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Can The CFA Weather The Euro Storm?

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Can The CFA Weather The Euro Storm?

In a worst-case scenario, the battered 13-year-old Eurozone could break-up, creating difficult policy options for the 14 economies of Africa’s Franc Zone whose currency, the CFA franc, is pegged to the euro. Is Africa’s Franc Zone braced to weather the storm in the event of a euro break-up?

Continued efforts by European leaders at numerous summits in 2011 to restore confidence in Eurozone public finances have been viewed as largely ineffective. They attempted to inject fiscal discipline and make the European Financial Stability Facility (the EU’s rescue fund) for troubled sovereigns, fully operational. The euro also recently plunged to its lowest level ($1.29) against the dollar in 18 months. London-based Lombard Street Research states predicts that “Europe’s current approach to its crisis will fail.”

A new set of stringent budgetary rules, to form a ‘fiscal compact’, may be hard to impose on Italy and Spain, which need to borrow a combined total of €590bn in 2012 to refinance maturing debts. The new pact commits Eurozone members to ‘structural’ fiscal deficits of just 0.5% of GDP – compared to the previous target of 3% of GDP under the Stability and Growth Pact which failed to control rising deficits over years and where penalties were usually waived. The last summit in December 2011 did not specify the penalties for non-compliance. This vague accord may not be ratified by some national Parliaments (notably Greece) and might not be enough to keep the euro intact over 2012.

One major worry is that proposed caps on government borrowing would hinder economic activity and make it even harder for stricken EU members (Greece, Ireland, Portugal, Spain and Italy) to grow their way out of debt. The UK’s Coutts Bank agrees: “Europe is now on a clear agenda of prolonged austerity,” it says, warning of a deep recession – far more severe than the 0.4% output contraction, which the European Central Bank (ECB) considers a worst-case scenario.

The markets fear that credit rating agencies Standard & Poor’s (S&P) or Moody’s will downgrade either France or the Eurozone’s credit rating, thereby pushing yields on government bonds above the sustainable 7-8% levels. S&P cited “continuing disagreements among European policy makers on how to tackle the immediate market confidence crisis and, longer term, how to ensure greater economic, financial and fiscal convergence among Eurozone members.” It also raised the probability of the Euro Area slipping into a recession this year – thus impacting global trade and leading to renewed credit crunches like in 2009.

The Eurozone was entirely a politically inspired project whose main goal was genuine economic and political union across the European continent. The longer-term viability of the euro depends on fiscal consolidations and real political will by member states to finance each other when credit markets dry up. Finance is not the issue. As a bloc, the European Monetary Union (EMU) enjoys surpluses on balance of payments – in contrast with perennial external deficits in the US.

The Economist magazine believes that only the creation of ‘full’ fiscal union, where rich northern countries subsidise poorer southern economies or unlimited bond purchases by the ECB could satisfy sceptical investors. An ECB sovereign guarantee programme would calm the credit markets and provide breathing space for the Eurozone to implement structural reforms. Time is fast running out for the euro – with repercussions across the globe, not least in Francophone Africa.

The Euro-CFA franc peg

Worldwide, there are only four monetary unions: the Euro Area, the Eastern Caribbean Currency Union, the Central African Economic and Monetary Community (CEMAC, with Yaounde-based BEAC as its central bank) and the West African Economic and Monetary Union (WAEMU, with Dakar-based BCEAO as the central bank).

The main institutional characteristics of the African unions are (1) a fixed peg to the euro; (2) a convertibility guarantee by the French Treasury; and (3) a set of legal, institutional, and policy requirements designed to ensure the sustainability of the arrangement.

The CFA zones have had one of the longest experiences with a fixed exchange regime for a convertible unit and with regional integration, of any group of developing economies. The current system has been operational for almost 65 years.

Over the past decade, the euro peg has underpinned macroeconomic stability. The Franc Zone tends to have lower inflation and more fiscal discipline compared to countries with flexible exchange rate regimes.

