Fix or free the West-African eco?

After a long history of colonial hegemony, France’s influence on the African continent is dwindling. In July 2020 eight West-African states will embark on a path to abolish the “CFA franc” and introduce the “eco” as currency, marking a symbolic feat of autonomy. French officials are withdrawn from local central bank management and reserve rules revoked. For now, the peg to the euro will persists and France guarantees its support in case of currency crisis. Change is imminent, reviving debates on economic integration, pegs vs. floating regimes and the future. 

Arguably the largest sacrifice in opting for a sustained fixed peg regime, is the use of monetary policy. Given free capital movements and arbitrage, the uncovered interest parity must hold (returns on eco deposits equal euro deposit returns). If the rate is pegged, expected depreciation equals zero and thus the home interest rate must equal the foreign interest rate. This anchor implies that the central bank is not able to freely respond to an adverse demand shock, whereas floating systems could just increase money supply, thus lower interest rates to boost domestic investment (cheap credit) and drive private spending (less saving incentives). Low interest would reduce domestic returns on savings accounts, depreciating the currency in the forex market, leading to higher real exchange rate. More expensive foreign goods cause an expenditure switch and elevated trade balance. Unfortunately, this theory does not hold in our case, as it ignores the issue of “liability dollarization”. Most West African countries are net debtors (Ghana, $21billion 50% GDP foreign debt). Their external debt, largely denominated in foreign currency, exceeds foreign assets. If a depreciation of the eco were to occur (e.g. by expansionary monetary policy), foreign liabilities would steeply increase in value, causing a detrimental reduction in local wealth. This reduces investment by domestic firms (reduced collateral and higher risk-premia), sharply decreasing demand and in effect domestic output. 

Another argument against floating regimes is “seignorage”. This is a financing scheme under which government debt is payed by printing money, effectively shifting the cost onto the money-holding public in the form of an ‘inflation tax’. Seignorage and foreign liabilities contribute to the “fear of floating” and justify the eco’s fixed exchange rate regime choice. 

Apart from avoiding political abuse or volatility risk, another central argument in favour of a pegged system is that it encourages trade. Stable exchange rates cause ‘certain’ international prices that converge due to arbitrage, thus lowering transaction-costs to efficient levels and reducing risk in cross-border capital and labour flows. Strong economic integration within the region and with the peg country is needed for this, meaning strong market linkages (high volume of trade). The greater the linkage is, the more the efficiency benefits of the eco region rise. This is crucial, because the long-term objective is uniting wider regions of West Africa and the central African bloc under the currency. These countries have remained with the CFA franc for now, but are expected to join once the economies have linked and integrated more. 

For the eco-region to gain international significance beyond France in the long run, it is crucial Nigeria joins. With an estimated GDP of $1.18 trillion (PPP, 2020 est.), Nigeria would constitute three quarters of the eco-zone’s output, posing challenges in aligning interests. Its dependence on oil makes it very susceptible to country-specific shocks. For example, in light of the corona-pandemic global demand for oil has collapsed (currently $31/barrel). The Nigerian government relies heavily on oil production to fund its national budget of $37billion, which anticipated a benchmark of $57/barrel. Along with the parallel pandemic demand shocks (reduced oil demand and stagnant investment), the government might thus have to cut spending further. Under a united currency union such an event would mean drastic monetary contraction for all members, just to maintain a fixed peg, threatening too big a fall in output of poorer countries for them to recover (visualised in figure1). For the near future until Nigeria’s economy has diversified, the risks of asymmetric shocks and misalignment of economic interests within the region might outweigh the benefits of joining together under the eco. 

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