## Toward a Monetary Union in the East African Community: Asymmetric Shocks, Exchange Rates, and Risk-Sharing Mechanisms (_afr1506)

## Source details

**Canonical URL:** [Toward a Monetary Union in the East African Community: Asymmetric Shocks, Exchange Rates, and Risk-Sharing Mechanisms (_afr1506)](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/dp/2015/_afr1506.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/dp/2015/_afr1506.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/dp/2015/_afr1506.pdf.json)

---

### Overview
- In late 2013 the East African Community (EAC) countries (Burundi, Kenya, Rwanda, Tanzania, and Uganda) signed a joint protocol setting out the process and convergence criteria for an EAC monetary union.
- Protocols preceding monetary union: customs union (2005) and common market (2010).
- Envisaged introduction of a common currency to replace national currencies in 2024.
- Institutional framework to monitor and enforce convergence includes:
  - East African Monetary Institute—to be set up by 2015, as a precursor to the East African Central Bank
  - East African Statistics Bureau
  - East African Surveillance, Compliance and Enforcement Commission
- Objectives:
  - Identify susceptibility of EAC economies to asymmetric shocks
  - Assess exchange rate’s role as a shock absorber
  - Review adjustment mechanisms to support a common currency

### Key findings on susceptibility to asymmetric shocks
- Country-specific shocks have been prevalent in the last two decades; EAC economies remain susceptible to asymmetric shocks.
- Limited synchronicity of growth rates across countries and limited economic convergence in the last decade.
- Cluster analysis from an optimal currency area perspective: dissimilarities across the five EAC economies remain large.
- Exchange rates absorb real asymmetric shocks in all EAC countries except Burundi.
- Exchange-rate shocks:
  - Do not seem materially to affect output
  - Are a source of disturbance to inflation, implying the need to modernize monetary policy frameworks
- Policy implication: Additional tools to stabilize economies will be needed once national exchange rates are relinquished.

### Stylized facts and selected statistics (as presented)
- GDP growth (average 2009–13, %):
  - Burundi 4.3; Kenya 5.8; Rwanda 6.7; Tanzania 6.7; Uganda 5.0; EAC (weighted PPP) 6.0; EAC (simple average) 5.7
- GDP growth volatility (standard deviation, 2009–13, %):
  - Burundi 0.5; Kenya 2.4; Rwanda 1.1; Tanzania 0.4; Uganda 1.5; EAC (weighted) 1.4; EAC (simple) 1.2
- Agriculture value added (% of GDP):
  - Burundi 34.7; Kenya 27.1; Rwanda 33.0; Tanzania 27.6; Uganda 23.4; EAC (weighted) 27.0; EAC (simple) 29.1
- Annual CPI inflation (average 2009–13, %):
  - Burundi 8.9; Kenya 8.8; Rwanda 5.7; Tanzania 11.2; Uganda 11.0; EAC (weighted) 9.9; EAC (simple) 9.1
- CPI inflation volatility (standard deviation, 2009–13, %):
  - Burundi 4.6; Kenya 3.9; Rwanda 3.1; Tanzania 3.7; Uganda 6.3; EAC (weighted) 4.3; EAC (simple) 4.3
- Export diversification index (2010):
  - Burundi 4.0; Kenya 2.5; Rwanda 4.0; Tanzania 2.6; Uganda 2.3; EAC (weighted) 2.6; EAC (simple) 3.1
- Trade openness (% of GDP):
  - Burundi 40.2; Kenya 49.3; Rwanda 50.6; Tanzania 66.5; Uganda 51.1; EAC (weighted) 55.4; EAC (simple) 51.5
- Trade linkages (% of total trade, average 2009–13):
  - Burundi 18.8; Kenya 8.7; Rwanda 30.4; Tanzania 6.6; Uganda 22.0; EAC (weighted) 12.7; EAC (simple) 17.3
- Internal and external balances:
  - Overall fiscal balance (% of GDP): Burundi –1.7; Kenya –5.7; Rwanda –4.5; Tanzania –4.0; Uganda –4.1; EAC (weighted) –4.6; EAC (simple) –4.0
  - Current account (% of GDP): Burundi –20.7; Kenya –8.7; Rwanda –7.1; Tanzania –13.8; Uganda –8.5; EAC (weighted) –10.6; EAC (simple) –11.8
- International reserves (months of imports):
  - Burundi 3.4; Kenya 4.1; Rwanda 4.4; Tanzania 3.7; Uganda 4.2; EAC (weighted) 4.0; EAC (simple) 4.0
- GDP PPP Weight (%, 2013):
  - Burundi 2.4; Kenya 34.0; Rwanda 6.9; Tanzania 33.6; Uganda 23.1
- Regional growth (average 2009–13): ~6 percent (range across countries 4 to 7 percent)
- Growth volatility and inflation patterns: High growth volatility across EAC; average inflation during 2009–13 slightly below double digits with country variation from about 6 percent in Rwanda to about 11 percent in Tanzania and Uganda.