The CFA arrangement has also been linked to stronger institutions, especially the well-recognised central banks and greater policy transparency. Yet, some analysts have argued that the CFA mechanism has certain drawbacks. Economic structures and developments in the two unions are increasingly diverging.

The CFA franc has appreciated against the dollar since the early 2000s, making exports less competitive and attracting a surge of cheap imports from Anglophone markets. There are also marked changes in export prices for the two unions. The CEMAC members (except CAR) are oil exporters, benefiting from strong prices. By contrast, the main export products of WAEMU are agricultural goods (mainly cotton), which have suffered chronic weak prices.

A common interest rate-exchange rate policy also entails costs, as the monetary conditions might be either too tight or too lax for individual members.

For example, in Burkina Faso the inflation rate in 2011 of 1.9% was below the Franc Zone average of 3.4% (according to the IMF), suggesting that monetary conditions were tight for this country. Inflation in Equatorial Guinea, on the other hand, has averaged above 7% over the past three years. Concurrently, the real exchange rate has appreciated, which reduces competitiveness of the non-oil sector.

Referring to the CFA system, the IMF’s chief Christine Lagarde said: “The Franc Zone has had the great benefit of the stability of the euro as a pillar currency. I don’t want to pass judgment on what the African countries that are part of the zone think about it, it is really for them to decide, but what I’ve heard from finance ministers in the various meetings we’ve had over the years in my previous capacity (as France’s finance minister) is that there were benefits to be had from that alignment with the euro, more than downsides to it.” The euro-peg eliminates exchange rate risk in trading between Franc Zone and EMU states

Altering or abandoning the peg?

The extent of the impact upon the Franc Zone would, however, depend on the manner of a Eurozone break-up. There are three possible scenarios:

1. Departure from the EMU of Greece and perhaps Italy in an orderly manner could strengthen the euro after short-term volatility, if investors’ faith in the EMU were quickly restored and members commit to debt reduction. But a stronger euro (hence the CFA franc) would make the zone’s exporters highly uncompetitive by global standards. Policy makers will face a choice of either maintaining an overvalued currency that hinders economic growth or implement a small ‘one-off’ devaluation aimed at boosting export competitiveness.          

A weaker currency also encourages ‘invisible exports’ chiefly tourism and inward investment by increasing the purchasing power of foreign tourists and investors. But on the downside, a hefty devaluation (like in 1994) can cause rapid ‘imported’ inflation and increase the costs of servicing external debt in local-currency terms. This would require more CFA francs to repay interest and principals on dollar-denominated loans.

2. EMU’s continuous instability prompts some Franc Zone members to withdraw unilaterally from CEMAC or WAEMU and adopt more flexible currency regimes. They could also peg their exchange rates to a basket of currencies – comprised of major trading partners. The Central African oil exporters (Gabon, (Equatorial Guinea and Congo Republic) may prefer leaving the Franc Zone by pegging their new currencies to the US dollar in which oil and gas contracts are priced. A stronger dollar (versus €) boosts oil earnings in dollar-terms, thereby enabling oil exporters to buy more imported goods from Europe and elsewhere.

3. An unlikely, but potentially more worrying, scenario is that Germany and France withdraw from the EMU and recreate the Deutschmark and the French franc in order to re-establish prudent fiscal and monetary policies and stronger national currencies. Without the two pillars of the euro, EMU will quickly disintegrate, causing turmoil in the financial markets. It is difficult, however, to foresee Francophone countries pegging their currencies solely to France. Such a move would face strong political opposition from nationalists in the region. Besides France is no longer a major trading partner of the Franc Zone.

Judging by market sentiments, the euro may survive without Greece. Meanwhile, the Franc Zone currency peg should continue, although a joint devaluation versus major currencies looks increasingly probable. The two African EMUs are embracing deeper regional integration and have intensified efforts to foster an effective regional bloc by ending existing barriers to intraregional trade and financial flows and improvements to labour mobility.

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