By Thorvaldur Gylfason
Professor of Economics, University of Iceland and CEPR Research Fellow
Does every country in Africa need a currency of its own?
No. This column describes the monetary zones in-the-making in Africa
and how a further reduction of the number of currencies in Africa would
likely encourage trade and growth and attract investors who are
understandably wary of weak and volatile currencies.
Africa’s great diversity of culture and languages, many Africans
identify themselves as Africans first, then as Congolese, Kenyans,
Nigerians, South Africans, and so forth. Most Europeans, North
Americans, and Asians have it the other way round – country first, then
continent. Even so, national boundaries within Africa are generally
less open than those within Europe, due to a variety of legal and
regulatory restrictions that hamper the cross-border flow of goods,
energy, services, capital, and labour. Many of these restrictions need
to be relaxed to spur growth.
For example, a pan-African energy grid could greatly reduce the cost
of energy across the continent and make air conditioning affordable to
vastly larger numbers of households and businesses. The taming of the
Congo River with one-sixth of the world’s harnessable hydro-energy
potential promises to deliver inexpensive power, through three
electricity superhighways – south to Angola, Botswana, and South
Africa, west toward Nigeria, and north to Egypt and even Europe. In his
memoirs, The Singapore Story (1998), Lee Kwan Yew, former
Prime Minster of Singapore, describes how air conditioning catapulted
his country to prosperity when the stifling heat gave way to cool air
indoors. But I digress.
Does every country in Africa need a currency of its own? No. Because
national currencies constitute an exchange and trade restriction, a
further reduction of the number of currencies in Africa would likely
encourage trade and growth in Africa. This is why the African Union
aims at pooling all the continent’s currencies into a single currency
by 2028. In the meantime, several regional monetary unions are on the
drawing board, and two monetary unions already exist, one de jure and the other de facto.
First, fourteen countries belonging to the Economic and Monetary
Community of Central Africa and the West African Economic and Monetary
Union use the CFA franc. Second, Lesotho, Namibia, Swaziland, and now
Zimbabwe use the South African rand. Botswana used the South African
rand for ten years following independence, 1966-76, before introducing
The Nigerian story
Before independence, pound sterling was Nigeria‘s legal tender. With
the establishment of the Central Bank of Nigeria in 1959, the Nigerian
pound became the nation‘s new currency. Nigeria‘s population at
independence in 1960 was 42 million compared with 52 million in
Britain. The exchange rate was a pound for a pound – one Nigerian pound
was equivalent to one British pound. This arrangement remained intact
until 1973 when the British adopted the decimal system in their
monetary affairs. That year they stopped dividing the pound into twelve
shillings and each shilling into twenty pence as they had done for
ages. Instead, the pound was now divided into a hundred new pence. The
same year, Nigeria adopted a new currency, the naira. The exchange rate
remained unchanged at one to one; one naira was equivalent to one
This arrangement did not last, however. Over time, the naira
weakened because Nigeria‘s macroeconomic policies were inadequate.
Government expenditure exceeded federally collected revenue despite
rapidly rising foreign exchange earnings from oil exports after 1970.
The federal government’s budget deficits were financed through
borrowing at home and abroad and through money creation which led to
inflation and a depreciation of the new currency. Today, it takes 220
naira to buy one British pound. This means that, since 1973, the naira
has depreciated by 15% per year on average vis-à-vis the pound. The
unofficial exchange rate of the naira is now about 20% lower than the
official exchange rate due to restrictions on current and capital
account transactions. For example, those who want to purchase certain
luxury items cannot normally buy foreign exchange from the banks for
this purpose, but they can try their luck in the black market where
virtually anything is available if the price is right. Nigeria is a
well-functioning market economy.
From monetary independence to inflation
The establishment of the naira as Nigeria‘s national currency in
1973 was intended to bolster the country‘s independence by making it
possible for the Central Bank of Nigeria to pursue an independent
monetary policy. It was also a matter of national pride. The thinking
behind the new arrangement was that an independent and flexible
monetary policy would serve the nation‘s interest better than a fixed
exchange rate between the naira and the pound which, in practice, had
been equivalent to using the pound as if it were Nigeria’s national
currency. What happened, however, is that, from 1973 to date, the naira
depreciated by 99.5% against the pound. This depreciation would perhaps
be justifiable had Nigeria managed to use easy money to narrow the gap
separating the standard of living for ordinary Nigerians from the
general standard of living in Britain, but that is not what happened.
