The ECCB maintains open access to a common pool of foreign exchange and aims its credit policy at providing strong foreign exchange backing for currency issued, thereby supporting the fixed exchange rate policy. Under this arrangement, of course, there is no scope for monetary policy at the national level, the trend rate of inflation in the region is determined fundamentally by inflation in the United States and the other main trading partners, and market interest rates within the region follow closely world interest rates with a premium reflecting local conditions. While the region’s trading systems have been relatively open by necessity, until recently the capital accounts have been relatively insulated from the rest of the world by restrictions and, perhaps, geographical isolation.

The Currency Union Arrangement

The ECCB maintains open access to a common pool of foreign exchange and aims its credit policy at providing strong foreign exchange backing for currency issued, thereby supporting the fixed exchange rate policy. Under this arrangement, of course, there is no scope for monetary policy at the national level, the trend rate of inflation in the region is determined fundamentally by inflation in the United States and the other main trading partners, and market interest rates within the region follow closely world interest rates with a premium reflecting local conditions. While the region’s trading systems have been relatively open by necessity, until recently the capital accounts have been relatively insulated from the rest of the world by restrictions and, perhaps, geographical isolation.

In practice, the ECCB operates as a quasi-currency board. It has maintained foreign exchange backing of close to 100 percent of monetary liabilities, well in excess of the minimum requirement of 60 percent set in the 1983 Act of Agreement. This has been possible because the 1983 Agreement stipulates that lending to governments, up to prescribed limits, is at the discretion of the ECCB, and because member governments have exercised restraint in borrowing from the ECCB.40

The ECCB management considers that the authorities in the region are satisfied with the currency union arrangement and with the price and exchange rate stability that it has facilitated. At the same time, there is awareness that to safeguard the arrangement and promote efficiency within the common currency area it is important to improve the flexibility of goods and factor markets, intensify efforts aimed at trade and capital liberalization, strengthen the banking system, and maintain fiscal discipline.

Fiscal Policy

Fiscal policy in the region is conducted independently by each member country. In contrast to the recent experience with European Monetary Union, there have been no fiscal harmonization criteria or targets, but the common currency arrangement has fostered a tradition of fiscal discipline. However, there have been exceptions, with some countries including at times sizable fiscal deficits without recourse to ECCB credit by borrowing from external or domestic creditors. Moreover, in several countries in the region, public sector saving has remained low in recent years, frequently with adverse consequences for public investment and the growth of output and employment. At the same time, the banana producing countries are facing an urgent need to restructure, as continued access to protected markets is in question.

Economic size, trade liberalization, and incentives for economic development also pose challenges to fiscal policy. Policymakers note that diseconomies of small scale lead to high unit costs in general, and to relatively large wage bills in particular. The unit cost of providing public goods and operating separate customs and tax collection services are relatively high. Further trade liberalization is likely to result in a need to offset import tax revenue losses. Revenue performance remains hindered by an extensive array of tax concessions, with exemptions widely granted on taxes on business income and on imports under incentive regimes favoring manufacturing, tourism, and agricultural firms as well as other activities that qualify on social and economic grounds.

Against this backdrop, the main policy issues are the need to raise public saving and investment, improve the quality of public expenditure, strengthen government revenue, increase the institutional efficiency of the governments, and find ways to intensify regional cooperation. Some of these issues carry greater urgency for certain countries. In particular, St. Kitts and Nevis has been undertaking a substantial reconstruction effort in the wake of Hurricane Georges, and Dominica and St. Vincent and the Grenadines are seeking to expand their airport facilities. Virtually all countries face the challenge of strengthening public saving in order to help fund needed improvements in infrastructure, particularly in view of the limited prospects for increased external grants.

Fiscal Reform Objectives and Measures Proposed by the ECCB

Raising central government saving to around 4–5 percent of GDP, and public sector saving to 7–8 percent of GDP

A tax reform to improve efficiency, equity, and buoyancy, in order to promote saving and investment and strengthen tax administration. Specific measures would include:

  • Harmonize the maximum rate for the personal and corporate income tax;

  • Exempt dividend and interest earnings from the personal income tax;

  • Broaden the tax base by introducing a tax on value-added, or a general consumption tax covering services with rebates on inputs for exports;

  • Eliminate the foreign exchange tax;

  • Adhere to CARICOM schedule for the implementation of the CET;

  • Extend the embarkation tax to seaport departures;

  • Preserve diversity in tax revenue by ensuring adequate balance between direct and indirect taxation;

  • Improve property valuation and registration, as well as the billing and collection of the property tax;

  • Streamline tax concessions;

  • Maintain the real value of licenses and government fees; and

  • Stricter application of penalties for tax crimes.

