## 1. Monetary and Exchange Regimes

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### Introduction and scope
- Purpose: economic analysis of advantages and disadvantages of maintaining São Tomé and Príncipe’s current monetary and exchange arrangements versus shifting to a system firmly anchored to a hard currency (memberships in monetary unions and hard pegs).
- Empirical focus: whether a small, open, low-income economy could benefit from a firmly anchored currency arrangement and conditions for desirability and feasibility.
- Organization: Section II describes economic characteristics and monetary history; Section III analyzes benefits and costs of alternative regimes; Section IV evaluates appropriateness and sustainability of a hard currency peg or joining a monetary union; final section summarizes findings.

### Key country characteristics relevant to regime choice
- Demographics and structure:
  - Population: about 150,000.
  - Small, open, low-income economy with narrow production and export base; cocoa is the main export commodity.
  - Cocoa exports: less than US$3 million (2 percent of GDP) a year in 2005–06.
  - Tourism: relatively small and brings in little net foreign exchange due to heavy reliance on imported goods and services.
  - Petroleum reserves: exploratory drilling has not yet confirmed commercially extractable reserves.
  - Economy dominated by nontradable activities: government, construction, and other services.
- Openness and trade patterns:
  - Imports of goods and nonfactor services: average 70 percent of GDP.
  - Exports of goods and services: about 20 percent of GDP in 2005–06.
  - Oil: country depends entirely on imported oil for domestic consumption; oil accounted for about 15 percent of total imports in recent years.
  - Trade partners (2006):
    - Exports: Europe accounted for over 75 percent.
    - Imports: Europe accounted for close to 65 percent.
    - Angola: main supplier of oil and provider of oil-related trade financing; Angola and the São Tomé and Príncipe government own the only oil importer and retailer in the country.
- External balances and capital flows:
  - Persistent large imbalances between exports and imports financed mainly by capital inflows: official transfers, external borrowing, and private sector inflows (including large oil signature bonuses in recent years).
- Debt and aid context:
  - Reached completion point under the enhanced HIPC Initiative in March 2007 and benefited from HIPC and MDRI debt relief.
  - Debt repayment capacity remains very limited; maintaining long-term debt sustainability, particularly beyond the year 2014 (sensitive to oil prospects), continues to be a challenge.

### Exchange rate regime history and current mechanism (to 2007)
- Monetary history highlights:
  - Dobra introduced as national currency in 1977.
  - Dobra depreciation against the U.S. dollar: from about Db25 to over Db14,000 over the past three decades.
  - As of December 2007, IMF classification: managed float with no pre-announced path for the exchange rate.
- Major transitions:
  - Pre-independence currency arrangements: use of Portuguese currency (1522–1867); currency board with Banco National Ultramarino (1868–1952); revamped currency board (1953–1975).
  - 1953–1975: fiscal deficits contained; money supply virtually constant; inflation averaged about 2 percent a year.
  - 1977: dobra introduced; initial pegs to Portuguese escudo at par, then to the SDR.
  - 1984–1987: official/parallel spread widened from over 100 percent in 1984 to 400 percent in 1986; 1987 abandonment of SDR peg and 56 percent devaluation; re-peg to basket of nine trading partners.
  - 1991: crawling peg introduced, leading to continued depreciation of about 20 percent a year.
  - By 1994: authorities stopped using currency basket for official rate; moved to de jure managed floating regime.
- Exchange rate mechanism (as of 2007):
  - BCSTP adjusts its exchange rate daily; calculated as the sum of 40 percent of the previous day’s selling rate quoted by commercial banks for transactions with the public and 60 percent of the central bank’s own previous day selling rate.
- Foreign exchange auctions started in 2004.

### Observed macroeconomic indicators (selected historical values)
- Real GDP growth (selected annual values across 1992–2006): 1.6, 2.5, 3.0, 3.0, 5.0, 6.8, 4.8, 5.4, 7.0.
- Consumer prices (end of period, selected values): 46.5, 9.6, 9.6, 13.9, 9.0, 10.0, 15.2, 17.2, 24.6.
- Domestic primary fiscal balance (percent of GDP, selected values): -3.2, 1.0, 2.3, -8.2, -7.0, -6.9, -10.9, -10.3, -8.6.
- External current account (excluding official transfers, percent of GDP, selected values): -49.7, -26.0, -30.4, -16.2, -14.0, -13.5, -13.7, -19.8, -40.1.
- Exports (percent of GDP, selected values): 5.2, 3.9, 2.7, 3.3, 5.1, 6.6, 3.6, 3.4, 3.8.
- Imports (percent of GDP, selected values): 21.7, 21.9, 25.1, 26.2, 28.4, 33.6, 36.0, 41.6, 70.5.
- Capital inflows (percent of GDP, selected values): 29.4, 21.2, 37.9, 26.3, 22.7, 26.9, 29.0, 47.2, 72.6.
- Official transfers (net, percent of GDP, selected values): 18.0, 11.6, 15.7, 18.7, 16.3, 22.1, 22.9, 22.1, 23.6.
- Public sector borrowing (percent of GDP, selected values): 11.5, 9.6, 0.0, 4.9, 2.0, 1.9, 3.9, 1.3, 4.4.
- Private inflows (net, selected sequence): 22.2, 2.7, 4.5, 2.9, 2.2, 23.8, 44.7.

### Inflation history, currency substitution, and pass-through
- Inflation dynamics:
  - 1977–1998: widening fiscal and external current account deficits and escalating inflation; real GDP growth low.
  - Inflation peak: annual rate of 80 percent in 1998.
  - 1999–2003: inflation reduced to 10 percent a year, driven by large inflows including official transfers, external borrowing, and payment by an oil company for exploration rights.
  - 2004–05: fiscal imbalances increased; deficits financed by external borrowing, accumulation of payment arrears, and central bank credits, fueling pressures on domestic prices.
  - August 2006: inflation rose to 26 percent year-on-year.
  - June 2007 (IMF-supported program): inflation reduced to 14 percent.
- Currency substitution and banking:
  - Chronic inflation and currency depreciation led to high currency substitution.
  - Foreign currency deposits: over 60 percent of broad money by mid-2007.
  - Foreign currency credits: account for 70–75 percent of total bank lending.
  - High import propensity implies rapid pass-through from exchange rate movements to domestic prices; 2006 data suggest exchange rate depreciation led inflation by about two months.
  - Disparity between U.S. and São Tomé and Príncipe inflation (December 1999–July 2007) had a statistically significant impact on share of foreign currency deposits in total deposits.

