## _wp10194

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---

### I. Introduction and objective
- EAC partner countries aim for full economic integration; Common Market Protocol ratified and attention turning to monetary and financial integration and a Monetary Union Protocol.
- Financial integration requires removal of barriers to international movement of capital and integration of foreign exchange and money markets.
- A well-established regional foreign exchange market is crucial because capital movement would be difficult if one country’s currency cannot be converted into another.
- Paper focuses on integration of foreign exchange markets and money markets among EAC countries and develops a CIP-deviation based indicator for Kenya, Tanzania, and Uganda.

### Definition, rationale, and methodology: CIP-based measure of financial openness
- Concept:
  - An integrated financial market: single set of rules, equal access, equal treatment (Baele et al, 2004).
  - For EAC interbank money market integration, banks from any EAC country should have equal access to every partner country’s money market; foreign exchange markets must function as one market.
- Rationale for measure:
  - Deviations from Covered Interest Parity (CIP) are used as a theoretically sound measure of financial barriers (Frankel 1993; Willet et al., 2001).
  - Deviations from CIP imply existence of financial barriers (counterparty risk, transaction costs, capital controls).
- Constructed measure B:
  - B = deviation of actual forward rates (OF) from CIP-implied forward rates (CIPF).
  - Interpretation:
    - Larger B → greater barriers to financial integration.
    - B < 0 → more restrictions on inflows than outflows.
    - B > 0 → more restrictions on outflows than inflows.
    - B = 0 → no empirical deviation from CIP (possible full financial integration), noting some deviations may persist even among integrated markets.
- Practical inputs:
  - Spot exchange rate to USD; forward exchange rates to USD by maturity; local-currency interbank interest rates; U.S. Libor used as proxy for USD interbank rate.

### Data description, limitations, and scope
- Countries analyzed: Kenya, Tanzania, Uganda (Burundi and Rwanda excluded due to lack of forward FX data).
- Data limitations and cautions:
  - Forward and interbank-rate data are spotty and sometimes unreliable.
  - Forward markets in EAC are shallow and illiquid; between January 2008 and June 2009 only 49 quotes reported for any given forward maturity.
  - Forward maturities observed: 1 month, 2 months, 3 months, 6 months, 9 months, 12 months (where available).
  - Interbank deposit rates:
    - Kenya and Tanzania: 1-month, 2-month, 3-month, 6-month, 12-month available; 9-month lacking.
    - Uganda: only 1-month, 2-month, 3-month interbank deposit rates available; cannot compute CIP deviations for 6-, 9-, 12-month for Uganda.
  - Spot exchange rate behavior (January 2008–June 2009): Kenya, Tanzania, and Uganda all experienced depreciation against the U.S. dollar (Bloomberg LP).

### Empirical results: CIP deviations and summary statistics
- General patterns (Feb-09 to Jun-09):
  - Kenya exhibits the least CIP deviation among the three.
  - CIP deviations tend to increase with forward maturity (12-month > 6-month > 3-month).
  - Single-country measure computed as arithmetic average across available maturities.
- Table 2 — Average CIP Deviations, in percent:
  - Kenya:
    - Max: 1.55
    - Min: –0.51
    - Mean: 0.34
    - Median: 0.30
    - St. Dev.: 0.50
  - Tanzania:
    - Max: 1.93
    - Min: –3.61
    - Mean: 0.37
    - Median: 0.74
    - St. Dev.: 1.01
  - Uganda (average using only 1-month, 2-month, 3-month series):
    - Max: 2.83
    - Min: –1.16
    - Mean: 0.78
    - Median: 0.81
    - St. Dev.: 0.76
  - United Kingdom (comparison, 12-month sterling-dollar forwards Jan 2006–Aug 15, 2008):
    - Max: 1.06
    - Min: –0.45
    - Mean: 0.14
    - Median: 0.11
    - St. Dev.: 0.19
- Table 3 — Absolute CIP Deviations, in percent:
  - Kenya:
    - Max: 1.55
    - Min: 0.00
    - Mean: 0.46
    - Median: 0.34
    - St. Dev.: 0.40
  - Tanzania:
    - Max: 3.61
    - Min: 0.01
    - Mean: 0.88
    - Median: 0.92
    - St. Dev.: 0.60
  - Uganda (average using only 1-month, 2-month, 3-month series):
    - Max: 2.83
    - Min: 0.02
    - Mean: 0.91
    - Median: 0.83
    - St. Dev.: 0.59
  - United Kingdom (comparison):
    - Max: 1.06
    - Min: 0.00
    - Mean: 0.17
    - Median: 0.14
    - St. Dev.: 0.15
- Interpretation:
  - Kenya has the lowest mean and median CIP deviation and the lowest volatility—suggesting least financial barriers among the three.
  - Tanzania and Uganda are both less open than Kenya; relative ranking between Tanzania and Uganda depends on mean vs median choice.
  - Kenya’s barrier measure is nearly 3 times higher than that of the U.K., indicating significant distance from developed-country levels.
  - Overall: EAC members significantly less open financially than developed countries.

