The CFA Franc Zone: A Biography
Abstract and Keywords
This chapter reviews the history of the CFA Franc Zone, and discusses whether membership in the zone has supported economic growth and reduced the need for economic adjustment. It concludes that the zone is not an optimal currency area and that the costs of belonging to it outweigh its benefits. It then assesses the alternatives to the fixed parity rate between the CFA franc and the euro. In the zone, proponents of the fixed rate point to its ability to provide stability by linking inflation levels of African countries to that in France and Europe; while opponents of fixed parity argue that it sends incorrect signals to the domestic economies. There are a number of exchange rate arrangements that differ from the fixed parity rate by degrees of flexibility, and the appropriateness of each depends upon the economic setting in which it is used. This chapter evaluates these alternatives.
The monetary regime and banking institutions of a large majority of African countries reflect in many ways an extension of what exists in their respective metropolitan centers. In fact, most of the present-day African monetary systems institutions were initiated by the colonial powers. While many African states have taken some steps to achieve some relative autonomy on matters of monetary policy, strong political and economic linkages with their former ruling entities remain. This is certainly the case of the CFA franc zone, subject of this chapter.
The CFA franc zone today encompasses 14 Western and Central African countries grouped in two monetary unions, of which the currency, the CFA franc, has been tied since its inception in 19451 to the French franc and to the euro (with the disappearance of the French in 2000) via a fixed exchange rate arrangement. The four central features of the zone are the convertibility of the CFA franc (the common currency of zone members), the pooled reserves system each union operates through the French Treasury, the fixed parity rate between the CFA franc and the French franc (and the euro after 1999), and the free capital mobility within the countries of the Zone and France.
Prior to the 1980s, it was widely believed that the membership in the zone would support economic growth and reduce the need for economic adjustment. The guaranteed convertibility of the CFA franc combined with its fixed parity to the French franc would provide a stable investment climate for both foreign and domestic investors, which in turn would (p. 115) contribute to economic growth and development (Devarajan and de Melo 1987; Elbadawi and Majd 1996).
In the 1980s, however, poor economic performance of the CFA zone countries relative to non-CFA zone countries in Africa led many to question the benefits of participating in the zone (Allechi and Niamkey 1994; Monga and Tchatchouang 1996). By the 1990s, it was widely held that the CFA franc had become overvalued, contributing to poor economic performance. Because the rules of the zone precluded use of the nominal exchange rate as a policy instrument, governments were forced to rely on other policies to counter the impact of the overvaluation. Many believed that the CFA zone countries were sufficiently equipped with policy instruments to achieve real exchange rate depreciation, but the use of these policies resulted in expenditure reduction in general, and decline in investment in particular (Devarajan and de Melo 1991). Though the countries of the zone elected to devaluate the CFA franc in early 1994, the fixed parity with the French franc, and later with the euro was maintained and as long as it prevails, the nominal exchange rate remains unavailable as a tool for policymakers should the CFA franc again become overvalued. Continued poor performance of the zone economies compared to non-CFA countries in Africa indicate that the arrangements between the CFA zone and France are not viable and call for a change.2
This chapter discusses alternatives to the fixed parity rate between the CFA franc and the euro. In the CFA zone, proponents of the fixed rate points to its ability to provide stability by linking inflation levels of the African countries to the inflation level in France and Europe, while opponents of fixed parity argue that, because it fails to change in response to shocks, the exchange rate sends incorrect signals to the domestic economies. There are a number of exchange rate arrangements that differ from the fixed parity rate by degrees of flexibility, and the appropriateness of each depends upon the economic setting in which it is used. This chapter will evaluate these alternatives in the setting of the CFA franc zone.
The remainder of this chapter is organized as follows. Section two will review the history, organization, and objectives of the CFA franc zone. The principles which govern the franc zone are the result of the peculiar relationship between France and her former colonies. This relationship has important consequences on the way the exchange rate arrangements play out in the zone. Section three discusses whether the CFA franc zone is an optimal currency area.3 Section four focuses on the exchange rate, briefly defining exchange rate concepts to provide a framework for a discussion of the performance of the CFA franc zone. It also presents a typology of exchange rates and how and why they are chosen. Section five discusses whether a fixed parity rate is an appropriate exchange arrangement for the CFA franc zone based on the economic performance of the CFA zone countries. Section six surveys alternatives to a fixed parity rate and briefly assesses their advantages and disadvantages in the setting of the CFA franc zone. It will also discuss practical considerations for changing the exchange rate arrangement in West and Central Africa.
(p. 116) 5.2 The Birth of a Monetary Union
The CFA franc zone finds its origin in the political and economic relations between France and her former African colonies. During the 1930s and the 1940s, France established currencies in each of its colonies that were pegged to the French franc. By the end of the Second World War, the currencies of the French colonies in Africa were consolidated into “le franc des Colonies Françaises d’Afrique” (CFA franc). Its parity was set in October 1948 at 0.5 CFA per French franc. The CFA was issued initially by the central bank of France’s overseas territories (Caisse Centrale de la France d’Outre Mer). However, following the independence of France’s former African colonies in the early 1960s, responsibility for issuing currency and overseeing the functioning of the zone was shifted to two regional central banks. These central banks were originally dominated by France, but by the early 1970s their control shifted to the member countries.
