East Africa might take longer to realise its dream of an effective single currency by 2012, with growing concerns that varying levels of financial openness and inadequate political will could derail faster integration of the five economies.

Research has shown that in the three key economies in the region surveyed - Kenya, Uganda and Tanzania - the differential in financial markets needs to be bridged before a meaningful drive towards monetary convergence can be achieved.

The monetary union is intended to set up a single currency that is critical in reducing cross-border transaction costs which are still high despite the rising amount of trade conducted in the region.

A new study by the International Monetary Fund (IMF) calls for intense financial sector openness in Tanzania and Uganda and even more so for both Rwanda and Burundi.

While Kenyan financial markets are the most open in the region, the paper, titled Measuring Financial Barriers Among East African Community Countries, shows that of the three original members of the EAC, Tanzania has the most barriers in its financial sector.

This corroborates a long-held view in the financial and investment circles that it is the least prepared of the three countries for the more advanced forms of integration in the region.

Monetary integration leaders in the region do not underestimate the work ahead.

Speaking at a forum on monetary integration, E. Tumusiime-Mutebile, Governor Bank of Uganda (BoU), anticipated setbacks in view of the enormity of the task ahead.

"The issue we must address ... is how to achieve the monetary union. We should, however, recognise that setting up a monetary union is a very challenging project that will require a lot of hard work and careful design. We will need to keep our nerves in the face of inevitable setbacks," Prof Tumusiime-Mutebile said.

He noted the benefits of the union.

He said: "The primary rationale for the monetary union is to reduce the costs and risks of transacting business across the national boundaries of those countries which comprise the members of the monetary union."

Speaking to Business Daily in a past interview, the BoU governor said it was anticipated that all countries in the region would be able to meet the criteria set out for monetary convergence by 2012.

Such criteria include having harmonised fiscal policies such that no country has more than five per cent of budget deficit as a percentage of the GDP.

He said that having a six-month import cover in terms of foreign exchange was a criterion that already agreed on even though the EAC countries were at different compliance levels.

Prof Tumusiime-Mutebile said he believed the project was "worthwhile and once monetary union comes to fruition, it will be one of the most important institutional foundations for the economic prosperity of East Africa in the 21st century."

Considerable gains

According to the IMF paper, the financial market in east Africa is such that there are more arbitrage opportunities -- implying that holding foreign exchange constant, you can move capital or investments from one country to another and make considerable gains.

Such gains are supposed to be virtually non-existent in a region that is getting ready for a monetary union.

The IMF has determined the degree to which the countries are ready for monetary integration by using what is called in jargon covered interest rate parity (CIP), which refers to the balance struck between interest rates and currency values of two countries that are involved in financial transactions.

CIP therefore signifies a state in which countries in a region cannot exploit the differences in their capital markets because currency differences quickly wipe out any gains.

The logic of the analysis is that countries would easily come into monetary integration when such gains don't exist.

In EAC, such gains currently exist even after taking account of foreign exchange differences but less so in relation to Kenya - where information circulates faster.

According to the same IMF paper, in developed countries CIP exists such that gains from arbitrage (exploiting rates in different countries) is wiped out by exchange rates within 15 minutes of their appearance.

Arbitrage may be what prompted the then IMF head of Africa department Godrey Kaling'a in 2004 - at the height of an unprecedented drop in short-term interest rates - to remark that he was afraid that if Kenya kept very low interest rates, there was a major risk that capital would flow out to neighbouring countries.

The newly elected regime was then trying to jump-start economic recovery by pushing commercial bank lending rates as low as possible.

Although Dr Kaling'a didn't say it then, he meant that this would have an impact on the exchange rates that has a tendency to feed into inflation.

Long-term trends

And that is the message that the state appears to have taken as, soon afterwards, it began to let interest rates edge upwards so that by January 2005, they were back to long-term trends in line with inflation and regional markets.

Trade is the key reason that a monetary union is seen as necessary.

For the region, Kenya's has been a major beneficiary of regional trade. In 2009, for example, its exports to Uganda and Tanzania totalled over Sh46 billion and Sh30 billion, respectively.

In fact, annual economic surveys show that Kenya's total exports to the EAC region were Sh90.5 billion last year compared to Sh83.9 billion in the previous year.

Over the five-year period beginning 2004, exports to the region have risen by an average of Sh5.3 billion annually.

According to the IMF report, since 2002 Kenya leads in terms of exports to the region as a proportion of total exports followed by Uganda, with Burundi coming third.

However, the EAC's largest economy hardly imports anything from the region, compared to a country such as Uganda which imports over 30 per cent of its total imports from the region.

The survey says: "It is evident from these figures that intra-regional trading activity varies across countries, but is significant and most substantial for Kenya. This suggests a commensurate need for foreign exchange among EAC members."

And that would indicate that the region requires a single currency for trading in order to cut costs across its borders.

"I think the possibility of having a single currency and monetary union is not a difficult thing at all. What is needed is political will. If politicians can agree to it, it can happen overnight," said Patrick Mugoya, of the Tanzanian Revenue Authority (TRA) in a telephone interview.

He said that it was even possible to have the east African federation endorsed sooner rather than later if only politicians were enthusiastic about it.

"So the biggest hindrance, even on the side of the customs union and the common market, is political will," said Mr Mugoya, who was one of the authors of a recent report on the implementation of the customs union.

The level of trade in the region makes it necessary to want to reduce foreign exchange risks, but then it is difficult for this to happen as long as arbitrage opportunities exist.

Studies suggest that the less financially open a country is the bigger the barriers to monetary integration.

Mitigating risks

Mitigating the risks is a function of the availability of products in the form of forward contracts and/or futures - products which can hedge against risk in the currency market.

These are mainly done with commercial banks, but then the five countries in the region have different levels of financial activity, therefore leading to differing levels of capacity to benefit from such an arrangement.

The trading activity within EAC is still lower compared to, for example, the Asian countries - therefore contributing to less demand for derivative or risk-control banking products.

But this trade is growing. "As import and export activities within the EAC increase and competition in the banking sectors intensifies, the depth and liquidity of forward markets would increase and this form of financial barrier would be alleviated," said the IMF.

But even with these reservations about the preparedness of the region for monetary integration, other researchers say that there is a considerable degree of trade, considering that some of it go unrecorded, that should drive the countries in the direction of monetary integration.

An academic analysis titled Eastern and Southern Africa Monetary Integration: A Structural Vector Autoregression Analysis by researchers from Georgia State University, US, states:

"Estimates of unrecorded trade in the sub-region (EAC) are also high, in some cases over 50 per cent of recorded trade. The stronger trade links may contribute to greater similarity of economic fluctuations and to potentially greater benefits of a monetary union among these groups of countries."

The study further suggest that "a single currency linked to the euro may lead to substantial gains" for countries in the southern and east African.

It proposes "a tripolar route to monetary integration" where the first is a monetary union to encompass the southern cone expanding northwards to include Botswana, Mozambique, and Zambia.

The second is an East African monetary union with the nucleus as the proposed EAC monetary union with this further expanding to include Ethiopia, Sudan and Egypt. EAC is seen as the right nucleus since it is showing the necessary political will and has taken concrete steps towards a monetary union.

With respect to Rwanda and Burundi, the IMF report says: "The trading volumes of Rwanda and Burundi are much smaller than those of the other EAC members. Since (they) are also the only two countries in the EAC without forward foreign exchange markets, it is possible that the lack of forward foreign exchange contracts in these two countries is due in part to a lack of demand for such products resulting from the low international trade activities."