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Eastern Caribbean Currency Union

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International Monetary Fund
Published Date:
March 2008
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I. Assessing Exchange Rate Competitiveness in the Eastern Caribbean Currency Union2

A. Introduction

1. This chapter assesses the evolution of Eastern Caribbean Currency Union (ECCU) real exchange rates over time, and examines whether the region has lost competitiveness. Two approaches are taken to assess the movement of the real exchange rate. First, a fundamentals-based approach is used to estimate the equilibrium real exchange rate in ECCU countries. The real exchange rate is then assessed by comparing the estimated equilibrium values to the actual values. Second, a macroeconomic balance approach is used to estimate the difference between the current account balance projected over the medium term, and an estimated equilibrium current account (or norm)—where a projected current account that exceeds the estimated norm suggests a potential overvaluation of the exchange rate.

2. The main finding is that there is little evidence of overvaluation of the Eastern Caribbean (EC) dollar.3 In all countries, real exchange rates currently appear to be close to their equilibrium levels, following a period of overvaluation in the early 1990s and early 2000s. In addition, while ECCU current account imbalances are projected to remain above estimated equilibrium levels for an extended period, they are expected to decline over the medium term to a sustainable level.

B. Evolution of the Real Exchange Rate in the ECCU

3. At end-2006, the EC dollar real effective exchange (REER) rate was at its most depreciated level in the last 20 years. After periods of significant real appreciation during the early and late 1990s, the EC dollar began depreciating in 2002. This depreciation of the EC dollar has been associated with a sharp nominal and real depreciation of the U.S. dollar against major currencies. Furthermore, this recent trend of depreciating real exchange rates in the ECCU is expected to continue, since the U.S. dollar is expected to depreciate further.4

ECCU: Real Effective Exchange Rate, 1979–2007 1/

(2000=100)

Sources: IMF Information Notice System; and Fund staff estimates.

1/ Trade-weighted index of nominal exchange rates deflated by seasonally adjusted relative consumer prices. An increase (decrease) indicates an appreciation (depreciation). Excludes Anguilla and Montserrat in the calculation of the ECCU average. Data up to June 2007 for all countries.

4. Real exchange rate measures based on currencies of ECCU tourism-customer and tourism-competitor countries show an even sharper depreciation since 2002.5 The customer-based exchange rate indicates in general that the rate was fairly stable during the 1990s, and has experienced a depreciation of over 15 percent starting in 2002. The competitor-based real exchange rate has depreciated steadily over the last two decades, in excess of 20 percent, with the exception of a brief period in 2002–03 when this trend was reversed because of the large depreciation of the Dominican Republic’s peso.

ECCU: Evolution of Tourism-Based Real Exchange Rates, 1979–2007

(Index 2000=100)

Source: Fund staff estimates.

C. Equilibrium Real Exchange Rate6

5. The fundamentals-based equilibrium real exchange rate (FEER) approach is followed to assess the real exchange rate in the ECCU. Panel regression techniques were used to estimate an equilibrium relationship between real exchange rates and a set of fundamentals, and the estimated relationship was then used to calculate equilibrium real exchange rates. The panel includes six ECCU countries for the period 1979–2006, and 16 other tourism-dependent countries as a robustness check.

Fundamentals

6. There is a large empirical literature on the determinants of the long-run real exchange rate. The literature has focused on sectoral productivity differentials, government spending, cumulative current account imbalances, movements in the terms of trade, and interest rate differentials as key drivers of long-run deviations from purchasing power parity (see Froot and Rogoff, 1995; Rogoff, 1996; Edwards, 1989; IMF, 2006). Since only “fundamentals” (real factors) can influence the long-run real exchange rate, the fundamentals-based equilibrium real exchange rate can be used to determine nominal misalignments by separating the factors that can affect the long-run equilibrium real exchange rate from those that may cause short-run misalignments. In the case of the tourism-dominated economies of the ECCU, the real exchange rate is expected to be driven by the following fundamentals (see Appendix I.1):