Expenditure reform aimed at raising quality and efficiency by:

  • Improving budgeting procedures and practices and preparing multiyear budgets;

  • Tightening expenditure controls;

  • Better targeting of welfare programs;

  • Privatizing utilities where there are identifiable benefits;

  • Introducing regional procurement of selected goods and services, including education and health services, and foreign representation and negotiations;

  • Framing the public sector investment program (PSIP) in the context of an overall development strategy and in a manner consistent with absorptive capacity; and

  • Strengthening coordination in the preparation, implementation, and monitoring of the PSIP.

Technical assistance and close collaboration with governments in financial programming and policy design. This would be complemented by the creation of a public sector database and by improved compilation of public sector statistics.

The ECCB has put forward a proposal to its member governments to address these issues through the creation of fiscal regimes conducive to economic growth and development, social equity, and fiscal stability over the medium term (Box 7). The ECCB considers that an increase in public saving is needed to help fund increased public investment, provide adequate counterpart funds for externally supported projects, eliminate arrears, help amortize debt by constituting sinking funds, and create reserves against emergencies. The proposed fiscal reform program envisages public saving targets in the range of 4–5 percent of GDP for central governments and 7–8 percent for the public sector that would help cover public investment of 12 percent of GDP. The ECCB keeps these targets under review in case of changing conditions.

Under the program, the ECCB would help governments institutionalize financial programming as a tool for fiscal management and promote the allocation of central bank profits to building up fiscal reserves. To do this, it created in 1995 a two-tranche fiscal reserve facility, with the first tranche funded with portions of the profits that the ECCB distributes annually and that governments deposit, at their discretion, in facility accounts at the ECCB. These resources, however, are freely available to governments, thereby constituting short-term liabilities of the ECCB. Before distributing profits to governments, the ECCB allocates EC$4 million annually into the second tranche of this facility, maintaining these resources pooled in its reserves. Use of second tranche reserves has to be approved by the Monetary Council, as these resources have been earmarked as saving to be used only in a last resort case or to help deal with natural disasters. The ECCB’s fiscal reform proposal calls for governments to raise public saving and deposit part of the increase into first tranche accounts. At the same time, the ECCB is proposing that governments forgo profit distributions, dedicating instead distributable profits to build up the fiscal reserve facility.

Governments are still to take ownership and adopt the ECCB proposals, or to set a timetable for implementation. In addition, a few aspects of the fiscal reform plan deserve review. Ways to achieve the targeted public saving should be identified, with a clear determination of the mix of revenue and expenditure measures. There is also awareness of the need to update the size of the required adjustment and calibrate the proposed adjustment measures to ensure that they adequately fit the needs of each country. Finally, there is a question whether the proposed fiscal saving targets can be achieved without addressing the issue of the public sector wage bill, not only through wage moderation, but also through compensation system reform and downsizing of the civil service, including through regional consolidation of the provision of certain public services. There also ought to be consistency between saving targets and the expectations and conditionality increasingly set by donors (Box 8).

While the ratio of taxes to GDP is already high, there is considerable scope in most countries to improve the efficiency of the tax system. With the reductions in import duty collections resulting from trade liberalization, sentiment for the adoption of value-added taxation seems to be increasing, despite the administrative difficulties perceived with such systems in very small states. Both Dominica and Grenada are considering it and have received technical assistance from the IMF for this. The ECCB has prepared a position paper and has advised that VAT is an economically efficient tax. The ECCB recommends the introduction of VAT only if there is strong political backing and after the high administrative demands are adequately addressed. Regional harmonization in sensitive areas such as tax incentives has proven to be difficult, but harmonization of tax laws and regulations in other areas is proceeding, albeit slowly. A recent ECCB report assessing the revenue losses from tax incentives and exemptions in the member countries has drawn attention to this issue and has spurred St, Lucia to undertake a review of discretionary exemptions. There is also scope in all countries for reform of property taxes by linking them more closely to property values.