The membership of the CFA franc zone has changed over time with the departure (and subsequent reentry in the case of Mali) of some former French colonies and the entry in recent years of two sub-Saharan African countries that had no colonial relations with France and are not French speaking (Equatorial Guinea in 1985 and Guinea Bissau in 1997). The zone currently comprises eight West African countries (Benin, Burkina Faso, Cote d’Ivoire, Guinea Bissau, Mali, Niger, Senegal, and Togo) that are members of the West African Economic and Monetary Union (WAEMU). Their common currency was rebaptized from “franc des Colonies Françaises d’Afrique” to “franc de la Communauté Financière de l’Afrique” (CFA franc), which is issued by the “Banque Centrale des Etats de l’Afrique de l’Ouest” (BCEAO). The zone also comprises the six countries (Cameroon, Central African Republic, Chad, Congo Republic, Equatorial Guinea, and Gabon) that are members of the Central Africa Economic Monetary Cooperation (CAEMC) and of the “Banque des Etats de l’Afrique Centrale” (BEAC), which issued the “franc de la Communauté Financière de l’Afrique Centrale” (CFA).
The two CFA currencies are legal tenders only in their respective region. However, because of the guaranteed convertibility into the euro, the free capital mobility between each region and France, and the fact that the two CFA francs have the same parity against the euro, the CFA franc zone has traditionally been considered as one currency area with a single currency. France is represented in the executive boards of the two regional central banks and has traditionally been the main trading partner and provider of extensive technical and financial assistance to all member countries of the CFA franc zone.
The CFA franc zone functions under a number of key operating principles: (i) a fixed parity against the euro, adjustable if required by economic conditions after consultations with the French government and unanimous decision of all member countries within each monetary area; (ii) convertibility of the CFA franc into the euro; (iii) guarantee of convertibility by France through the establishment by each regional central bank of an operating account with the French Treasury; (iv) free capital mobility between the two regions and France; and (v) the pooling of foreign exchange reserves of each regional monetary area.
Thus the CFA franc zone effectively operates as a credit mechanism organized by France which, while serving to maintain the guaranteed convertibility of the CFA franc, simultaneously grants all holders of CFA franc access to the international capital markets. So the (p. 117) characteristics of a currency-board type of monetary system are in place. However, the Banque de France is not involved in formal terms, and the fixed CFA franc exchange rate is guaranteed instead by the French Ministry of Finance and administered by the exchequer (Treasury). The credit creation mechanism is in turn derived from the system in which the French Treasury traditionally also functioned as the bank of the state and local prefectures.
To preserve the principles referred to above, and as a means of encouraging financial discipline, a number of operating rules are stipulated in the statutes of the central banks. These rules require that each central bank: (i) maintains at least 50% of its foreign assets in its operating account with the French Treasury; (ii) maintains a foreign exchange cover of at least 20% for its sight liabilities; and (iii) limits credit to each government of member countries to a ceiling equivalent to 20% of that country’s government revenue in the previous year. Taken together, observance of these operating rules limits in practice the potential drawings by the two central banks from their overdraft facility with the French Treasury.
With the accession of France to EMU on January 1, 1999, the only change was the recalculation of the CFA franc peg so that the exchange rate was quoted in euros instead of French francs, while the CFA franc zone system, its instruments and its modus operandi all remained unchanged.4
5.3 Is the CFA Franc Zone an Optimum Currency Area?
One way of evaluating the economic performance of the CFA franc zone is in terms of a currency area, a concept introduced by Mundell (1961). An optimum currency area (OCA) is defined as a region characterized by high degrees of the following criteria: factor mobility, economic interdependence, sectoral diversification, and wage and price flexibility (Mason 1994). The basic idea behind an OCA is that these four criteria are able to act as substitutes for, or simply reduce the need of, exchange rate adjustment. For example, a terms-of-trade shift might increase demand for a good in one country of a currency area, leading to inflation in that country, while decreasing demand for the same good in another country of the area, increasing unemployment there. If factor mobility exists, adjustment through a movement in the supply of labor could replace exchange rate adjustment.
Regarding the CFA zone’s ability to meet these criteria, Boughton (1992) stated that “there are positive aspects on each front, but on none of these economic grounds would the zone appear to be a natural candidate for a common currency area.”
Notwithstanding some economic progress achieved since the devaluation in 1994, the CFA franc zone remains confronted with sizable domestic and external imbalances and continue to be subject to structural rigidities and vulnerable to exogenous shocks. Additional reform efforts are required by all individual CFA franc countries to achieve a sustainable expansion of output as well as to promote regional integration and preserve the exchange (p. 118) arrangement. In this context, it is generally recognized that the CFA franc zone does not meet the conventional criteria for the formation of optimum currency areas, even after 60 years of existence.
With a total population of about 136 million in 2010, the CFA franc zone roughly compares to the Russian Federation (the ninth most populous nation in the world) while its combined GDP of $142 billion compares to that of Kazakhstan. The annual average per capita income reached US$1044.0 in 2010, far below the per capita income in sub-Saharan Africa of USD1202.05. The zone is dominated by Cameroon and Cote d’Ivoire, which account for 30% and 40% of their regional output respectively. The per capita income of the richest country, Equatorial Guinea, at USD16,000.0 in 2010, is 32 times larger than that of the poorest country, Central African Republic (CAR).
The CFA franc zone remains a fairly heterogeneous entity, with very limited intra-regional trade, and highly dependent on the production and export of limited number of primary commodities, with a narrow industrial base, making them highly vulnerable to external shocks. Intra-regional trade has traditionally remained modest, because of limited size of domestic markets, poor regional transportation and communication facilities, and high protection of domestic producers. Estimates indicate that intra-regional trade amounted to about 11% of total external trade of the WAEMU countries, 6% of the CAEMC countries, and 9% of all the CFA countries.6 By comparison, intra-regional trade in European Union exceeds 60% of EU total international trade.