### Background: intra-EAC trade as proxy for financial flows and implications
- Trade used as proxy for financial flows because direct intra-EAC financial flow data unavailable.
- Table 1 (2008) — absolute trade and GDP values:
  - Imports:
    - Kenya: $12.3Bn
    - Tanzania: $6.9Bn
    - Uganda: $3.3Bn
    - Rwanda: $1.0Bn
    - Burundi: $0.47Bn
  - Import/GDP (in percent):
    - Kenya: 40.8
    - Tanzania: 33.2
    - Uganda: 22.8
    - Rwanda: 22.6
    - Burundi: 42.9
  - Exports:
    - Kenya: $5.7Bn
    - Tanzania: $1.9Bn
    - Uganda: $1.0Bn
    - Rwanda: $0.29Bn
    - Burundi: $0.09Bn
  - Export/GDP (in percent):
    - Kenya: 18.8
    - Tanzania: 9.3
    - Uganda: 7.2
    - Rwanda: 6.5
    - Burundi: 8.6
  - GDP:
    - Kenya: $30.2Bn
    - Tanzania: $20.7Bn
    - Uganda: $14.5Bn
    - Rwanda: $4.5Bn
    - Burundi: $1.1Bn
- Observations:
  - Rwanda and Burundi trading volumes much smaller; both lack forward FX markets.
  - Forward markets in EAC are mostly trade-driven and banks do not actively trade forwards—shallowness and illiquidity are financial barriers that can cause CIP deviations.

### Country foreign exchange market features and specific barriers
- Kenya:
  - Currency: Kenya shilling. Regulator: Central Bank of Kenya (CBK).
  - Exchange rate policy (AREAER 2008): “managed floating with no predetermined path for the exchange rate.”
  - Dollar is principal intervention currency; interventions frequent.
  - Market: authorized commercial banks and foreign exchange bureaus transact in spot; interbank (wholesale) and retail spot markets exist.
  - Commercial banks can enter forwards conditional on CBK approval; foreign exchange bureaus prohibited from forwards.
  - In practice only dollar-shilling forwards trade; no well-established direct forwards between Kenya shilling and other EAC currencies.
  - Forwards mostly entered on behalf of importers/exporters; low arbitrage activity.
- Tanzania:
  - Currency: Tanzania shilling. Regulator: Bank of Tanzania (BOT).
  - Exchange rate regime: reclassified to “managed floating with no predetermined path” (AREAER 2008); prior to April 2007 classified as independently floating.
  - Interbank and retail spot markets exist; authorized dealers may offer forwards primarily for trade hedging.
  - BOT does not offer forward cover.
  - Explicit capital movement restrictions exist (Jafarov 2010): examples include restrictions on borrowing abroad by economic agents and participation of nonresidents in domestic money market.
- Uganda:
  - Currency: Uganda shilling. Regulator: Bank of Uganda (BOU).
  - Exchange rate regime: reclassified in April 2007 from “independently floating” to “managed floating with no predetermined path” (AREAER 2005–2008).
  - Forward FX market exists in which authorized banks may deal with customers.
- Burundi:
  - Currency: Burundi franc. Foreign exchange market highly fragmented; multiple exchange rates (official vs market).
  - BRB sets official exchange rate daily based on a weighted average of commercial bank rates; different commercial banks transact at different spot rates.
  - BRB conducts foreign exchange auctions; prior to end-2007 significant deviations among winning bids (> 2 percent).
  - Since December 28, 2007: auction rule change placed an upper bound of 2 percent on variations of winning bids for a given auction.
  - Fragmented spot market makes a unified forward market impossible or hard to monitor.
- Rwanda:
  - Currency: Rwanda franc. Exchange rate heavily regulated by National Bank of Rwanda (NBR).
  - Since abolition of FX auctions in June 2007, NBR sells francs at a predetermined reference price (effectively pegging the Rwanda franc to the U.S. dollar).
  - NBR is sole primary supplier of foreign currency; sells to banks which conduct secondary interbank spot trades; retail banks set spot rates with customers.
  - Forward market authorized (short-term forwards 1–12 months) but not operational—limited demand given peg and limited exchange rate variability.