### Econometric evidence (VEC model) — money, exchange rate, and inflation
- Model variables: CPI (price level), M3 (broad money), ER (exchange rate), RGDP (real income).
- Cointegrating and dynamic equation framework as specified in the source (equations preserved in original form).
- Main empirical findings (1992–2007 and updates):
  - Reasonable long-run relationship between prices, monetary aggregates, the exchange rate, and real economy developments.
  - Over the long run, both money supply and changes in the exchange rate affect inflation.
  - Exchange rate depreciation immediately affects inflation; causality is two-way and statistically robust (exchange rate depreciation Granger-causes inflation, and vice versa).
  - Substantial inflation inertia: lagged inflation explains a relatively large part of current inflation.
  - High degree of euro-ization severely limits the effectiveness of monetary policy:
    - Rapid monetary expansion associated with a fall in real demand for dobras, sharp depreciation of the exchange rate, and increase in share of foreign currency deposits in broad money.
  - Time lag between exchange rate depreciation and CPI inflation shortened as foreign currency deposits rose:
    - Lag about four months in 1997-98 when foreign currency deposits < 40 percent of broad money.
    - Lag about two months in 2006 when foreign currency deposits ~ 60 percent of broad money.

### Potential benefits of a firmly anchored arrangement (hard peg or monetary union)
- Price stability:
  - Monetary union or hard peg can have a noticeable effect on price stability; consumer price inflation in African countries in a monetary union or under a hard peg to a reserve currency has been relatively low in the last 15 years (source: Table 2 and Figure 5 in the paper).
- Fiscal discipline:
  - CEMAC and WAEMU members have had lower fiscal deficits relative to GDP compared to small countries with a hard peg or floating exchange rate; unions typically subject members to limits on fiscal deficits and public debt.
- Trade, FDI, and growth:
  - Reducing exchange rate uncertainty can facilitate trade and may facilitate FDI inflows, though FDI also depends on natural resource endowment and business/investment climate.
  - Cape Verde example: pegged to the euro in 1999; tourism income increased rapidly after the peg and policy improvements.
- Cross-country empirical comparisons (1990–2006 averages): selected indicators compared across regimes in Table 2 (specific values preserved in source tables).

### Potential costs of a firmly anchored arrangement
- Loss of monetary policy independence:
  - Joining a monetary union or adopting a hard peg entails giving up autonomy over monetary and exchange rate policies.
  - Cost may be limited for São Tomé and Príncipe because:
    - Extensive euro-ization limits monetary authority’s ability to affect real dobras monetary aggregates.
    - Foreign currencies act as store of value; banks do not effectively intermediate local currency saving and investment.
    - Narrow production and export base and inflexible markets: large real depreciation had limited impact on tradable sector output and exports.
    - Operating expenses of administering a national currency and independent monetary policy could be high relative to GDP.
    - Financial institutions devote substantial resources to exchange rate-related activities at the expense of credit intermediation.
- Loss of seigniorage:
  - Joining a monetary union will lead to loss of seigniorage depending on the union’s sharing arrangements.
  - In economies with a high degree of currency substitution, the loss of seigniorage may be very small.
  - A highly dollarized country may gain by joining a monetary union if transfers under the union exceed seigniorage under the alternative arrangement.

### Oil production implications for regime choice
- Key issues when oil exports become large:
  - (i) effectiveness of a flexible exchange rate as a “shock absorber”;
  - (ii) rate of return on the country’s foreign assets.
- Large oil exports can change the economy’s structure and appropriate macroeconomic policy mix; oil price fluctuations can have a much larger impact on national income than cocoa price changes.
- Flexible exchange rate may help address volatility in oil revenues; losing flexibility could be costly.
- Choice depends on ability to use fiscal and structural policies to address terms-of-trade shocks:
  - Sound and sustainable fiscal policies can buttress a firmly anchored arrangement.
  - Structural reforms enhance competitiveness and resilience.
- Monetary union membership considerations:
  - Members must abide by rules on pooling reserves; the rate of return on foreign assets placed with the union’s central bank matters for countries with large balance of payments surpluses.
  - Example: Equatorial Guinea in CEMAC faced negative real returns on BEAC deposits in 2006 (about 2½ percent negative real return relative to inflation), prompting institutional reforms and reconsideration of BEAC investment strategy.

### Anchor-currency selection and institutional options
- Methods applied:
  - Gravity model (trade-based, 1995–2006 data) identifies the euro as preferred anchor because Europe (including Portugal) predominates in external trade; Africa (mostly Angola) ranks second.
  - Currency mapping (five criteria) ranks: CEMAC CFA franc (most preferable), WAEMU CFA franc, the euro, then the U.S. dollar.
- Gravity model empirical findings (pooled least squares, model 7):
  - Domestic output has no effect on total trade.
  - Foreign output positively related to total trade.
  - Distance negatively related to trade.
  - REER negatively affects total trade.
  - Binary variables: Europe dummy positive and significant; Africa dummy negative and significant; language dummy positive and significant.
- Currency mapping criteria: distance; economic size (sum of GDP of union members); output fluctuation (growth correlation); trade and production structure similarity; inflation rate similarity.
  - Weighting assumptions (equal weights 20 percent and alternative with 25 percent to gravity-model variables) did not change ranking.
- Choosing between monetary union and hard peg:
  - Both gravity model and currency mapping point to the euro as anchor (CEMAC and WAEMU CFA francs are firmly pegged to the euro).
  - Similarities between hard peg to the euro and CFA franc monetary union: can be based on international agreements on hard-currency credit facilities and monitoring/enforcement mechanisms.
  - Choice depends on political, historical, and implementation considerations, and domestic institutional capacity.
  - Internal trade in unions is relatively small (intra-WAEMU about 11 percent of total trade in 2006; intra-CEMAC about 1.5 percent), so external ties matter for choice.
  - On balance, a hard peg to the euro may have a slight edge over joining CEMAC or WAEMU if domestic institutional capacity is adequate and international support and surveillance can be secured.

### Prerequisites for a sustainable regime change
- Fiscal discipline and prudent debt management:
  - Monetary union membership involves common fiscal codes (ceiling on overall deficit and government debt), common accounting standards, and budgetary procedures to maintain fiscal discipline.
  - An exchange rate peg requires strong fiscal discipline to sustain it without undue pressure on official reserves.
  - Fiscal consolidation and improved public financial management should precede any currency exchange system reform.
- Structural reforms:
  - Reduce impediments to private investment and increase market flexibility (regulatory and labor market reforms; competition policy changes).
  - Harmonization of legislation, regulation, and supervision necessary to realize benefits of financial and monetary integration.
- Increased transparency:
  - Comparable and transparent macroeconomic and financial statistics needed to assess developments and progress toward convergence and policy objectives.