### Nature and drivers of shocks (1990–2013)
- Country-specific growth shocks frequent and substantial (identified via residuals from quarterly regressions with eight lags and synthetic EAC-area exclusions).
- Major drivers:
  - Political instability/conflict (notably Rwanda)
  - Terms of trade shocks
  - Aid flow disruptions
  - Supply fluctuations and droughts (Kenya, Tanzania, Uganda)
- Country-specific examples:
  - Burundi: growth shocks coincide more with regional shocks
  - Kenya: droughts in 1997, 2007, and 2011; aid flow disruptions during 1995–99
  - Rwanda: frequent high-magnitude shocks reflecting the mid-1990s genocide and subsequent rebound
  - Tanzania: terms of trade shocks in early 1990s and early 2000s; droughts affecting agriculture and energy
  - Uganda: single large negative shock in early 1990s related to terms of trade; East Africa drought impacted more recently

### Exchange rate role and empirical insights
- Main empirical conclusion: EAC exchange rates mostly absorb real asymmetric shocks, with the exception of Burundi.
- Empirical results indicate:
  - Exchange-rate shocks do not materially affect output
  - Exchange-rate shocks disturb inflation dynamics
- Policy implication: modernize monetary policy frameworks and develop non-exchange-rate adjustment mechanisms prior to relinquishing national exchange rates.

### Methodology and empirical specifications
- Identification: Structural VAR (SVAR) with endogenous variables: change in log output; foreign nominal interest rate; domestic nominal interest rate; change in log prices; change in log nominal exchange rate (foreign currency units per domestic currency; increase = domestic appreciation).
- Data and measures: output = GDP; nominal interest rate = three-month Treasury bill rate (90- or 91-day T-bill) except U.S. federal funds rate for United States; prices = CPI; quarterly seasonally adjusted data; variables in first differences of logs.
- Identification assumptions: supply shock = only shock with permanent effect on output (Blanchard and Quah, 1989); foreign monetary policy shock treated as exogenous contemporaneously.
- Distinction between domestic monetary policy and exchange-rate shock: follows Smets (1997) by estimating weight ߱ central banks place on the exchange rate when setting policy; ߱ estimated via non-linear GMM (Hansen 1982). Extreme cases: ߱ = 0 (pure interest rate targeting); ߱ = 1 (pure exchange-rate targeting).

### Empirical results: impulse responses, variance decompositions, and robustness
- Exchange rate as absorber of real shocks:
  - Burundi: nominal exchange rate does not react to supply or demand shocks.
  - Kenya: appreciation after positive supply shock; depreciation after positive demand shock; supply and demand shocks account for about 80 percent of exchange rate forecast error variance up to five years.
  - Rwanda: similar tendency to Kenya with lower initial share and higher share at longer horizons.
  - Tanzania and Uganda: similar tendencies though responses are borderline significant; supply and demand shocks account for a material share at longer horizons.
- Exchange-rate shocks:
  - Kenya and Rwanda: low persistence; do not elicit strong exchange-rate own persistence.
  - Burundi, Tanzania, Uganda: exchange rates vulnerable to their own shocks to varying degrees.
  - Across countries: exchange-rate shock has little-or-no effect on output; Tanzania is a possible exception where exchange-rate shock accounts for at most 12.25 percent of output forecast error variance.
  - Exchange-rate shocks generally have a significant impact on prices.
- Robustness and sensitivity:
  - Baseline analysis sets ߱ to zero for all countries except Burundi (with United States as foreign country).
  - Sensitivity analyses with ߱ set to 0.5 and to 0.75 yielded qualitatively very similar results; overall conclusions unchanged.

### Empirical specifications and key estimates
- Country sample periods used:
  - Burundi 1988:Q2 – 2012:Q4
  - Kenya 1980:Q1 – 2013:Q3
  - Rwanda 2001:Q3 – 2012:Q4
  - Tanzania 1993:Q4 – 2013:Q4
  - Uganda 1980:Q1 – 2013:Q4
- Lag lengths selected (AIC and likelihood ratio tests) — Lags included (Foreign Country: USA / Foreign Country: Kenya):
  - Burundi 3 / 3
  - Kenya 4 / -
  - Rwanda 2 / 1
  - Tanzania 7 / 4
  - Uganda 7 / 4
- Estimates of ߱ (using full samples; standard errors in brackets):
  - Burundi 0.10*** (0.02) and ‒0.04 (0.03) (Foreign country: US; Foreign country: Kenya)
  - Kenya 0.34 (0.84) (Foreign country: US)
  - Rwanda 0.31 (0.71) and ‒0.17 (0.05) (Foreign country: US; Foreign country: Kenya)
  - Tanzania 0.05 (0.23) and 0.05 (0.08)
  - Uganda 0.14 (0.09) and 0.10 (0.26)
- Interpretation:
  - Only Burundi has a statistically significant coefficient in the full-sample estimates reported.
  - Excluding post-2007 observations increased Kenya’s estimate to a significant 0.7 for ߱.
  - Significance notation: */**/*** denote significance at the 10%/5%/1% levels, respectively.