### Caveats and limitations of the CIP-deviation approach for regional integration
- Ideal measure would use EAC currency-pair forwards; these mostly do not exist, so U.S. dollar cross is used.
- Using deviations vis-à-vis the U.S. dollar is useful if observed deviations reflect barriers imposed by EAC countries rather than by the U.S.
- Data-sparse and illiquid forward markets limit inference and raise concerns over measurement error and representation.

### Conclusions and policy recommendations
- Main conclusions:
  - Financial barriers exist within the EAC; EAC members are significantly less financially open than developed countries.
  - Among Kenya, Uganda, Tanzania: Kenya most open, Uganda next, Tanzania least open (with ranking nuances depending on statistic used).
  - Burundi and Rwanda: no forward FX contracts observed; likely greater financial barriers. Specific prerequisites missing:
    - Burundi: needs to unify fragmented spot market.
    - Rwanda: lacks exchange rate flexibility (Rwanda franc effectively pegged to U.S. dollar), reducing demand for forwards.
- Policy recommendations and steps toward regional financial integration:
  - Remove and lower existing financial barriers to facilitate integration.
  - The EAC agreement to abolish existing capital controls by the year 2015 is a positive step.
  - Removal of capital controls, combined with policies to encourage trade among EAC members, should allow foreign exchange markets to grow in size and depth and increase prevalence of FX instruments.
  - Coordination among countries and joint reduction of financial barriers are crucial for deeper integration.

*Source: _wp10194 - References*

### References .............................................................................................................

### _wp10194 - References

### I. Introduction and objective
- The countries of the East African Community (EAC partner countries) are aiming for full economic integration and have recently ratified the Common Market Protocol; attention is now turning to monetary and financial integration and the negotiation of a Monetary Union Protocol.
- Financial integration requires removal of barriers to international movement of capital across national boundaries; free capital movement among countries with different currencies requires integration of foreign exchange and money markets.
- A well-established regional foreign exchange market is a crucial step towards financial integration because capital movement would be difficult if the currency of one country cannot be converted into that of another.

### Definition and concept of market integration
- An integrated financial market is one in which potential market participants face a single set of rules, have equal access, and are treated equally (Baele et al, 2004).
- For an integrated interbank money market in the EAC, all banks—regardless of country origin—should have equal access to the money market of every EAC partner country.
- Given each EAC country has its own currency, the foreign exchange markets of EAC members must function as one market to facilitate interbank money market integration.
- The paper focuses on integration of foreign exchange markets and money markets among EAC countries.