### Comparative and historical lessons
- Cape Verde experience (peg to euro in 1999):
  - Started from structural imbalances and low reserves; inconsistent policies led to balance of payments deterioration; subsequent fiscal reform, liberalization, and an Exchange Cooperation Accord with Portugal (short-term precautionary credit line and surveillance) were crucial to sustain the peg.
  - Post-crisis results: fiscal deficit reduced to around 5 percent of GDP; current account deficit declined to less than 10 percent of GDP; inflation fell to low single digits; tourism income grew to over 10 percent of GDP.
- Liberia experience (Box 7 lesson):
  - Even the strongest exchange rate commitment is not a panacea; lax fiscal policy under dollarization can still produce large imbalances and force abandonment of the regime.
  - Lesson: sound domestic policies are fundamental for regime sustainability.

### Conclusions
- Structural characteristics affecting policy: very small size; extensive use of foreign currencies; rapid exchange rate pass-through; inflexible product and factor markets.
- Monetary policy is relatively ineffective as a counter-cyclical tool under these features; benefits exist from “outsourcing” monetary policy through appropriate currency arrangements.
- Benefits of a firmly anchored currency arrangement (lower transaction costs, higher policy credibility, price stability) could outweigh the cost of losing an independent monetary policy, provided prerequisites (fiscal discipline, structural reforms, transparency, and institutional capacity) are met.

*Source: _wp08118 - 1. Monetary and Exchange Regimes (PDF chapter/section) — IMF.*

### 1.    Monetary and Exchange Regimes ....................................................................................

### 1.    Monetary and Exchange Regimes

### Introduction: purpose and scope
- The paper provides an economic analysis of the advantages and disadvantages of maintaining São Tomé and Príncipe’s current monetary and exchange rate arrangements compared to shifting to a system firmly anchored to a hard currency.
- For this paper, firmly anchored currency arrangements include memberships in monetary unions and hard pegs.
- The paper is empirical and focuses on whether a small, open, low-income economy could benefit from a firmly anchored currency arrangement and the conditions under which such an arrangement is desirable and feasible.
- The choice of monetary and exchange rate arrangements depends not only on economic factors but also on historical, political, and geographic considerations, and is ultimately a sovereign decision.
- Organization: Section II describes economic characteristics and monetary history of São Tomé and Príncipe; Section III analyzes benefits and costs of alternative regimes (drawing on African comparisons); Section IV evaluates appropriateness of a hard currency peg or joining a monetary union and sustainability conditions; the final section summarizes key findings.

### Key characteristics of São Tomé and Príncipe relevant to monetary and exchange choices
- Demographics and economy:
  - Population: about 150,000.
  - Small, open, low-income economy.
  - Narrow production and export base; cocoa is the main export commodity.
  - Cocoa exports were less than US$3 million (2 percent of GDP) a year in 2005–06.
  - Tourism is relatively small and brings in little net foreign exchange due to heavy reliance on imported goods and services.
  - Petroleum reserves: exploratory drilling has not yet confirmed commercially extractable reserves.
  - Economy dominated by nontradable activities: government, construction, and other services.
- Openness and trade:
  - Imports of goods and nonfactor services average 70 percent of GDP.
  - Exports of goods and services were about 20 percent of GDP in 2005–06.
  - Most consumer goods, including some agricultural products, are imported.
  - The country depends entirely on imported oil for domestic consumption.
  - Oil accounted for about 15 percent of total imports in recent years.
  - Trade partner concentration (2006):
    - Exports: Europe accounted for over 75 percent.
    - Imports: Europe accounted for close to 65 percent.
    - Angola is the main supplier of oil and has provided oil-related trade financing; Angola and the São Tomé and Príncipe government own the only oil importer and retailer in the country.
- External balances and capital flows:
  - Persistent large imbalances between exports and imports are financed mainly by capital inflows: official transfers, external borrowing, and private sector inflows (including large oil signature bonuses in recent years).
- Debt and aid:
  - São Tomé and Príncipe reached the completion point under the enhanced HIPC Initiative in March 2007 and benefited from HIPC and MDRI debt relief.
  - The country’s debt repayment capacity remains very limited.
  - Maintaining long-term debt sustainability, particularly beyond the year 2014 (which is sensitive to oil prospects), continues to be a challenge.

### Exchange rate regime history and current classification
- Monetary history highlights:
  - The dobra has been the national currency since 1977.
  - The dobra depreciated against the U.S. dollar from about Db25 to over Db14,000 over the past three decades.
  - As of December 2007, the IMF classified São Tomé and Príncipe’s exchange rate regime as a managed float with no pre-announced path for the exchange rate.
- Historical arrangements and major transitions:
  - Pre-independence: de facto currency zone for about 450 years; used Portuguese currency (1522–1867); currency board with Banco National Ultramarino (1868–1952); revamped currency board (1953–1975).
  - During 1953–1975: fiscal deficits were contained; money supply kept virtually constant; inflation averaged about 2 percent a year.
  - 1977: Central Bank of São Tomé and Príncipe (BCSTP) introduced the dobra.
  - Initial pegs: dobra pegged to the Portuguese escudo at par, then to the SDR.
  - 1984–1987: spread between official and parallel exchange rates widened from over 100 percent in 1984 to 400 percent in 1986; in 1987 the peg to the SDR was abandoned; after a 56 percent devaluation the dobra was re-pegged to a basket of currencies of nine trading partners.
  - 1991: crawling peg introduced, leading to continued depreciation of about 20 percent a year.
  - By 1994: authorities stopped using the currency basket in setting the official exchange rate; the dobra moved to a de jure managed floating regime.

### Institutional and regional context
- Regional monetary integration discussions and membership:
  - WAEMU and CEMAC are considering eventual creation of a single currency area.
  - SADC (which includes countries in the CMA) intends to establish a common currency by 2018.
  - The African Union has been discussing a single African currency.
- Sub-Saharan Africa context (as of end-2006):
  - 29 countries in SSA are not members of CEMAC, WAEMU, or CMA (excluding Sudan).
  - Ten countries in SSA had GDP below US$1.5 billion in 2006; São Tomé and Príncipe is one of them.
- Monetary regime framing (Box 1 summary points):
  - Monetary regime: system of expectations and consistent monetary authority behavior (Leijonhufvud, 2000).
  - Exchange rate options include: free float; managed float; band, basket, or crawl; target zone; fixed but adjustable peg (hard peg); currency board; dollarization/euro-ization; membership in a monetary union.
  - Choice depends on economic, political, and geographic considerations: structure of the economy and trade patterns; degree of openness and capital mobility; vulnerability to external shocks; exchange rate pass-through; business cycle synchronization with major partners; capacity of government and monetary authorities.
  - Matrix of monetary and fiscal regimes: outcomes depend on strength/weakness of monetary and fiscal frameworks (weak/strong combinations yield unsustainable, unstable, or stable outcomes).

