Usefulness of the article: This article identifies the risk-sharing channels that operate within ECOWAS (Economic Community of West African States) in order to cope with any asymmetric shocks that the creation of a monetary union within ECOWAS could exacerbate.
Summary:
• The heterogeneity of ECOWAS (Economic Community of West African States) countries should not be an obstacle to the project of creating a monetary union if there are mechanisms other than the exchange rate to deal with asymmetric shocks (oil shock, monetary policy shock, etc.).
• Official development assistance, remittances from emigrants, and gross savings are the main channels for risk sharing in the region.
• The ineffectiveness of the primary income channel in smoothing asymmetric shocks could be explained by the procyclicality of taxes on products and production.
• Given the low degree of risk sharing in the region, the establishment of a budgetary fund to support risk-sharing channels appears necessary.
According to Frankel and Rose (1998), failure to meet the ex-ante criteria described in traditional theories of Optimal Currency Areas (OCAs) does not preclude the ex-post success of a monetary union, provided that there is gradual synchronization of economic cycles.
However, Krugman (1993) shows that monetary integration could lead countries to specialize in sectors where they have comparative advantages. Indeed, with exchange rate risk, it is difficult, for example, for Ivorian companies to relocate part of their production to Ghana (where labor is high-quality and low-cost) in order to be more competitive on the international market.
With the elimination of exchange rate risk and increased competition, companies will be encouraged to relocate their activities to where factor endowments are most advantageous in order to be more efficient. Thus, inter-industry specialization among regions will develop. The productive structures of member countries would therefore tend to diverge after the creation of the monetary union. Inter-industry trade would inevitably lead to an increase in asymmetric shocks.
This is in line with the theory of risk sharing, which explains that greater economic and financial integration tends to increase the heterogeneity of the productive structures of countries in the zone. However, in a context of increasing financialization of economies, interregional holdings of securities or income in other regions allow for better risk sharing alongside increasing specialization (Clévenot and Duwicquet, 2011).
This article identifies the channels for risk sharing in ECOWAS in a context where heads of state are considering the creation of a monetary union.
Indeed, the stability of a monetary union depends on its ability to cope with asymmetric shocks in the absence of an independent monetary policy. In addition, price and wage rigidity and the low mobility of production factors between countries, whether due to legal constraints or cultural factors such as language differences, also reduce a country’s ability to adapt to asymmetric shocks. In this context, the existence of risk-sharing mechanisms to smooth asymmetric shocks to income and consumption becomes essential (Furceri and Zdzienicka, 2013).
Risk sharing changes the contours of the debate on optimal currency areas (OCAs). The main criterion is no longer the symmetry of cycles but the decorrelation between the well-being of economic agents (measured by consumption) and domestic income.
1. Coping with asymmetric shocks: Beyond savings
The national cost of participating in a monetary union stems mainly from the renunciation of a specific policy and the loss of the exchange rate as an instrument for adjusting to external shocks. This loss can be all the more damaging when member countries are affected by asymmetric shocks. However, the union is not defenseless if it can identify other mechanisms capable of coping with asymmetric shocks. With this in mind, numerous studies have focused on risk-sharing mechanisms (Afonso and Furceri, 2008; Astrubali et al. 1996; Sorensen and Yosha, 1998; Tapsoba, 2009).
However, to our knowledge, only Tapsoba (2009) analyzes risk-sharing channels in ECOWAS. Over the period 1970-2004, he shows that savings are the only risk-sharing channel in the region, as they contribute to smoothing 22% and 21% of asymmetric shocks in the West African Economic and Monetary Union (UEMOA) and ECOWAS, respectively. In addition, he finds that net primary and secondary income have no significant impact on the smoothing of shocks in the region.
According to risk-sharing theory, savings play an important role in smoothing asymmetric shocks because they increase when the economic situation is favorable and decrease when it is not. This procyclical behavior would contribute to smoothing asymmetric shocks in the region.
These results are confirmed by econometric estimates covering a more recent period (Zouri, 2020). However, we believe that, beyond savings, there are other risk-sharing channels that operate in the ECOWAS region.
2. Official development assistance
Figure 2 shows that official development assistance (ODA) peaked in the late 1980s. This is not surprising, as the period from 1986 to 1993 was characterized by growing financial imbalances, with disastrous consequences for government debt, economic growth, and, more broadly, the economic and financial sustainability of West African countries (Revue d’économie financière, 2013). The period following the devaluation of the CFA franc in 1994 saw an acceleration in economic growth in the ECOWAS region. This growth was accompanied by a decline in ODA. ODA has been on the rise again since the adoption of the Millennium Development Goals (MDGs) in 2000.
Figure 2: Evolution of official development assistance in ECOWAS
Source: Zouri (2020), BSI Economics.
