Chapter 1

Introduction

Lessons from the WAEMU: Findings and Recommendations

Alexei Kireyev

The West African Economic and Monetary Union (WAEMU) is one of four currency unions in the world. The WAEMU consists of eight low-income countries—Benin, Burkina Faso, Côte d’Ivoire, Guinea-Bissau, Mali, Niger, Senegal, Togo. It coordinates its member countries' macroeconomic policies, and addresses a number of important common challenges they face. The Central Bank of West African States (BCEAO),1 the central bank of the WAEMU, issues the common currency, the Communauté Financière Africaine (CFA) franc, pegged to the euro; conducts a single regional monetary policy; pools foreign exchange reserves of members; and supervises the banking system of the WAEMU. The WAEMU has reached an important milestone in its development and needs to advance to the next level, which would bring most of its countries closer to the status of emerging econo­mies. Against the background of the long and varied history of this unique monetary union, this book examines how the WAEMU can achieve its development and stability objectives, improve the livelihood of its people and inclusiveness of economic growth, while preserving financial sta­bility, enhancing competitiveness, and maintaining the fixed exchange rate.

The WAEMU and its member countries face five distinct challenges in meeting these goals:

• Increasing trend growth, while making it more inclusive and poverty-reducing.
• Creating sufficient fiscal space for growth-enhancing projects, while preserving macroeconomic stability and avoiding unsustainable debt buildup.
• Improving the efficiency of regional monetary policy so that it can contribute more actively to achieving the goals of price stability and credibility of the currency peg, and to the overall economic development of the union. Enhancing financial inclusiveness, stability, and depth so that the financial sector can play its role in mobilizing savings and converting them into productive investments.
• Accelerating regional integration, deriving more benefit from regional trade and financial integration, while using the benefits of the economy of scale to increase international competitiveness.

These five challenges are the organizing principle for this book.

OVERVIEW AND POLICY SETTING

The WAEMU, simultaneously a customs and a currency union, is probably one of the most advanced integration groups among developing countries. Improved competitiveness, economic convergence, common market, policy coordination, and law harmonization are the statutory objective of the Union. Achievements have been substantial but much remains to be done. Several countries remain noncompliant with the convergence criteria, that is, the common integration goals set by WAEMU members, which were revised in 2015 and should be met by 2019. The WAEMU is moving toward harmonizing budget laws and procedures in member countries, including budget and accounting laws, and laws governing public accounting and the chart of accounts, although progress has been slow. Multilateral surveillance focuses on members’ compli­ance with convergence criteria and their compatibility with the Union’s monetary policy. The Union has achieved progress in pursuing a common market and has established a common exter­nal tariff, which was expanded and revised in 2015 to include all Economic Community of West African States (ECOWAS) countries. However, nontariff restrictions on regional trade still persist and not all impediments to the declared free movement of people and capital in the region have been eliminated. Finally, the WAEMU conducts a single monetary policy, with the goal of preserv­ing price stability, although its effectiveness remains constrained by shallow financial markets.

The macroeconomic performance of the WAEMU has been uneven and has not yet led to decisive breakthroughs in poverty reduction or improvement in overall quality of living. Though historically low, growth in the WAEMU has increased recently, driven by structural reforms and economic recovery in the region’s largest countries. With the currency pegged to the euro, inflation in the region had traditionally been low. However, high fiscal deficits have been exerting increasing pressures on the external position. The combined fiscal deficit of the WAEMU has widened recently, largely reflecting rising levels of public investment in infrastructure in several countries. Because of the high import content of this investment, the rising fiscal deficits have exerted pres­sure on the current account deficit, the gross reserves of the BCEAO, and the net foreign assets of commercial banks. Fiscal consolidation is needed in coming years, consistent with the recently reaffirmed WAEMU convergence criteria. To maintain much-needed infrastructure investment, including public investment, steps to increase tax revenue and control current expenditure will be essential. Should the planned fiscal consolidation in member countries fail to materialize, the BCEAO may need to consider a tighter stance. Prudential standards in the WAEMU are weaker than in comparable countries. About a quarter of banks do not meet these prudential standards. Ongoing efforts to strengthen bank supervision and raise prudential standards go in the right direction but will take time and need to be accelerated. Steps to upgrade the regulatory framework and build buffers in the financial system should be accelerated before downside risks materialize.