### Output drops, growth decelerations, and synchronization (1990–2013)
- Output Drops (Burundi, Kenya, Rwanda, Tanzania, Uganda):
  - Frequency (in % of country years): Burundi 11.3%; Kenya 1.4%; Rwanda 4.3%; Tanzania 3.4%; Uganda 1.5%
  - Duration (in years): Burundi 16.3; Kenya 2.0; Rwanda 6.3; Tanzania 5.0; Uganda 2.3
  - Average annual output loss (in % of pre-event GDP): Burundi 14.6%; Kenya 0.7%; Rwanda 46.1%; Tanzania 13.9%; Uganda 8.9%
- Growth Deceleration (episodes and lengths):
  - Episodes of growth deceleration: Burundi 2; Kenya 3; Rwanda 2; Tanzania 4; Uganda 2
  - Average length (in years): Burundi 3.5; Kenya 2.2; Rwanda 2.4; Tanzania 1.9; Uganda 1.5
  - 30th growth rate percentile: Burundi 0.9%; Kenya 2.4%; Rwanda 3.2%; Tanzania 2.5%; Uganda 6.0%
- Dispersion of growth rates:
  - Declined from about 7 percent in 2003 to 4 percent in 2013, indicating convergence in the last decade.
- Cross-country correlations:
  - Correlations between a country and the synthetic EAC economy excluding the same country are close to zero, especially in the later period.
  - Rwanda–Uganda pair shows relatively strong positive correlation.
  - Some country pairs moved from negative correlation in 1990–99 to positive correlation in 2000–13; half of bilateral correlations show no significant change.

### Risk-sharing mechanisms and adjustment levers (policy recommendations)
- Key levers to mitigate costs of a common monetary policy:
  - Labor mobility
  - Capital mobility
  - Price flexibility
  - Wage flexibility
  - Fiscal risk-sharing mechanisms and the ability to use fiscal policy counter cyclically
- Recommended policy actions before introducing a single currency:
  - Agree on and implement mechanisms to adjust to shocks before introducing the single currency to reduce risks and signal commitment to macroeconomic stability.
  - Continue modernization of monetary policy frameworks to better manage inflationary disturbances from exchange-rate shocks.
  - Strengthen trade facilitation, harmonize standards, and reduce non-tariff barriers to deepen market integration and increase intra-EAC trade linkages.
- Institutional/policy instruments discussed:
  - Inter-governmental fiscal transfers to counteract adverse asymmetric shocks.
  - Supra-national EAC bonds (facility similar to European Financial Stability Facility).
  - Creation of an EAC fiscal stabilization fund (rainy-day fund) financed by initial member contributions and replenished as output recovers.
    - Comparative estimates: EU ex-ante support via 1½ to 2½ percent of GNP annual contributions could smooth 80 percent of regional income shocks; WAEMU estimate of about 1–1¼ percent of GDP contribution needed to insure against severe downturns.
  - Formation of a banking union with common bank-resolution framework, resolution fund, and common backstop (credit line from EAC central bank and pooled fiscal resources).
- Safeguards and fiscal governance to mitigate moral hazard and free-riding:
  - Options range from self-imposed budget constraints and strong market discipline with no bailout (Canada, United States), to coordination and centralization of fiscal governance (Fiscal Compact in EU), to intermediary intergovernmental coordination (Australia, Belgium) or direct democracy mechanisms (Switzerland).
- Limitations on insurance-style mechanisms:
  - An EAMU unemployment insurance fund is infeasible currently given low formal employment shares:
    - Formal employment: Kenya 17 percent (2013); Uganda 14 percent (2009); Tanzania <10 percent (2009)

### Natural resource discoveries and forward-looking risks
- Potential to alter member-country positions in external balances and create asymmetric policy preferences:
  - Kenya: estimated reserves above 600 millions of barrels of oil equivalent; potential to become self-sufficient in 3–5 years and a net exporter in 5–10 years.
  - Tanzania: recoverable deep offshore gas resources estimated at least 24–26 trillion cubic feet; large-scale LNG project decision may be delayed until 2016 with production no earlier than 2020.
  - Uganda: current reserves estimated at 3.5 billion barrels, placing Uganda among the 30 largest reserves globally and fourth in sub-Saharan Africa.
- These developments could increase export concentration in resource-rich members and create divergent policy preferences (e.g., looser monetary policy during low global oil/gas prices).

### Conclusions and policy priorities
- EAC economies face prevalent country-specific shocks and limited growth synchronicity, implying notable susceptibility to asymmetric shocks.
- Exchange rates have been important shock absorbers in most EAC countries; loss of national exchange rates under a monetary union will heighten the importance of other adjustment mechanisms.
- Priority actions before introducing a single currency:
  - Establish labor and capital mobility
  - Enhance price and wage flexibility
  - Develop fiscal risk-sharing mechanisms
  - Modernize monetary frameworks (press ahead toward inflation targeting)
  - Implement EAC Customs Union and Common Market protocols and harmonize financial regulation and supervision

*International Monetary Fund. African Departmental Paper: Toward a Monetary Union in the East African Community: Asymmetric Shocks, Exchange Rates, and Risk-Sharing Mechanisms.*

### 1. East African Community. 2. East African Monetary Union 3. Currency unions 5. Exchange

### Toward a Monetary Union in the East African Community: Asymmetric Shocks, Exchange Rates, and Risk-Sharing Mechanisms

### Overview
- In late 2013 the East African Community (EAC) countries (Burundi, Kenya, Rwanda, Tanzania, and Uganda) signed a joint protocol setting out the process and convergence criteria for an EAC monetary union.
- The protocol follows earlier protocols for a customs union (2005) and the common market (2010).
- Envisaged in 2024 is the introduction of a common currency to replace the national currencies of member countries.
- Institutional framework to monitor and enforce convergence includes:
  - East African Monetary Institute—to be set up by 2015, as a precursor to the East African Central Bank
  - East African Statistics Bureau
  - East African Surveillance, Compliance and Enforcement Commission
- Objectives of the paper:
  - Identify how susceptible EAC economies are to asymmetric shocks
  - Assess the exchange rate’s role as a shock absorber
  - Review adjustment mechanisms to help ensure success under a common currency

