The Effect Of Southern Africa’s Common Monetary Area On Trade

Growth is at the core of Africa’s policies. Trade is seen as a way to achieve that. Means are being sought to create more trade. However, weak productive capacities, tariffs and non-tariff measures(NTMs) are some of the challenges obstructing trade expansion. Considerable success has been achieved on tariffs. Less and less tariffs are being applied. Nonetheless, the challenge still remains on the NTMs. While some NTMs are easy to deal with, many require costly structural changes. One such NTM is the use of different currencies for international trade, which can be dealt with by forming monetary unions. This study empirically investigates the effect of southern Africa’s Common Monetary Area(CMA) on trade. The study specifically pursues five key objectives. The first objective is to empirically analyze the effect of CMA on trade. I use two different samples of unbalanced panel data. One sample comprises of 158 countries, while the other sample includes 48 exclusively African countries. The sample period is from 2001 to 2013. With the unbalanced panel data, I estimate a gravity model and apply country pair fixed effect method. The study produces results indicating that the CMA has a trade creation effect on the members. Members of the CMA trade with each other about four times more than those outside the monetary union. The two samples produce similar results. I also estimate a random effects model. However, a Breusch – Pagan random effects test fails to support the use of this model. The empirical analysis leads to the conclusion that African countries can use monetary unions as a strategy for promoting trade, which carries the promise of supporting the needed growth. The second objective is to assess if the CMA is an optimal currency area. The CMA has been intact since its formation in 1986. The experiences from the CMA could be of use to other African countries that are aspiring to form their monetary unions like the South African Development Community(SADC), Common Market for Eastern and Southern Africa(COMESA) and the East African Community(EAC). The theory of Optimum Currency Areas(OCA) outlines conditions under which it can be desirable to form or join a monetary union. The suitable conditions include symmetric shocks; flexible wages and prices; factor mobility; high level of openness; high level of product diversification; fiscal integration; and fiscal transfers. So, the study assesses the degree to which CMA meets some of the conditions of the OCA theory. Particular attention is given to the level of openness and product diversification. The analysis establishes that there is high level of openness and product diversity in the CMA. The high level of openness suggests suitability for a monetary union. However, a clear conclusion based on product diversity cannot be made because earlier studies have shown that the implications are contradictory. High product diversity may mean a window for insulating product specific shocks, making it suitable for a monetary union. On the other hand, it may suggest a need for different policies, making it unsuitable for a monetary union. The third objective is to critically review the existing literature on the trade effect of monetary unions. The review finds that there are diverging results. Some studies have found that monetary unions have a huge effect on trade, while others have established just small effects. The results vary with methodologies, sample size and period. This finding leads to a conclusion that the magnitude of the monetary union effect on trade is sensitive to the type and locality of a monetary union. Furthermore, results are very sensitive to methodology and therefore due diligence has to be given to estimation methodology to get reliable results. The fourth objective is to analyze the transmission mechanism through which monetary unions could affect trade. The analysis involves reviewing different theories that seek to explain the link between monetary unions and trade. The investigation establishes that there exist multiple channels through which monetary unions can affect trade. These transmission channels include reduced transaction costs, elimination of risk associated with exchange rate volatility, increased competition; increased market access; lowered barriers to trade; economies of scale; and lowered interest rates. The conclusion from this analysis is that there is basis for expecting monetary unions to improve trade among members. The last objective is to suggest policy recommendations relevant for forming monetary unions. The study draws recommendations from the analysis, results and conclusions. Among the policy recommendations are that African countries should support the formation of monetary unions in their RECs for the benefit of trade expansion because empirical evidence in support of the same, from an African monetary union with comparable economic structure, has been established. The other policy recommendation is that future monetary unions shall need to take into account economic needs of all members for the stability of the group. Furthermore, the study recommends countries with duo Regional Economic Community(REC) membership to decide their future and start preparing switching to one REC because they will have to if the RECs become monetary unions. This study makes three major contributions. The first one is that it advances the existing knowledge about the monetary union effect on trade, particularly in the southern Africa’s CMA, where less attention had been received. Empirical evidence is now available that monetary unions can have a huge trade creation effect, specifically among developing countries. The second contribution is that lessons from the CMA have been extracted, which the African RECs like SADC and COMESA could find useful for their upcoming monetary unions. One of the main lessons is that a monetary union needs support of the citizens from the grass roots level. The third contribution is a suggestion that the OCA theory should be developed further by introducing weights on the conditions. Contradictory conditions should be refined and measurements should be properly quantified to take out ambiguities in the theory. On the overall, this study carries both theoretical and practical significance. On the theoretical part, the study illuminates the underlying reasoning why monetary unions could be part of a solution to economic growth through trade. Furthermore, the study also suggests how the existing theory of Optimal Currency Areas can be developed further to strengthen its prediction ability on whether it may be optimal for a country to join a monetary union. On the practical side, the study provides evidence for the potential trade gain to developing countries from joining or forming a monetary union. Additionally, the study provides lessons from the CMA to other African countries that intend to form monetary unions. The lessons could benefit the aspiring countries with insights on how their monetary unions better be structured to succeed.