The key macroeconomic convergence criteria used in gauging progress towards monetary union include: annual inflation rates below 3%, a positive fiscal balance (excluding grants and foreign-financed investments), and an annual level of public debt to GDP of less than 70%. According to the IMF, after a sharp increase from 17 to 27 from 2004 to 2008, the annual number of violations has declined to its 2004 level, which, however, is still very high.
The requirement of business cycle synchronization is important of an OCA in that it guarantees symmetric responses to both real domestic and foreign nominal shocks affecting member states economies. The evidence however suggests that the production structures and structural characteristics of WAEMU and CAEMC zone economies differ significantly. For instance, all CAEMC states (with the exception of the diamond-exporting Central Africa Republic) are mainly oil exporters, with oil accounting over 90% of exports and 40% of GDP. WAEMU states, on the other hand, are mainly non-oil agricultural commodity exporters. The implications of these divergent production structures is that CAEMC states tend to respond differently from WAEMU states (with exception of Cote d’Ivoire) when faced by external shocks.
The spillover effects of the underlying differences in economic structures between WAEMU and CAEMC is a worrisome policy issue. For instance, the evidence suggests that, while liquidity has systematically been declining in the WAEMU zone since 2004, CAEMC states have been characterized by high excess liquidity in commercial banks. The high excess liquidity in CAEMC is the result of higher oil revenues that have improved the fiscal space for CAEMC governments. These elements explain why the stance of monetary policy in the (p. 119) WAEMU has been markedly different from that in the CAEMC and why the feasibility of a common monetary policy for both regions is limited.
Recent work on economic integration among a set of countries in a monetary union has shown that to be optimal it is important to also coordinate fiscal policies of member countries. Given the structural differences among the members of the union, fiscal policies are used as stabilizers. In the case of the United States for instance, Sala-i-Martin and Sachs (1992) showed how the federal fiscal system is used to offset economic shocks in different regions of the union. No comparable scheme of this nature exists in the CFA franc zone. Thus, the “fiscal federalism” that helps the US, Germany, and many other federal regions succeed despite economic structural divergence, is totally absent in the CFA franc zone.
5.4 Flexible Versus Fixed Rate: A Conceptual Framework
The exchange rate plays two main roles in an economy: (i) it can help achieve and maintain international competitiveness; and (ii) it can act as stable anchor for domestic prices. The choice of an exchange rate regime, then, reflects a government’s preferences for domestic economic stability and for independence in determining the appropriate mix of macroeconomic targets (inflation versus employment) (Salinger and Stryker 1994).
There are basically two exchange rate concepts: the nominal exchange rate and the real exchange rate. The nominal exchange rate is simply the value of one country’s currency in terms of another, in order words, the price of foreign exchange. The exchange rate can be determined by market forces or it can be set by a government, in which case the government would be required to defend an increase in the currency’s value. If the price of foreign exchange were to decrease (an appreciation of the exchange rate), demand for foreign exchange might exceed supply and the government could be required to meet that excess demand with foreign exchange reserves.
The nominal exchange rate measures the relative prices of currencies. The real effective exchange rate (REER), on the other hand, measures the relative price of two goods (Edwards 1994). The REER, then, can be seen as the measure of country’s competitiveness in producing tradable goods7 .
For countries that cannot change the value of the nominal exchange rate, (which is the case for those in the CFA zone), the REER is influenced primarily by controlling domestic inflation. This can be done with policies that either restrict aggregate demand or expand aggregate supply. Countries that can change the nominal exchange rate may devalue a currency to compensate for increases in inflation. However, this increase in the nominal exchange rate often causes domestic price levels to increase, negating the intended effect of the devaluation.
(p. 120) At the equilibrium level, the REER clears the foreign exchange market (the supply of and demand for foreign exchange are equal, and the current account is balanced). If the REER is below its equilibrium level, the demand for foreign exchange currency exceeds its supply, and the currency is said to be overvalued. The result is that tradable goods become relatively cheap compared to non-tradable goods. To correct for overvaluation, a country can devalue the currency. The basic goal of any devaluation is to increase the price of tradable goods relative to non-tradable goods. The desired result is twofold: first, to shift domestic consumption toward domestically produced goods by making imports more expensive and second, to increase domestic production of tradable goods, as their price is now higher in domestic currency terms. All else equal, the REER will increase in value (depreciate), demand for foreign exchange in the home country will decrease, the supply of foreign exchange will increase, and the REER will move toward the equilibrium level.
Alternatively, a government can try to stimulate the effects of a devaluation, either with expenditure reducing policies (fiscal and monetary policies), expenditure switching policies (trade and exchange rate policies), or some combination of the two. The goal of expenditure reducing policies is to lessen domestic consumption and investment, thereby restoring balance to the current account. Expenditure switching policies attempt to reduce the demand for foreign exchange by shifting economic activity between the tradable and non-tradable sectors.
The type of exchange rate employed by a country will have a bearing on which policies will be more effective in achieving a country’s economic objectives. In choosing an exchange rate arrangement, a country must weigh up two different sets of concerns. First, the choice of an exchange rate arrangement depends on three things: (i) policymakers’ objectives, (ii) the source of shocks to the economy, and (iii) the structural characteristics of the economy in question. Second, with both a fixed parity rate and a clean float, a government cannot use the nominal exchange rate as a policy instrument to achieve either internal or external balance. The options that lie between theses extremes, for instance a crawling peg or a managed float, allow a government to alter the nominal exchange rate to appreciate or depreciate the value of the REER.
