Monday January 13 2014

Practise financial restraint for common currency to benefit EAC

By Corti Paul Lakuma

Fiscal deficits and control of government debt will be a major concern to East African monetary policy makers in the next 10 years or so. The interest in government debt has mainly been wrought by the ratification, by the five Presidents of East Africa, of a protocol on establishing an East African Monetary Union. Plausibly, all members of the East African Community must change the course of the growth of sovereign debt to comply with the East African Average, 50 per cent of the Gross Domestic Product (GDP). It is not hard to notice that 50 per cent is a comparatively generous amount; in the Maastricht Treaty, the harbinger of the Euro, a single currency used in the European Union, debt to GDP ratio is in the south of 20per cent.

On one hand, the size of public debt in Kenya and Burundi has hit the ceiling, 50 per cent or more of the GDP. Ultimately, Kenya and Burundi face the task to reign in on the growth of public debt before the single currency takes effect, so as to ensure a stable value of the East African currency. On the other hand, the size of debt in Uganda, Rwanda and Tanzania continues to increase, but at a rate lower than the expansion of GDP; so far, this is very good.

More interesting, most monetary economists (read the Chicago School of thought) argue that fiscal deficit has no ramifications on price levels because the value of a currency is a preserve of monetary policy which is a sole responsibility of an independent central bank; therefore, if central banks are served with a proper mission, that is to maintain price stability, fiscal policy is of no consequence. Moreover, monetarists postulate, fiscal deficit is one of the least determinants of aggregate demand. This suggests that East Africans will , correctly, anticipate changes in government debt and will, therefore, adjust private saving to offset any changes in the national saving. Notice that such an analysis is abstract, incongruent with determinants of nominal variables in East Africa such as food prices and cost of energy and fuel and ignores the fact that the level of East African financial sophistication is negligible.

I, however, argue that fiscal deficits and more broadly public debt does not only affect aggregate demand but it exacerbates price instability; ordinarily, the transmission channel is uncoordinated government budget and monetary policies that are inconsistent with the level of public debt. More so, with the new found oil and the urgent infrastructural needs, so as to grow our economies and the availability of the development assistance and loans, especially from China; a predilection to accumulate more debt is common practice. After all, we can service our debts. Under such an analysis, fiscal instability will complicate the mandate of the common central bank, but the desire for price stability does not suggest that fiscal policy be subordinated to that end.

Assuming that most, if not all, East African Community members pay attention to the welfare effects of price instability, it suffices that none of the members would wish to bear the cost accruing from financing a hedonist neighbour who cannot control the size of her public debt, for this amounts to offering your neighbour a kind of a blank cheque, so as to eliminate the need for borrowing. Indeed, this is something no government is willing to offer to the other.

Nevertheless, the administration of Presidents Museveni, Kenyatta, Kikwete, Kagame and Nkuruzinza will control the path of public debt and harmonise the variations in different government budgets to eliminate the obstacles posed on price stability, for it is neither feasible for the common central bank to follow a monetary policy rule (adjustment of interest rates) which is completely unresponsive to the size of public debt. Nor is it optimum to use an appropriate policy rule to, fleetingly, respond to fiscal shocks.

There is no misgiving that a shared currency will reduce the cost of doing business in East Africa, strengthen our common market and accelerate the path to political integration. However, to avoid fiscal shock, price instability and financial contagion, the five countries have to exercises fiscal reticence.
Mr Lakuma is a Policy Analyst at The Economic Policy Research Centre (EPRC) and a former WCS Scholar at Department of Economics, University of Essex, United Kingdom.