The purchasing power of national income per person in Nigeria is now
50% lower relative to Britain’s than it was in 1980.
In view of this experience, Nigeria now has plans to abolish the
naira in favour of joining a monetary union with four or five other
West African countries (The Gambia, Ghana, Guinea, Sierra Leone, and
perhaps also Liberia). The planned monetary union, until recently
envisaged to be launched in 2009, has now been put on ice, however.
Why? The smallest countries show no signs of fear of being swamped by
Nigeria, by far the most populous country in the group (155 million out
of 200 million in the six countries combined). Others, though, may fear
the dilution of their sovereignty when the new Central Bank of the West
African Monetary Zone takes over some of the policymaking
responsibilities of individual national central banks, but that, of
course, is the chief purpose of a monetary union. The new West African
Central Bank will be located in Accra, the capital of Ghana (24
million). The central bank of a monetary union does not belong in the
capital of the union‘s most populous country. The success of the
European Union and of the euro since its launch in 1999 has made an
impression in Africa.
Fewer currencies than countries
The world‘s currencies are declining in number as more and more
nations eye the potential benefits of sharing currencies with their
neighbours. Currencies are like democracies, to paraphrase Winston
Churchill – the best way to preserve their integrity is to share them.
When the West African Monetary Zone comes into being, the number of
currencies in Africa will equal about half the number of countries. And
when the East African Community re-emerges as scheduled with its five
members (Burundi, Kenya, Rwanda, Tanzania, and Uganda), the number of
the continent’s currencies will be reduced by another four. A strive
for efficiency dictates the use of fewer and larger currencies and so
do foreign investors who are understandably wary of weak and volatile
currencies. This centripetal force is opposed by a centrifugal force
rooted partly in national pride but also, more importantly, in the
belief that sovereign national currencies make it possible to pursue
independent and flexible monetary policies to foster economic and
social development. This was the vision of Nigeria’s leaders in 1973,
even if things turned out differently.
How about Iceland?
Now, please fasten your seatbelts. The Icelandic króna was
established in 1886 and maintained its parity with the Danish krone
until 1920. Thereafter, the Icelandic króna lost a fifth of its value
before re-attaining parity with the Danish krone in 1933, a parity that
lasted until the outbreak of World War II in 1939. Until the war, the
general level of prices in Iceland did not rise significantly more
rapidly than in Denmark. During the war, however, prices in Iceland
began to rise at much quicker pace than in Denmark because – you
guessed it – Iceland‘s macroeconomic policies were inadequate.
Therefore, the króna was bound to depreciate. Now, seventy years later,
it takes 23 Icelandic krónur to buy one Danish krone. Actually, the
exchange rate is 2,300 Icelandic krónur for one Danish because two
zeros were chopped off the Icelandic króna in 1981. This means that,
since 1939, the Icelandic króna has depreciated by 99.95% against its
mother currency. Thus, since 1939, the exchange rate of the króna has
fallen by 12% per year on average vis-à-vis its Danish namesake.
Consumer prices in Iceland rose by 18% per year on average during
1960-2008 compared with 17% in Nigeria (see Figure 1). The Central Bank
of Nigeria has plans to chop two zeros off the naira, as Iceland did,
should the advent of the West African Monetary Zone encounter an
Figure 1. Consumer prices in Iceland and Nigeria
Note: Series are normalised so that consumers prices equal 100 in 2000.
Source: World Bank, World Development Indicators 2008 plus updates from local sources.
Was Iceland’s inflation worthwhile? No. The inflation resulted from
lax economic policies and casual attitudes that were conducive to an
escalation of foreign indebtedness and institutional fractures,
including fragile checks and balances and politically motivated
mismanagement of the privatisation of the commercial banks in 1998-2003
that paved the way to the banking system’s spectacular growth followed
by a sudden and complete collapse in 2008. Even so, Iceland managed to
catch up with Denmark. In 1904, when Iceland attained home rule from
Denmark, Iceland’s national income per person amounted to a half of
Denmark’s. Today it is about the same. The current financial crisis
seems unlikely to alter this arithmetic except perhaps briefly because
Iceland’s social and economic foundation remains strong. The
fundamental things apply as time goes by. The crisis seems to have
opened the eyes of many more Icelanders to the advantages of retiring
the króna in favour of the euro and joining the EU. The government of
Iceland has now asked the parliament to approve an immediate
application for EU membership. Stay tuned.