The WAEMU has all the necessary institutional instruments to implement sound and coor­dinated macroeconomic policies. Fiscal-monetary policy coordination is an important precondi­tion for macroeconomic stability in a currency union. There is room for improvement of such coordination in the WAEMU. A coherent framework is needed for the WAEMU Commission and the BCEAO. This could help align and mutually reinforce their so-far largely autonomous efforts at implementing fiscal and monetary policies. There is ample theoretical evidence that mutual adaptation of fiscal and monetary policy on a continuous timeline can lead to success­fully reaching policy objectives. In normal times, ministries of finance should continue to target long-term debt sustainability, while the BCEAO should focus on inflation. This can be achieved through mutual adaptation of fiscal deficit levels and policy rates. During stress times, the fiscal policies of finance ministries should still target debt sustainability, while the BCEAO’s monetary policies should target inflation. However, in the short term, the BCEAO should be willing to tolerate temporarily high inflation as a strategy for increasing the likelihood of meeting the infla­tion target in the long term. Ministries of finance can focus on stabilizing output and employ­ment at the expense of a temporary deviation from a sustainable debt path.

GROWTH AND INCLUSIVENESS

The WAEMU remains vulnerable to exogenous shocks. It should increase its resilience to these shocks and reduce its macroeconomic volatility. The WAEMU’s economic performance has improved only modestly, while idiosyncratic shocks have been frequent. Although further growth diagnostics would be needed to better understand the cause of these shocks, some unambiguous recommendations emerge at this point. Political stability is clearly a must. At the same time, continuous broad-based reforms are needed to foster investment, trade and structural competi­tiveness, and financial development. Improvements in health, education, and institutional quality also are essential for economic development. In addition, there is a need for more efficient shock-smoothing mechanisms such as larger fiscal buffers, greater financial market development and, eventually, a centralized insurance scheme.

The WAEMU’s insufficient product diversification is one reason for the region’s low resilience to shocks. Diversification should be strengthened through further structural transformation. The structure of economies in the WAEMU has changed very slowly over the past decades, as has been the case for many other low-income countries. The majority of the region’s population is still employed in low-productivity agriculture and the secondary sector is underdeveloped. Further structural transformation and diversification of output and exports could yield signifi­cant growth dividends as resources are reallocated from low-productivity sectors, such as agricul­ture, to higher productivity sectors, such as manufacturing. This process should be assisted by policies that focus on addressing weaknesses that hinder entry into new lines of economic activ­ity. These weaknesses include deficiencies in infrastructure, education and training, financial services, trade networks, functioning factor markets, and supportive regulatory environments. The regional economic plan hopes to target key areas such as improvements to governance, access to energy, and the development of regional infrastructure and human resources. But struc­tural transformation can also occur “within sectors” and create productivity gains through, for example, implementation of quality improvements to existing products and services. To promote strong, inclusive growth, agriculture should be a particular focus of “within sector” productivity improvements in the WAEMU, as well as in other low-income countries where the primary sector employs a relatively high share of the workforce and has a low productivity level. Agriculture is particularly important in the context of rapid population growth, since other sec­tors are unlikely to be capable of creating sufficient jobs to absorb the large projected increases in the workforce.