### Observed macroeconomic indicators (selected historical facts from figures and table summaries)
- Inflation and monetary performance:
  - During 1953–1975 period under currency board-like arrangements inflation averaged about 2 percent a year.
  - Post-independence and later periods saw episodes of high inflation and volatility (figures indicate episodes with substantially higher inflation and exchange rate movements).
- Trade, fiscal, and capital flow dynamics (selected figures from 1992–2006 table):
  - Real GDP growth (selected annual values): 1.6, 2.5, 3.0, 3.0, 5.0, 6.8, 4.8, 5.4, 7.0 (sequence appears across 1992–2006 period in table).
  - Consumer prices (end of period, selected values): 46.5, 9.6, 9.6, 13.9, 9.0, 10.0, 15.2, 17.2, 24.6.
  - Domestic primary fiscal balance (percent of GDP, selected values): -3.2, 1.0, 2.3, -8.2, -7.0, -6.9, -10.9, -10.3, -8.6.
  - External current account (excluding official transfers, percent of GDP, selected values): -49.7, -26.0, -30.4, -16.2, -14.0, -13.5, -13.7, -19.8, -40.1.
  - Exports (percent of GDP, selected values): 5.2, 3.9, 2.7, 3.3, 5.1, 6.6, 3.6, 3.4, 3.8.
  - Imports (percent of GDP, selected values): 21.7, 21.9, 25.1, 26.2, 28.4, 33.6, 36.0, 41.6, 70.5.
  - Capital inflows (percent of GDP, selected values): 29.4, 21.2, 37.9, 26.3, 22.7, 26.9, 29.0, 47.2, 72.6.
  - Official transfers (net, percent of GDP, selected values): 18.0, 11.6, 15.7, 18.7, 16.3, 22.1, 22.9, 22.1, 23.6.
  - Public sector borrowing (percent of GDP, selected values): 11.5, 9.6, 0.0, 4.9, 2.0, 1.9, 3.9, 1.3, 4.4.
  - Private inflows (net): sequence includes 22.2, 2.7, 4.5, 2.9, 2.2, 23.8, 44.7 (values correspond to selected years shown in the table).

### Analytical emphasis and implications highlighted in the paper
- The choice of a monetary and exchange rate arrangement is important for small African countries; price stability requires fiscal discipline, a nominal anchor, strong institutions, and policy credibility.
- For highly open economies, reducing the cost of international transactions is important for achieving sustainable private sector-led growth.
- Globalization and regional integration pressures have made the choice of monetary and exchange arrangements a key policy agenda item for many African governments.
- The paper intends to help determine whether there is a case for changing from São Tomé and Príncipe’s current managed float regime to a system with a foreign currency anchor, and to study the conditions under which a hard peg or monetary union membership would be appropriate and sustainable.

*Source: _wp08118 - 1.    Monetary and Exchange Regimes (PDF chapter/section) — IMF.*

### 12.      In 2004, the country started foreign exchange auctions. As of 2007, the BCSTP

### 12. In 2004, the country started foreign exchange auctions. As of 2007, the BCSTP

### Exchange rate mechanism
- As of 2007, the BCSTP adjusts its exchange rate daily; it is calculated as the sum of 40 percent of the previous day’s selling rate quoted by commercial banks for transactions with the public and 60 percent of the central bank’s own previous day selling rate.

### Inflation history and drivers (1977–2007)
- The first two decades of the dobra era (1977–1998) witnessed widening fiscal and external current account deficits and escalating inflation (Table 1).
- Real GDP growth was low throughout 1977–1998.
- Inflation peaked at an annual rate of 80 percent in 1998.
- Inflation was brought down to 10 percent a year for 1999–2003, largely due to a sharp reduction in fiscal and external current account deficits driven by a large inflow of resources, including official transfers, external borrowing, and payment by an oil company for exploration rights.
- After 2003, inflation proved tough to reduce:
  - Fiscal imbalances increased in 2004–05.
  - Deficits were mainly financed by external borrowing, accumulation of payment arrears, and central bank credits, which fueled pressures on domestic prices.
  - By August 2006, inflation had risen to 26 percent year-on-year.
  - As part of the IMF-supported adjustment and reform program, by June 2007 inflation had been reduced to 14 percent.

### Currency substitution and pass-through
- Chronic inflation and currency depreciation over the last 30 years have led to a high degree of currency substitution in São Tomé and Príncipe.
- Foreign currency deposits amounted to over 60 percent of broad money by mid-2007.
- Commercial banks operate largely with foreign currency; foreign currency credits account for 70–75 percent of total bank lending.
- High import propensity of spending implies rapid pass-through from exchange rate movements to domestic prices—data for 2006 suggest that exchange rate depreciation led inflation by about two months.
- Note: Between December 1999 and July 2007, the disparity between inflation rates in the U.S. and São Tomé and Príncipe had a statistically significant impact on the share of foreign currency deposits in total deposits.

### Econometric evidence: money, exchange rate, and inflation
- Empirical questions addressed:
  - Dynamics between money, the exchange rate, and inflation.
  - Causal relationship between currency depreciation and consumer price inflation.
  - Impact of currency substitution on the effectiveness of monetary policy.
- Prior studies and data:
  - Kuijs (2000): monthly data January 1992–May 1998.
  - Iimi (2006): monthly data January 1998–September 2005; analysis updated through January 2007.
- Key model specification (VEC model):
  - Variables: CPI (price level), M3 (broad money), ER (exchange rate), RGDP (real income).
  - Equation forms:
    - Cointegrating equation: tt tttt RGDP ER M CPI ln ln 3 ln ln 3210 αααα−−−−= (equation (1) as presented).
    - Dynamic equation: Δln terms with an error correction term and lagged differences (equation (2) as presented).
- Main econometric findings (1992–2007 and updates):
  - There is a reasonable long-run relationship between prices, monetary aggregates, the exchange rate, and developments in the real economy.
  - Over the long run, both money supply and changes in the exchange rate affect inflation.
  - Exchange rate depreciation immediately affects inflation; causality is two-way and statistically robust (exchange rate depreciation Granger-causes inflation, and vice versa).
  - Substantial inflation inertia: lagged inflation explains a relatively large part of current inflation.
  - High degree of euro-ization and substitution between dobra-denominated and dollar- or euro-denominated assets severely limits the effectiveness of monetary policy:
    - Rapid monetary expansion is associated with a fall in the real demand for dobras, causing a sharp depreciation of the exchange rate and an increase in the share of foreign currency deposits in broad money.
  - Time lag between exchange rate depreciation and CPI inflation shortened as foreign currency deposits rose:
    - Lag about four months in 1997-98 when foreign currency deposits < 40 percent of broad money.
    - Lag about two months in 2006 when foreign currency deposits ~ 60 percent of broad money.