### Key findings on susceptibility to asymmetric shocks
- Despite some similarities in economic structures, country-specific shocks have been prevalent in the last two decades; EAC economies remain susceptible to asymmetric shocks.
- Evidence indicates limited synchronicity of growth rates across countries and limited economic convergence in the last decade.
- Cluster analysis suggests from an optimal currency area perspective that dissimilarities across the five EAC economies remain large.
- Exchange rates absorb real asymmetric shocks in all EAC countries except Burundi.
- Exchange rate shocks:
  - Do not seem materially to affect output
  - Are a source of disturbance to inflation, implying the need to modernize monetary policy frameworks
- Policy implication: Additional tools to stabilize economies will be needed once national exchange rates are relinquished.

### Stylized facts and selected statistics (as presented)
- GDP growth (average 2009–13, %): Burundi 4.3; Kenya 5.8; Rwanda 6.7; Tanzania 6.7; Uganda 5.0; EAC (weighted PPP) 6.0; EAC (simple average) 5.7
- GDP growth volatility (standard deviation, 2009–13, %): Burundi 0.5; Kenya 2.4; Rwanda 1.1; Tanzania 0.4; Uganda 1.5; EAC (weighted) 1.4; EAC (simple) 1.2
- Agriculture value added (% of GDP): Burundi 34.7; Kenya 27.1; Rwanda 33.0; Tanzania 27.6; Uganda 23.4; EAC (weighted) 27.0; EAC (simple) 29.1
- Annual CPI inflation (average 2009–13, %): Burundi 8.9; Kenya 8.8; Rwanda 5.7; Tanzania 11.2; Uganda 11.0; EAC (weighted) 9.9; EAC (simple) 9.1
- CPI inflation volatility (standard deviation, 2009–13, %): Burundi 4.6; Kenya 3.9; Rwanda 3.1; Tanzania 3.7; Uganda 6.3; EAC (weighted) 4.3; EAC (simple) 4.3
- Export diversification index (2010): Burundi 4.0; Kenya 2.5; Rwanda 4.0; Tanzania 2.6; Uganda 2.3; EAC (weighted) 2.6; EAC (simple) 3.1
- Trade openness (% of GDP): Burundi 40.2; Kenya 49.3; Rwanda 50.6; Tanzania 66.5; Uganda 51.1; EAC (weighted) 55.4; EAC (simple) 51.5
- Trade linkages (% of total trade, average 2009–13): Burundi 18.8; Kenya 8.7; Rwanda 30.4; Tanzania 6.6; Uganda 22.0; EAC (weighted) 12.7; EAC (simple) 17.3
- Internal and external balances:
  - Overall fiscal balance (% of GDP): Burundi –1.7; Kenya –5.7; Rwanda –4.5; Tanzania –4.0; Uganda –4.1; EAC (weighted) –4.6; EAC (simple) –4.0
  - Current account (% of GDP): Burundi –20.7; Kenya –8.7; Rwanda –7.1; Tanzania –13.8; Uganda –8.5; EAC (weighted) –10.6; EAC (simple) –11.8
- International reserves (months of imports): Burundi 3.4; Kenya 4.1; Rwanda 4.4; Tanzania 3.7; Uganda 4.2; EAC (weighted) 4.0; EAC (simple) 4.0
- GDP PPP Weight (%, 2013): Burundi 2.4; Kenya 34.0; Rwanda 6.9; Tanzania 33.6; Uganda 23.1
- Regional growth (average 2009–13): ~6 percent (range across countries 4 to 7 percent)
- Growth volatility and inflation patterns: High growth volatility across EAC; average inflation during 2009–13 slightly below double digits with country variation from about 6 percent in Rwanda to about 11 percent in Tanzania and Uganda.

### Nature and drivers of shocks in the EAC (1990–2013)
- Country-specific growth shocks frequent and substantial across 1990–2013, identified via residuals from quarterly regressions with eight lags and synthetic EAC-area exclusions.
- Major shock drivers:
  - Political instability/conflict (notably Rwanda)
  - Terms of trade shocks
  - Aid flow disruptions
  - Supply fluctuations and droughts (Kenya, Tanzania, Uganda)
- Country-specific examples:
  - Burundi: growth shocks coincide more with regional shocks
  - Kenya: droughts in 1997, 2007, and 2011; aid flow disruptions during 1995–99
  - Rwanda: frequent high-magnitude shocks reflecting the mid-1990s genocide and subsequent rebound
  - Tanzania: terms of trade shocks in early 1990s and early 2000s; droughts affecting agriculture and energy
  - Uganda: single large negative shock in early 1990s related to terms of trade; East Africa drought impacted more recently

### Exchange rate role and empirical insights
- Exchange rates in EAC countries absorb real asymmetric shocks in all countries except Burundi.
- Empirical results indicate:
  - Exchange-rate shocks do not materially affect output
  - Exchange-rate shocks disturb inflation dynamics
- Policy implication: need to modernize monetary policy frameworks and develop non-exchange-rate adjustment mechanisms prior to relinquishing national exchange rates.