For growth in the WAEMU to be durable and sustained, it should be inclusive, with benefits shared widely across income and gender groups, and between rural and urban areas. Growth performance depends on its distributional characteristics. While inclusivity is good for poverty reduction, growth is even more important. Although growth episodes in the world have some­times been accompanied by increased inequalities, the fundamental question is one of equality: Are the benefits of growth shared equally across different income groups and do all income groups and both genders have an equal opportunity to contribute their fair share to growth? While poverty has fallen in the last two decades in most WAEMU countries, poverty reduction has slowed in recent years. Although available indicators sometimes give conflicting signals on distributional shifts, two case studies—one on Senegal and one on Mali—suggest that people in the middle of the income distribution usually receive the most benefit of growth, and mainly in urban areas. Further progress in poverty reduction and inclusiveness would require sustained high growth and exploration of growth opportunities in the sectors with high earning potential for the poor. Better-targeted social policies and more attention to regional distribution of spending would also help reduce poverty and improve inclusiveness.

To achieve sustainable high growth, substantial additional financial resources should be mobi­lized from both regional and international sources. The regional financial market has grown substantially in the past decade but still remains relatively shallow and falls short of supplying sufficient long-term financing for growth-enhancing public and private investment projects. Although the institutional structure for financing mobilization is broadly in place, a number of factors increase financing costs and hinder market efficiency. These include the undiversified issuer and narrow investor bases, banks’ preference for short-term securities, the limited set of maturities offered by sovereigns, underdeveloped secondary markets for bills and bonds, organizational issues, and limited access to information. The yield curve in the region has been generally upward sloping as interest rates at issuance were higher for securities with longer maturities. Interest rates have been largely driven by country ratings, market liquidity conditions, and bidder appetite at the time of issuance. The principal component analysis suggests that the issuance volumes offered also affected the level of interest rates, with seasonality, issuance proce­dures, and the frequency and predictability of issues each playing a role. Further reforms could help the region reap the full benefits of a more dynamic securities market to finance growth-enhancing projects.

FISCAL POLICY AND COORDINATION

Fiscal policy will remain the primary policy tool available to individual WAEMU countries and should be strengthened by the application of well-designed fiscal rules. However, high fiscal defi­cits are exerting increasing pressures on the external position often reflecting the high import content of domestic investment. These rising fiscal deficits continue to exert pressure on the current account deficit, the gross reserves of the BCEAO, the common central bank, and the net foreign assets of commercial banks. Fiscal consolidation during the coming years is needed, con­sistent with the recently reaffirmed WAEMU convergence criteria. In this context, well-designed fiscal rules could be helpful in achieving the consolidation objective and disciplining individual countries’ performance. In practice, the existing convergence criteria and other fiscal rules applied in the WAEMU have proven to be of limited effectiveness.

Economic convergence and the recently revised convergence criteria provide an important tool for safeguarding macroeconomic stability in the monetary union and preserving the single cur­rency and the fixed exchange rate regime. The recent revision of convergence criteria is a step in the right direction, with its reduction in the number of convergence criteria and focus on fiscal sustainability of the revised surveillance framework. However, scope should be provided to exceed the budget deficit convergence criterion for temporary periods in the event of adverse economic shocks, subject to well-defined rules. The 70 percent of debt-to-GDP ratio should be viewed as an upper limit and not an optimal level toward which to converge, and debt management should be driven by regular debt sustainability analyses rather than by the debt criterion. Steps are needed to increase countries’ ownership of the new criteria by encouraging them to transpose regional rules into national laws and strengthen monitoring and oversight, including through the establishment of fiscal councils at the national level.

Markets have an important role to play in enforcing macroeconomic discipline and their further development should be a significant part of the agenda of WAEMU governments. Achieving fiscal discipline in a monetary union without a central fiscal authority, while crucial for the union’s stability, is challenging institutionally and practically. While sovereign interest rates are broadly responsive to governments’ fiscal behavior, further development of the regional financial market is needed for an improvement of the effectiveness of market discipline in the WAEMU. In addition, fiscal aspects of the WAEMU’s regional surveillance framework should be reconsidered to improve both design and enforceability. Fiscal risks should be better mitigated. In particular, as countries start to broaden their financing options for large investment projects, policymakers’ attention should turn to fiscal risks, including those related to contingent liabilities and off-balance-sheet items, which may not be fully apparent in “headline” fiscal indicators. Transparent disclosure and management of fiscal risks would help reach this objective. This should be carried out by strengthening incentives to ensure that risks are identified, estimated, and carefully managed; promoting earlier, smoother policy responses; increasing confidence among stakeholders in the quality of fiscal management; reducing uncertainty for investors and taxpayers; and improving access to international capital markets.