Monetary Issues

The Regional Government Securities Market

An important issue in the launching of the RGSM is the extent of ECCB involvement in the operations of the market. If the ECCB were to provide liquidity support in the event of undersold auctions, either directly as a “buyer of last resort” or indirectly through the commercial banks, the backing ratio could drop below its traditionally high levels. Thus, the integrity of the current quasi-currency board arrangement would be best preserved by avoiding the potential moral hazard problem that could ensue from providing governments with the incentive to issue more debt than they would otherwise, and shielding governments with unsound policies from the rigors of market assessment by allowing enlarged access to financing.

The ECCB’s position regarding its likely activity in the RGSM is that it will only purchase unsold treasury bills in the primary market up to an amount that would effectively roll over its holdings of that country’s government securities. This would help preserve the current level of the foreign exchange cover. That is, it will be prepared to access the primary auction to replace bills maturing at that time (and which would have been rolled over automatically in the absence of the RGSM). If the private demand is there, the ECCB would not replace bills and reduce its holdings. Preserving the existing holdings of bills, however, would require some reallocations should the three member states that do not presently issue government securities choose to enter the government securities market. Although the precise scope of the Bank’s activity in the secondary market has not yet been defined, the principle has been established that acquisitions of securities through the secondary market will be temporary in nature, through auction-based agreements that call for repurchase before maturity.

The Interbank Market

Most interbank lending is believed to take place on a bilateral basis, at rates that are higher than the official interbank rate and vary depending on lenders’ assessment of credit risk. Based on the loan amounts outstanding in the official interbank market and the outstanding amounts shown in the commercial banks’ accounts due to and from banks in other ECCB territories, it can be estimated that over 90 percent of interbank trading takes place in the unofficial market. One possible explanation is the absence of a securitization requirement (which is particularly relevant given the shortage of eligible securities partly because of oversubscription of the central bank’s rediscount window) in the unofficial market, where loans are essentially transacted on the basis of creditworthiness and guided by credit line limits. There are also indications that some liquidity-constrained commercial banks have made a practice of borrowing interbank funds in the unofficial market for periods in excess of 30 days, for the purpose of extending further credit.

The ECCB is presently discussing with the commercial banks a proposal to integrate the two markets that would allow the rate in the official market to be market determined. Under this proposal, the central bank would still help to minimize bank search and information costs by matching bids and offers, but current securitization requirements would be eliminated and the central bank would no longer guarantee interbank transactions. Market determination of the interbank rate is an important feature of ongoing money and capital markets reforms. Since the interbank rate is a critical factor affecting the cost of funds, its market determination should serve as a useful reference for interest rates in general. Moreover, the ECCB can encourage participation in the interbank market by maintaining its discount rate above the prevailing interbank rate, which would also serve as a cap on the interbank rate (see discussion below).

The Treasury Bill Rediscount Window

The ECCB’s capacity to rediscount treasury bills is circumscribed by the legal limits on its holdings of each member’s bills and its commitment to a high foreign exchange backing ratio. The present rediscount window is ordinarily “fully subscribed” owing to various market imperfections that discourage active commercial bank participation in the secondary treasury bill market. For instance, interest payments and redemptions of bills and debentures are sometimes delayed owing both to management inefficiency and occasional cash shortages in countries facing difficult fiscal positions. Since the ECCB guarantees the interest and principal payments of treasury bills that it rediscounts and the bills can be resold to the ECCB at the banks’ discretion, these assets are, however, perfectly liquid and essentially risk-free for the commercial banks, which in turn routinely roll over their holdings. The appeal of these instruments to commercial banks is enhanced by a shortage of viable investment alternatives, owing partly to the tendency of many local banks to limit their investments to the home country, which is reinforced by several capital account restrictions. Oversubscription of the rediscount window constrains the ECCB’s ability to tighten monetary conditions.

In order to strengthen credit policy, the ECCB plans to replace the existing treasury bill rediscount window with a market-based government securities repurchase (repo) auction as part of the introduction of the RGSM. This system would facilitate market determination of the rediscount rate, which would then better reflect prevailing liquidity conditions. A gradual phasing in would be a way to start this program, commencing with an initial auction of a small proportion (say 25 percent) of the current fixed rate facility. This proportion could then be increased steadily as and when the bills rediscounted through the existing rediscount window mature. Alternatively the new system could be initiated once all the existing bills mature, since they are short-term instruments.