### Potential benefits of alternative regimes (monetary union or hard peg)
- Price stability:
  - Monetary union or hard currency peg can have a noticeable effect on price stability; in the last 15 years consumer price inflation in African countries in a monetary union or under a hard peg to a reserve currency has been relatively low (Table 2 and Figure 5).
- Fiscal discipline:
  - Countries in CEMAC and WAEMU have had a lower fiscal deficit relative to GDP compared to small countries with a hard peg or a floating exchange rate; members of a monetary union are typically subject to limits on fiscal deficits and public debt.
- Trade, FDI, and growth:
  - Reducing exchange rate uncertainty can facilitate trade in goods and services.
  - Example: Cape Verde pegged to the euro in 1999; tourism income increased rapidly after the peg and policy improvements (Box 3).
  - Reducing exchange rate risks may facilitate FDI inflows, although FDI also depends on natural resource endowment and business/investment climate.
- Empirical cross-country comparisons (1990–2006 averages shown in Table 2):
  - Selected indicators include GDP growth, inflation, real exchange rate changes, overall balance (percent of GDP), current account (percent), financial account, FDI, official reserves (months of imports), external openness, and volatility measures.
  - Specific values and country group comparisons are presented in Table 2 as in the source.

### Potential costs of alternative regimes
- Loss of monetary policy independence:
  - Joining a monetary union or adopting a hard peg entails giving up autonomy over monetary and exchange rate policies.
  - Reasons the cost may be limited for São Tomé and Príncipe:
    - Persistent, extensive euro-ization limits the monetary authority’s ability to affect real dobras monetary aggregates; exchange rate depreciation and inflation react to monetary expansion with a very short time lag.
    - Foreign currencies act as store of value; banks do not effectively intermediate local currency saving and investment.
    - Narrow production and export base and inflexible product and factor markets: large real depreciation has had limited impact on resource allocation between tradable and nontradable sectors (cocoa and other agricultural output and exports have been stagnant despite large cumulative real depreciation since early 1990s).
    - Operating expenses of an agency to administer a national currency and independent monetary policy could be high relative to GDP in a very small, poor country (Kuijs, 2000).
    - Financial institutions devote substantial resources to exchange rate-related activities at the expense of credit intermediation.
- Loss of seigniorage:
  - (Section begins in source but continuation beyond provided extract not included here.)

*Source: _wp08118 - 12.      In 2004, the country started foreign exchange auctions. As of 2007, the BCSTP*

### 26.      Depending on the sharing arrangements, joining a monetary union will lead to

### _wp08118 - 26.      Depending on the sharing arrangements, joining a monetary union will lead to

### Seigniorage and joining a monetary union
- Joining a monetary union will lead to the loss of seigniorage, depending on the union’s sharing arrangements.
- In economies with a high degree of currency substitution, the loss of seigniorage may be very small.
- A country that is already highly dollarized may gain by joining a monetary union if transfers under the union’s sharing arrangement are larger than seigniorage under the alternative monetary and exchange rate arrangement.

### The cost-benefit analysis and initial conditions
- For small, open, low-income economies in Africa, the evidence favors a monetary and exchange system firmly anchored to a hard currency because:
  - such a system provides an anchor for inflation;
  - it reduces transaction costs and exchange risks and is likely to promote growth.
- Question posed: Would poor initial conditions (limited official reserves, weak capacity to generate foreign exchange earnings) change the cost-benefit analysis and the sustainability/credibility of a firmly anchored arrangement?
- Cape Verde case:
  - Pegged national currency to the euro in 1999.
  - Suffered structural imbalances, lack of foreign earning capacity, and low official reserves at the start of the peg.
  - Inconsistent domestic policies led to a rapid deterioration of the balance of payments in the subsequent two years.
  - Fiscal reform, current and capital account liberalization, and reform of state-owned enterprises since 2001 were crucial to sustain the peg.
  - The Exchange Cooperation Accord with Portugal provided a short-term precautionary credit line and strong surveillance to ensure fiscal discipline.

### Effects of large oil exports on the cost-benefit analysis
- Key issues when oil exports become large:
  - (i) effectiveness of a flexible exchange rate as a “shock absorber”;
  - (ii) rate of return on the country’s foreign assets.
- Large oil exports can change the structure of the economy and the appropriate macroeconomic policy mix; fluctuations in oil prices can have a much larger impact on national income than changes in cocoa prices.
- A flexible exchange rate may help address volatility in oil revenues; thus the cost of losing a flexible exchange rate could be high.
- Choice of arrangement under an oil production scenario depends on the country’s ability to use fiscal and structural policies to address terms-of-trade shocks:
  - Sound and sustainable fiscal policies can buttress a firmly anchored arrangement and reduce the cost of losing a flexible exchange rate.
  - Structural reforms can enhance competitiveness and resilience to external shocks.
- Monetary union membership implications:
  - A member must abide by rules on pooling reserves; the rate of return on foreign assets placed with the union’s central bank matters for countries with large balance of payments surpluses.
  - Example: Equatorial Guinea (CEMAC member) is addressing the rate of return on oil surpluses jointly with other members and through institutional reform of the monetary union.

### Equatorial Guinea / CEMAC reserve management (Box 4 — key points)
- Equatorial Guinea joined CEMAC in 1985; started exporting oil in the mid-1990s; by end-2006 contributed about one-third of BEAC’s gross international reserves.
- CEMAC reserve pooling rules:
  - All members must pool foreign assets at the BEAC.
  - Required to repatriate all export earnings and deposit a minimum 65 percent of those earnings at the French treasury.
  - Remainder can be invested in line with BEAC reserve investment rules; members may invest amounts consistent with region’s fiscal policy in oil stabilization funds at the BEAC.
  - BEAC deposit terms include a remuneration rate linked to, but lower than, the short-term rate in the euro area, restrictions on new deposits, and penalties on deposit withdrawals.
- Rate of return on member foreign assets (Equatorial Guinea, 2006):
  - Government placed about one-third of its fiscal surplus with the BEAC and deposited the remainder in commercial banks abroad.
  - Inflation in Equatorial Guinea in 2006 exceeded the interest rate on BEAC deposits by an average of about 2 percent, resulting in a negative real rate of return of about 2½ percent.
  - Deposits held abroad in U.S. dollars had CFA franc returns reduced by the depreciation of the dollar against the euro, though those returns remained higher than BEAC’s remuneration rates.
- CEMAC reform: Authorities working on BEAC institutional reforms (resource sharing, governance, remitting funds held abroad); BEAC investment strategy may need revision to raise real returns on member financial assets.