The procyclical nature of public investment is a significant impediment to stable and high growth in the WAEMU and needs to be reconsidered. Countries facing difficulties seem com­pelled to drastically cut back investment in bad times. Countercyclical fiscal policy rules could help preserve investment levels in the WAEMU, where such rules can become important anchors of medium-term fiscal policy over the cycle. This would help preserve fiscal discipline at the aggregate level. Some flexibility in fiscal convergence criteria could help mitigate the strong pro-cyclicality of public investment. A countercyclical fiscal rule would allow for some positive cor­relation, with smaller deficits (larger surpluses) in booms and larger deficits (smaller surpluses) in contractions. At the same time, because shocks affecting WAEMU countries are highly asym­metric, there is room for establishing fiscal federalism arrangements or for adopting a form of risk sharing (or group insurance) to mitigate the incidence of these shocks. Risk-sharing mechanisms would aim to allocate larger financial resources to the union members exposed to negative shocks.

Creating the fiscal space needed to finance growth-enhancing projects will remain a major challenge for all WAEMU countries. This should be addressed on both the country and the regional level. To create more fiscal space for priority spending, including infrastructure invest­ment, it will be important to look at how much current spending could be constrained, for example, by reducing subsidies and transfers. It will also be essential to minimize the risk that a gradual increase in some countries’ central government wage bill as a share of GDP undermines the capacity to undertake progrowth policies in the Union. The reversal of any such trend (cur­rently projected for some countries) will require firm regional resolve. Additional efforts in these areas will be instrumental to closing the gap between the WAEMU and high-growth countries. In the context of supporting growth, tax policies should also aim at enhancing efficiency, in addi­tion to creating fiscal space. To improve the quality of spending, greater emphasis needs to be placed on adequate safeguards for a well-functioning public investment system. Such safeguards could include strategic guidance for public investment and preliminary screening for consistency with the strategic goals of government; formal project appraisal; independent review of appraisals; transparent project selection and well-structured budgeting; timely project implementation; active adjustment for changes in project circumstances; facility operation; and ex-post project evaluations against approved projects. Additional efforts are needed to raise revenue and improve fiscal institutions to enhance the composition and quality of spending. Also, investments need to be fully integrated in medium-term budget frameworks and significant maintenance costs must be taken into account.

Better tax coordination and tax policy harmonization could help improve revenue collection and enhance the fiscal space. The WAEMU’s tax coordination process is one of the most advanced in the world but remains in many areas ineffective. The framework has, to some extent, succeeded in converging tax systems, particularly statutory tax rates, and may have contributed to improving revenue mobilization. Important lessons can be drawn from the WAEMU experience, especially whether it’s best to take a top-down approach to coordination or a softer approach of sharing best practices and limiting certain types of harmful tax competition. Sound budget institutions are essential to implementing tax and broader fiscal policies effectively and efficiently. Such institutions—defined as the structures and formal and informal rules and procedures that govern budget planning, approval, and implementation—help ensure government accountability and prevent leakage of public funds. They also increase efficiency of scarce public resources and improve the chance of maintaining fiscal stability and meeting social development needs.