### Measure of financial openness: deviations from Covered Interest Parity (CIP)
- It is possible to construct a theoretically sound and computationally easy measure of financial openness based on deviations from covered interest rate parity (CIP).
- This paper develops such an indicator for Kenya, Tanzania, and Uganda using forward foreign exchange and inter-bank interest rate data.
- The analysis examines empirical deviations from CIP for each of these countries using forward contracts between domestic currency and the U.S. dollar.
- Burundi and Rwanda are excluded because forward foreign exchange data for these countries is not available.
- Deviations from CIP imply existence of financial barriers rather than other types of barriers; Frankel (1993): “only...CIP is an unalloyed criterion for capital mobility in the sense of the degree of financial market integration across national boundaries.”
- Some scholars see CIP as a necessary condition for perfect capital mobility; hence deviations from CIP are evidence of limited capital mobility (Willet et al., 2001).

### Empirical background and literature context
- Montiel (1994) cited lack of data—especially forward foreign exchange rates—as a main reason for not using deviations from CIP as a measure of financial openness for developing countries.
- In developed markets, most empirical studies suggest CIP holds well. Using high frequency data, Akram and others (2008) find deviations occur for dollar-euro, dollar-sterling, and dollar-yen but are relatively short lived, lasting no more than 15 minutes.
- During the global financial turmoil around September 2008, deviations from CIP became more persistent in some markets (e.g., dollar-euro) (Sarkar 2009, Baba and Packer 2009, Mancini-Griffoli and Ranaldo 2009):
  - Sarkar (2009) identified a drastic increase in magnitude of deviations in the dollar-euro forward market following the Lehman Brothers bankruptcy in September 2008.
  - Baba and Packer attribute CIP deviations to differences in counterparty risk between European and U.S. financial institutions.
  - Mancini-Griffoli and Ranaldo (2009) point to liquidity constraints in the dollar money market as the primary cause of observed CIP deviations.
  - Coffey and others (2009) argue CIP violations between developed-country currency pairs were due to liquidity constraints and heightened counterparty credit risk.

### Expected patterns and EAC-specific considerations
- Given CIP deviations exist even in developed markets, one should expect higher levels of deviations among EAC countries due to likely higher counterparty and illiquidity risks and turbulence.
- Transaction costs can be very high in EAC countries; such risks can be interpreted as specific forms of financial barrier and are therefore relevant to a financial barrier measure.
- Forward markets in EAC countries lack depth because of modest levels of cross-country trade in the region and banks’ limited engagement in proprietary trading; banks may prefer other more profitable activities over forward trading.
- Increased financial integration, trade activity among EAC countries, and greater competition in banking sectors might alleviate limited forward market depth in the future.

### Interpretation and comparative findings from data
- Deviations from CIP using forward contracts between EAC currencies and the U.S. dollar measure financial openness vis-à-vis the United States.
- Differences among EAC members in openness vis-à-vis the United States can be used to infer how far each partner country is from full financial integration with each other.
- If the EAC were fully integrated financially, all EAC members should converge in terms of their openness vis-à-vis the United States.
- Data from Kenya, Tanzania, and Uganda suggest different levels of financial openness:
  - Kenya is most open.
  - Uganda is next.
  - Tanzania is least open.
- From this, one can infer that financial markets of these countries are not very integrated.

### Structure of the paper (as provided)
- Section II: gauges intra-regional financial flows by analyzing trade flow data.
- Section III: provides an overview of the foreign exchange markets in these countries, including exchange regulations and restrictions.
- Section IV: explains the use of deviations from the CIP as an aggregate measure of financial barriers, and describes data sets for Kenya, Uganda, and Tanzania.
- Section V: presents estimates of the financial barrier proxy for these three countries and addresses caveats to the analysis.

