Once again, the Euro zone is in trouble after the Greek elections last Sunday failed to produce a majority government in support of Euro membership and its implications. While Greece may want to leave the Euro zone, the consequences of such exit cannot be confined Greece alone. The BIS data for locational banking statistics on an ultimate risk basis are also now available for the end of 2011, and show consolidated claims on Greece of EUR 90.5bn (136bn a year earlier) for European banks, with France 44bn (56bn a year ago), most exposed. Portuguese banks remain exposed as well, and Spanish banks in turn to Portugal’s banks. And so on…Greek cross border claims remain high on Turkey, Bulgaria and Romania, so dislocation from an impaired Greek banking system would imply sudden stops for these countries. My best bet is, therefore, that Greece will not be allowed to leave – yet.
One reason is that there is widespread “fear of floating” in small open economies. Governments in a typical emerging country can hardly tolerate massive overvaluation or undervaluation of their
currencies. Reasons for fear of floating are the devastating balance–sheet effects and the growth disruptive effects of prolonged periods of misalignment.
Whether hard pegs or membership in monetary unions are a better alternative for open economies depends very much on institutional and regulatory prerequisites and on their degree of endogeneity with respect to the exchange–rate regime. Braga, Cohen and Reisen (2001)[i] summarized these requirements as follows:
· the banking system must be strengthened, so that the central banks’ more limited capacity to provide lender–of–last–resort services does not expose the country to financial instability;
· the fiscal position needs to be strong so that the absence of the central banks’ ability to absorb new public debt does not end in a funding crisis;
· commercial and intergovernmental credit lines must have been negotiated to secure liquidity in an investor sentiment crisis;
· the labour market must be made flexible in order to accommodate asymmetric shocks without higher levels of un(der)development; and
· the real economy structures should be aligned to ensure that cyclical and monetary conditions coincide with the pegging partner.
This is a long list which is not easily met. And it was certainly not met by Greece, which was clear from the outset. In order to see why one should not take for granted that these conditions will be met (somehow endogenously), the CFA experience could have told a lesson already more than a decade ago. Even when monetary unions survive, they can be harmful to growth when the effective (trade–weighted) exchange rate gets out of line, which can happen to a dollarized Latin America as it has happened to the CFA franc zone in Africa, which had been pegged to the French franc since 1949. When the French franc started to appreciate in the mid–1980s against the dollar, but at the same time a prolonged fall in commodity prices reduced the CFA zone terms of trade, the CFA zone countries recorded low growth relative to the rest of Africa, increased current–account deficits and a build–up of external debt. Alternative adjustment measures were unable to rectify the imbalances, and 1994 saw the end of the longest peg in memory: a 50 per cent devaluation of the CFA franc against the French franc.
Arguably, the fragility of the Euro zone today gives CFA zone (and French) authorities reason to reconsider the peg of the CFA franc to the Euro[ii]. The Euro peg undoubtedly garners benefits for the CFA (e.g., lower transaction costs in trading with EU countries), but its fate is not intrinsically tied to the euro. In the case of a breakup of the Euro zone, it would be a big policy mistake for CFA countries to return to a French franc peg.
Even with the former significance of the trade relationship between African countries and Europe, the degree of monetary and economic integration was lower than was apparent at first sight. With a high share of exports commodity based, much of African trade was sold on dollar denominated markets. Pegging to the euro made those countries vulnerable to fluctuations of the real exchange rate of the euro to other currencies. The same could be said of the opposite choice in favour of the dollar. Both pegs very much destabilize the real effective exchange rate for African exporters, hence providing a disincentive to invest in nontraditional export activities. Now, with the strong rise of the emerging countries (EPs for Partners) over the past decade, the negative impact on growth of a currency peg to either dollar or euro would be even more felt, as a result of further destabilized effective exchange rates and the wrong growth anchor as the engine is now China. With the inclusion of the renminbi in the Special Drawing Rights (SDR) basket of currencies planned for 2014, the CFA zone has a new anchor to peg its currency to, with more stability in prospect.
[ii] Consultancy Africa Intelligence (2012), The Impact of Eurozone crisis on the West African Monetary Union zone, polity.org/za, 20 April.