Euro indexation, similar to that of Cape Verde, is best monetary solution, IMF concludes

26 May 2008

Washington, USA, 26 May – Monetary indexation, or ‘pegging’, to the Euro, similar to that of the Cape Verdean escudo, would be more favourable to the economy of Sao Tome and Principe than other monetary policies, such as linking to the dollar or other regional currencies.

This is the conclusion of economists Jian-Ye Wang, Marcio Ronci, Nisreen Frahan, Misa Takebe and Amar Shanghavi, authors of the study “The Choice of Monetary and Exchange Rate Arrangements for a Small, Open, Low-Income Economy: The Case of Sao Tome and Principe”, published this month in Washington by the International Monetary Fund.

“The Euro seems to be the best choice” conclude the authors, who looked at the economic characteristics of the archipelago, where important oil exploration is in progress, involving Chinese company Sinopec, as well as at the potential effects – statistically tested – of each of the possible arrangements.

Association with the currency of the EU, where Sao Tome’s most important commercial partners, like Portugal, Spain and France are found, could be done directly by a hard peg or indirectly via membership of the CFA franc monetary union, a currency with a strong link to the Euro.

The choice between these two solutions “depends on domestic institutional capacity and whether an international agreement on external support and effective surveillance of domestic policies can be secured,” say the authors.

“A hard peg to the euro may have a slight edge over joining the Central African Economic and Monetary Community (CEMAC) or the West Africa Economic and Monetary Union (WAEMU), provided that domestic institutional capacity is adequate” and external support is in place, as in the case of Cape Verde, they said.

Cape Verde that, like Sao Tome, is a small, open island economy, linked its escudo to the euro in 1999, with the support of Portugal.

This alteration caused some initial economic difficulties, but is today seen as instrumental in the financial stability and economic growth enjoyed by the North African archipelago, that has allowed it to rise to the category of medium income country in 2008.

The report says that since 2001 the exchange peg has been supported by an exhaustive program of economic reforms that diversified the composition of the Cape Verde economy and reduced its vulnerability to external shocks, while at the same time a reduction in inflation and an increase in tourist revenue were reported.

The Exchange Cooperation Accord with Portugal is considered “decisive” for the success of the process, providing a credit line for short-term needs and also surveillance to ensure continued fiscal discipline.

The authors also draw a parallel with the case of Equatorial Guinea, an oil producing country in the region and CEMAC member, and underline the importance that monetary flexibility can have in maximizing petrol revenues.

“Fluctuations in oil prices could have a much larger impact on national income than changes in cocoa prices, given the potential size of the oil sector (…) As a flexible exchange rate may help address the volatilities in oil revenues, the cost of losing it could be high,” they say.

The question of the future of the Sao Tome dobra has been discussed by the authorities with ever greater urgency over recent months in the light of the escalation in the price of essentials such as rice and fuel.

Apart from being small and low-income, the economy of Sao Tome is characterized by the extensive use of foreign currency and inflexible product market and factors.

Due to these characteristics, say the authors, “monetary policy is a relatively ineffective counter-cyclical tool,” which leads to the advantages of “out-sourcing” in this area – lower costs for international transactions and higher policy creditability and price stability.

They add that these benefits “could outweigh the cost of losing an independent monetary policy.”

Whatever the option chosen by the authorities of Sao Tome, the authors maintain that the success of any initiative is dependent upon fiscal discipline and prudent debt management, structural reforms to facilitate private investment and to increase labour market flexibility, as well as greater transparency. (macauhub)