  • Productivity differentials. According to the Balassa-Samuelson effect, higher productivity in tradables will result in a real appreciation of the exchange rate. Per capita tourist arrivals as a share of per capita tourist arrivals in The Bahamas—the country with the highest per capita arrivals in the Caribbean region—are used as a proxy for productivity differentials.7
  • Terms of trade. Higher terms of trade may appreciate the real exchange rate through wealth effects. A positive terms of trade shock will induce an increase in domestic demand, hence an increase in the relative price of nontradables, yielding a real exchange rate appreciation. Given the dominance of tourism in the region, we use a proxy for tourism terms of trade—movements in the terms of trade of goods and services not explained by movements in the terms of trade of goods.
  • Government consumption. Higher government consumption (measured as a share of GDP) is likely to appreciate the real exchange rate to the extent that it falls mostly on nontradables.
  • Net foreign assets. Macroeconomic models predict that countries with higher net foreign assets can in principle sustain a stronger real exchange rate due to the income flow they receive on their assets.

Estimation results

7. The estimated model found a significant long-run relationship between the real exchange rate and most of the identified fundamentals, particularly tourism-driven productivity differentials and the tourism terms of trade. The estimation results proved robust to different specifications and three different sets of samples for the period 1979–2006: (i) ECCU countries only; (ii) ECCU countries plus Jamaica, Barbados, The Bahamas, and Belize; and (iii) ECCU countries plus 16 tourism-dependent countries. Estimated coefficients imply that (see Appendix Table I.1):

  • An increase of 10 percent in per capita tourist arrivals relative to per capita tourist arrivals in The Bahamas is associated with an appreciation of around 2 percent in the equilibrium real exchange rate. This is in line with the findings of IMF (2006) for a panel of developed and developing economies.
  • A 10 percent increase in the tourism terms of trade is associated with an equilibrium appreciation of the real exchange rate of 2 percent. This elasticity with respect to the tourism terms of trade is similar to that found for commodity-currencies by Cashin and others (2004), which ranged between 0.2 and 0.4.
  • An increase in the government consumption-to-GDP ratio of 10 percentage points is associated with an appreciation of the equilibrium real exchange rate of around 5 percent. The implied semi-elasticity of 0.5 is lower than the 2.6 value found by IMF (2006).
  • A deterioration of the ratio of net foreign assets to GDP of 10 percentage points would imply a depreciation of the equilibrium exchange rate by one-fifth of 1 percent. This is in line with that found in IMF (2006).
  • The half-life of deviations from equilibrium is around 1½ years, some 18 months less than those predicted by the simple purchasing power parity (PPP) model. This is consistent with the findings of Cashin and others (2004) that controlling for the influence of real factors—such as real commodity prices—is an important channel to reduce the persistence of real exchange rate shocks.

Equilibrium real exchange rates

8. Equilibrium real exchange rates were computed using the estimated relationship between the real exchange rate and the fundamentals.8Figures I.1 and I.3 show the evolution of the actual and equilibrium values for the REER in ECCU countries between 1979–2006. In all cases, current values of the real exchange rates are close to their equilibrium level, after experiencing a period of overvaluation in the early 1990s and early 2000s.

Figure I.1.ECCU: Actual and Equilibrium REER, 1979–2006

Sources: IMF, Information Notice System; and authors’ calculations.

1/ The shaded band around the equilibrium exchange rate represents ±1 standard error of the prediction (see Appendix Table I.1).

D. Macroeconomic Balance Approach

9. The macroeconomic balance approach was used to estimate equilibrium current account norms and to assess real exchange rates in the ECCU. Panel regression techniques were used to estimate an equilibrium relationship between current account deficits and a set of macroeconomic fundamentals. The estimated relationship was then used to calculate equilibrium current account balances or “norms.” The difference between the current account balance projected (by staff) over the medium term at the prevailing exchange rate, and an estimated equilibrium current account, was used to assess the level of the real exchange rate (see Appendix I.1). In particular, if the projected current account exceeds the estimated equilibrium current account, this suggests a potential overvaluation of the real exchange rate.