### Risk-sharing mechanisms and adjustment levers (policy recommendations)
- Key levers to mitigate costs of a common monetary policy include:
  - Labor mobility
  - Capital mobility
  - Price and wage flexibility
  - Fiscal risk-sharing mechanisms and the ability to use fiscal policy counter cyclically
- Recommendations:
  - Agree on and implement mechanisms to adjust to shocks before introducing the single currency to reduce risks and signal commitment to macroeconomic stability
  - Continue modernization of monetary policy frameworks to better manage inflationary disturbances from exchange-rate shocks
  - Strengthen trade facilitation, harmonize standards, and reduce non-tariff barriers to deepen market integration and increase intra-EAC trade linkages

### Additional considerations and forward-looking risks
- Natural resource discoveries (Box 1) — potential to alter member-country positions in external balances and create asymmetric preferences for monetary policy:
  - Kenya: estimated reserves above 600 millions of barrels of oil equivalent; potential to become self-sufficient in 3–5 years and a net exporter in 5–10 years.
  - Tanzania: recoverable deep offshore gas resources estimated at least 24–26 trillion cubic feet; large-scale LNG project decision may be delayed until 2016 with production no earlier than 2020.
  - Uganda: current reserves estimated at 3.5 billion barrels, placing Uganda among the 30 largest reserves globally and fourth in sub-Saharan Africa.
- These developments could increase export concentration in resource-rich members and create divergent policy preferences (e.g., looser monetary policy during low global oil/gas prices).

### Conclusions (as summarized)
- EAC economies face prevalent country-specific shocks and limited growth synchronicity, implying notable susceptibility to asymmetric shocks.
- Exchange rates have been important shock absorbers in most EAC countries, but their loss under monetary union will heighten the importance of other adjustment mechanisms.
- Prioritizing the establishment of labor and capital mobility, price and wage flexibility, fiscal risk-sharing, and modern monetary frameworks is essential before introducing a single currency.

*International Monetary Fund. African Departmental Paper: Toward a Monetary Union in the East African Community: Asymmetric Shocks, Exchange Rates, and Risk-Sharing Mechanisms.*

### 2.6 episodes in the region. The length of the event varies from 1.5 years in Uganda to 3.5 years

### _afr1506 - 2.6 episodes in the region. The length of the event varies from 1.5 years in Uganda to 3.5 years

### Output Drops and Growth Decelerations (1990–2013)
- Table 2: Output Drops (Burundi, Kenya, Rwanda, Tanzania, Uganda)
  - Frequency (in % of country years): Burundi 11.3%; Kenya 1.4%; Rwanda 4.3%; Tanzania 3.4%; Uganda 1.5%
  - Duration (in years): Burundi 16.3; Kenya 2.0; Rwanda 6.3; Tanzania 5.0; Uganda 2.3
  - Average annual output loss (in % of pre-event GDP): Burundi 14.6%; Kenya 0.7%; Rwanda 46.1%; Tanzania 13.9%; Uganda 8.9%
- Growth Deceleration (episodes and lengths)
  - Episodes of growth deceleration: Burundi 2; Kenya 3; Rwanda 2; Tanzania 4; Uganda 2
  - Average length (in years): Burundi 3.5; Kenya 2.2; Rwanda 2.4; Tanzania 1.9; Uganda 1.5
  - 30th growth rate percentile: Burundi 0.9%; Kenya 2.4%; Rwanda 3.2%; Tanzania 2.5%; Uganda 6.0%

### Dispersion of Growth Rates and Cross-Country Correlations
- Growth dispersion evolution
  - Dispersion declined from about 7 percent in 2003 to 4 percent in 2013, indicating convergence in the last decade.
- Cross-country correlations (1990–99 vs 2000–13)
  - Correlations between a country and the synthetic EAC economy excluding the same country are close to zero, especially in the later period.
  - Rwanda–Uganda pair shows a relatively strong positive correlation.
  - Burundi–Kenya, Tanzania–Uganda, and Burundi–Tanzania moved from negative correlation in 1990–99 to positive correlation in 2000–13.
  - Half of the bilateral country correlations show no significant change, indicating persistence of asymmetric shocks and policies.
- Conclusion: Evidence suggests a moderate increase in business cycle synchronization in the EAC in recent years.

### Clustering Based on Principal Component Analysis (1990–2013)
- Method and indicators
  - Principal component analysis applied to annual data using four indicators from the optimal currency area literature: business cycle synchronization, regional trade intensity, trade openness, and real exchange rate volatility.
  - Sample partitioned into 1990–99 and 2000–13; 22 low-income SSA countries (non-oil exporters) included (list of countries provided in source).
- Findings
  - Significant and persistent heterogeneity among EAC economies despite some grouping patterns.
  - Burundi, Rwanda, and Uganda tend to belong to the same group in both periods.
  - Overall level of dissimilarities between the five EAC economies remains large.
- Summary: Despite some similarities, EAC economies remain heterogeneous, though overall dispersion of growth rates declined in the last decade.

### Does the Exchange Rate Cause or Absorb Shocks in the EAC?
- Context
  - Central question: whether nominal exchange rates in the EAC tend to absorb shocks or cause fluctuations in output — key consideration for joining a currency union.
- Main empirical conclusion
  - EAC exchange rates mostly absorb real asymmetric shocks, with the exception of Burundi.
  - Exchange-rate shocks do not seem to materially affect output but are a source of disturbances to inflation.
  - Policy implication: need to modernize monetary policy frameworks to better anchor inflation expectations before a currency union is established.