*Source: _wp10194 - References*

### Section VI concludes.

### Section VI concludes.

### Background: intra-EAC trade and implications for foreign exchange markets
- Trade used as a proxy for financial flows (arguably a lower bound) because direct data on financial flows among EAC members are not available.
- Figures (from 2000–2008) show intra-regional imports and exports vary across countries and are most substantial for Kenya, indicating a commensurate need for foreign exchange among EAC members.
- Table 1 (2008) — absolute trade and GDP values:
  - Imports:
    - Kenya: $12.3Bn
    - Tanzania: $6.9Bn
    - Uganda: $3.3Bn
    - Rwanda: $1.0Bn
    - Burundi: $0.47Bn
  - Import/GDP (in percent):
    - Kenya: 40.8
    - Tanzania: 33.2
    - Uganda: 22.8
    - Rwanda: 22.6
    - Burundi: 42.9
  - Exports:
    - Kenya: $5.7Bn
    - Tanzania: $1.9Bn
    - Uganda: $1.0Bn
    - Rwanda: $0.29Bn
    - Burundi: $0.09Bn
  - Export/GDP (in percent):
    - Kenya: 18.8
    - Tanzania: 9.3
    - Uganda: 7.2
    - Rwanda: 6.5
    - Burundi: 8.6
  - GDP:
    - Kenya: $30.2Bn
    - Tanzania: $20.7Bn
    - Uganda: $14.5Bn
    - Rwanda: $4.5Bn
    - Burundi: $1.1Bn
- Observations:
  - Trading volumes of Rwanda and Burundi are much smaller than those of other EAC members.
  - Rwanda and Burundi are the only two EAC countries without forward foreign exchange markets; lack of forward contracts may stem from low trade volume (low demand) or may exacerbate external trade difficulties due to inability to manage foreign exchange risk.
  - Since forward transactions in the EAC are mostly trade driven and banks do not actively trade the forward market, forward-market trading value should be even less than total imports and exports. This shallowness and illiquidity are a form of financial barrier and can cause deviations from CIP.

### Foreign exchange markets in EAC member countries — features and financial barriers
- General:
  - The paper describes market structures and specific financial flow restrictions that may prevent Covered Interest Parity (CIP) from holding.
- Relatively developed EAC countries (Kenya, Tanzania, Uganda):
  - Kenya:
    - Official currency: Kenya shilling.
    - Regulator: Central Bank of Kenya (CBK).
    - Exchange rate policy (AREAER 2008): “managed floating with no predetermined path for the exchange rate.”
    - Dollar is the principal intervention currency; interventions frequent.
    - Market structure:
      - Authorized commercial banks and foreign exchange bureaus can transact in the spot market.
      - Interbank (wholesale) spot market and a retail spot market exist.
      - Commercial banks can enter into forward contracts conditional on CBK approval; foreign exchange bureaus prohibited from forward market participation.
      - No legal restrictions on currencies traded in forward market, but in practice only dollar-shilling forwards trade.
      - No well-established forward market between Kenya shilling and any other EAC currency; hedging among EAC currencies likely carried out via two dollar-denominated forwards.
    - Most forwards appear entered on behalf of importers/exporters; arbitrage activity in forwards appears low.
  - Tanzania:
    - Official currency: Tanzania shilling.
    - Regulator: Bank of Tanzania (BOT).
    - Exchange rate regime: reclassified to “managed floating with no predetermined path for the exchange rate” (AREAER 2008); prior to April 2007 classified as independently floating.
    - Market structure:
      - Interbank spot market and retail spot market exist.
      - Authorized dealers (banks) are allowed to offer forward contracts, primarily for hedging import/export transactions.
      - BOT does not participate in forward market by offering forward cover.
    - Explicit capital movement restrictions exist (Jafarov 2010) that may prevent CIP from holding (examples: borrowing abroad by economic agents and participation of nonresidents in the domestic money market are restricted).
  - Uganda:
    - Official currency: Uganda shilling.
    - Regulator: Bank of Uganda (BOU).
    - Exchange rate regime: reclassified in April 2007 from “independently floating” to “managed floating with no predetermined path for the foreign exchange rate” (AREAER 2005–2008).
    - There is a forward foreign exchange market in which authorized banks may deal with customers.
- Relatively less developed EAC countries (Burundi, Rwanda):
  - Burundi:
    - Official currency: Burundi franc.
    - Foreign exchange market is highly fragmented; more than one exchange rate (official vs market).
    - BRB sets official exchange rate daily based on a weighted average of commercial bank rates; different commercial banks transact at different spot rates.
    - BRB conducts foreign exchange auctions; prior to end-2007, significant deviations among winning bids (greater than 2 percent), contributing to fragmentation.
    - Since December 28, 2007, auction rule changes placed an upper bound of 2 percent on variations of winning bids for a given auction.
    - Without a unified spot market, a unified forward market would be impossible; allowing forward transactions in this fragmented environment would yield a fragmented and hard-to-monitor forward market.
  - Rwanda:
    - Official currency: Rwanda franc.
    - Exchange rate heavily regulated by National Bank of Rwanda (NBR).
    - Since abolition of foreign exchange auctions in June 2007, NBR has been selling francs at a predetermined reference price (effectively pegging the Rwanda franc to the U.S. dollar).
    - NBR is the sole primary supplier of foreign currency; sells foreign exchange directly to banks, which then conduct secondary trades in an interbank spot market; at retail level, banks may freely set exchange rates in spot transactions with customers.
    - A forward exchange market has been authorized (short-term forwards only, 1–12 months), but the forward market is not operational—limited demand given the peg and limited exchange rate variability.