Exchange rate arrangements are typically divided into two categories, fixed and flexible. Fixed exchange rate arrangements generally involve pegging the value of the exchange rate either to one other currency or to a basket of currencies. Flexible exchange rates allow the nominal exchange rate to either adjust to a predetermined indicator or to be determined by market forces.
Between 1945 and 1973 (the Bretton Woods period), fixed exchange rates were standard practice worldwide, with most currencies fixed to the US dollar by an adjustable peg. However, fixed rates became increasingly difficult to maintain as world capital markets developed in the 1960s. Exchange rate adjustments became more frequent to account for inflation differences, and as devaluations appeared imminent, capital flight would ensue. After 1973, most major currencies were floating while developing countries maintained fixed rates. This changed in the 1980s with the introduction of structural adjustment programs, when many developing countries began to add flexibility to their exchange rate regimes.8
(p. 121) In the post-Bretton Woods period, the focus of the debate concerning exchange rate choice in the developing world was whether these countries should peg their currencies to a basket or the currency of a major trading partner (Devarajan and de Melo 1987). In 1976, 63% of developing countries pegged their exchange rate to the currency of an industrial country. But, by 1989, only 38% of developing country currencies were pegged to a single currency. For the same two years, the number of countries fixing their exchange rate with a currency basket increased from 13% to 23%.
The increase in the number of basket and floating arrangements was partly in response to a desire to minimize the adverse effects caused by fluctuations between the major currencies since the implementation of the floating exchange rates in 1973. Examples of adverse effects include uncertainty about the profitability of investment in the traded goods sector, and problems in managing foreign exchange reserves, public finances, and external debt. In addition, high domestic inflation rates were an important factor in the increase in the number of flexible arrangements in developing countries. Flexibility allows the nominal exchange rate to adjust for inflation differentials, which can help maintain a constant REER. Furthermore, flexibility relaxes the political burden of devaluation, as a government is not forced to take full responsibility for changing the value of a currency, as is usually the case with a fixed peg arrangement.
Corden (1993) presented two approaches for determining exchange rate policy: the real targets approach and the nominal anchor approach. The nominal anchor approach advocates fixing a country’s exchange rate to the currency of a low-inflation country. This is the approach that has been followed in the CFA franc zone. Corden warned, however, that a commitment to a fixed exchange rate arrangement can be risky without both discipline and credibility. The discipline to maintain a fixed rate requires strong monetary and fiscal policies to ensure that real adjustment is not prevented, and a government’s commitment to such policies plays a large role in determining the credibility of the arrangement. As Williamson (1993) noted, should discipline falter, a devaluation may be needed to realign the REER, which in turn can lead to a loss of credibility of the exchange rate regime.
In the CFA franc zone, the commitment to the French government to support the institutional arrangements of the zone has maintained the credibility of the CFA franc. Yet the inability of the CFA countries to change the nominal exchange rate appears to have contributed to the economic downturn in the late 1980s. Nevertheless, the CFA countries and France have elected to keep the fixed parity arrangement between the CFA franc and the euro, even while the majority of developing countries have added varying degrees of flexibility to their exchange rate regimes.
What has been the impact of the fixed rate on the economies of the CFA franc zone members? This question is discussed in the nest section.
5.5 The CFA Franc: Chronicle of a Death Foretold?
The two principal benefits of pegging the exchange rate to a single currency are (i) the facilitation of trade among the countries whose currencies are linked by reducing uncertainty in (p. 122) the value of the currency; and (ii) the promotion of domestic price stability in the country pegging its currency, as the fixed nominal exchange rate acts as an anchor for domestic price levels. The latter depends on the willingness of a government (or the governments of the CFA countries and France in the case of the franc zone) to support the exchange rate through appropriate fiscal and monetary policies.
There are also some potentially bad consequences to an exchange rate peg. The primary drawback is for a developing economy to be caught by the strengthening of a developed country’s currency (Dornbush 1988), which is what occurred in the CFA franc zone in the 1980s. Additional drawbacks include (i) a loss of flexibility in defining domestic monetary and fiscal policy (Salinger and Stryker 1994); and (ii) a possible barrier to regional trade efforts, as different countries in a region may peg their currencies to different developed country currencies, increasing exchange rate variation between the developing countries (Crockett and Nsouli 1977). This section shows that in the late 1980s and the early 2000s, even though the CFA zone had achieved price stability, external conditions changed so that the drawbacks increased relative to the benefits.
During the period from the early 1950s to the mid-1980s, the economic performance of the CFA franc countries compared favorably with that of other sub-Saharan African countries, the former achieved stronger real GDP growth and lower inflation. However, during 1986–1993, the economic and financial situation of the CFA franc zone seriously deteriorated, initially driven by external shocks and inadequate policy adjustments by member countries (Clément 1994). By the late 1980s, the CFA franc had become seriously overvalued, and both operations accounts were rapidly accumulating deficits, putting heavy pressure on the French Treasury. Additionally, internal structural problems (e.g. demographic pressures, rapid urbanization, and poor economic management) constrained productivity growth in the zone (relative to France), further contributing to overvaluation (Dioné et al. 1996).
The overvalued CFA franc particularly hurt the countries of the zone in two areas, production and investment. Van de Walle (1991) noted that during the late 1980s overvaluation was “in the process of demolishing the production apparatus in these countries, resulting in deep economic recession.” Local products were unable to compete with imported goods, and agricultural production shifted away from tradable goods. In addition, the overvaluation encouraged the use of imported inputs as factors of production, further hurting domestic production incentives. The strong currency also discouraged foreign investment, as investors began to doubt the ability of the zone to maintain convertibility of the CFA franc in the face of overvaluation. Furthermore, capital flight became a problem as the overvaluation endured.