### Methodology (Structural VAR and Identification)
- Endogenous variables in SVAR vector: change in log output; foreign nominal interest rate; domestic nominal interest rate; change in log prices; change in log nominal exchange rate (foreign currency units per domestic currency; increase = domestic appreciation).
- Data and measures
  - Output: GDP; nominal interest rate: three-month Treasury bill rate (90- or 91-day T-bill) except U.S. federal funds rate for United States; prices: CPI; quarterly seasonally adjusted data; variables in first differences of logs correspond to quarter-over-quarter growth rates.
  - Included linear trend and oil price shocks (exogenous).
- Identification strategy
  - Supply shock identified as only shock with permanent effect on output (Blanchard and Quah, 1989).
  - Demand and supply shocks affect output contemporaneously; nominal shocks affect output with lag.
  - Foreign monetary policy shock: foreign interest rate does not react contemporaneously to domestic monetary policy shocks or to the bilateral exchange rate.
  - Distinction between domestic monetary policy and exchange-rate shock follows Smets (1997) by estimating weight ߱ central banks place on the exchange rate when setting policy; ߱ estimated via non-linear GMM with instruments (Hansen 1982).
  - Extreme cases: ߱ = 0 corresponds to pure interest rate targeting; ߱ = 1 corresponds to pure exchange-rate targeting.

### Empirical Results: Impulse Responses and Variance Decompositions
- Theoretical predicted responses summarized (supply, demand, foreign monetary, domestic monetary, exchange-rate shocks) consistent with Mundell-Fleming-Dornbusch framework.
- Supply and demand shocks
  - Real shocks are asymmetric between EAC countries and the United States in most cases.
  - Nominal exchange rate's role as absorber:
    - Burundi: nominal exchange rate does not react to supply or demand shocks.
    - Kenya: appreciation after positive supply shock; depreciation after positive demand shock; supply and demand shocks account for about 80 percent of exchange rate forecast error variance up to five years.
    - Rwanda: similar tendency to Kenya with lower initial share and higher share at longer horizons.
    - Tanzania and Uganda: show similar tendencies though responses are borderline significant; supply and demand shocks account for material share at longer horizons.
  - Overall: exchange rate acts as absorber of real shocks in EAC countries except Burundi.
- Exchange-rate shocks
  - Kenya and Rwanda: exchange rate shocks display low persistence and do not elicit strong exchange-rate own persistence.
  - Burundi, Tanzania, Uganda: exchange rates vulnerable to their own shocks to varying degrees.
  - Across countries: exchange-rate shock consistently has little-or-no effect on output; Tanzania is a possible exception where exchange-rate shock accounts for at most 12.25 percent of output forecast error variance.
  - Exchange-rate shocks generally have a significant impact on prices, indicating exchange rate as a source of inflation disturbances.
- Policy implication reiterated: need additional stabilization tools (labor mobility, institutional risk sharing) and modernization of monetary policy (press ahead toward inflation targeting).

### Risk Sharing and Mechanisms to Mitigate Shocks (Policy Options and Institutional Preconditions)
- Stylized facts motivating mechanisms
  - Wide prevalence of asymmetric shocks among EAC members.
  - Exchange rate pivotal for adjustment; loss of national exchange rate requires alternative shock absorbers.
- Preconditions and current integration status
  - Monetary Union Protocol prerequisites: full implementation of EAC Customs Union and Common Market; harmonization and coordination of fiscal, monetary, exchange rate policies; integration of financial systems; adoption of common rules for financial regulation and supervision.
  - Protocol commands partner states to establish mechanisms for managing exogenous economic shocks and to build strong institutions and a well-capitalized East African central bank independent of political influence.
  - Progress: price and wage flexibility generally present; EAC Common Market Protocol aims for free movement of workers and capital and mutual recognition of qualifications. Implementation challenges remain (weak capacity, legal and regulatory gaps, lingering nationalistic tendencies, differences in education systems, cultural and language barriers, disparities in development levels, incomplete harmonization).
- Lessons from other unions
  - WAEMU/CEMAC: positive for macro stability (low inflation) but frequency and asymmetry of shocks remain high; need better fiscal coordination and possible reconsideration of convergence criteria.
  - European crisis: highlighted prevalence of country-specific shocks, wage rigidities, sub-optimal labor mobility, contagion via trade/finance, weak fiscal governance, and need for common backstops and fiscal buffers. Fiscal devaluations are a potential adjustment tool in absence of exchange rate flexibility.
- Policy options for the EAC (to implement before single currency, planned for 2024 per source context)
  - Implementation of EAC Customs Union and Common Market protocols to enhance price and wage flexibility, and labor and capital mobility.
  - Early discussion and adoption of risk-sharing mechanisms:
    - Inter-governmental fiscal transfers to counteract adverse asymmetric shocks and discourage conflicting national fiscal measures.
    - Supra-national EAC bonds (facility similar to European Financial Stability Facility) to provide assistance backed by member guarantees.
    - Creation of an EAC fiscal stabilization fund (rainy-day fund) financed by initial member contributions and replenished as output recovers.
      - Comparative estimates: for the EU, Allard and others (2013) estimate ex-ante support via 1½ to 2½ percent of GNP annual contributions could smooth 80 percent of regional income shocks. For WAEMU, estimate of about 1–1¼ percent of GDP contribution needed to insure against severe downturns (Hitaj and others, 2013).
    - Formation of a banking union with common bank-resolution framework, resolution fund, and common backstop (credit line from EAC central bank and pooled fiscal resources).
  - Safeguards and fiscal governance needed to mitigate moral hazard and free-riding:
    - Options range from self-imposed budget constraints and strong market discipline with no bailout (Canada, United States), to coordination and centralization of fiscal governance (Fiscal Compact in EU), to intermediary intergovernmental coordination (Australia, Belgium) or direct democracy mechanisms (Switzerland).
  - Other considerations
    - An EAMU unemployment insurance fund is infeasible currently due to low formal employment shares (formal employment: Kenya 17 percent (2013); Uganda 14 percent (2009); Tanzania <10 percent (2009)) and data/timeliness and harmonization requirements.