### Methodology for gauging financial openness (CIP-based measure)
- Rationale:
  - Use deviations from Covered Interest Parity (CIP) as a measure of financial barriers (including counterparty risk and transaction costs).
  - CIP condition (no arbitrage, no counterparty default risk, no transaction cost) implies forward exchange rate equals spot rate multiplied by ratio of interest rates.
- Constructed measure B:
  - B measures the deviation of actual forward rates (OF) from the CIP-implied forward rate (CIPF).
  - Interpretation of B:
    - The greater the B, the greater the barriers to financial integration.
    - If B is negative, there are more restrictions on inflows than outflows.
    - If B is positive, there are more restrictions on outflows than inflows.
    - B = 0 indicates no empirical deviation from CIP (possible full financial integration), but some deviations may persist even among integrated markets.
  - Economic intuition for signs:
    - B < 0 (OCIP F ≤ CIPF): suggests barriers on financial inflows (increased cost to convert USD into local currency reduces arbitrage opportunities).
    - B > 0 symmetrical argument suggests barriers on financial outflows.
- Practical application:
  - For each country, need spot exchange rate to USD, forward exchange rates to USD for different maturities, interbank interest rates of the local currency, and interbank interest rates of the U.S. dollar.
  - U.S. Libor used as proxy for U.S. dollar interbank rate.

