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Kingdom of the Netherlands—Aruba: 2013 Article IV Consultation

Author(s):
International Monetary Fund. European Dept.
Published Date:
August 2013
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Sustaining Potential Growth1

As in the other Caribbean countries, there are growing concerns in Aruba about the slowdown in economic growth over the past two decades and the consequent tepid outlook for potential growth. Tackling such concerns requires identifying the underlying factors. This chapter presents an overview of Aruba’s economic growth performance since 1990, analyzes factors behind the slowdown, and discusses how potential growth can be sustained.

A. Growth Performance

1. Aruba’s real GDP growth has been on a downward slide since 1990. After growing on average by 4.8 percent in the 1990s and close to 2 percent during 2000-07, real GDP contracted on average by 2.4 percent during 2008-12. While a slowdown in growth was felt everywhere in the region in recent years, Aruba’s downturn was particularly deep. Real GDP contracted by over 11 percent in 2009 as global financial crisis and shut down of refining by Valero hit Aruba’s economy. There was a temporary turnaround in output in 2011, based on a recovery of the tourism sector and the resumption of oil refining. However, real GDP contracted again in 2012 due to the second shutdown of refining in March 2012, which eventually led to the decision of converting the company into a transshipment facility, thereby eliminating its refining function. Aruba has lost, at least for now, a significant source of export and investment. The level of real GDP in 2012 remained 12 percent below its pre-crisis level and its recovery is expected to be slow.

Five Year Moving Average Real GDP Growth

(Percent)

Sources: CBA; CBS; WEO; and IMF staff calculations.

2. The volatility of GDP growth has increased over time. The standard deviation of real GDP growth rose from 2.8 in the 1990s to 4.2 during 2000-07 and 5.6 during 2008-12. The volatility, which is considerably higher than in other Caribbean countries, reflects (i) Aruba’s vulnerability to business cycles in source countries that drive tourism and FDI into Aruba, and (ii) the fluctuation in international oil prices that affect the profitability of oil refining. Tourism accounts for over 80 percent of economic activities with more than 60 percent of Aruba’s tourists originating in the US. This highlights Aruba’s susceptibility to economic slowdown in the US. Similarly, the slim margins of the oil refining industry are sensitive to the crude/light oil price ratio and a fall in this margin has led to repeated suspension of oil refining in recent years.

GDP Growth and Volatility(Based on real GDP Growth rates)
CountriesAverage growthAverage Std. Dev.
1990-992000-072008-121990-992000-072008-12
Aruba4.81.9-2.42.84.25.6
Caribbean 1/3.24.32.62.12.11.3
ECCU3.33.5-1.01.72.43.3
OECD2.72.60.60.80.92.6
Sources: WEO; ECCB; and IMF staff calculation.

3. Potential output in Aruba has also declined over time. We derive Aruba’s potential output using two methods, a time-trend polynomial function and the HP filter. Both methods show that potential output has been on a declining trend over the years, with current potential growth near or below zero depending on the estimation method. The declining trend is also visible in the Eastern Caribbean Currency Union (ECCU) countries, but Aruba’s shows a faster pace.

Aruba: Real GDP Growth, Actual vs. Potential

(Percent)

Sources: CBA; CBS; and IMF staff calculations.

ECCU: Real GDP Growth, Actual vs. Potential

(In percent)

Source: IMF Staff Report of 2012 Article IV Consultation of ECCU (SM/13/38).

B. What Explains the Modest Growth Performance

4. A lack of competitiveness in the tourism sector, which plagues some of Aruba’s Caribbean neighbors, does not seem to be the explanation.

  • Aruba’s market share in Caribbean tourism has increased signaling sound competitiveness. The sector has navigated the most recent financial crisis better than its Caribbean peers with a faster rebound. Strong efforts by the authorities to diversify the market favoring fast-growing South American emerging market economies (such as Venezuela, Brazil, Chile, and Colombia) and Aruba’s reputation as a “high-end” destination have helped with the faster recovery, as tourism losses have been concentrated more in the lower-cost segments of the market. Revenue per available room has also been consistently higher than the Caribbean average. A sizable share of Aruba’s resorts is owned by timeshare owners which provided stability during the global crisis.

Aruba: Tourism Market Share and Visitors Nights, 2000-12

Sources: CBS; CBA; and Aruba Tourism Authority.

Revenue Per Available Room

(U.S. dollars)
  • Input costs, such as electricity and wages, and cost to import are low compared to other countries in the region. Electricity tariff, at US$0.26 per kwh, is among the lowest in the region. Many firms, especially in the ECCU countries, identify high electricity tariff as a major constraint to doing business. Moreover, tourism requires large labor input and imported intermediate goods making wage and import costs a major issue in competitiveness. Limited data does not allow us to make a sectoral wage analysis. But a very broad comparison based on the ratio of average wage to per capita income, and the shipping costs of imports shows Aruba’s competitive strength in the region.