*Sources: IMF, International Financial Statistics; and IMF staff calculations.*

### Conclusions

### _afr1506 - Conclusions

### Susceptibility to asymmetric shocks
- Country-specific shocks have been prevalent in the last two decades; EAC economies remain susceptible to asymmetric shocks.
- Declining dispersion of growth rates across countries suggests only a gradual move toward economic convergence in the last decade.
- Cluster analysis indicates that from an optimal currency area perspective, dissimilarities remain large.
- Backward-looking measures are imperfect for a forward-looking assessment; long-term structural differences may rapidly disappear in the run up to the establishment of the monetary union.
- Asymmetric shocks could be policy-induced rather than exogenous, and loss of policy independence may not always be necessarily costly.

### Role of the exchange rate
- The exchange rates appear to absorb real asymmetric shocks in all cases save that of Burundi, highlighting the need for additional tools to stabilize the EAC economies once country-specific (nominal) exchange rates are no longer available as shock absorbers.
- Exchange-rate shocks do not seem materially to affect output but are a source of disturbances to inflation.
- This suggests EAC countries should press ahead to modernize their monetary policy frameworks.

### Empirical specifications and key estimates
- Country sample periods used:
  - Burundi 1988:Q2 – 2012:Q4
  - Kenya 1980:Q1 – 2013:Q3
  - Rwanda 2001:Q3 – 2012:Q4
  - Tanzania 1993:Q4 – 2013:Q4
  - Uganda 1980:Q1 – 2013:Q4
- Lag lengths selected (AIC and likelihood ratio tests) — Lags included (Foreign Country: USA / Foreign Country: Kenya):
  - Burundi 3 / 3
  - Kenya 4 / -
  - Rwanda 2 / 1
  - Tanzania 7 / 4
  - Uganda 7 / 4
- Estimates of  (using full samples; standard errors in brackets):
  - Burundi 0.10*** (0.02) and ‒0.04 (0.03) (Foreign country: US; Foreign country: Kenya)
  - Kenya 0.34 (0.84) (Foreign country: US)
  - Rwanda 0.31 (0.71) and ‒0.17 (0.05) (Foreign country: US; Foreign country: Kenya)
  - Tanzania 0.05 (0.23) and 0.05 (0.08)
  - Uganda 0.14 (0.09) and 0.10 (0.26)
- Interpretation and robustness:
  - Only Burundi has a statistically significant coefficient in the full-sample estimates reported.
  - Excluding post-2007 observations increased Kenya’s estimate to a significant 0.7 for .
  - Baseline analysis sets  to zero for all countries except Burundi (in the case with the United States as the foreign country).
  - Sensitivity analyses with  set to 0.5 and to 0.75 yielded qualitatively very similar results; overall conclusions remained unchanged.
- Significance notation used: */**/*** denote significance at the 10%/5%/1% levels, respectively.

### Adjustment mechanisms and policy recommendations for the monetary union
- Member countries should design and put in place adequate mechanisms to adjust to future shocks once the Monetary Union is consolidated.
- Key levers to mitigate costs of a common monetary policy include:
  - Labor mobility
  - Capital mobility
  - Price flexibility
  - Wage flexibility
  - Various risk-sharing mechanisms, including fiscal
- These levers should be agreed among member countries before the introduction of the single currency to reduce risks and signal early commitment to macroeconomic stability.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/dp/2015/_afr1506.pdf*

### References

### References

### Exchange rate dynamics and shock analysis
- Artis, M.J., and Ehrmann, M., 2000, “The Exchange Rate – A Shock-Absorber or Source of Shocks? A Study of Four Open Economies,” EUI Working Paper No. 2000/38, Florence: European University Institute. 
- ———, 2006, “The Exchange Rate – A Shock-Absorber or Source of Shocks? A Study of Four Open Economies.” Journal of International Money and Finance 25(6): 874–93. 
- Becker, T., and Maouro, P., 2006, “Output Drops and the Shocks that Matter,” IMF Working Paper 06/172, Washington: International Monetary Fund. 
- Blanchard, O.J., and Quah, D., 1989. “The Dynamic Effects of Aggregate Demand and Supply Disturbances.” American Economic Review 79(4): 655–73. 
- Clarida, R., and Galí, J., 1994, “Sources of Real Exchange Rate Fluctuations: How Important Are Nominal Shocks?” NBER Working Paper No. 4658, Cambridge, Massachusetts: National Bureau of Economic Research. 
- Frenkel, M., and Nickel, C., 2002, “How Symmetric Are the Shocks and the Shocks Adjustment Dynamics Between the Euro Area and Central Eastern European Countries?” IMF Working Paper 02/222, Washington: International Monetary Fund. 
- Gauthier C., and Tessier D., 2002, “Supply Shocks and Real Exchange Rate Dynamics: Canadian Evidence,” Bank of Canada Working Paper 2002-31, Ottawa. 
- Gulde, A., 2008, "Overview." In The CFA Franc Zone: Common Currency, Uncommon Challenges. A. Gulde and C. Tsangarides (eds.) Washington: International Monetary Fund. 
- Smets, F., 1997, “Measuring Monetary Policy Shocks in France, Germany, and Italy: the Role of the Exchange Rate.” Swiss Journal of Economics and Statistics 133(3): 597–616. 
- Obstfeld, M., 1985, “Floating Exchange Rates: Experience and Prospects.” Brookings Papers on Economic Activity 2:    369-450 
- Clarida, R., and Galí, J., 1994, “Sources of Real Exchange Rate Fluctuations: How Important Are Nominal Shocks?” NBER Working Paper No. 4658, Cambridge, Massachusetts: National Bureau of Economic Research. 