The worsening of the terms of trade led to a substantial depreciation of the equilibrium real effective exchange rate of the zone. However, in the absence of nominal exchange rate flexibility, and in the context of a sizable strengthening of the French franc against the US dollar following the Plaza Accord among the G5 countries, the CFA franc appreciated markedly in nominal effective terms. The internal adjustment efforts pursed by most CFA franc countries gave rise to only a modest depreciation of the real effective exchange rate of the CFA franc countries as a group that was not sufficient to offset the impact of the terms of trade loss, thereby leading to competitiveness problems.
(p. 123) The operating rules, and in particular the statutory limit on government borrowing from the central banks, did not prove adequate to instill fiscal discipline. Against the background of narrowing government revenue base, these statutory ceilings were exceeded significantly by several CFA franc countries, particularly during the early 1990s. Moreover, the fiscal imbalances and the external public debt of the CFA franc countries increased substantially in relation to their GDP during 1986-1993. The large fiscal imbalances also contributed to the emergence of sizable domestic and external payment arrears, as well as to a major weakening of the soundness and financial position of the banking systems in the CFA franc zone. In addition, the two regional central banks sustained large declines in their net foreign assets, necessitating a rundown of their deposits in the operations accounts with the French Treasury and a limited use of their overdraft facilities.
Because changing the parity rate of the CFA franc was considered a last resort, the zone member countries were forced to rely on other policies to change the REER and simulate the effects of devaluation (e.g. export subsidies and import taxes). Van de Walle (1991) argued that these policies created “incredible incentives for fraud and rent seeking, particularly when the high level of overvaluation necessitates greater distortion of the market prices.” He also argues that the failure to reduce overvaluation of the CFA franc was political in nature, as governments lacked the financial discipline to achieve a depreciation of the REER. The social groups that benefitted from cheap imports were primarily urban workers, whose support was important to the government, and the overvaluation also provided revenue to the state via financial policies implemented to mimic the effects of devaluation (e.g. import taxes in rice).
Faced with economic conditions that continued to deteriorate, the members of the franc zone eventually devalued the CFA franc on January 12, 1994, doubling the parity rate of 50CFA francs per French franc to 100CFA francs per French franc.9 The devaluation was accompanied by extensive fiscal, wage, monetary, and structural measures, and it received substantial financial support from the International Monetary Fund (IMF) and the World Bank (Clément 1994).
The new policy package, with devaluation as its central piece, contributed to a resumption of growth in real per capita income in the CFA franc zone at a rate of 0.8% a year during 1994–1996, after annual decline of 2.6% during 1986–1993. After a sharp initial increase following the devaluation, the zone’s inflation rate was brought down to single-digit levels by end of 1996. Fiscal imbalances were reduced, with primary balance shifting to a modest surplus after sizable deficits during 1986–1993. The overall balance of payments deficits were also contained, while the external public debt burden was eased significantly for most CFA franc countries through concessional debt relief. By May 1997, about half of the gains in external competitiveness—as measured by changes in the consumer price-based real effective exchange rates—brought about by the devaluation were preserved.
As an integral part of the adjustment efforts, the two regional central banks shifted away from direct instruments of monetary control toward indirect market-based instruments, and established interbank money markets and new central bank financial instruments through auctions.
(p. 124) The 1994 devaluation was successful in achieving its stated aims, as growth rates recovered and inflation controlled. Yet, adherence to the fixed parity rate continues to hinder the ability of the CFA countries to adjust to changing external conditions in a timely manner. As long as the fixed parity remains in place, external shocks and slow productivity growth can again cause an overvaluation of the CFA franc.
This is exactly what happened over the 2000–2005 period. In their 2006 study of the equilibrium real exchange rate of the CFA franc, Yasser Abdih and Charalambos Tsangarides found out that, after 1994 and a few years of “correction,” both CAEMC and WAEMU REERs remained above their equilibrium levels for the rest of the period of analysis as a result of changes in the underlying fundamentals, which differed for the two regions. The CAEMC REER temporarily exceeded its equilibrium level in 1999, and again during the period 2001–2004, with statistically significant misalignments during those episodes. In the case of WAEMU, there were no statistically significant misalignments after the devaluation until a short period in 2003–2004 (Abdih and Tsangarides 2006).
In the case of CAEMC, the REER appreciated by about 13% in the 2001–2005 period as a result of 23% increases in terms-of-trade, and a depreciation caused by government consumption and productivity decreases (2% and 7%, respectively) and openness increase (about 1%). For WAEMU, in the period 2001–2005, the REER appreciated by about 12% as a result of increases in the term-of-trade and government consumption (accounting for an appreciation of the equilibrium real exchange rate in the order of about 9% each), while the increases in investment and openness and decreases in the productivity index contributed to REER depreciations of 2, 1, and 3%, respectively. Abdih and Tsangarides also observed very different speeds of adjustment for the two regions. For the CAEMC region, on average, about 0.12% of the overvaluation is eliminated every year, which implies that, in the absence of further shocks, about half of the gap would be closed within 5.6 years. However, for the WAEMU region, the adjustment is faster, with 0.24% of the gap is eliminated every year implying that, in the absence of further shocks about half of the gap would be closed within 2.9 years, almost half the time estimated for the CAEMC.