Fundamentals

10. Following the substantial body of literature on the subject, we used the following determinants to estimate equilibrium current account balances (IMF, 2006; Isard and Faruqee, 1998; Isard and others, 2001; and Obstfeld and Rogoff, 1996):

  • Fiscal balance. A fiscal surplus raises national saving and thereby increases the equilibrium current account balance. The measure of fiscal balance used in this chapter is the deviation of the central government budget balance (as a ratio of GDP) of each ECCU country from the average budget balance of the U.S. and the U.K., the ECCU’s main trading partners.
  • Oil balance. Higher oil prices decrease the equilibrium current account balance of oil-importing countries such as those of the ECCU; at the same time it should improve the current account balance of oil-exporting countries.
  • Relative income. The impact of relative per capita income on the equilibrium current account may differ depending on the level of development. At relatively low stages of development, increases in relative income would tend to improve a country’s access to foreign capital and thus be negatively correlated with the current account balance. The ratio of PPP-based per-capita income to the average of the U.S. and the U.K. levels is taken to measure the relative stage of development.
  • Relative economic growth. Among countries at a similar stage of development, the stronger is economic growth relative to trading partners, the higher is the equilibrium current account deficit. The deviation of the real per-capita GDP growth rate from the average of the U.S. and the U.K. is the variable used to capture relative economic growth.
  • Demographics. A higher relative number of young and elderly tends to reduce national saving and thus decrease the equilibrium current account balance. As a proxy for this impact we use population growth, which is expected to capture the share of economically-dependent young people.
  • Net foreign assets. Economies with high net foreign assets (NFA) benefit from higher net foreign income flows, which tend to create a positive association between NFA and the equilibrium current account balance.

Estimation results

11. The estimated model found a significant long-run relationship between the current account deficit and identified fundamentals, with many of the fundamentals possessing the expected signs. As with the earlier analysis of the equilibrium real effective exchange rate, the same three sets of samples were used in the panel estimation for the period 1979–2006. Estimated coefficients imply that for the ECCU countries (see Appendix Table I.2):9

  • A 1 percentage point increase in the fiscal balance (relative to trading partners) would lead to around one-third of a percentage point of GDP improvement in the current account balance. This coefficient is consistent with those found by Chinn and Prasad (2003), who estimated a coefficient of 0.39 for a panel of developing countries.
  • A 1 percentage point increase in the oil balance would be reflected in an increase in the current account balance of about 1.5 percentage points of GDP. This coefficient is significantly larger than that found by IMF (2006) for a panel of industrial countries (0.23), probably reflecting the fact that many ECCU countries have been slow to adjust the price of gasoline and other oil related products, thus reducing the substitution impact produced by a hike in oil prices.
  • A country whose income is half the average of the U.S. and the U.K. level would have a current account balance 0.35 percentage points of GDP larger than that of the U.K. and the U.S.; this is consistent with the results found by Chinn and Prasad (2003) for African countries.
  • At similar stages of development, a 1 percentage point increase in real GDP growth reduces the current account balance by about 0.3 percentage points of GDP. This is in line with the results found by the CGER for a panel of industrial countries (IMF, 2006).

Current account norms

12. The relationship summarized above permits the calculation of equilibrium current account balances or norms (Figure I.2). In computing the norms, medium-term (2012) values of the fiscal balance, oil balance, economic growth, and relative income are obtained from staff projections.

Figure I.2.ECCU: Current Account Deficit, Actual and Estimated Norms 1/

(In percent of GDP)

Sources: ECCB; and Fund staff estimates and projections.

1/ In computing the norms, medium-term values of the fiscal balance, oil-balance, output growth, and relative income are drawn from staff projections. Band is ±1 standard error of the prediction. ECCU sample includes only the 6 ECCU countries. CARICOM sample includes ECCU countries and The Bahamas, Barbados, Belize, and Jamaica. Full sample includes 22 tourism-dependent economies as defined by Bayoumi and others (2005).

2/ Based on Fund staff estimates. Medium-term is 2012.

Figure I.3.ECCU: Actual and Equilibrium REER, 1979–2006 1/

(Index 2000=100)

Sources: IMF, Information Notice System; and Fund staff calculations.

1/ The shaded band around the equilibrium exchange rate represents ±1 standard error of the prediction (see Appendix Table I.1).