Household Electricity Tariffs Per kwh, June 2011

(US dollars)

Sources: Utility Companies, International Energy Agency, U.S. Energy Information Administration, Europe’s Energy Portal.

Sources: World Bank, Doing Business Indicators; National pension companies for ECCU countries; OECD; and Aruban authorities.

Box 1.Aruba’s Labor Law: Examples of Rigidities

Aruba’s labor market is highly regulated:

  • An employment contract will be entered before the hiring and the employer is not allowed to ask the employee to perform other jobs except the one specified in the contract.

  • Temporary workers are only allowed to be hired through a temporary agency for a period of up to 12 months in the same position/function. After 12 months, there is a pause of 3 months before it is possible to use the same temporary worker in the same position/function.

  • To lay-off workers, employers are required by law to obtain a dismissal permit from the Director of the Department of Labor and make severance pay based on the employee’s last salary and the years of service.

  • The total working time in a week (including overtime) cannot exceed 55 hours.

Source: Aruban Authorities.

5. However, Aruba’s structural competitiveness portray a more mixed picture. Aruba is not included in the World Bank’s Doing Business Indicators. But anectodal evidence suggests that there are impediments to doing business in the form of restrictive hiring and firing procedures (Box 1), high borrowing costs for new entrepreneurs, and unclear and complex licensing requirements for starting a business. These challenges aggravate further the obstacles to economic diversification that are common to small island economies.

6. We used a Cobb-Douglas production function with constant returns to scale to calculate the contribution of each factor to growth. The basic production function includes capital and labor as factor inputs:

where, Y is aggregate output, A is total factor productivity, K is the physical capital stock, L is the stock of labor, and α is the factor-income share of capital. Taking logs, differentiating with respect to time, and expressing the variables as growth rates give us:

The contribution of each factor is then calculated as its growth rate multiplied by its share, with TFP as the residual. Following Lee (2005), α is assumed to be 0.35, constant and equal across countries. We construct labor stock L using labor force data from Aruba Central Bureau of Statistics (CBS). The physical capital stock is constructed using investment data from the national accounts. Average depreciation (δ) is assumed to be 6 percent per year over the period. So capital stock accumulates according to the following formula:

Where, Kt denotes the capital stock at time t and It denotes investment at time t.

7. The results indicate that the slowdown in growth during the past decade can largely be attributed to falling total factor productivity (TFP). Similar to its Caribbean peers, Aruba’s TFP has declined noticeably since the 1990s, partly as a result of economy’s greater reliance on the labor-intensive tourism sector. High dependency on tourism could lead to lower productivity growth in the future—on the critical assumption that other sectors (e.g., manufacturing) are more prone to stimulate productivity growth (WEO, 2011). However, since TFP captures productivity developments and shocks, larger negative contribution in recent years also reflects negative shocks experienced in the last four years. In addition, labor’s contribution has also declined over time.

Aruba: Contrubutions to Growth

(In percentage points)

Source: IMF staff calculations.

Growth Accounting in the ECCU

(In percentage points)

C. Outlook for Potential Growth

8. Aruba’s projected decline in labor force poses a challenge for sustaining current potential growth rate. The 2010 census shows that the share of population above 65 years has increased from 7.4 percent in 2000 to 10.4 percent in 2010, and is expected to more than double in 2030. Based on this, the CBS projected three growth scenarios for 2010-2030: low, medium and high. Under the low growth scenario, Aruba would need a total of 45,025 immigrant workers in 2030, accounting for 37.4 percent of the projected population, to sustain a growth rate of around 1 percent. In the medium scenario, a total of 74,121 immigrant workers would be needed in 2030, or about 52 percent of the total projected population, to sustain a growth rate of 1.6 percent (the current potential growth rate). Such high levels of immigrant workers, required under all growth scenarios, is likely to pose pressures on housing, other existing infrastructure, and the already burdened health and education services. Attention therefore needs to be given on how to increase productivity through improving the business environment, increasing labor force participation rate, skill improvements and technological upgrading. At 64.7 percent, labor force participation rate in Aruba is low even compared to the members of the European Union (average participation rate at 72.2 percent), where low participation is recognized as a key obstacle to growth performance.

Aruba: CBS’s Three Scenario Projection 2010-2030
2030
2010-20152015-20202020-20252025-2030Required

immigration

(person)
Immigrants

(% of total

population)
Low scenario4502537.4
Growth real GDP (%)1.261.191.121.06
Growth labor productivity (%)0.5111
Unemployment7555
Mid scenario7412148.3
Growth real GDP (%)2.131.931.761.61
Growth labor productivity (%)0000
Unemployment7655
High scenario8874152.1
Growth real GDP (%)3.012.622.312.07
Growth labor productivity (%)0000
Unemployment7655
Source: Aruba authorities and staff calculations.