ODA can thus act as a shock-absorbing mechanism, as it plays a major role in financing the needs of West African governments. When a country faces a recession, ODA increases in order to stimulate economic growth and reduce poverty. The increase in ODA provides insurance against asymmetric shocks.
In this sense, we show through econometric estimates (Zouri, 2020) that ODA contributes to smoothing asymmetric shocks by 11.65% between countries in the non-WAEMU zone. We believe that the ineffectiveness of ODA in smoothing asymmetric shocks in the WAEMU stems from both the countercyclical and procyclical nature of ODA, which helps to neutralize the absorption capacity of official development assistance.
ODA can be procyclical in the sense that it increases when the economic environment is favorable and decreases when it is not. A country’s strong economic performance facilitates the implementation of certain conditionalities and makes it more attractive to donors. Conversely, difficult economic circumstances require adjustments to the reform program, causing interruptions in aid programs.
3. Remittances from emigrants
Over the last decade, remittances from emigrants have grown much faster than other private capital flows and official development assistance (ODA), becoming an essential source of external financing for developing countries (Ebeke and Le Goff, 2010). In ECOWAS, Figure 3 shows that net remittances from emigrants have increased since the early 1980s.
Figure 3: Evolution of net remittances from migrants in ECOWAS
Source: Zouri (2020), BSI Economics.
Given their importance in the region, migrant remittances deserve special attention from ECOWAS leaders as they can help stabilize economic fluctuations. Indeed, the stabilizing effect of remittances is justified by the assumption that they are guided by « altruistic behavior. » Under this hypothesis, remittances are countercyclical because migrants tend to send more when the economy of origin is experiencing or has experienced a shock.
To this end, we show through econometric estimates (Zouri, 2020) that remittances from emigrants help to smooth asymmetric shocks between WAEMU countries (by 3.6%). However, we show that this channel unfortunately has no significant smoothing power in the non-WAEMU zone and in ECOWAS because in these two regions, remittances play both a countercyclical and procyclical role, which contributes to canceling out the effect of absorbing asymmetric shocks. Remittances from emigrants can be procyclical in the sense that migrants send money to invest in profitable projects. They send more when the economic situation is favorable and less when it is not.
4. Tax on products and production
Tapsoba (2009) attributes the inefficiency of the primary income channel to low factor mobility. Based on the decomposition of national aggregates (balance of payments, BPM6), we wish to show that the countercyclical and procyclical behavior of primary income components also limits the efficiency of the primary income channel.
Figure 4: 10-year rolling correlation between net tax on products and production (constant USD per capita) and real GDP per capita
Source: Zouri (2020), BSI Economics.
With this in mind, we focus on taxes on products and production (value added tax, import duties, export taxes, etc.) due to the availability of data. For the net primary income channel to be effective, any change in GDP (following a shock) should not have an impact on national income. Therefore, the net primary income channel (or its components) must be countercyclical.
However, Figure 4 shows that, on average, net taxes on products and production (constant USD per capita) and real GDP per capita move in the same direction due to their positive correlation coefficient. This is not surprising, as taxes will increase during periods of expansion and decrease during periods of recession. This procyclical behavior would contribute to rendering the primary income channel ineffective in the region.
To this end, we show through econometric estimates (Zouri, 2020) that taxes on products and production would contribute to exacerbating (or smoothing) asymmetric shocks in the WAEMU (or in the non-WAEMU zone) by 6%.
Given the ineffectiveness of the net primary income channel, the creation of a budgetary fund could provide an additional tool for smoothing asymmetric shocks. An ECOWAS-wide budgetary fund could be created, where taxes proportional to the GDP of each member state would be collected and used to help countries in difficulty.
Whenever an ECOWAS country is affected by a shock with disastrous consequences, it will receive budgetary assistance proportional to the size of the shock, the size of its economy, and the resources available in the stabilization fund. If no member suffers a shock with disastrous effects, the taxes collected will be preserved in full in the budgetary fund. To be optimal, the fund must be simple and automatic in order to reduce moral hazard; it must also be non-regressive, meaning that contributions to the budgetary fund and the amount of aid allocated to countries in difficulty should not decrease as per capita GDP declines (Von and Hammond, 1998).
Conclusion
In this article, it would appear that official development assistance, migrant remittances, and gross savings are the main channels for risk sharing in ECOWAS. In addition, taxes on products and production would limit the effectiveness of net primary revenues in smoothing asymmetric shocks.
Therefore, for better risk sharing in the region, countries should prioritize financial innovation, emphasizing the role of savings and financial institutions by actively participating in the expansion of regional credit markets. The fight against corruption in the region should be on the agenda in order to contribute to the effectiveness of official development assistance in smoothing asymmetric shocks. Given the low level of risk sharing in the region, the creation of a budgetary fund could provide an additional tool for mitigating asymmetric shocks in the region.
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