### Monetary unions, regional integration, and African context
- Debrun, X., Masson P., and Pattillo C., 2010, “Should African Monetary Unions be Expanded? An Empirical Investigation of the Scope for Monetary Integration in Sub-Saharan Africa,” IMF Working Paper 10/157, Washington: International Monetary Fund. 
- Drummond, P., Wajid K., and Williams O. (eds.), 2014, The Quest for Regional Integration in the East African Community, Washington: International Monetary Fund.  
- East African Community (EAC), 2011, EAC Development Strategy (2011/12–2015/16): Deepening and Accelerating Integration, Arusha, Tanzania. 
- —————, 2013, Protocol on the Establishment of the East African Community Monetary Union, Kampala, Uganda. 
- Gulde, A., 2008, "Overview." In The CFA Franc Zone: Common Currency, Uncommon Challenges. A. Gulde and C. Tsangarides (eds.) Washington: International Monetary Fund. 
- Hitaj, E., Kolerus C., Shapiro D., and Zdiziencka A., 2013, “Responding to Shocks and Maintaining Stability in the West African Economic and Monetary Union,” African Departmental Paper No. 13/07, Washington: International Monetary Fund. 
- Qureshi, M., and Tsangarides, C., 2006, “What is Fuzzy About Clustering in West Africa?” IMF Working Paper 06/90, Washington: International Monetary Fund. 
- Saxena, S., 2005, “Can South Asia Adopt a Common Currency?” Journal of Asian Economies 16: 635–62. 
- Slavov, S.T., 2013, “De Jure versus De Facto Exchange Rate Regimes in Sub-Saharan Africa.” Journal of African Economies 22(5): 732–56. 
- van der Ploeg, R., and Wills, S., Forthcoming, "Monetary Union and East Africa's Resource Wealth," World Bank Report. Washington: The World Bank Group. 
- Wills, S., and van der Ploeg, R., 2014, “Monetary Union and East Africa’s Resource Wealth,” Washington: World Bank. 
- Wang, Y. D., 2010, “Measuring Financial Barriers among East African Countries,” IMF Working Paper 10/194, Washington: International Monetary Fund. 

### IMF frameworks, exchange rate classifications, and policy tools
- Allard, C., Brooks, P., Bluedorn, J., Borlhorst, F., Christopherson, K., Ohnsorge, F., Poghosyan, T., 2013, “Toward a Fiscal Union for the Euro Area,” IMF Staff Discussion Note 13/09, Washington: International Monetary Fund. 
- Habermeier, K., Kokenyne, A., Veyrune, R., and Anderson, H., 2009, “Revised System for the Classification of Exchange Rate Arrangements,” IMF Working Paper 09/211, Washington: International Monetary Fund. 
- Ilzetzki, E., Reinhart, C.M., and Rogoff, K.S., 2010, “Exchange Rate Arrangements Entering the 21st Century: Which Anchor Will Hold?” Unpublished. March 15th 2001 version retrieved July 21st 2014 from http://personal.lse.ac.uk/ilzetzki/index.htm/Data.htm. 
- International Monetary Fund (IMF), 2011, Fiscal Monitor, September, Washington. 
- Debrun, X., Masson P., and Pattillo C., 2010, “Should African Monetary Unions be Expanded? An Empirical Investigation of the Scope for Monetary Integration in Sub-Saharan Africa,” IMF Working Paper 10/157, Washington: International Monetary Fund. 

### Methodology, labor markets, and fiscal policy
- Hansen, L.P., 1982, “Large Sample Properties of Generalized Method of Moment Estimators.” Econometrica 50(4): 1029–54. 
- Kingdon, G., Sandefur J., and Teal F., 2006, “Labour Market Flexibility, Wages and Incomes in Sub-Saharan Africa in the 1990s.” African Development Review 18(3): 392–427. 
- de Mooij, R., and Keen, M., 2013, 'Fiscal Devaluation' and Fiscal Consolidation: the VAT in Troubled Times, In Fiscal Policy after the Financial Crisis, A. Alesina and F. Giavazzi (eds.) Chicago: University of Chicago Press, 443–85. 
- Mundell, R.A., 1961, “A Theory of Optimum Currency Areas.” American Economic Review 53: 657–64. 

*Source: _afr1506 - References*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/dp/2015/_afr1506.pdf_