### Data description, estimation results, and key statistics
- Data limitations and cautions:
  - Forward and interbank-rate data for EAC countries are spotty and sometimes unreliable (Bloomberg data not frequently updated; interbank interest rates are spotty; limited variance raises data-integrity concerns).
  - Forward markets in EAC are shallow and illiquid; forward quotes between January 2008 and June 2009: only 49 quotes reported for any given forward maturity.
  - Forward maturities available: 1 month, 2 months, 3 months, 6 months, 9 months, 12 months (where available).
  - Interbank deposit rates for Kenya and Tanzania: 1-month, 2-month, 3-month, 6-month, 12-month available; 9-month data lacking.
  - For Uganda, only 1-month, 2-month, 3-month interbank deposit rates available; CIP deviations using 6-month, 9-month, 12-month forwards cannot be calculated for Uganda.
- Spot exchange rate behavior (January 2008–June 2009):
  - Kenya, Tanzania, and Uganda all experienced depreciation against the U.S. dollar since June 2008 (Bloomberg LP).
- Estimation results (CIP deviations B):
  - Figure 7 shows deviations from CIP for Kenya, Tanzania, and Uganda by forward maturity (1-, 2-, 3-, 6-, 12-month where available) over Feb-09 to Jun-09.
  - General patterns:
    - Kenya exhibits the least amount of CIP deviation over the period among the three countries.
    - CIP deviations tend to be greater with longer forward maturities (12-month > 6-month > 3-month); traders charge higher premiums for longer maturities to compensate for uncertainty about the extent of restrictions.
  - To generate a single measure per country, the arithmetic average of CIP deviations across maturities was taken.
- Summary statistics (Table 2 — Average CIP Deviations, in percent):
  - Kenya:
    - Max: 1.55
    - Min: –0.51
    - Mean: 0.34
    - Median: 0.30
    - St. Dev.: 0.50
  - Tanzania:
    - Max: 1.93
    - Min: –3.61
    - Mean: 0.37
    - Median: 0.74
    - St. Dev.: 1.01
  - Uganda (note: average calculated using only 1-month, 2-month, 3-month series because Uganda has no longer term forward contracts):
    - Max: 2.83
    - Min: –1.16
    - Mean: 0.78
    - Median: 0.81
    - St. Dev.: 0.76
  - United Kingdom (comparison, 12-month sterling-dollar forwards between January 2006 and August 15, 2008):
    - Max: 1.06
    - Min: –0.45
    - Mean: 0.14
    - Median: 0.11
    - St. Dev.: 0.19
- Summary statistics (Table 3 — Absolute CIP Deviations, in percent):
  - Kenya:
    - Max: 1.55
    - Min: 0.00
    - Mean: 0.46
    - Median: 0.34
    - St. Dev.: 0.40
  - Tanzania:
    - Max: 3.61
    - Min: 0.01
    - Mean: 0.88
    - Median: 0.92
    - St. Dev.: 0.60
  - Uganda (average calculated using only 1-month, 2-month, 3-month series):
    - Max: 2.83
    - Min: 0.02
    - Mean: 0.91
    - Median: 0.83
    - St. Dev.: 0.59
  - United Kingdom (comparison):
    - Max: 1.06
    - Min: 0.00
    - Mean: 0.17
    - Median: 0.14
    - St. Dev.: 0.15
- Interpretation of estimation results:
  - Kenya has the lowest mean and median deviation from CIP among the three studied EAC countries; suggests Kenya has the least financial barriers and is most ready for financial integration among the three.
  - Kenya’s barrier measure exhibits the lowest volatility among the three.
  - Tanzania and Uganda are both less open than Kenya and have comparable financial openness vis-à-vis each other; which country is more open depends on whether mean or median is used (Tanzania has a lower mean but higher median).
  - Kenya’s measure of financial barriers is nearly 3 times higher than that of the U.K., indicating significant distance from developed-country levels.
  - Overall, EAC members are significantly less open financially than developed countries; EAC financial integration has a significant way to go.
  - Data and methodological caveats:
    - The CIP-deviation measure has drawbacks for regional integration analysis because forward contracts among EAC currencies do not exist; the ideal measure would use EAC currency-pair forwards.
    - Using the U.S. dollar as a common benchmark is useful if observed deviations reflect barriers imposed by EAC countries rather than by the U.S.

### Conclusions and policy recommendations
- Main conclusions:
  - Financial barriers exist within the EAC; EAC members are significantly less financially open than developed countries.
  - Among the three more advanced EAC countries studied (Kenya, Uganda, Tanzania), ranking of financial openness: Kenya (most open), Uganda, Tanzania (least open).
  - Burundi and Rwanda: no forward foreign exchange contracts observed; they likely have greater financial barriers than their more advanced neighbors. Specific prerequisites for a forward market are missing:
    - Burundi needs to unify its fragmented spot market.
    - Rwanda lacks exchange rate flexibility (Rwanda franc effectively pegged to U.S. dollar), reducing demand for forwards.
- Policy recommendations and steps toward regional financial integration:
  - EAC members can remove and lower existing financial barriers to facilitate integration.
  - The EAC agreement to abolish existing capital controls by the year 2015 is a positive step toward financial integration.
  - Removal of capital controls, combined with policies to encourage trade among EAC members, should allow foreign exchange markets to grow in size and depth and increase prevalence of foreign exchange instruments.
  - Coordination among countries and joint reduction of financial barriers are crucial for a more integrated EAC.