13. Using the macroeconomic balance approach, the equilibrium current account deficit (the current account ‘norm’) is estimated at between 9–15 percent of GDP, for sample sets consisting of tourism-based economies. Estimates based only on ECCU countries give a norm of about 20 percent of GDP, though this may overstate the equilibrium level as the estimation covers a period of rapid debt accumulation. Accordingly, the staff’s projected medium-term current account balance for the ECCU is close to the estimated level of the equilibrium current account when using either (i) the ECCU-only sample or (ii) an extended sample of tourism-dependent countries, including a dummy variable for the ECCU. This indicates that there is little evidence of overvaluation of the real exchange rate, as the medium-term current account balance is close to the current account norm. However, when the extended sample is used without a dummy variable for the ECCU, the projected medium-term current balance is significantly above the estimated equilibrium level (Figure I.2 and Appendix Table I.2). In the estimation without the ECCU dummy, biases can arise if there are important factors explaining the cross-country variation in the data that are not captured in the specification but are correlated with the other variables. While the specification with the dummy controls for this possibility, the resulting estimates may be unduly influenced by historical realizations of the dependent variable. For this reason estimation results are presented for both specifications.10

14. The financing of ECCU current account imbalances appears stable. The large projected current account deficits are not expected to be financed by the accumulation of external sovereign debt or by resources intermediated through domestic financial systems, but rather by private capital inflows (particularly FDI). Tourism sector investment, particularly for hotel construction, continues to be overwhelmingly financed by FDI. As tourism-based investment opportunities in the ECCU decline over the medium term, capital inflows and current account imbalances will narrow. As noted by Isard (2007), the macroeconomic balance approach to the assessment of exchange rate competitiveness may not be helpful for countries (like those of the ECCU) that have healthy future growth prospects and are thereby attracting sizeable external capital inflows, which are then mirrored in large current account deficits. In such cases, assessments of the level of the exchange rate would need to take into account, among other things, the extent to which such foreign capital inflows are used for productive investments that engender a reduction in current account imbalances over time.

15. While current account imbalances are projected to remain above estimated equilibrium levels for an extended period, they are expected to decline over the medium term to a sustainable level. The recent increase in current account deficits reflects, in large part, an uptick in imports accompanying preparations for the Cricket World Cup (CWC) and expanding tourism capacity as ECCU countries develop their tourism sectors. The size of future current account imbalances is expected to taper off in line with the decline in the construction of new resort facilities, though much of the decline is likely to occur after the end of the projection period (after 2012). This implies that despite their apparent high levels, medium-term current account imbalances in the ECCU appear sustainable. Nevertheless, the high levels of current account imbalances, public debt and associated financing needs do pose risks that warrant careful monitoring and continued efforts at fiscal consolidation.

E. Conclusions

16. Real exchange rates in the region do not appear to be overvalued. The equilibrium real exchange rate estimation signals that the EC dollar real exchange rate is close to the level indicated by fundamentals. The empirical analysis shows that the depreciation of the EC dollar beginning in 2002 corrected a period of overvaluation, leaving the current real exchange rate closely aligned with fundamentals. Furthermore, while current account imbalances are projected to remain above equilibrium levels for an extended period, as tourism-based investment opportunities in the ECCU decline over the medium term, private capital inflows and current account imbalances will narrow. This implies that despite their current high levels, medium-term current account deficits in the region appear sustainable.

17. This chapter also provides evidence on the distinctive impact that tourism plays in the determination of the real exchange rate in tourism-driven economies. In estimating the equilibrium real exchange rate for a panel of 22 tourism-dependent economies, the analysis demonstrates that the impact of tourism on the real exchange rate is twofold. First, the real exchange rate is affected by the tourism terms of trade, where an increase in the price of the tourism good relative to the price of the imported foreign good induces an appreciation of the real effective exchange rate through wealth effects. Second, the real exchange rate is affected by an increase in the productivity of the tourism sector (associated with a Balassa-Samuelson effect) that increases wages in the nontradable sector, and thereby appreciates the real exchange rate.

Appendix I.1. Data Sources and Estimation Methodology

The dataset consists of annual observations for ECCU countries and 16 other tourism dependent economies for the period 1979–2006.11 The ECCU average is the GDP-weighted average of the six ECCU countries.

