Othieno Ferdinand Okoth

The ratification of the East African Community (EAC): the regional intergovernmental organization of the Republics of Kenya, Uganda, Tanzania, Rwanda and Burundi, calls for a close examination of the countries’ economic policy decisions that affect the level and stability of prices, long-term interest rates, the fiscal position and the nominal exchange rate. The question that arises however is whether the EAC economies are ready for a Common Currency. This study sought to answer the question: “Are the five countries that comprise the EAC ready to form a Common Currency Area?”  To achieve this the study carried out various empirical analysis using fifty years time series data on each country’s real GDP per capita, external debt as surrogate for budget deficit, consumer price index, interest rates and the exchange rates between each country’s local currency and the US dollar for the period between 1961 and 2010.

 First the study employed stationarity (unit root) tests, using the Augmented Dickey Fuller (ADF) approach, and the Johansen cointegration test to assess whether the three international parity relations – purchasing power parity (PPP), Uncovered Interest rate parity (UIP), and Real Interest rate parity (RIP) - hold on a paired basis for all the EAC member countries.  The study further employed the Structural Vector Autoregressive (VAR) modeling approach developed by Blanchard and Quah (1989) to identify shocks affecting real GDP per capita in the EAC countries. To assess the direction and magnitude of the shocks the study employed Impulse Response Analysis and Variance Decomposition Analysis respectively. The study failed to find evidence that the individual international parity relations hold for the data set. All the calculated Augmented Dickey Fuller (ADF) statistics for Purchasing Power Parity and Uncovered Interest Parity were larger than the ADF critical values at 1%, 5% and 10% level of significance. Only the ADF statistic showing Real Interest Parity (RIP) between Uganda and Tanzania was significant at 5% level of significance. Based on the Johansen Cointegration test the study established that for the 50 years period between 1961 and 2010, there existed three, two, four, five and four steady-state relationships between the macroeconomic variables for Kenya, Uganda, Tanzania, Rwanda and Burundi respectively in relation to the other four EAC countries.
Contrary to expectation and the cointegration test results the study fails to find support for the Structural VAR model especially if exchange rate between the local currencies and the US dollar is taken to be exogenous to the system of each country’s variables. The study did establish through the impulse response and variance decomposition analysis that the variability of the EAC countries’ real GDP per capita has significantly been prone to the exchange rate fluctuation between the US dollar and respective local currencies with Burundi and Kenya leading in response at 82% and 50% respectively. Tanzania is the least responsive to US dollar fluctuations at a response rate of 5%. Uganda and Rwanda exhibit similar response rates at 25% and 27% respectively. The only endogenous response to EAC GDP per capita that was deemed significant was observed in Tanzania and Rwanda real GDP per capita which recorded responses of 50% and 43% respectively. Kenya, Uganda and Burundi all recorded paltry response rates of less than 10%. As such the most significant external force to the EAC countries macroeconomic system is the exchange rate between the local currency and the US dollar. It was interesting to note that Rwanda and Burundi, which had highest external debt, were the most consistently vulnerable to external shocks from external debt and exchange rate fluctuations. All the EAC countries’ real GDP per capita experienced an increasing response rate to inflation movements in the remaining EAC countries. Kenya’s response increases from a minuscule 9% in year one and increases steadily to 26% by year ten, Uganda increases from 0.7% in year one to 43% in year ten, Tanzania, Rwanda and Burundi all start off at below 0.5% in year one, but increases steadily to explain about 15% of the variability in their GDP per capita by year ten. The study makes the following recommendations: (1) that the EAC countries should address the monetary and fiscal differences in order to achieve reasonable convergence and hence integration as stipulated in the EAC integration criteria, (2) the EAC member countries address their local currencies volatility response to the US$, and (3) increase the openness of the economy so that the net foreign resource inflows (principally for FDI) may supplement domestic saving and help the country to reach higher levels of integration.