishment of a framework conducive to increased lending to the economy.
References
https://www.bceao.int/sites/default/files/2018-12/Rapport_PM_Decembre_2018.pdf
https://dumas.ccsd.cnrs.fr/CREG/halshs-00632362
[1] Under a flexible exchange rate regime, monetary policy would prove to be an effective economic policy tool, unlike fiscal policy.
[2] The CEMAC zone comprises Cameroon, Gabon, Congo, Equatorial Guinea, Chad, and the Central African Republic, while the UMOA zone comprises Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, and Togo.
[3] https://dumas.ccsd.cnrs.fr/CREG/halshs-00632362