Williamson (1991) has developed a set of four qualifications that, if all are met, would identify a country as a good candidate for a fixed exchange rate regime. First, a country’s economy must be small and open, and thus meet the requirements of membership in a larger currency area. The economies of the CFA zone are small and open, and they are members of a larger currency area, so this qualification is satisfied. Second, at least 50% of a country’s trade must be with the country to whose currency it is pegging. Williamson deems 60% more than adequate, but 40% not enough. While the CFA countries certainly met this qualification when the CFA franc was established, they do not meet it now.
Third, the country must pursue macroeconomic policies that will result in a domestic rate of inflation that matches the rate of inflation in the country to whose currency it is pegging. This qualification is met by the CFA franc countries; its average inflation rate for all zone countries is 3%, compared with also the same level for France and for the EU. Fourth, the country must have institutional arrangements in place that can guarantee the credibility of the fixed rate arrangement. The CFA franc countries meet this requirement via the convertibility guaranteed by the French Treasury, though the 1990s changes regarding the convertibility of the CFA franc have lessened the currency’s credibility.
(p. 125) Thus, the CFA franc zone countries meet three out of Williamson’s four qualifications for use of a fixed exchange rate, when applying these qualifications to arrangement between the CFA franc and the euro. The primary reason why the fixed rate no longer appears to be appropriate for CFA countries is that their trade has become more diversified, and the fixed rate no longer provides as much benefit as in the past of facilitating international trade. External conditions have also changed significantly since the establishment of the CFA franc zone, and as African countries’ trade has diversified, movements in the euro have, at times, hurt their competitiveness in world export markets.
5.6 Exchange Rate Options for the CFA Franc Zone
Williamson (1991) also stated that “the objective of exchange rate management is to keep the actual exchange rate reasonably close to the target, in order to give the correct price signals to a market economy.” He added that the choice of the exchange rate management strategy should depend on the economic conditions, and that the way the target rate is determined and adjusted over time is always very important. The objective should be to determine the REER that allows a country to achieve its goals, and then manage the nominal exchange rate to maintain the target REER. The target rate should satisfy the following criteria: (i) it should not cause economic incentives to change erratically over time; and (ii) it should adjust to account for persistent real shocks and to ensure external equilibrium can be achieved.
We have already discussed the nominal anchor approach to exchange rate management. The alternative approach is the real targets approach. The real targets approach advocates the use of the nominal exchange rate as a policy tool to attain economic objectives, especially when the current account is in deficit. This approach depends on three assumptions: (i) nominal wages and the price of non-tradable goods must not adjust fully to account for a nominal devaluation, meaning that the economy must experience a real devaluation; (ii) real devaluations must lead to substantive changes in the long run, for example increased exports; and (iii) shocks faced by a country, whether external or internal, must be different from shocks faced by the anchor country, should the currency be pegged (Corden 1993).
When assessed only against these assumptions, it appears that the CFA countries are well suited for the real targets approach. We indicated previously that the 1994 devaluation did lead to a real devaluation (as wage and price increases did not match the magnitude of the devaluation), and the devaluation also induced a supply response, especially in the agriculture sector. Therefore, the first two qualifications for the real targets approach are met. Finally, the economic shocks facing the CFA countries are much different from those facing their trading partners, mainly industrial countries. The CFA countries mainly export primary products, and a decline in world prices decrease would not hurt industrial countries as it would for the CFA countries. In addition, with the coming into force of the fiscal compact in the Eurozone, France is increasingly subjected to limits on its deficits and, thus, cannot be counted upon to continue proving unlimited lines of credit to buffer the CFA franc, even if it wanted to do so. The fact that the French treasury would not be able to inject unlimited amounts of liquidity without further consequences casts doubts on the credibility of the CFA (p. 126) franc fixed regime going forward. Future constraints on the guarantee of convertibility by France imply that the CFA franc countries would need to maintain increasingly higher levels of foreign reserves by themselves. The main problems with the requirement of increasingly higher future reserve levels are that reserve accumulation continues to be largely supported by oil exports, and oil bases are fast depleting. Higher reserves cover also has an opportunity cost in terms of lost investment and growth. An empirical study by Gulde and Tsangarides suggests that during 1999–2004, the total cost of holding reserves amounts, on average, to 0.5% and 1.6% of annual GDP in CAEMC and WAEMU respectively. Thus, without the French convertibility guarantee, overall CAEMC GDP growth would fall by 0.5% annually due to higher level of required reserves (Gulde and Tsangarides 2008). This would raise the question of how to manage the exchange rate in the current institutional arrangements of the CFA franc zone.
Four options, listed below would be available to the CFA countries should they choose to exit from the current monetary arrangements.
5.6.1 Pursuing the goal of an OCA for each sub-region
Considering that the WAEMU and the CAEMC have each a common central bank, and each sub region has already established its own customs union with a common external tariff, its own common market allowing for free mobility of goods and factors of productions and its own economic union allowing for the integration of monetary and fiscal policies, these sub-region groupings-WAEMU and CAEMC- could independently pursue the goal of becoming an OCA by setting up the “CEMAC Franc” and the “WAEMU Franc” within the framework of a system of stable exchange rates with fluctuation margins. Choosing this type of regime would likely be prompted by considerations relating to the revamping of regional integration, on one hand, and to the existence of a dominant State on both sides (Cameroon and Côte d’Ivoire), that should be able to impose rules on members and support the related costs. Some of the new issues to be addressed by this new monetary strategy include the question as to whether the new CFA franc should be disconnected to the euro with the suppression of the “Operation Account,” and the consequential loss of the French guarantee of convertibility of the CFA franc. The solutions will depend on the capacity of member states to undertake, jointly and equally, the necessary measures for convergence of economic, financial and social policies in the new monetary territory. Anyway, such a move calls for more boldness from the CFA member countries in order to avoid the Malian and Malagasy experiences.