### Choice of anchor currency and other arrangements
- For a very small, highly open economy, a system firmly linked to a hard currency provides a simple, effective, and instantly observable anchor for monetary policy and increases policy credibility by reducing discretionary power.
- Methods applied to choose an anchor currency:
  - Gravity model (trade-based, 1995–2006 data) finds the euro is the preferred anchor for São Tomé and Príncipe because Europe (including Portugal) has a predominant share in external trade; Africa (mostly Angola) ranks second.
  - Currency mapping (five selection criteria) ranks preferences as: CEMAC CFA franc (most preferable), WAEMU CFA franc, the euro, then the U.S. dollar.
- Gravity model key empirical findings (pooled least squares, model 7):
  - Domestic output has no effect on total trade.
  - Foreign output is positively related to total trade.
  - Distance is negatively related to trade.
  - REER has a negative effect on total trade.
  - Binary variables: Europe dummy positive and significant; Africa dummy negative and significant; language dummy positive and significant, with common language with Europe significant.
- Gravity model sample and data:
  - Data cover 59 countries trading with São Tomé and Príncipe in 2006; sample period 1995 to 2006.
  - Variables expressed in logs except binary variables and REER (a ratio).
- Currency mapping method and results:
  - Selection criteria: distance, economic size (sum of GDP of union members), output fluctuation (growth correlation), trade and production structure similarity, inflation rate similarity.
  - Two weighting assumptions tested: equal weights (20 percent) and higher weights (25 percent) to gravity-model variables (distance, economic size).
  - Resulting ranking unchanged under both weight assumptions: CEMAC CFA franc preferred, followed by WAEMU CFA franc, euro, and U.S. dollar.

### Choosing between a monetary union and a hard peg
- Both gravity model and currency mapping point to the euro as the hard currency anchor because CEMAC and WAEMU CFA francs are firmly pegged to the euro.
- Similarities between a hard peg to the euro (e.g., Cape Verde) and a CFA franc monetary union:
  - Both can be based on international agreements on a hard currency credit facility and on firm mechanisms for monitoring and enforcement regarding domestic policies.
- Choice depends largely on political, historical, and implementation considerations:
  - A hard peg to the euro may be more demanding in terms of domestic institutional capacity.
  - Internal trade within CEMAC and WAEMU is relatively small (intra-WAEMU trade about 11 percent of total trade in 2006; intra-CEMAC about 1.5 percent), so existing economic ties matter in choosing an arrangement.
  - On balance, a hard peg to the euro may have a slight edge over joining CEMAC or WAEMU provided domestic institutional capacity is adequate and an international agreement on external support and effective surveillance of domestic policies can be secured.

### Prerequisites of a sustainable regime change
- Successful implementation of a new monetary and exchange rate arrangement requires:
  - Fiscal discipline and prudent debt management:
    - Monetary union membership typically involves a common code of fiscal conduct (reference values for fiscal variables such as ceilings on the overall deficit and government debt), common accounting standards, and budgetary procedures to maintain fiscal discipline.
    - An exchange rate peg requires strong fiscal discipline to sustain it without undue pressure on official reserves.
    - Fiscal consolidation and improved public financial management should precede any reform of the currency exchange system.
  - Structural reforms to reduce impediments to private investment and increase market flexibility:
    - Regulatory and labor market reforms; changes in competition policies.
    - Harmonization of legislation, regulation, and supervision to achieve full benefits of financial and monetary integration.
  - Increased transparency:
    - Comparable and transparent macroeconomic and financial statistics are necessary for assessing economic developments and progress toward convergence criteria and policy objectives.

### Conclusions
- The paper analyzes monetary and exchange rate arrangement choices for a very small, highly open, low-income economy, highlighting structural characteristics that affect policy:
  - very small size;
  - extensive use of foreign currencies;
  - rapid exchange rate pass-through;
  - inflexible product and factor markets.
- Monetary policy is relatively ineffective as a counter-cyclical tool under these features, so benefits exist from “outsourcing” monetary policy through appropriate currency arrangements.
- Benefits of a firmly anchored currency arrangement (lower transaction costs, higher policy credibility, price stability) could outweigh the cost of losing an independent monetary policy.

*Source: IMF working paper text provided in the content unit.*

### 41.      The paper uses statistical methods but also takes into account other factors to

### 41.      The paper uses statistical methods but also takes into account other factors to

### Choice of anchor currency and institutional arrangements for São Tomé and Príncipe
- The euro emerges as the preferred choice for São Tomé and Príncipe, either:
  - directly through a hard peg, or
  - indirectly through a CFA franc monetary union that is firmly linked to the euro.
- The paper notes similarities between a monetary union and a hard peg; the choice between the two depends on:
  - domestic institutional capacity, and
  - whether an international agreement on external support and effective surveillance of domestic policies can be secured.
- The choice of monetary and exchange rate arrangements depends on a variety of economic and non-economic factors and is ultimately a sovereign decision.

### Box 7 — Liberia’s experience: sound domestic policies are fundamental
- Historical context:
  - Liberia adopted dollarization in 1946; the U.S. dollar became the principal medium of exchange.
  - Liberian dollars coexisted with the US dollar but only as a secondary medium of exchange at par with the US dollar.
- Fiscal and external deterioration:
  - From the mid-1980s, the government ran chronic budgetary deficits, reaching more than 10 percent of GDP by late 1980s.
  - External balance worsened with weak international commodity prices.
  - Foreign funding inflows were discouraged and eventually stopped.
- Consequences under dollarization:
  - Sharp reduction of currency circulation and a substantial liquidity squeeze.
- Policy reversal and currency dynamics:
  - In 1988 the government abandoned dollarization and formally introduced the Liberian dollar, fixed at par with the US dollar.
  - Broad money composition shifted: Liberian currency share increased from 10 percent in 1982 to 39 percent in 1988.
  - The Liberian dollar quickly depreciated in the parallel market.
- Civil war period (1989–1996) and aftermath:
  - Both US dollar and Liberian dollar circulated; credibility of Liberian dollar diminished and economy predominantly ran on the US dollar.
  - In 1998 government-depreciation: Liberian dollar declined to 40 Liberian to US dollar from the official par value.
  - Since the war ended, the Liberian dollar restored some credibility, but the economy remains highly dollarised:
    - 95 percent of all commercial bank loans to the private sector are in U.S. dollars.
    - 79 percent of all commercial bank deposits are in U.S. dollars.
- Key lesson:
  - Even the strongest form of exchange rate commitment is not a panacea for macroeconomic stability.
  - Under full dollarization, lax fiscal policy is still possible.
  - Large internal and external imbalances could force abandonment of dollarization.
  - Dollarization can bring some degree of economic policy discipline, but does not guarantee macroeconomic stability without appropriate supporting policies, especially when a country suffers an extremely tight liquidity squeeze.