Variables

  • Log REER: Logarithm of the real effective exchange rate. Source: Information Notice System (INS).
  • Government Consumption: Central government consumption as a share of GDP. Source: IMF, WEO database.
  • Log Terms of Trade of Tourism: The proxy used is the movement in the terms of trade of goods and services (TT) not explained by the movement in the terms of trade of goods (TTG). Sources: IMF, WEO database; and authors’ calculations.
  • Log Terms of Trade of Goods: Logarithm of the terms of trade of goods only. Source: IMF, WEO database.
  • Productivity Differentials: Per capita tourist arrivals as a share of per capita tourist arrivals in The Bahamas. Source: World Tourism Organization and Caribbean Tourism Organization.
  • Net Foreign assets: Net foreign assets as a share of GDP, estimated as the accumulated current account balances for the equilibrium exchange rate estimation. For the macrobalance approach, net foreign assets are proxied by the level of public sector external debt (to reduce problems of endogeneity). Sources: IMF, WEO database; and Cashin and Rodriguez (2004).
  • Current Account Balance: Current account balance as a share of GDP. Source: IMF, WEO database.
  • Fiscal balance: Deviation of the central government budget balance (as a ratio of GDP) from the average budget balance of the U.S. and the U.K., the ECCU’s main trading partners. Source: IMF, WEO database.
  • Oil balance: Difference between oil imports and oil exports as a ratio of GDP. Source: IMF, WEO database.
  • Relative income: The ratio of PPP-based per-capita income to the average of the U.S. and the U.K. Source: IMF, WEO database.
  • Per capita growth: The deviation of the real per-capita GDP growth rate from the average of the U.S. and the U.K. is the variable used to capture relative economic growth. Source: IMF, WEO database.
  • Population growth: Annual population growth. Source: IMF, WEO database.

Estimation of the equilibrium REER

As suggested by Breitung and Pesaran (2005) in panels where N is small (less than 10) and T is relatively large, the standard approach is to treat the equations from the different crosssection units as a system of seemingly unrelated regression equations (SURE) and then estimate the system by generalized least squares (GLS) techniques.12 A main advantage of these type of models is that correlation across units becomes a natural part of the specification, whereas in large N small T panels this type of correlation is always assumed away. Furthermore, the autoregressive distributed lag (ARDL) model specification advanced by Pesaran and Smith (1995) is used. The main advantage of this specification is that valid asymptotic inferences on the short-run and long-run parameters can be made, using the least or generalized squares estimator of the ARDL model, even in the presence of a lagged dependent variable and irrespective of the order of integration. The results are then rewritten in an error-correction formulation, in order to assess the speed of adjustment of the real exchange rate towards its long-run equilibrium. The long-run relationship should be interpreted as an equilibrium relationship rather than a causal one, since the presence of reverse causality is expected, particularly between the real exchange rate and tourism.

As a robustness check, three sets of samples were used: (i) ECCU only; (ii) ECCU countries plus Jamaica, The Bahamas, Barbados, and Belize—the main tourism competitors in the region; and (iii) ECCU countries plus 16 tourism-dependent countries. This was done to account for the possibility that the true FEER could be significantly below (or above) any of the realized REER for individual ECCU countries, but the methodology/sample would not be able to detect it.

As an additional robustness check, the pooled-mean group estimator (PMG) was used with the extended sample. This methodology proposed by Pesaran, Shin and Smith (1999) constrains the long-run coefficients to be identical in an error correction framework, but allows the short-run coefficient and error variances to differ. The main attraction of the GLS-SUR procedure lies in the fact that it allows the contemporaneous error covariances to be freely estimated. However, this is possible only when N is reasonably small relative to T.

When N is of the same order of magnitude as T, as is the case in the full sample, GLS-SUR becomes less reliable. The PMG estimator is an alternative way to the panel corrected standard error (PCSE) to account for heterogeneity across the sample when N is relatively large.

