In late 2013 the East African Community (EAC) countries (Burundi, Kenya, Rwanda, Tanzania, and Uganda) signed a joint protocol setting out the process and convergence criteria for an EAC monetary union. The signing of the protocol represents a further step toward regional economic integration. It follows ratification of the protocols for a customs union (2005) and the common market (2010). Envisaged in 2024 is the introduction of a common currency to replace the national currencies of member countries.

Economic integration offers numerous benefits; the path toward a common currency, however, will present significant challenges. Implementation of the protocols for the customs union and common market is still far from complete and the convergence criteria for monetary union are ambitious. The institutional framework to monitor and enforce convergence includes the East African Monetary Institute – to be set up by 2015, as a precursor to the East African Central Bank – East African Statistics Bureau and East African Surveillance, Compliance and Enforcement Commission.

Adopting a common currency will entail significant economic changes for the EAC countries. Member countries will benefit from closer integration, and related gains from lower transaction costs, price stabilization, more efficient resource allocation, and improved access to goods, labor, and financial markets – stimulating trade, investment, and economic growth. At the same time, relinquishing independent monetary policy implies having to accept a monetary policy tuned to EAC-area-wide rather than national conditions. The costs associated with this change will reflect the size, nature, and frequency of asymmetric shocks (“susceptibility”) as well as the ability of countries to adjust to shocks that are asymmetric with respect to the EAC area through other channels – fiscal policy, labor mobility, and wage and price flexibility (“adaptability”).

The objectives of this paper are, first, to identify how susceptible are the EAC economies to asymmetric shocks; second, to assess the value of the exchange rate as a shock absorber for these countries; and third, to review adjustment mechanisms that would help ensure a successful experience under a common currency-EAC. While the analysis draws on recent experience, backward-looking measures are imperfect for a forward-looking assessment. The paper thus also draws attention to likely further structural changes in the EAC economies (for example, large oil discoveries in some countries) as well as the intrinsic endogeneity of further integration to the currency union project itself.

The paper main findings are as follows:

• Despite some similarities in the structures of EAC economies, country-specific shocks have been prevalent in the last two decades with economies in the EAC remaining susceptible to asymmetric shocks.

• Evidence on lack of synchronicity of growth rates across countries suggests only limited economic convergence in the last decade, and cluster analysis would seem to suggest that – from an optimal currency area perspective – dissimilarities across the five EAC economies remain large.

• The exchange rates for the EAC appear to absorb real asymmetric shocks in all cases save that of Burundi, highlighting the need for additional tools to stabilize EAC economies once country-specific (nominal) exchange rates are no longer available as shock absorbers. Our results also indicate that, while exchange rate shocks do not seem materially to affect output, they are a source of disturbance to inflation, suggesting that EAC countries should press ahead on their journey to modernize their monetary policy frameworks.

• Against this background, it will be key for the EAC to continue to direct its efforts to design and establish adequate mechanisms that can help member countries adjust to future shocks once the monetary union is consolidated. This includes the usual levers to mitigate costs of common monetary policy such as labor and capital mobility, price and wage flexibility, as well as various risk sharing mechanisms, including fiscal. These levers should be agreed among member countries before the introduction of the single currency to reduce risks and signal early commitment to macroeconomic stability.