### Fiscal discipline and prudent borrowing under firmly anchored arrangements
- Successful implementation of a firmly anchored currency arrangement (monetary union or hard peg) demands:
  - fiscal discipline, and
  - prudent borrowing policies.
- In a firmly anchored currency arrangement:
  - fiscal and other domestic policies are the main instruments of adjustment to exogenous real shocks.
  - prudent debt management is critically important to minimize risks of financial imbalances, including currency and maturity mismatches.

### Appendix I — Monetary history of São Tomé and Príncipe before independence
- Monetary regime highlights:
  - Banco Nacional Ultramarino created in 1868 as Portugal’s private monopoly note-issuer for its colonies.
  - 1948: separate colonial foreign-currency funds centralized in Lisbon.
  - 1953: currency reform unified the Portuguese escudo and currencies of Portuguese colonies; Monetary Fund of the Escudo Zone established.
  - February 1963: ministerial decree liberalizing capital movements in the escudo zone.
  - March 1963: measures to organize a new payments system; exchange controls on private transfers from overseas territories to Portugal imposed.
- Macroeconomic performance under the currency board (1956–73):
  - Inflation averaged only 2 percent.
  - Production and electricity consumption increased substantially.
  - Trade balance was in surplus most of the time.
  - M1 and real credit to the private sector grew considerably without significantly affecting inflation.
  - Fiscal deficit averaged Escudos 33 million during 1956-73; with GDP growth indicators, the fiscal deficit was actually declining as a percent of GDP.
- Chronology table (selected entries preserved as in source):
  - 1522-1859: None; Fixed; Portuguese and foreign coins.
  - 1859-1868: None; Fixed; Portuguese real.
  - 1868-31 December 1913: Pegged; 1 local real = 1 Portuguese real.
  - 1914-1974: Private monopoly issue (1969-53) and Currency Union (1953-73); Pegged; 1 local escudo = 1 Portuguese escudo.

### Appendix II — Cape Verde’s currency peg
- Pre-euro peg period (-1998):
  - Cape Verde escudo (CVEsc) introduced in 1977.
  - Initially pegged to the Portuguese escudo; later re-pegged to a basket of currencies (approximately 70 percent of the basket is composed of euro currencies).
  - Central bank maneuvered the basket, consistently devaluing the CVEsc by 6-10 percent a year to maintain competitiveness.
  - Central bank rationed foreign currency when excess demand emerged; foreign exchange queues were frequent.
- Macroeconomic conditions pre-peg:
  - Small open economy, very narrow production base, heavily dependent on remittances and foreign aid.
  - Exports, including tourism, virtually did not exist in the pre-euro peg period.
  - Imports-to-exports ratios reached 27 for goods and 4 for goods and services in the 1990s.
  - Main trading partners (Portugal, France, and the Netherlands) made up over 80 percent of total trade.
  - Inflation often ran above 10 percent.
  - Fiscal deficit and current account deficit frequently exceeded 10 percent of GDP.
  - Current account deficit funded by foreign aid; remittances equivalent to 20 percent of GDP helped mitigate imbalances.
  - External and domestic debt reached 56 percent and 40 percent of GDP, respectively, in 1998.
- Introduction of the euro-peg system (1998):
  - 1998: full convertibility of CVEsc; peg initially changed to the Portuguese escudo with a 6 percent devaluation at rate 0.55 CVEsc/ PSE, then to the Euro at rate 110.3 CVEsc/€.
  - IMF provided a precautionary Stand-by-Arrangement for 1998 to 2000 to underpin a donor-supported domestic debt operation; the arrangement expired without any withdrawals.
  - Main reform pillars:
    - Credit line arrangement with Portugal: July 1998 Exchange Cooperation Accord provided a short-term precautionary credit line up to US$ 50 million, repaid by the end of each year with an annual interest rate of 0.5 percent; a joint committee was established to monitor macroeconomic conditions.
    - Fiscal reform: large scale fiscal restructuring to abide by Maastricht criteria; strengthened tax collection; prepared for VAT; reduced current primary expenditure; halted bank financing in 1998; law limiting statutory advances to 5 percent of the previous year’s revenues; reduction of domestic debt using privatization proceeds and foreign aid; domestic debt gradually replaced with securities issued by the Trust Fund.
    - Current and capital account liberalization: foreign exchange law in June 1998 to remove restrictions; 2004 acceptance of Article VIII of the IMF’s Articles of Agreement.
    - Structural reform: large scale privatization to enhance efficiency and fund fiscal reform and debt reduction.
- Post-euro peg period (crisis 1999-2000 and recovery by late 2001):
  - Immediate post-peg growth driven by foreign direct investment, tourism development, and increasing remittances.
  - Fiscal situation worsened in 1999 and 2000 due to elections, severe drought, and banking-sector cleanup costs; government breached statutory limits on central bank financing.
  - By mid-1999, central bank depleted foreign reserves defending the peg; government temporarily reintroduced foreign exchange rationing and used privatization receipts for current budget obligations.
  - 2000: government failed to meet end-year repayment of Portuguese credit line, triggering temporary suspension; external assistance dried up.
  - With significant help from the Portuguese government, reforms were reinitiated and the situation normalized by late 2001.
- Post-crisis improvements:
  - Fiscal deficit reduced to around 5 percent of GDP.
  - Current account deficit declined to less than 10 percent of GDP.
  - Inflation fell to low single digits.
  - Dynamic private sector and a larger, more diversified export base driven by foreign direct investment.
  - Tourism income grew to over 10 percent of GDP.
  - Foreign reserves were accumulated and the central bank developed policy instruments to control inflation and currency pressures.

