#04: The African Continental Free Trade Area: Exchange Rate Misalignment's

It is not clear if the hopes of Africans are on the rise because of the African Continental Free Trade Area (AfCFTA) but it is evident that it is a step in the right direction. This agreement became effective on January 1ST, 2021. It was celebrated as revolutionary for Africa by the Foreign Policy because it has the potential to be the world’s largest free trade area since the World Trade Organization (WTO). To be honest, the excitement is understandable. After all, the AfCFTA will cover a market of 1.2 billion customers and an estimated $3 trillion in combined GDP, with the potential of increasing intra-African trade by over 50%. A publication made by The World Bank in July of 2020 projected that the agreement could lift millions on the continent out of extreme poverty whiles casually adding an extra $76bn to the Global GDP.

Despite these projections the implementation of the trade agreement is going to be a long and uphill battle. The major problems of the continent such as Political turmoil, gaps in infrastructure, and security threats are among the impediments to free trade in much of Africa. Of particular importance here is the mix of exchange rate regimes from one sub-regional market to another, which entails heterogeneous reactions to price, fiscal, productivity, and debt shocks, resulting in significant misalignment's and substantial growth disparities among countries. In this post, I will lay out my thoughts on the relevance of monetary and exchange rate policy for the different governance structures and membership in trade agreements.

EXCHANGE RATE MISALIGNMENT'S AND WHY THEY MATTER.

In every country there exist an exchange rate regime. They essentially define the rules under which most if not all central banks would intervene to determine the exchange rate. The exchange rate being the price of one currency in terms of another currency or a basket of currencies. These rules translate into a wide range of regimes, from purely floating exchange rates like we have in Ghana to fixed or rigid regimes like in China in which the central bank tries to make sure that the exchange rate does not vary (too much) over time.

One big problem that exists for economic policy s that the diversity of exchange rate regimes entails divergent exchange rates and big departures from equilibrium levels, viz., what the exchange rate level would be in the best possible situation for a country. Looking at Figure 1, deviations on either side of the supposed equilibrium level are referred to as exchange rate misalignment's. On the one hand, misalignment's may translate into overvaluation phases where a country’s currency value is higher than it should be, implying lower competitiveness compared to trading partners. On the other hand, they might instead converge to undervaluation periods characterized by a cheaper currency value than expected implying, ceteris paribus, higher competitiveness margins.

Figure 1

Source: Author

The consequences of these various dynamics are clear. If countries face an overvalued currency, the central bank must sell its reserves of foreign currency to "mobilize" its own currency's excess supply. In contrast, the domestic inflation rate could eventually be reduced and a nominal increase could result, pushing the exchange rate towards the peg.

The success of this strategy is obviously limited by the size of the country’s reserves that can become seriously depleted in case of a persistent misalignment. And if market agents believe that the government lacks sufficient reserves to support the peg, then a country is exposed to a speculative run on its currency.

If the currency is undervalued, the situation somewhat varies. In view of this, a central bank will respond by extending its own supply of money to purchase foreign currency. Since the creation of fiat money is beyond intrinsic restrictions, no apparent restriction can be placed on the willingness of central banks to play this game. We realize the expansion of money supply may inevitably be inflationary, but it will reduce the unrestricted fluctuation of the currency itself.

CURRENCY REGIMES ARE NOT BY THEMSELVES THE REASON FOR MISALIGNED EXCHANGE RATES

Looking at the economic efficiency costs and advantages of alternate exchange-rate systems, unified exchange-rate regimes have been shown to far outperform dual or multiple exchange rate structures. While causal evaluation has not been imputed, the recent findings are strong example in Nigeria's multiple exchange rate windows and its poor growth output over the last 10 years or so. Despite their benefits (e.g., a reduction in uncertainty), fixed regimes gradually lead developing countries to overvaluation over time, undermining competitiveness and reducing trade. Based on policy research working paper by the world bank, it was put forward that the extent of the misalignment in flexible regimes appears significantly higher than in fixed regimes.

The paper is aimed to regard participation in regional trade, investment and political governance arrangements as explanatory reasons for exchange rate misalignment's.

It reveals that fixed regimes in less mature democracies appear to restrict exchange rate misalignment's as trade and investment deals become more and more active, whereas more mature democracies have the ability by using flexible exchange rate regimes to prevent these misalignment's. However, for mature democracies, high openness to trade and investment might also come with some drawbacks in the form of higher misalignment's in non-fixed regimes (see Figure 2). Hence, by combining three topics usually addressed separately in economic literature, it is suggested that the exchange rate system per se is not responsible for misalignment's. Instead, what seems to matter a lot is whether countries have mature democracies and are members of trade/investment agreements.

Figure 2: Average of Exchange Rate misalignments

Percent of absolute values

Source: World Bank

WHAT CAN THE AFCFTA TAKE FROM THIS

Due to weak governance, it could be more difficult for less mature democracies to adapt to exogenous shocks. A further degree of complexity reflects the variety of exchange rate arrangements in a single free trade region which results in variations between "winners" and "losers." There is a probability that winners will be found in countries with better governance and political structures and more flexible systems, which can produce competitiveness gains in sound monetary and exchange rate policies. The loser of less advanced democracies, on the other hand, would be the most popular tolerant of overvalued currencies, in which AfCFTA would not generate net positive profits because of their less efficient capacity.

Concluding this post, I would iterate that, no single exchange rate regime is good for all countries. Good governance plays a key role in good macroeconomic management. I postulate that more mature democracies are likely to be more resilient to shocks and benefit more from the AfCFTA. The less mature democracies have two alternatives, it is either they resist continental trade and investment agreements or institute stronger democracies at home. AfCFTA’s success will depend on how effective it is in convincing them to eschew the former and adopt the latter.

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This blog is sponsored by Traide Africa