REGIONAL MONETARY POLICY

Regional monetary policy has substantial scope for becoming a more active contributor to regional development and financial stability, but remains constrained by shallow financial markets. The institutional and other characteristics jointly needed for an independent monetary policy under a fixed exchange rate regime are present. The BCEAO can control regional interest rates, which diverge substantially from the euro area rates, as capital mobility is limited. Moreover, the BCEAO has substantial weight in the banking system and therefore can exercise sufficient influence on monetary conditions in the area. The BCEAO has the needed instruments (interest rates and reserve requirements) for achieving the goals of its mon­etary policy. In the absence of the exchange rate channel, all other channels of monetary policy transmission (through the volume of credit, interest rates, asset prices, and expectations) can in principle be more active. However, shallow financial markets and interest rate rigidities impede the transmission of monetary policy signals and the link from the BCEAO’s policy actions to market interest rates. Inflation remains extremely weak and can affect both only marginally. To improve monetary policy implementation, the BCEAO should also continue developing deep and functioning interbank, secondary debt, stock, and other financial mar­kets. Improving the transmission of BCEAO policy actions to inflation by reducing price and interest rate rigidities, in particular by introducing more flexibility of deposit rates, is also important. The current monetary stance remains appropriate. However, if the planned fiscal consolidation in member countries fails to materialize, the BCEAO will need to monitor the risks and consider a tighter stance.

Regional monetary policy could have a stronger impact on liquidity conditions and inflation in the region and on individual WAEMU countries if the transmission mechanism were improved. The transmission to individual WAEMU countries of the BCEAO’s single monetary policy has remained, on average, limited and asymmetric. This is despite some recent progress in regional financial development. The impact of a single monetary policy can be limited for the region as a whole, but may be significant for individual countries with more developed financial markets and/or different product market structures and institutions. The hypothesis of an asym­metric transmission of single monetary policy actions to individual countries can be tested empirically, in particular, the impact of the policy interest rate changes on each WAEMU coun­try’s deposit and lending rates and inflation. BCEAO policy rate changes have no impact on deposit rates. The main channel of transmission of a single monetary policy to individual coun­tries is through the link between BCEAO’s single policy rate and the lending rates in individual countries; this link is relatively strong in Benin, Burkina Faso, Guinea-Bissau, Mali, Senegal, and Togo. It is very weak in Cote d’Ivoire and Niger. The link to core inflation is observed only in the same countries. However, the link to overall inflation, which is the ultimate goal of monetary policy, can be reliably traced only in Benin, Senegal, and Togo. In this context, further developing financial markets, increasing financial intermediation, and fostering competition in the banking sector are crucial to improving the effectiveness of a single monetary policy for individual WAEMU countries.

Elevated levels of central bank liquidity provision to commercial banks poses potential risks to stability. Commercial bank borrowing from the central bank represents around 10 percent of total liabilities in WAEMU countries compared with less than 1 percent in most other African countries. The underlying causes of elevated liquidity provision are likely to include a combina­tion of widening fiscal and external imbalances, and carry trade activity by some banks. To the extent that these drivers, in turn, result from weaknesses in fiscal, monetary, or supervisory coordination between national and supranational bodies, the WAEMU experience may also provide lessons for other monetary unions. High levels of central bank borrowing by the bank­ing sector can pose risks to fiscal and financial stability, financial development, and monetary policy effectiveness. Therefore, even in the absence of a change in the inflation outlook, the BCEAO should monitor closely the evolution of such risks and consider whether any preemp­tive policy action might be appropriate. Possible measures might include reducing fiscal deficits of individual countries in the Union, which would reduce commercial banks’ demand for cen­tral bank funding to finance them; discouraging carry trade activity by commercial banks; mitigating market distortions through changes in prudential regulation; relaxing regulatory barriers to entry for financial institutions other than domestic banks; and issuing a greater share of public debt externally. The implementation of the BCEAO’s monetary policy with a view to achieving the price stability objective requires a better understanding of the degree of sensitivity of the inflation rate to changes in the economic and financial environment. The results show that monetary and financial variables have an influence on inflation. Their impact on the evolution of prices is evi­dent over the short and long terms. In particular, the impact of the BCEAO marginal lending rate and money market rate on inflation is significant, whatever the time horizon. Domestic credit is just as significant as the BCEAO’s key rates and the money supply. The impact of domes­tic credit on inflation appears to be stronger than that of interest rates. Furthermore, the output gap, which has been negative, has had an overall moderating effect on inflation over the recent period. The impact observed over the long term is related to the fact that the transmission of interest rate fluctuations to inflation depends heavily on the manner and speed with which they are reflected in borrowing rates and in demand among economic agents. In addition, the fiscal deficit (or public spending), as well as imported inflation, have considerable effects on the dynamics of inflation in the WAEMU. The impact of imported inflation is stronger than that of the marginal lending rate.