*IMF working paper content as provided in the source PDF.*

### Appendix III

### Appendix III

### Oil and Exchange Rate Pegs
- Increased oil revenues are likely to raise São Tomé and Príncipe’s real exchange rate either through a rise in the nominal exchange rate or through higher inflation.
- Policy options when oil comes on stream:
  - adopt a flexible exchange rate regime;
  - re-peg the currency at a more appropriate level;
  - engineer an improvement in competitiveness through structural reforms (increasing the flexibility of the economy or improving total factor productivity).
- Appropriateness of the peg currency must be assessed if the U.S. dollar becomes the main trading currency after oil production begins.
- Key considerations if pegging to the euro is maintained:
  - euro/dollar exchange rate volatility and euro/dollar medium- to long-term movements;
  - impact on imported inflation given the country’s high dependence on imports;
  - effects on current account imbalances.
- Experience from recent years with rising oil prices shows:
  - overheating economies, rapid credit growth, rising inflation, and asset price booms;
  - for countries with a peg to the dollar or the euro, interest rates were too low or often negative, reflecting those of the U.S. or the euro area.
- Implication: a more flexible exchange rate regime may be more appropriate to regain control of monetary policy, influence inflation developments, and better manage oil price shocks.

### Oil and Currency Unions (CEMAC)
- If São Tomé and Príncipe chooses CEMAC membership, oil inflows raise several membership-related issues tied to CEMAC responsibilities:
  - Fiscal policy rules:
    - CEMAC fiscal convergence rule: no negative balance.
    - Reserve management rule: limits credit to member governments by the BEAC to 20 percent of tax revenues of the previous year.
    - These constraints may restrict the country from spending according to its own needs and will put pressure on the real exchange rate and competitiveness.
  - Exchange rate parity:
    - Membership implies adopting the CFA franc and a fixed parity with the euro.
    - The CEMAC arrangement is more rigid than an independent peg, being bound by CEMAC institutional rules and strict agreements with the French treasury and euro area institutional rules.
    - Oil inflows may prompt reassessment of the appropriateness of CEMAC membership for São Tomé and Príncipe’s economic developments.
  - Reserve management:
    - Membership requires repatriation of all export earnings and depositing a minimum 65 percent of foreign exchange earnings at the French treasury (the remainder can be invested according to BEAC’s own reserve investment rules).
    - Current returns on BEAC pooled reserves and on oil stabilization funds do not provide adequate financial incentives for member governments to comply with reserve rules.
    - Some CEMAC authorities have taken ad hoc initiatives to ensure adequate remuneration and preserve oil wealth.
    - São Tomé and Príncipe must decide if CEMAC regional reserve management policies would remain appropriate given future oil-related deposits, consumption needs, and impacts on the real exchange rate and competitiveness.

*Source: Appendix III of the IMF content unit.*

### Appendix IV

### CEMAC, WAEMU, and Other Currency Arrangements — Institutional Framework
- The CFA franc zone:
  - created in 1945; initially fixed to the French franc.
  - parity changed in 1994 to reflect a euro-zone decision to devalue; parity shifted to the Euro at the euro’s inception in 1999.
  - Currency issued by two regional central banks:
    - Banque centrale des Etats l’Afrique de l’Ouest (BCEAO) — responsible for the WAEMU states.
    - Banque des Etats de l’Afrique centrale (BEAC) — responsible for the CEMAC states.
  - France participates in the executive boards of both banks.
  - Two different currencies (both called the CFA franc) are legal tender only in their respective regions.
  - Convertibility of the currency is guaranteed by the French treasury.
- Treaties establishing WAEMU and CEMAC were ratified in 1994 and 1999, respectively, with objectives:
  - harmonizing indirect taxes and business laws;
  - harmonizing macroeconomic conditions;
  - creating a common market;
  - freeing movement of capital, services, and people;
  - coordinating sectoral policies.
- Four convergence criteria under multilateral surveillance:
  - non-negative fiscal balance;
  - average inflation not exceeding 3 percent;
  - public debt not exceeding 70 percent of GDP;
  - no increase in internal or external arrears in any current year.

### CEMAC: Reserve Management and Oil Inflows
- Reserve pooling and French cooperation:
  - All export earnings must be repatriated and a minimum of 65 percent of foreign exchange earnings must be deposited in the operations account with the French Treasury; the remainder can be invested according to BEAC’s own reserve investment rules.
  - Arrangement aims to limit drawings on the overdraft facility provided by the French Treasury by imposing:
    - a floor on BEAC’s foreign assets with the French Treasury;
    - a minimum level of net foreign assets equivalent to at least 20 percent of sight liabilities;
    - a limit on credit to governments by BEAC to 20 percent of tax revenues.
  - Current interest rate paid by BEAC on member countries’ government deposits range between 50 to 75 basis points below the euro Libor 90 days.
  - Net returns on pooled regional reserves are distributed to member states according to an agreed formula.
- Governance and gaps:
  - BEAC does not have a strategy to assess the needed level of reserves to support the CFA franc.
  - Reserve management arrangement allows countries to hold oil stabilization funds at the BEAC (CFA-denominated accounts remunerated at an interest rate linked to what BEAC earns on its French Treasury accounts (ECB rate plus 100 basis points)).
  - No region-wide limits and no reserve-pooling-limits must be satisfied before channeling savings to oil funds.
  - Oil stabilization funds are not currently based on public financial management strategies or on medium-term fiscal frameworks in member countries.
  - Some member countries invest their oil reserves in offshore accounts instead of at the BEAC.
- Distribution of BEAC net profits:
  - 15 percent to all members in an equal amount;
  - 15 percent according to each member’s share in currency in circulation;
  - 70 percent according to each member’s relative contribution to the BEAC’s profits.

### Currency Board
- Components of a currency board:
  - a pegged exchange rate to a foreign currency;
  - automatic convertibility (exchanging domestic currency at a fixed rate whenever desired);
  - a credible (often legally set) long-term commitment.
- Institutional design:
  - monetary authority can be divided into two independent agencies: a currency board (exclusive power to issue currency) and a central bank (other responsibilities).
- Credibility requirement:
  - central bank must hold sufficient official foreign exchange reserves to at least cover 100 percent of base money.
- Main benefit:
  - a transparent and credible anti-inflationary policy.

### Dollarization
- Definition: official dollarization occurs when a government adopts foreign currency as the predominant or exclusive legal tender.
- Typical motivations and contexts:
  - used in exceptionally difficult conditions (examples: Kosovo, Timor Leste).
  - can reduce inflation expectations by imposing fiscal discipline and enhancing policy credibility.
- Costs and trade-offs:
  - loss of monetary policy independence and lender of last resort capacity;
  - high setup costs (using official reserves to buy back national currency);
  - lost income from both official reserves and seignorage from issuing national currency.

*Source: Appendix IV of the IMF content unit.*

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