Phyllis Papadavid (Research Associate, ODI) and Sherillyn Raga (Senior Research Officer, ODI)
5 February 2020
West Africa started the decade with plans for the eco – its newest single currency. It was announced that, in 2020, the 74-year old CFA franc would be replaced in the 8 member states of West African Economic and Monetary Union (WAEMU). This blog identifies three key risks for the eco and its links to prospects for economic transformation – those of devaluation, shocks and debt.
The eco’s devaluation risk
The eco will signal greater regional independence. France’s Board representation at the Central Bank of West Africa (BCEAO) will be withdrawn. And WAEMU members will no longer keep half of their reserves at the French Treasury. However, there will still be a crucial link to Europe, given the eco’s euro peg. To support West Africa’s economic transformation, the eco needs to be a stable store of value.
There are two probable sources of devaluation risk. The first is the likely market assessment that the eco is overvalued and at an uncompetitive level for WAEMU countries, given the euro’s trade-weighted value. To the extent that it is overvalued, there is a risk that the BCEAO would devalue from the level of the current CFA franc. This would provoke inflation. The 50% devaluation of the CFA franc in 1994 led to an average inflation spike of 28% in WAEMU countries.
A second source of devaluation could come from the BCEAO’s credibility being tested. This could stem from France’s loosened supervision; from the fact that a date has yet to be set for the eco’s introduction, preventing market positioning; or from opposition to the peg from the policy makers of the larger economies, such as Ghana. If fiscal discipline is also judged to be insufficient, this will pressure the eco and prompt BCEAO intervention.
Amid devaluation risk, the BCEAO has a balancing act to perform, which includes ensuring exchange rate stability and facilitating liquidity. Both are essential to sustained economic transformation. For example, the former will prevent losses to early-stage export manufacturing industry owing to excessive currency fluctuations. Equally, credit provision (in the form of access to finance and low borrowing costs) is crucial to support investment in new industry.
The eco’s vulnerability to shocks
The BCEAO’s capacity may be limited by WAEMU economies’ vulnerability to shocks, particularly when it comes to commodity prices. Most of these countries are oil importers but commodity (mineral and agricultural) exporters. To take one example, an oil price decline would improve member countries’ trade positions. However, a persistent oil price decline, coinciding with lower global demand and commodity prices, would not augur well. The CFA franc typically shows sensitivity to these shocks (Figure 1).
Figure 1. The CFA franc tend to move with global commodity prices
WAEMU’s vulnerability to commodity price shocks could mean that reserves are tied up in a precautionary liquidity cushion. As things stand already, recent estimates suggest that, at 4.3 months, WAEMU economies’ import cover is below the 5.8 considered appropriate by the IMF. The case of Nigeria is illustrative. Despite its natural wealth, adverse price shocks coupled with a naira peg meant reserve depletion (and FX rationing) at the expense of Nigeria’s economic transformation and diversification away from oil.
Similarly, the BCEAO may have to defend the eco through selling foreign reserves via open market operations. As with many emerging market central banks, the BCEAO could also increase its policy rate or banks’ reserve requirements to mitigate depreciation. But there is an opportunity cost in holding up reserves that could have been employed in productive investment. Moreover, a tighter monetary stance, via higher reserve requirements, would curtail bank funding to the productive sector.
A problematic pegged exchange rate regime with limited foreign reserves is a familiar one in the case of Papua New Guinea (PNG). PNG is an oil and commodity exporter and operates an Australian dollar currency peg. During the 2014 oil price decline, its reserves declined by 29% as it defended the kina. Eventual FX rationing limited financial transactions and firms’ production, particularly those that required imported inputs. There was minimal to no economic transformation: in 2014, the financial services and manufacturing industries contracted by 16% and 1%, respectively.
The eco’s fiscal convergence risks
Realising the vision of the Economic Community of West African States (ECOWAS) for economic and monetary union has been a bumpy journey. In 2000, ECOWAS created a roadmap for a single currency by 2020. Although the first phase was to introduce the eco by 2015 in the West African Monetary Zone (WAMZ), comprising The Gambia, Ghana, Liberia, Nigeria and Sierra Leone and Liberia, this was abandoned owing to insufficient economic convergence. With the eco now due to launch in WEAMU economies in 2020, there is still a desire for its usage across ECOWAS – but convergence remains a problem.
Economic convergence will be key for the eco. And there is likely to be little of it. ECOWAS convergence criteria include a budget deficit limit of 3% of GDP, an inflation rate cap of 5%, a debt-to-GDP ratio of 70% and exchange rate fluctuation within a +/-10% band. As of December 2019, only Togo had met these. Inflation has not converged and is as high as 24% in Liberia. When it comes to fiscal convergence, not only have targets been missed (Figure 2) but also the IMF assessed The Gambia, Cabo Verde, Ghana and Sierra Leone as in debt distress in 2019.
Figure 2. Most ECOWAS countries do not meet the fiscal deficit criteria
Source: 2019 IMF Fiscal Monitor Report
As Europe’s experience has shown, political partnership is important for monetary and economic union. ECOWAS leaders have expressed the belief that, as countries meet convergence targets, an ever wider union will emerge. However, in practice, there has been little real cohesion. WAMZ heads recently released a joint communiqué expressing concerns over WAEMU’s eco adoption. And the region’s two big economies are at odds: Nigeria indicated that it was not ready for an ‘ECOWAS eco’ in 2020, while Ghana is keen. An Extraordinary Summit of WAMZ heads of government will be held soon. A commitment to follow WAEMU and plan for eco adoption would be positive. Crucially, an ECOWAS central bank could promote the financial stability that is crucial for economic transformation. One way would be to reduce political influence from any country pursuing high-risk policy, such as excessive debt financing. A commitment to a stable (and eventually freely floating) regional eco, low inflation and fiscal discipline would improve investment ratings and promote investment inflows geared towards greater economic transformation.
Photo: CFA Francs from Benin. Arne Hoel / World Bank / World Bank. CC BY-NC-ND 2.0