*Source: _wp10194 - Section VI concludes.*

### REFERENCES

### REFERENCES

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- Dooley, M. P. and P. Isard, 1980, “Capital Controls, Political Risk, and Deviations from Interest-Rate Parity,” Journal of Political Economy 88, pp. 370–384.
- Eichengreen, B., 2001, “Capital Account Liberalization: What do Cross-country Studies Tell Us?” World Bank Economic Review 15, pp. 341–365.
- Frankel, J.A., 1993, “Measuring International Capital Mobility: a Review.” AER. 82, pp. 197–202.
- García-Herrero, A. and P. Wooldridge, 2007, “Global and Regional Financial Integration: Progress in Emerging Markets.” BIS Quarterly Review, pp. 57–70.
- Holmes, M. J., 2000, “Some New Evidence on Exchange Rates, Capital Controls, and European Union Financial Integration.” International Review of Economics and Finance 10, pp. 135-146.
- Jafarov, E., 2010, “East African Community: Cross-country Financial Linkages.” IMF Working Paper. Forthcoming
- Leblang, D. A., 1997, “Domestic and Systemic Determinants of Capital Controls in the Developed and Developing World,” International Studies Quarterly, 41 pp. 435–454.
- Mancini-Griffoli, T. and A. Ranaldo, 2009, “Limits to Arbitrage During the Crisis: Funding Liquidity Constraints and Covered Interest Parity.” Working Paper, Swiss National Bank.
- Montiel, P. J., 1994, “Capital Mobility in Developing Countries: Some Measurement Issues and Empirical Estimates,” World Bank Economic Review 8, pp. 311–350.
- Phylaktis, K., 1999, “Capital Market Integration in the Pacific Basin Region: An Impulse Response Analysis,” Journal of International Money and Finance 18, pp. 267–287.
- Popper, H., 1993, “Long-term Covered Interest Rate Parity: Evidence from Currency Swaps.” Journal of International Money and Finance 12, pp. 439–448.
- Sarkar, A., 2009, “Liquidity Risk, Credit Risk, and the Federal Reserve’s Responses to the Crisis.” Financ Mark Portf Manag 33, pp. 335–348.
- Thornton, D. L. (1989). “Tests of Covered Interest Rate Parity.” The Federal Reserve Bank of St. Louis Review, pp. 55–66.
- Wang, Y. D., 2010, “Anomaly in China’s Dollar-RMB Forward Market.” China & World Economy 18:2, 96–120.
- Willet, T. D., M. W. Keil and Y. S. Ahn, 2002, “Capital Mobility for Developing Countries May Not be so High,” Journal of Development Economics 68, pp. 421–434.

### Reports, datasets, and online sources
- Annual Report on Exchange Arrangements and Exchange Restrictions, 2004 (Washington: International Monetary Fund).
- Annual Report on Exchange Arrangements and Exchange Restrictions, 2005 (Washington: International Monetary Fund).
- Annual Report on Exchange Arrangements and Exchange Restrictions, 2006 (Washington: International Monetary Fund).
- Annual Report on Exchange Arrangements and Exchange Restrictions, 2007 (Washington: International Monetary Fund).
- Annual Report on Exchange Arrangements and Exchange Restrictions, 2008 (Washington: International Monetary Fund).
- British Bankers’ Association, 2009, “Historical Dollar Libor and Historical 1-year Sterling Libor” [online], April.
- Bloomberg, 2009, “Historical Dollar–Sterling 1-year Forward Rates, Historical Dollar Exchange Rates, Interbank Interest Rates, and Forward Rates of Kenya Shilling, Tanzania Shilling, and Uganda Shilling”: Dollar-Sterling 1-year forward rate.
- Federal Reserve Board of Governors, 2009, “Historical US/UK Foreign Exchange Rate and Historical Fed Funds Rate,” [online], April.
- Decressin, J., H. Faruqee, and W. Fonteyne, 2007, “Integrating Europe’s Financial Markets.” (Washington: International Monetary Fund).

*Source: _wp10194 - REFERENCES*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp10194.pdf_