5.6.2 Pegging to a basket
This exchange rate arrangement has the same advantages as a single currency peg, and it attempts to minimize the disadvantages by accounting for the fact that few countries trade exclusively with one other country. By not pegging to a single currency, a country can minimize adverse effects resulting from movements in the exchange rate of any one of its trading partners. Thus, a basket peg provides macroeconomic stability by minimizing changes in the REER. Crokett and Nsouli (1977) identified four alternatives for use as basket pegs: an (p. 127) export-weighted index, an import-weighted index, a bilateral trade index, and an index based on the SDR. They argue that a basket peg based on an import-weighted index is the most useful for developing countries. An export-weighted index would not be as effective because most developing countries export primary commodities, and world prices for these goods are independent of trade partners. As imports are more diversified, an import-weighted index will be more representative of the patters of trade. They also argue that pegging to the SDR can be practical as its value is well known and may reduce exchange rate variability between developing countries.
How might this exchange rate be applied to the CFA zone? The first step would be to decide on a trade index of the main economic partners for the zone. Based on the preceding argument, the appropriate choice would be an import-weighted index. The fact that imports to the WAEMU are more diversified than imports to the CAEMC countries suggests that different peg rates for the two unions should be considered.
5.6.3 Crawling pegs
Under a crawling peg arrangement, a currency is adjusted at frequent intervals by relatively small amounts, though the actual size and timing of the adjustments are random, in the sense that they are unannounced (Dornbusch 1988). The goal of a crawling peg over the long run is to fix the REER by adjusting the nominal exchange rate for inflations differentials, whether against a single currency or a basket of currencies. The frequency with which these adjustments occur provides some certainty to the value of the exchange rate. In other words, even though traders may not know exactly when the exchange rate will move, they know that it will not get too far out of line with an indicator such as the consumer price index.
The primary benefits of a crawling peg are (i) it limits speculative activity surrounding the exchange rate; and (ii) it depoliticizes the process of exchange rate management by eliminating the temptation to delay adjustment. However, though a crawling peg prevents a rise in the general price level from affecting a country’s international competitiveness, external shocks can still cause appreciation of the REER. Thus, a crawling peg arrangement may still require additional policies to maintain its effectiveness.
One of the fears of ending the fixed arrangement between the CFA and the euro has been that the anchor for inflation provided by the arrangement would be lost. The anticipated result is higher rates of inflation in the African economies, leading to frequent adjustments of a crawling peg. However, Corden (1993) found that, for a sample of ten countries that switched from a fixed rate to a flexible rate, seven were able to maintain inflation rates reasonably close to the rate before the switch through conservative monetary and fiscal policies. Therefore, a crawling peg can be an appropriate rate for the CFA zone, provided monetary and fiscal discipline is maintained.
5.6.4 Currency floating
Floating exchange rates can either be dirty (managed by the government) or clean (wholly determined by market forces). With a dirty float, a government frequently adjusts its (p. 128) exchange rate based upon developments in its current account balance or payments position (Guitian 1994). Generally, a stable floating exchange rate regime can be maintained if the foreign exchange market allows capital to shift easily between domestic and foreign assets, via sufficient depth, forward exchange facilities, and markets for stocks and securities (Salinger and Stryker 1994). Yet because such capital markets do not exist in most developing countries, floating rates have generally not been regarded as viable alternatives for them. However, the number of developing countries implementing floating exchange rates has increased, primarily in response to severe balance of payments problems. Many developing countries simply do not have the reserves needed to defend a fixed exchange rate. Indeed, one of the main benefits of a floating exchange rate “is that it minimizes the need for foreign exchange reserves” (IMF 1993). Additional reasons countries have chosen the floating exchange rate include: lack of information necessary to determine a basket or crawling peg; macroeconomic stability; and political considerations.
In a practical sense, the debate over the introduction of floating exchange rates in developing countries has focused on the degree of centralization of the system for determining the nominal exchange rate. For example, one of the key questions to be addressed is whether auctions or private sector (interbank) markets should be used, and will non-bank foreign exchange dealers be allowed to participate in the latter?
There are at least three conditions for successful management of a flexible exchange rate, in terms of delivering low and stable inflation at the same time as the exchange rate works as a real shock absorber (Mar Gudmundsson 2006). First, the existence of a foreign exchange market with some minimum depth and efficiency; second, a domestic anchor for monetary policy; third, minimum independence and capacity of the central bank in order to be able to deliver an effective monetary policy.
The importance of floating exchange rates of the CFA is perhaps most relevant in the scenario where each of the member countries is faced with the decision of which exchange rate arrangement to use, should the franc zone cease to exist.
The majority of the studies on the OCA in Africa are centered on the CFA countries, perhaps because they are part of a more highly integrated monetary system than the rest of Africa and the relatively good quality of relevant data. Most of the studies suggest that increased monetary integration leading to monetary union would not be beneficial. Several reasons are suggested from the literature. Primarily, the heterogeneity of external and internal shocks that increase the cost of abandoning exchange rate controls, and the heterogeneity of fiscal demands (as highlighted by the work of Debrun, Masson, and Patillo 2003) which would require strict, possibly asymmetric central bank arrangements to make monetary union beneficial.