FINANCIAL DEVELOPMENT AND STABILITY

The level of financial development in the WAEMU remains insufficient to support financial inclusion and broad-based growth. The financial system in the WAEMU is dominated by the banking sector, but is evolving rapidly with the emergence of new transnational banking groups and microfinance institutions. The regional securities and equity market is a marginal source of funding, except for governments. The interbank market remains shallow. The banking system in the region is highly heterogeneous. While most banks are adequately capitalized and profitable, pockets of vulnerability, including public banks, have been identified. Compliance with pruden­tial norms remains low for a number of ratios, suggesting a degree of regulatory forbearance, and some of these norms are not in line with international standards. Stress tests and financial sound­ness indicators show that concentration of lending and asset quality pose significant risks. The rising sovereign-bank linkage requires close monitoring. Compliance with key prudential ratios remains insufficient and needs to improve. Recent capacity building efforts at the WAEMU Banking Commission are welcome but need to be reinforced by strengthening and effectively implementing risk-based supervisory tools and processes, including those related to supervision of anti-money laundering/countering the financing of terrorism (AML/CFT) measures. A stron­ger corrective action framework should be put in place to reduce regulatory forbearance and better enforce compliance with prudential norms. This should include taking timely and effective corrective measures against weak and/or noncompliant banks. The move to Basel II/III standards will be an opportunity to bring prudential rules closer to international norms. As this process is taking time, authorities should meanwhile tighten certain rules, such as that governing risk con­centration and the provisioning of nonperforming loans. Authorities should also increase banks’ capital adequacy levels, including by raising operating banks’ minimum share capital to 10 billion CFA franc. The authorities should also closely monitor banks’ exposure to foreign exchange risks and strengthen prudential limits to address them. Moving to consolidated supervision and appli­cation of International Financial Reporting Standards should also be a high priority.

Financial inclusion is an important component of inclusive growth and needs to be improved in the WAEMU. WAEMU countries lag behind peer countries in several dimensions of financial inclusion: access to finance is low, especially for the most vulnerable parts of the population, and the financial sector appears to only modestly contribute to the population’s ability to deal with shocks. Private sector credit-to-GDP ratios, however, appear broadly in line with WAEMU coun­tries’ fundamentals. Public policies, such as investments in infrastructure and the social sectors, could help close these gaps. From the firms’ perspectives, policies to reduce participation costs in the financial sector and to lower collateral requirements could increase firms’ access to financing, and thus significantly boost GDP. Further development of well-regulated and supervised micro­finance institutions could also help improve financial inclusion. Trust is an essential ingredient for financial sector development. To build this trust, it is essential that first-time depositors in microfinance institutions have a positive experience with depositing their hard-earned savings in these institutions. This seems to require a consolidation of the many small and unprofitable microfinance institutions that have proliferated and operated out of the authorities’ control.

Preserving financial stability will be critical for the proper functioning of the financial system and growth as the regions open up to more foreign investment and capital flows. The WAEMU authorities should enforce existing prudential regulations and raise standards to international best practice. Ongoing efforts to strengthen bank supervision and raise prudential standards are going in the right direction but will take time and need to be accelerated. In the interim, it is important to proceed expeditiously with plans to raise banks’ capital requirements. Steps to upgrade the regulatory framework and build buffers in the financial system should be accelerated before downside risks materialize. It is also urgent to subject bank holding companies incorporated in the WAEMU to appropriate banking regulation and consolidated supervision. Deposit insurance and financial stability funds should be made operational as a matter of priority. A single and independent administrative resolution authority should be established to ensure prompt and effective resolution of banks with negative capital. The emergence of regional banking groups requires the development of supervision on a consolidated basis and strengthening of cooperation with banking supervisors in countries where these groups operate. The increasing exposure of banks to sovereigns is also a risk that needs to be recognized, including through a nonzero weight on government paper in capital adequacy calculations. Microprudential regulation should be revised to bring certain prudential standards closer to international best practice, for example on risk concentration, classification of claims, and provisioning, while taking into account the regional context. The move to Basel II will help address many of these issues.

The WAEMU’s financial crisis prevention mechanism is a critical instrument in the mainte­nance of macroeconomic stability, and its framework needs strengthening. Crisis prevention requires greater transparency, including through the regular and timely compilation and publica­tion of financial soundness indicators for all member countries. Regular stress tests would be a welcome step toward the introduction of an early warning system. There is also substantial scope for improving the bank resolution framework, which would reduce the budgetary cost of govern­ment intervention. Swift action is necessary, including giving broader powers to the supervisor and close collaboration with other supervisors in the case of cross-border groups. To improve transparency and market discipline, authorities should improve the quality of financial data as well as compile and publish financial soundness indicators on a regular and timely basis. They should also continue developing macroprudential policy and analyses, with regular stress tests and early-warning indicators. The deposit insurance and financial stability funds are key components of a financial stability and resolution toolkit and should be made operational without any further delay. Bank resolution is a protracted process in the WAEMU, due to the division of power among a number of institutions at the regional and national levels. The authorities should recon­sider this architecture and put in place a single and independent administrative resolution author­ity to allow for a less complicated and faster resolution, in line with international standards and best practices.

Mobile banking offers opportunities to jump-start financial inclusion in the WAEMU. Mobile phone penetration in the WAEMU is the same as it is in Kenya and Tanzania. However, while mobile banking has taken off in these countries, it has not done so in the WAEMU. Transaction costs, issues of network interoperability, and legal and regulatory barriers may repre­sent substantial constraints to the mobile market development in the WAEMU. To increase mobile banking in the WAEMU, several safeguards will have to be put into place including minimum market entry requirements, financial integrity controls, funds safeguards, and payment stability.

Fast-developing regional banking groups create new opportunities but also new risks for finan­cial sector stability and development in the WAEMU. Pan-African banking groups hold about 50 percent of the assets of the WAEMU banking system. Some originated in neighboring coun­tries and brought along expertise in providing financial services to underserved customers such as women, people with primary or less education, and people living in rural areas. A few of these pan-African banking groups originated in the WAEMU and hold more assets abroad than they hold in the WAEMU. To reap the full benefits of these pan-African groups, the authorities need to subject resident holding companies of banking groups to bank regulation and supervision, consolidated supervision, and stress tests. They also need to build on their experience in supervi­sory colleges of pan-African banking groups with a non-resident parent to set up supervisory colleges for pan-African groups with a WAEMU parent.

COMPETITIVENESS AND INTEGRATION

With very few exportable products, external competitiveness largely depends on upgrading capac­ity in a few key sectors. The WAEMU’s external competiveness remains low. The current account deficit is relatively high and driven by continued investment efforts. In the medium term, it would gradually decline and be matched by sufficient financial inflows subject to the implemen­tation of government’s consolidation plans, and helped by a favorable oil price outlook. The real effective exchange rate of the CFA franc appears to be broadly in line with fundamentals based on different methodologies that give a qualitatively similar assessment. However, international reserve coverage should increase to provide stronger buffers against immediate short-term risks. Structural nonprice competitiveness and investment efficiency are also insufficient, and improve­ments will be essential to ensure that planned large investment programs translate into growth and export gains as well as increased private inflows into the region.

WAEMU countries should start exploiting the full potential of regional trade as an engine for growth. Regional trade is dominated by a few countries and flows. The basic structure of trade interconnectedness in the WAEMU remains broadly unchanged, although regional trade became, on average, tighter with increased bilateral flows and more focus by individual countries on regional trade. The power structure in the region has shifted as Côte d’Ivoire emerged as the only key trading partner and Senegal remained mainly an intermediary. There is a large core and a small periphery in regional trade. All WAEMU countries participating in regional trade experi­ence a network effect. This explicitly takes into account the fact that a country is connected to other countries in the region and assesses the value of these connections. The difference between the nominal GDP and the network value of a country can be positive, neutral, or negative, depending on the value of its connections to other countries in the region. Côte d’Ivoire, Senegal, and Mali can be the main origin of shocks for the rest of the WAEMU economies, including the core and the periphery. They can also be the main origin of shocks to each other, as they belong to the same cluster. Côte d’Ivoire and Senegal are simultaneously playing the gate-keeping role and can be factors for either propagation or absorption of shocks originating elsewhere in the network.

To preserve the gains of regional integration, WAEMU countries should refrain from deviat­ing from the common external tariff of the ECOWAS. The macroeconomic effects of a replace­ment of the WAEMU common external tariff with the ECOWAS common external tariff on WAEMU member states could be substantial. The new tariff would have an impact on trade levels, government revenue, and growth. The change in the tariff would increase WAEMU imports from other ECOWAS countries but reduce imports from the rest of the world. The impact on government revenue would vary widely by country, ranging from a loss in most coun­tries of up to 2½ percent of current revenue to an increase in a few countries of up to 3 percent. Finally, an increase in relative import prices induced by an increase in the average tariff rate could yield a negative effect on GDP. The WAEMU Commission’s intention to safeguard the common market through a uniform application of the ECOWAS common external tariff across WAEMU member countries and nonapplication of additional protection to 3 percent of tariff lines is welcome.

The WAEMU region can do more to attract foreign investment. Even government debt, the least risky investment instrument, attracts very little attention from nonresident investors, unlike in neighboring Ghana and Nigeria. Possible reasons for this situation include unattractive nomi­nal interest rates in the region, the relatively small size of the market, the lack of a secondary market, cumbersome exchange controls and regulations, fragmentation of the regional market, insufficient communication on the issuances and the language issue, insufficient political stability, and poor investment climate. To make the regional market more attractive to foreign investors, sound macroeconomic policies and a solid financial sector are prerequisites. Beyond this, com­munication with nonresidents should be improved with Agence UMOA Titres playing a key role in this area; the development of WAEMU financial markets, including the secondary market for government securities, should be accelerated; the size of the market should be increased by eliminating segmentation of the sovereign bond market; and finally, taxation needs to be harmo­nized and double taxation avoided.

The WAEMU’s experience shows that economic integration may have a significant impact on poverty reduction. Until now, the capacity of trade and financial and deep integration to foster growth has been rather disappointing. This result has been partly due to weak implementation of regional rules. However, the WAEMU has benefitted from a good growth-to-poverty reduction conversion. The WAEMU’s experience suggests two lessons to improve the poverty reduction impact of economic integration. First, community policies should be targeted in sectors where regional policies’ comparative advantage is the strongest. It is therefore a political priority to strengthen regional public goods supply, particularly for regional transportation and energy net­works, but also for regional financial information networks. Second, particular attention must be given to the distributive effects of economic integration. The effect of integration policies on living and poverty standards within the WAEMU is different across sectors. A number of regional policies spontaneously contribute to gap reduction between member countries. These include agricultural market integration, epidemic reduction programs, and financial service access devel­opment. Inversely, trade integration, transportation network development, and skilled labor mobility can lead to a concentration of benefits in the countries initially the richest. Increased momentum for intracommunity transfers must accompany a strengthened integration in order to compensate its distributive effects.