Appendix Table I.1 shows the equilibrium relationship found with the different samples and the PMG estimator. The estimation results confirm the significant and positive association between tourism-driven productivity differentials and the REER. Similarly, it confirms the significant and positive association between tourism terms of trade and the REER. The coefficient for terms of trade of goods becomes significant in the extended sample, most likely reflecting the relatively lower reliance on tourism by countries such as Jordan, Uganda or Egypt. Overall, these results confirm the distinct impact of tourism on the real exchange rate in tourism-dominated economies through: (i) Balassa-Samuelson effects driven by increases in productivity in the tourism sector; and (ii) changes in the tourism terms of trade. For additional details on the estimation, see Pineda and Cashin (2008).

Appendix Table I.1.Results of the Error Correction Specification for Different Samples(Dependent variable: Real effective exchange rate)
SUR PCSE 1/PMG 2/
SpecificationECCUCARICOMAllAll
Estimates of the long-run relationship
Government consumption0.481.40***−0.04−0.29***
(1.44)(3.22)(−0.49)(−3.01)
Terms of trade of tourism0.15**0.16**0.09*0.54***
(2.48)(2.39)(1.87)(5.57)
Terms of trade of goods−0.04−0.010.07***0.38***
(−1.24)(−0.14)(2.62)(8.45)
Productivity0.15***0.17***0.16***0.58***
(3.19)(3.03)(2.86)(4.25)
Net foreign assets0.02*0.03*0.03*0.11***
(1.90)(1.91)(1.95)(2.62)
Constant2.16***1.77***1.66***0.66***
Half-life of deviation 3/1.441.651.743.08
Prob > X20.000.000.000.00
N6102222
Source: Authors’ calculations.

OLS-based Panel Corrected Standard Errors assuming cross-sectional correlation, panel heteroskedasticity, and AR(1) process.

Pooled Mean Group Estimator.

Half-life of deviation (in years) is estimated as -ln(2)/ln(r) where r is the error correction coefficient.

Note: Coefficients in parentheses represent the respective z and t values.*,**,*** denote significance at 10, 5, and 1 percent, respectively.
Source: Authors’ calculations.

OLS-based Panel Corrected Standard Errors assuming cross-sectional correlation, panel heteroskedasticity, and AR(1) process.

Pooled Mean Group Estimator.

Half-life of deviation (in years) is estimated as -ln(2)/ln(r) where r is the error correction coefficient.

Note: Coefficients in parentheses represent the respective z and t values.*,**,*** denote significance at 10, 5, and 1 percent, respectively.

Estimation of the current account norms

Similar econometric techniques described in the previous section were used for the ECCU only panel, and for the CARICOM and tourism-dependent country samples. Appendix Table I.2 reports the results of the estimation, where most coefficients are statistically significant with the expected signs. For additional details on the estimation, see Pineda and Cashin (2008).

Appendix Table I.2.Estimation Results Macroeconomic Balance Approach(Dependent variable: Current account balance as a share of GDP)
SUR GLS 1/SUR PCSE 2/
SpecificationECCUCARICOMAll
Fiscal balance0.34***0.41***0.51***0.42***0.39***
(3.33)(4.42)(5.95)(14.43)(14.92)
Oil trade balance1.60***0.130.59***0.14***0.22***
(4.11)(0.86)(4.41)(7.01)(9.75)
Relative income−0.69**0.14***−0.10***0.06***−0.01**
(−1.99)(4.39)(−2.79)(5.40)(−0.77)
Population growth0.39−0.03−0.51*0.25**−0.12
(0.40)(−0.10)(−1.81)(2.19)(−1.18)
Per capita growth−0.27**−0.14−0.12−0.04−0.01
(−2.13)(−1.56)(−1.45)(−1.41)(−0.56)
Net foreign assets 3/0.06*
(1.83)
ECCU dummy−0.14***−0.13***
(−9.99)(−14.92)
Constant0.01−0.17***0.01−0.09***−0.02**
Prob > X20.000.000.000.000.00
Source: Authors’ calculations.

Feasible Generalized Least Squares assuming cross sectional correlation, panel heteroskedasticity, and AR(1) process.

OLS-based Panel Corrected Standard Errors assuming cross-sectional correlation, panel heteroskedasticity, and AR(1) process.