There are a number of scenarios that can play out in the CFA zone in the near future, one of which is to end the fixed parity with the euro. When this occurs, will France be willing or able to guarantee the convertibility of the CFA franc without fixed parity? And will the CFA zone continue to exist, or will monetary integration and cooperation end.
Given that many regions in Africa are contemplating to create their monetary unions, the OCA studies in Africa should focus on designing an OCA index along the lines of Celestin (p. 129) Monga (1997) to evaluate the economic outcome of entering a monetary zone. Such a framework would enable a systematic analysis of the suitability of Africa and its regions to enter into a currency union.
Abdih, Y., and Tsangarides, C.G. (2006). FEER for the CFA Franc. IMF Working Paper WP/06/236.Find this resource:
Allechi, M., and Niamkey, M.A. (1994). Evaluating the net gains from the CFA franc zone membership: A different perspective. World Development, 22(8):1147–1160.Find this resource:
Boughton, J.M. (1992). The CFA Franc: Zone of fragile Stability in Africa. Finance and Development, 29(4):34–36.Find this resource:
Clément, Jean A. P. (1994) Striving for stability: CFA franc realignment. Finance and Development, 31(2):10–13.Find this resource:
Crockett, A.D., and Nsouli, S.M. (1977). Exchange rate policies for developing countries. Journal of Development Studies, 13(2):125–143.Find this resource:
Corden, W.M. (1993). Exchange rate policies for developing countries. Economic Journal, 103(416):198–207.Find this resource:
Devarajan, S., and de Melo, J. (1987). Evaluating Participation in African Monetary Union: A Statistical Analysis of the CFA Zones. World Development, 15(4):483–496.Find this resource:
Dornbusch, R. (1988). Overvaluation and trade balance, in D. Rudiger, F. Leslie, and C.H. Helmers (eds), The Open Economy: Tools for Policymakers in Developing Countries. New York: Oxford University Press for the World Bank.Find this resource:
Edwards, S. (1994). Exchange rate Misalignment in Developing Countries, in R.C. Barth and W. Chorng-Huey Wong (eds), Approaches to Exchange Rate Policy: Choices for Developing and Transition Economies. Washington, DC: International Monetary Fund.Find this resource:
Elbadawi, I., and Majd, N. (1996). Adjustment and economic performance under a fixed exchange rate: a comparative analysis of the CFA zone. World Development, 24(5):939–951.Find this resource:
Gulde, A.M., and Tsangarides, C. (2008) The CFA Franc Zone: Common Currency, Uncommon Challenges. Washington, DC: IMF.Find this resource:
Masson, P., and Pattillo, C. (2003). The Monetary Geography of Africa. Washington, DC: Brookings Institution.Find this resource:
Monga, C. (1997). Currency reform for Western and Central Africa. World Economy 20(1):103–126.Find this resource:
Monga, C., and Tchatchouang, J.C. (1996). Sortir du Piège Monétaire. Paris: Economica.Find this resource:
Mundell, R.A. (1961). A theory of optimum currency areas. American Economic Review, 51(2):657–665.Find this resource:
Sala-i-Martin, X., and Sachs, J. (1992). “Fiscal federalism and optimum currency areas: Evidence for Europe from the United States, in: M. Canzoneri, V. Grilli, and P. Masson (eds) Establishing a Central Bank: Issues in Europe and Lessons from the U.S. Cambridge: Cambridge University Press.Find this resource:
Van de Walle, N. (1991). The decline of the franc zone: monetary policies in francophone Africa. African Affairs, 90:383–405.Find this resource:
Williamson, J. (1991). Advice on the choice of an exchange rate policy, in E. M. Classen (ed.), “Exchange rate policies in developing and post socialist countries”. San Francisco: International Centre for Economic Growth and ICS Press.Find this resource:
Williamson, J. (1993). Exchange rate management. Economic Journal, 103(416):188–197.Find this resource:
(1) The CFA franc was created on 26 December 1945, along with the CFP franc. The reason for their creation was the weakness of the French franc immediately after World War II. When France ratified the Bretton Woods Agreement in December 1945, the French franc was devalued in order to set a fixed exchange rate with the US dollar. New currencies were created in the French colonies to spare them the strong devaluation, thereby facilitating exports to France. French officials presented the decision as an act of generosity.
(2) See Ibrahim Edbadawi and Nader Madj (1992), Fixed parity of the Exchange rate and economic performance: a comparative study, World bank Policy research working Papers, 1992; Aloysius Ajab Amin (2000), Long term Growth in the CFA countries, World Institute for Development Economic Research, August 2000; Issiaka coulibaly and Junior Davis (2013), Exchange rate regimes and economic performance: Does the CFA zone membership benefit their economies? MPRA Paper N0 54075.
(4) The legal basis for the changeover was provided by Article 109(5) of the Treaty of Maastricht. This documents the sovereign right of EMU participant states to negotiate in international bodies with non-EMU counties on economic and monetary matters and to enter into treaties with them.
(5) Data from the Africa Development Indicators 2012/2013.
(6) Data from WAEMU and CAEMC annual reports.
(7) It should be noted here, even in just a footnote, that one can find at least five definitions of the REER in the literature. See Célestin Monga’s chapter on the economics of African monetary unions in this Handbook.
(8) See World Bank (The Berg Report) (1981), Accelerated Development in Sub-Saharan Africa, Washington, DC.
(9) After France joined the Euro Zone at a fixed rate of 6.65957 French francs to one euro, the CFA rate to the euro was fixed at CFA 665.957 to each euro, maintaining the 100 to 1 ratio.