Business Cycle Synchronization in the Proposed East African Monetary Union: An Unobserved Component Approach

Abstract

This paper uses the business cycle synchronization criteria of the theory of optimum currency area (OCA) to examine the feasibility of the East African Community (EAC) as a monetary union. We also investigate whether the degree of business cycle synchronization has increased after the 1999 EAC Treaty. We use an unobserved component model to measure business cycle synchronization as the proportion of structural shocks that are common across different countries, and a time-varying parameter model to examine the dynamics of synchronization over time. We find that although the degree of synchronization has increased since 2000 when the EAC Treaty came into force, the proportion of shocks that is common across different countries is still small implying weak synchronization. This evidence casts doubt on the feasibility of a monetary union for the EAC as scheduled by 2012.The strength of economic ties between countries is reflected by the degree of trade and labor market integration. According to Canova and Dellas (1993) and Frankel and Rose (1998) large trade volumes can increase the co-movement of output. Table 1 shows that the EAC intra-regional trade is low and that on average the EAC states trade more with the Euro-area, Asia, and Middle East than with each other.The low EAC intra-regional trade can be attributed to poor transportation and communication infrastructure, plus a narrow range of primary commodities making up the EAC countries' major exports. Burundi's top exports are coffee, gold, and tea; Kenya's are tea, coffee, and fish; Rwanda's is coffee; Tanzania's are coffee, tobacco, and cotton; Uganda's are coffee, fish, and gold. This also reduces the ability to cope with the idiosyncratic macroeconomic shocks, and there might be limited gains from trade within the region. Given that at the moment labor mobility is low and intra-regional trade faces strong limitations, it is compelling that we examine the synchronization between business cycles for the feasibility of the EAC monetary union.

A Literature Survey on Proposed African Monetary Unions

“…Falagiarda (2010) has suggested that, whereas a common currency area in the region is a viable option, there are some statistical and country-specific anomalies that raise some doubts on quality of findings. Additionally, Kishor and Ssozi (2011) have used synchronization of the business cycle as criteria of optimum currency area to conclude that, while the rate of harmonization has increased since the EAC Treaty was enforced in the year 2000, the degree of interrelatedness is still relatively weak, given that the proportion of shocks common to candidate states is still small. On the same basis of business cycle co-ordination, Sheik et al (2011) have used extracted business trends and cycles to examine correlations and variances of annual GDP data.…”

“…(ii) an anti-thesis on papers that have recommended against the common currency area (Buigut, 2011;Rusuhuzwa & Masson, 2012;Davoodi et al, 2013;Mafusire & Brixiova, 2013;Lepetit et al, 2014;Asongu, 2014bc) and (iii) a synthesis for inquiries that have presented a case for the monetary zone, contingent on substantial policy efforts from candidate countries (Buigui & Valev, 2005 ;Falagiarda, 2010;Kishor & Ssozi, 2011;Sheik et al, 2011). From an initial assessment, like with the case of the WAMU, we find that empirical results and corresponding recommendations differ by authors, periodicity, sampled countries and methodology.…”

Assessing Inflation Convergence in the East African Community

“…Examples include Drummond et al . (), Mafusire and Brixiova (), Kishor and Ssozi () and Buigut and Valev ().…”

A Literature Survey on Proposed African Monetary Unions

“…We summarise in Table empirical studies on the proposed EAMU in a chronology that is consistent with Hegelian dialectics, notably: (i) a thesis on studies presenting a case for the monetary union (Mkenda, ; Bangaké, ; Asongu, ), (ii) an anti‐thesis on papers that have recommended against the common currency area (Buigut, ; Rusuhuzwa and Masson, ; Davoodi et al ., ; Mafusire and Brixiova, ; Lepetit et al ., ; Asongu, , ) and (iii) a synthesis for inquiries that have presented a case for the monetary zone, contingent on substantial policy efforts from candidate countries (Buigui and Valev, ; Falagiarda, ; Kishor and Ssozi, ; Sheik et al ., ). From an initial assessment, as with the case of the WAMU, we find that empirical results and corresponding recommendations differ by authors, periodicity, sampled countries and methodology.…”