# **I. INTRODUCTION AND BACKGROUND**

_Currency moves are a normal part of global trade. Their impact generally is best left for financial geeks and really bored people to ponder. But not now. The dollar's long slide — and widespread expectations that it will slip further — has officials on three continents fearing that their economies are stretched to the breaking point._ _(Time, December 21, 2004)_ _Perhaps economic historians will look back on today's patchwork global exchange-rate arrangements as a latter-day Tower of Babel. But what other system is there? With freely flowing capital, a fixed exchange rate has the life expectancy of a Hollywood marriage._ _(Rogoff, 2002)_ _I find it difficult to imagine a world in which it would not be important to estimate exchange rate misalignments._ _(Williamson, 1999)_ Proper exchange rate alignment is an important characteristic of sound macroeconomic management in all economies of the world. In recent years with the collapse of the Bretton Woods system of fixed exchange rates among industrial countries, exchange rate issues have become salient. There is a growing recognition that exchange rate overvaluation has a long-term pernicious effect on the performance of manufacturing exports in particular and on economic growth in general (Sekkat and Varoudakis, 1998; Easterly and Levine, 2002). In this context, a broad consensus has emerged that the overriding objective of exchange rate policy in developing countries should be to avoid episodes of prolonged and substantial misalignment. (Hinkle and Montiel, 1999). Moreover, in a world of volatile capital and aid flows, the successful management of the exchange rate regime becomes even more difficult as manifested by the plethora of exchange rate regimes and institutional arrangements that proliferate in the developing world.

One of the oldest and most durable fixed exchange rate regimes in the world is the CFA zone, encompassing 14 francophone countries in Western and Central Africa. A relic of French rule, the CFA zone includes seven countries of the West African Economic and Monetary Union (WAEMU) –Senegal, Cote d’Ivoire, Mali, Burkina Faso, Niger, Togo, and Benin, and six countries of the Central African Economic and Monetary Community (CEMAC) – Cameroon, Gabon, Chad, Central African Republic, Republic of Congo, and Equatorial Guinea. One of the interesting features of the CFA zone has been the surprising resilience of the fixed exchange parity, especially in a post-Bretton Woods world where flexible exchange rates have become more the norm than the aberration.

Originally pegged to the French franc since 1948, the CFA franc was pegged to the euro after the introduction of the euro on January 1, 1999. Under the guidelines of the euro introduction, all existing pegs were revised based on the original conversions, so that CFA 100 = FF1 was replaced by CFA 665.957 = EURO 1. This rate defines all official trade flows between the countries of the CFA zone and the euro-zone countries. The rationale of the system has been to maintain macroeconomic stability in West and Central Africa as well as strengthen trade and financial flows between Europe and the two zones by creating an environment with a stable exchange rate.

The common currency and free trade zones have several relevant and interesting institutional features. Firstly, the central bank of each zone maintains an Operations Account with 5