9. Another possible challenge may be limited room for growth in tourism. Following Thacker, Acevedo, and Perrelli (2012), a model was estimated to capture the “exhaustion effect” of tourism on growth. The 5-year moving average growth rate was regressed on tourist arrivals (as a ratio to population), trade openness, annual inflation rate and the “exhaustion effect”, which was approximated by a quadratic representation of the ratio of tourist arrival to population. The results of three alternative estimations are shown in the text table. The sample covers 1990-2012. Tourist arrival as a ratio to total population always has a positive effect on growth. However, the quadratic representation of the ratio shows a negative effect in contrast to the positive effect found in Thacker, Acevedo, and Perrelli (2012) for other Caribbean countries. The results indicate that the tourism industry in Aruba may have reached a saturation point with a possible declining rate of growth dividend.2 Limited availability of still-to-be-developed land and the need for immigrant labor also provide support for the “exhaustion effect”.

Aruba: The impact of tourism on growth
Dependent variable: 5-

year moving agerage

growth rate
(1)(2)(3)
Tourist arrival (ratio of total population)0.79**0.79**0.65**
(0.29)(0.30)(0.28)
Tourist arrival (ratio of total population)^2-0.05**-0.05**-0.04**
(0.02)(0.02)(0.02)
Trade openness0.00
(0.01)
Inflation0.005**
(0.002)
Constant-2.98**-2.96**-2.44**
(1.13)(1.16)(1.06)
Note: ** denotes significant at 5 percent level.

D. Potential for Developing Renewable Energy

10. The government of Aruba has identified the renewable energy sector as a new growth pillar. Their goal is to make Aruba 100 percent dependent on solar and wind energy. One windmill park is currently in use and provides about 15 percent of total energy needs. Another windmill park is planned to be built in 2014 and is expected to increase the share of wind energy to 25 percent. The government also plans to establish research laboratories, to attract companies from overseas to use the island as a test platform for renewable energy products and to turn Aruba into a gateway between South America, the U.S. and Europe for commerce and investment.

11. Aruba holds considerable potential for developing the renewable energy sector. Solar and wind resources are abundant in the island. There is potential for boosting productivity through technological advances and a knowledge-based platform. If successful, developing the renewable energy sector would help reduce input cost, boost competitiveness, and reduce pollution to the environment by replacing the fuel- and gas-powered energy.

12. However, developing the renewable energy sector requires huge upfront investment (Figure 1). Based on the report of International Energy Agency and Nuclear Energy, a very high portion of the Leveraged Cost of Electricity (LCOE) of onshore wind energy is investment cost while operation management (O&M) costs are minimal. In contrast, fuel and carbon costs comprise the majority of LCOE of gas-powered energy. Securing such financing without jeopardizing external sustainability would require success in attracting FDI inflows.

Figure 1:Selected Countries: Leveraged Cost of Electricity

Source: Projected Costs of Generating Electricity, 2010 Edition, by International Energy Agency and Nuclear Energy.

13. Being an island economy and having a shortage of skilled labor may also pose constraints. As Aruba is an island and cannot hook up to the electrical grid of other countries, it may not be possible for it to be 100 percent dependent on renewable energy. Backup power plants will always be necessary. There are also technological and other constraints to storing wind energy, which worsens as the number of windmills increases. Exporting non-tourism services to South America, including in the field of renewable energy, may face difficulties in light of shortage of skilled labor.

E. Policy Recommendations

14. Aruba needs to maintain its current price competitiveness in tourism. Continued diversification in the tourism source markets is useful. Marketing efforts in the past have almost doubled the tourist arrivals from Latin America between 2005 and 2013. Given that tourists from U.S. still account for more than 60 percent of the total, there is room to diversify more.

Visitor Arrivals

(in percent of total)

Sources: CBA; and Aruba Tourism Authority.

15. Improving structural competitiveness is important for economic diversification. Efforts should focus on:

  • Improving the ease of doing business by making the recently established one-stop-shop for investors operational;

  • Improving labor market flexibility, pursuing domestic reforms (such as, social benefits and the pension scheme) to increase the labor force participation rate, and adopting a comprehensive immigration plan in coordination with social partners;

  • Working with new entrepreneurs to foster an understanding of financial management, and create incentives for reducing borrowing costs, including through greater competition in the banking system.

16. Aruba should aim to finance its renewable energy and other future growth initiatives sustainably. Aruba’s external debt at around 105 percent of GDP is very high. Given the high investment needs of developing renewable energy, it is important that Aruba finances these and other future projects through FDI.

References

Prepared by Haiyan Shi. The author would like to thank the Aruban authorities, Sebastian Acevedo, and Xin Li for sharing the data, and seminar participants at the Central Bank of Aruba for useful comments.

Based on the 2013 report of World Travel & Tourism Council, Aruba ranks second highest in the world on the contribution of tourism sector to GDP.

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