To reduce problems of endogeneity net foreign assets is proxied by the level of public external debt following Cashin and Rodriguez (2004). This proxy was only available for the ECCU countries.

Note: Coefficients in parentheses represent the respective z and t values.*,**,*** denote significance at 10, 5, and 1 percent, respectively.
Source: Authors’ calculations.

Feasible Generalized Least Squares assuming cross sectional correlation, panel heteroskedasticity, and AR(1) process.

OLS-based Panel Corrected Standard Errors assuming cross-sectional correlation, panel heteroskedasticity, and AR(1) process.

To reduce problems of endogeneity net foreign assets is proxied by the level of public external debt following Cashin and Rodriguez (2004). This proxy was only available for the ECCU countries.

Note: Coefficients in parentheses represent the respective z and t values.*,**,*** denote significance at 10, 5, and 1 percent, respectively.
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1The ECCU consists of six Fund-member countries (Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines) and two territories of the United Kingdom (Anguilla and Montserrat).
2Prepared by Emilio Pineda and Paul Cashin.
3The EC dollar has been pegged to the U.S. dollar at a rate of EC$2.7 per US$1 since 1976 in the context of a quasi-currency board arrangement.
4According to staff analysis by the Consultative Group on Exchange Rates (CGER) as of July 2007, further real effective dollar depreciation of 10–30 percent would be required to eliminate the misalignment relative to medium-term macroeconomic fundamentals. See United States—Staff Report for the 2007 Article IV Consultation (IMF Country Report No. 07/264).
5Since the ECCU economies are dominated by tourism, it is of interest to analyze the evolution of the real exchange rate against some key tourism customers and competitors. These measures are variants of the traditional real effective exchange rate index calculated by the IMF. Customers: Antigua and Barbuda-(Canada, U.K., U.S.), Dominica-(France, U.K., U.S.), Grenada-(Trinidad and Tobago, U.K., U.S.), St. Kitts and Nevis-(Canada, U.K., U.S.), St. Lucia-(Canada, U.K., U.S.), St. Vincent and the Grenadines-(Trinidad and Tobago, U.K., U.S.). Competitors: The Bahamas (23.4 percent), Barbados (8.0 percent), Dominican Republic (43.5 percent), Jamaica (19.4 percent), and Trinidad and Tobago (5.7 percent). The weights, in parentheses, are chosen based on the share of tourism arrivals to the Caribbean in 2001.
6Estimates of the equilibrium REER are sensitive to the methodology used, and are particularly challenging in developing countries where the data are relatively weak (see Di Bella and others, 2007).
7Other countries—such as Antigua and Barbuda or Barbados—were used as benchmarks with similar results.
8The fundamentals can exhibit a substantial degree of “noise” or fluctuations. To ameliorate the impact of these fluctuations we applied a Hodrick-Prescott filter with a smoothing factor of 10.
9As shown in the Appendix, net foreign assets and population growth were statistically insignificant.
10Macroeconomic balance-based estimates of the equilibrium current account position are typically subject to uncertainty, given the large variation in current account balances across countries and over time, and the limits of the common specification imposed across a diverse set of countries.
11Following Bayoumi and others (2005), we defined tourism-dependent countries as those where tourism exports exceeded a threshold of 20 percent of total exports. Bayoumi and others (2005) find 29 tourismdependent countries; however, given the lack of tourist arrivals time-series for seven of them, we were left with the following 22 countries: Antigua and Barbuda, The Bahamas, Barbados, Belize, Cyprus, Dominica, Dominican Republic, Egypt, Fiji, Greece, Grenada, Jamaica, Jordan, St. Kitts and Nevis, Malta, St. Lucia, St. Vincent and the Grenadines, Mauritius, Samoa, Seychelles, Uganda, and Vanuatu.
12Our finding that the real exchange rate in the ECCU countries does not exhibit a unit root rules out the possibility of cointegration, and thus standard panel models used in the literature such as dynamic ordinary least squares (DOLS) cannot be used. This strategy is also consistent with that adopted by Chen and Rogoff (2003), who argue that it is plausible to assume that over finite samples real exchange rates are stationary.

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