Thorvaldur Gylfason 50 TH ANNIVERSARY CELEBRATION OF THE CENTRAL BANK OF NIGERIA, 4-6 MAY 2009

 Despite Africa’s great diversity of culture and languages, many Africans identify themselves as Africans first, then as Congolese, Kenyans, Nigerians, South Africans, etc.  Most Europeans, North Americans, and Asians have it the other way round: country first, then continent  Yet, national boundaries within Africa are generally less open than those within Europe  Various restrictions on trade and migration  Restrictions need to be relaxed to spur growth  National currencies constitute a trade restriction

 In view of the success of the EU and the euro, economic and monetary unions appeal to many Africans and others with increasing force  Consider four categories  Existing monetary unions  De facto monetary unions  Planned monetary unions  Previous – failed! – monetary unions

 CFA franc  14 African countries  CFP franc  3 Pacific island states  East Caribbean dollar  8 Caribbean island states Picture of Sir W. Arthur Lewis, the great Nobel-prize winning development economist, adorns the $100 note  Euro, more recent  16 EU countries plus 6 or 7 others Thus far, clearly, a major success in view of old conflicts among European nation states, cultural variety, many different languages, etc.

 Australian dollar  Australia plus 3 Pacific island states  Indian rupee  India plus Bhutan (plus Nepal)  New Zealand dollar  New Zealand plus 4 Pacific island states  South African rand  South Africa plus Lesotho, Namibia, Swaziland – and now Zimbabwe  Swiss franc  Switzerland plus Liechtenstein  US dollar  US plus Ecuador, El Salvador, Panama, and 6 others

 East African shilling (2009)  Burundi, Kenya, Rwanda, Tanzania, and Uganda  Eco (2009)  Gambia, Ghana, Guinea, Nigeria, and Sierra Leone (plus, perhaps, Liberia)  Khaleeji (2010)  Bahrain, Kuwait, Qatar, Saudi-Arabia, and United Arab Emirates  Other, more distant plans  Caribbean, Southern Africa, South Asia, South America, Eastern and Southern Africa, Africa

 Danish krone  Denmark and Iceland : 1 IKR = 1 DKR  2009: 2,300 IKR = 1 DKR (due to inflation in Iceland)  Scandinavian monetary union  Denmark, Norway, and Sweden  East African shilling  Kenya, Tanzania, Uganda, and 3 others  Mauritius rupee  Mauritius and Seychelles  Southern African rand  South Africa and Botswana  Many others No significant divergence of prices or currency rates following separation

 Centripetaljoin  Centripetal tendency to join monetary unions, thus reducing number of currencies stable exchange rates  To benefit from stable exchange rates at the expense of monetary independence  Centrifugalleave  Centrifugal tendency to leave monetary unions, thus increasing number of currencies monetary independence  To benefit from monetary independence often, but not always, at the expense of exchange rate stability  With globalization, centripetal tendencies appear stronger than centrifugal ones  What does this mean for Africa?

FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Monetary Union (EU) Monetary Free to choose only two of three options; must sacrifice one

FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Capital controls (China) Free to choose only two of three options; must sacrifice one

FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Flexibleexchange rate (US, UK, Japan) Flexibleexchange Free to choose only two of three options; must sacrifice one

FREE CAPITAL MOVEMENTS FREE CAPITAL MOVEMENTS FIXED EXCHANGE RATE FIXED EXCHANGE RATE MONETARY INDEPENDENCE MONETARY INDEPENDENCE Monetary Union (EU) Monetary Flexibleexchange rate (US, UK, Japan) Flexibleexchange Capital controls (China) Free to choose only two of three options; must sacrifice one

free trade four freedoms  If capital controls are ruled out in view of the proven benefits of free trade in goods, services, labor, and also capital (four freedoms), … monetary independence flexible exchange rates) vs. fixed rates  … then long-run choice boils down to one between monetary independence (i.e., flexible exchange rates) vs. fixed rates  Cannot have both!  Either type of regime has advantages as well as disadvantages  Let’s quickly review main benefits and costs

BenefitsCosts Fixed exchange rates Floating exchange rates

BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Floating exchange rates

BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates

BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium

BenefitsCosts Fixed exchange rates Stability of trade and investment Low inflation Inefficiency BOP deficits Sacrifice of monetary independence Floating exchange rates Efficiency BOP equilibrium Instability of trade and investment Inflation

 In view of benefits and costs, no single exchange rate regime is right for all countries at all times  The regime of choice depends on time and circumstance inefficiency  If inefficiency and slow growth due to currency overvaluation are the main problem, floating rates can help inflation  If high inflation is the main problem, fixed exchange rates can help, at the risk of renewed overvaluation  Ones both problems are under control, time may be ripe for monetary union

 The real exchange rate always floats  Through nominal exchange rate adjustment or price changes  Even so, it does make a difference how countries set their nominal exchange rates because floating takes time  Currency misalignments can persist  Hence, a wide spectrum of options, from absolutely fixed rates anchored through monetary unions to completely flexible exchange rates  What do countries do?

No national currency 17% Other types of fixed rates 23 Dollarization 5 Currency board 4 Crawling pegs 3 Bilateral fixed rates 3 Managed floating 26 Pure floating % 49% tendency towards floating increased interest in fixed rates Gradual tendency towards floating, from 10% of LDCs in 1975 to over 50% today, followed by increased interest in fixed rates through economic and monetary unions

 Governments sometimes prefer fixed exchange rates so they can try to keep their national currencies overvalued  To keep foreign exchange cheap  To retain power to ration scarce foreign exchange  To make GNP in dollars look larger than it is  Another reason for persistent overvaluation, and thereby also sluggish trade and slow growth  Inflation!  Show by simple numerical example

Time Real exchange rate Average = 105 Suppose inflation is 10 percent per year and exchange rate adjusts with a lag

Time Real exchange rate 110 Average = 110 as long as nominal exchange rate adjusts with a lag So, increased inflation increases real exchange rate as long as nominal exchange rate adjusts with a lag Suppose inflation rises to 20 percent per year

not too high  Many African countries’ history of inflation, overvaluation, and slow growth is stark reminder that one of the keys to successful entry into monetary union is making sure that initial exchange rate at point of entry is not too high  European countries on euro zone’s doorstep – Baltic countries, Sweden, Iceland – face same challenge Thank you These slides can be viewed on my website: These slides can be viewed on my website: