The Impact of East African Community Macroeconomic Convergence Criteria on the Ugandan economy: A Dynamic General Equilibrium Analysis

The East African Community member states of Kenya, Uganda, Tanzania. Rwanda and Burundi have over the years, established closer economic links through a Free Trade Area, a Customs Union, and a Common Market. These efforts have led to a deeper regional integration and trade within the EAC and have contributed to East Africa’s overall fast growth. Given the progress with intra-regional trade, the objective of the EAC countries is establishment of the East African Monetary Union (EAMU), with the circulation of the single currency in 2021. The establishment of the EAMU has gained momentum with the signing of the EAMU Protocol in November 2013. Successful implementation of the proposed monetary union would yield several economic and social benefits including promotion of trade through the enhancement of the payments system for goods and services in the region; creation of a larger regional market and broadening of business and trade-related income earning opportunities for the sub-region; and promotion of competitiveness and efficiency in production leading to increased Gross Domestic Product (GDP). However, there are also costs linked to the unification, including loss of national autonomy in the monetary policy, possibility of increased inflation and unemployment, loss of exchange policy and fiscal independence (Schuberth and Wehinger, 1998; Bean, 1992; Calmfors, 2001). The magnitude of this loss depends on how well individual countries were conducting monetary policy prior to joining the currency union. But in order to reap the maximum benefits and minimize costs, there ought to be a sufficient degree of macro-economic convergence, and financial integration among the aspiring economies preceding the union. Thus the EAC countries have put in place macro convergence criteria to be met by the each country prior to entry into the monetary union. These have included three phases: first phase (2007-2010), second phase (2011-2014); which was revised in 2013 and to be achieved within period of eight years (2013-20). The revised performance convergence criteria which each of the EAC countries must achieve are the following macroeconomic status: (a) headline inflation of no more than 8%; (b) fiscal deficit, including grants of no more than 3% of GDP; (c) gross public debt of no more than 50% of GDP in Net Present Value terms; and (d) maintenance of official foreign reserves of at 4.5 months of imports. But how far the nations will progress in aligning their economies to the set bench marks remains a question given the discrepancies in institutional mechanisms, social and economic structures. The prospective impact of (i.e. macroeconomic, sectoral and welfare effects) of the macroeconomic convergence criteria on the economies have also not been ascertained. For example, what would be the impact of adjustment of fiscal policy to meet the thresholds in the convergence criteria on GDP, sectoral performance and house welfare? Which mixture of fiscal policy adjustment (i.e. what percentage change in capital and/or recurrent expenditure) would maximize benefits for the economies? Therefore, the above issues call for a careful assessment of the prospective impacts of the macroeconomic convergence criteria on the economies. Objectives of the study The study aims to assess the prospective impact of the macroeconomic convergence criteria on the Ugandan economy. The specific objectives are: i. To critically examine the prospects of Uganda achieving the macroeconomic convergence criteria. ii. To assess the prospective macroeconomic, sectoral and welfare effects of the macroeconomic convergence criteria on the Ugandan economy. iii. To draws policy implications for achieving the convergence criteria. This paper addresses the above objectives using a Dynamic CGE Model. The data is obtained from the 2009/10 Social Accounting Matrix. The model is composed of the behavior of households, investors, industries, government and exporters that are based on the theoretical structure of the ORANI-G model (Dixon et al., 1982). Dynamic equations are extracted from ORANIGRD model to produce a Recursive Dynamic (forecasting) model. The dynamic equations are used to derive the capital accumulation and investment allocation as well as real wage and employment adjustment mechanisms. Households are assumed to maximize utility whereas firms minimize costs subject to input prices. Domestic and imported commodities are assumed to be imperfect substitutes and are combined using a constant elasticity of substitution (CES). Production for domestic market and export is captured using the Constant Elasticity of Transformation (CET). Additional variables and behavioral and/or identity equations are included in this model to capture the additional data from the Social Accounting Matrix (SAM). Simulation design The convergence simulation hinges on the adjustment of the fiscal policy to meet the thresholds in the EAC macroeconomic convergence criteria. Given that the debt sustainability analysis (DSA) for FY 2013/14 reveals that Uganda external debt is highly sustainable, the simulation mainly focuses on meeting the thresholds on inflation (8 %) and fiscal deficit as a percentage to GDP (3 %). The simulation is developed in such a way that, fiscal policy is expanded until the EAC thresholds are met. Two simulations are developed including a) Simulation in which both government development and recurrent expenditures are equally shocked with the same percentage expansion, b) In simulation 2 we shock fiscal policy in proportions of 60:40, for development and recurrent expenditure. The paper analyzes the prospective macroeconomic, sectoral and welfare effects of the East African Community macroeconomic convergence criteria, on the Ugandan economy using a Dynamic CGE model. The results indicate that the impact of the convergence criteria is positive on the aggregate demand throughout the simulation period, mainly attributed to strong performance in government and private consumption. FY 2014/15 the consumer prices would increase by 2.84 percent higher than it would be without the EAC convergence criteria. This positive deviation would break in FY 2018/19 to -1.23% less than it would be without the EAC convergence. The key drivers for the consumer prices are for sectors whose investment follows government investment and have government as the biggest consumer of their products including social sectors. Achieving the convergence criteria would lead to a deterioration of the competiveness of the Ugandan exports in the medium term, but lead to improvement of Uganda’s competiveness in the export market in long run, as fiscal policy subsides and external debt forex inflows reduce. While achieving the convergence criteria targets, the growth in government revenue (mainly indirect taxes) would be outstripped by fiscal expansion and this leads to an increase in the fiscal deficit thus having negative implications for debt sustainability. As regards to sectoral performance, sectors whose investment is not mainly driven by profit but follow aggregate investment are those that would perform much better compared to the rest of the sectors. Sectors producing traded goods would be the most negatively affected, mainly due to their loss of competitiveness in the external market. Fiscal policy adjustments post a positive effect on household income throughout the simulation period, mainly due to an increase in increase in nominal wage and transfers to households. However, this improvement can only be sustained in the medium term but collapses in the long run as the EAC macroeconomic thresholds are reached. In the long-run debt accumulates and fiscal deficit percentage to GDP hits the threshold of 3%, fiscal policy is forced to contract to keep within the EAC Macroeconomic criteria. Similarly, household savings would improve in the medium term but deteriorate in the long term, due to the unsustainable household consumption patterns. This simulation reveals that to improve national savings, there is a need to enhance factor payments and employment as well as creating a good macroeconomic environment to enable profitable international transactions. The results justify the existence of the impossible macroeconomic trinity. That is, it’s not possible to have low fiscal deficit, low inflation and a sustainable high growth at the same time. For the economy to clear, one of these aggregates must be compromised to attain the two. For instance, if the high economic growth is to be attained, inflation and deficit need to be allowed to adjust upwards by expanding the fiscal space. However, GDP would grow faster if the fiscal space is focused on the government investment. This would improve technical and production efficiency in the economy as well as sustaining a low inflation as shown in Table 5 above. Since government investment has a mild impact on inflation, this would generate more fiscal space than when the fiscal policy in geared towards recurrent expenditure. In addition, the speed of expansion of the fiscal policy determines the nature of the sectoral impacts. If government spending rises quickly to exhaust the fiscal space created as seen above, aggregate demand outstrips the supply capacity for non traded goods. This generates a construction boom with increasing construction and falling quality. The results also postulate that faster fiscal policy expansion would have a negative impact on Uganda’s competiveness through appreciating the real exchange rate and speedy improvements in the terms of trade. The best economic results would be attained by a gradual fiscal policy expansion mainly focusing infrastructure (investment).