The ECCB is also considering whether to transform the discount window into a Lombard Facility, with commercial banks being given only limited access (say, the equivalent of a bank’s capital) to short-term loans (ranging in maturity from one to seven days) in the form of repurchase operations in treasury bills. The proposed Lombard Facility would serve as a useful complement to the reforms proposed in the interbank market, as banks would have direct recourse to ECCB credit only through the Lombard Facility. The Lombard loans could be priced at a penalty over rates prevailing on the interbank market to help stimulate activity in the interbank market, and the Lombard rate could be used by the ECCB to signal its monetary stance.

The Statutory Minimum Savings Deposit Rate

The statutory minimum rate on saving deposits was introduced in 1984, at the inception of the ECCB, ostensibly in order to encourage private savings (and discourage financial disintermediation) by ensuring that the banking industry, then dominated by the branches of foreign banks, provide a positive real rate of return to depositors. To the extent that it induces a proliferation of small savings deposit accounts, it raises bank marginal costs, which in turn contributes to a wider spread between lending and deposit rates. Under conditions of excess liquidity, banks may also encounter difficulty earning an appropriate return on deposited funds given a shortage of viable investment opportunities. Consequently, in order to cover operating costs, banks could be compelled to offset the holding of excess reserves through an increase in the average lending rate. Depending on the underlying parameters characterizing the supply and demand of loanable funds, the statutory minimum savings rate could, therefore, lead to a further divergence between the average lending and average deposit rates. Furthermore high lending rates may give rise to an adverse selection problem that could undermine the stability of the banking system.

The ECCB’s current plan is to propose that the statutory minimum savings rate be eliminated once the range of competing instruments is sufficiently broadened and an adequate degree of market-driven flexibility has taken hold in determining interest rates, as envisaged with the establishment of the RGSM and other money and capital market initiatives.

Banking System Soundness

The ECCB considers that the major institutions are sound, including the foreign (mainly Canadian and British) branch banks, the local subsidiaries of foreign-owned banks, and most domestic banks. A number of small domestic banks, however, operate precariously at very high asset to capital ratios. Since the ECCB was established in 1983, there has been just one case where it has had to intervene, namely the bailout in 1993 of the Bank of Montserrat, which failed largely because of bad management practices. All eight countries had to pass emergency legislation to enable the ECCB to intervene. The intervention took the form of the establishment of an ECCB subsidiary called Caribbean Assets and Liabilities Management Services Limited, which acquired the bank’s bad assets (EC$15 million) in exchange for a promissory note. The Government of Montserrat became the bank’s major shareholder. Recovery of the bad assets was proceeding relatively well until the eruptions of the volcano brought the island’s economy to a halt in 1996–97. This legislation is still on the books, and the subsidiary still exists and can serve a similar function in the future should the need arise.

An independent assessment of the degree of compliance with ECCB requirements is precluded by the absence of published statistics on commercial bank performance. The only data available cover nonperforming loans and are limited. As of December 1998, the unsatisfactory assets to total assets ratio ranged from a low of 8 percent in Antigua and Barbuda to a high of 15 percent in Dominica, with the average for the ECCB area at about 12 percent—in excess of the maximum ratio of 10 percent permitted by the ECCB.41 By September 1999, the regional average ratio had increased to 14.5 percent, primarily reflecting a break in the series caused by the inclusion of the commercial bank overdraft of the St. Kitts Sugar Manufacturing Corporation beginning in March 1999. When the ECCB began tightening enforcement of its guidelines, banks not in compliance were given time to reduce the bad loan portfolio according to schedules specified in the memorandum of understanding with the ECCB.

As the region’s financial markets become more integrated both regionally and globally, greater competition is likely to raise both the entry and exit of firms (through mergers and acquisitions and the privatization and closure of weak government-owned banks), and the industry can be expected to undergo a process of restructuring. Thus, increased banking supervision could facilitate early identification of problem banks and prevent an escalation of the economic impact of bank failures.

Accordingly, in addition to the recent introduction of more stringent prudential requirements noted above, and the emergency legislation introduced in 1993, the ECCB has proposed a number of amendments to its charter and to the Uniform Banking Act that together would enhance prudential standards, strengthen the ECCB’s hand in ensuring compliance, and allow it to act quickly should a major bank be in trouble. One is an amendment to the Charter that would give the Monetary Council circumscribed legislative powers during a bank crisis. The specifics, however, are still to be defined. Another is an amendment to the Banking Act that would enhance the ECCB’s enforcement and penalization powers over financial institutions, partly through granting of authorization to issue cease and desist orders outside of the context of a banking crisis. Other proposed legislative changes include amendments to the individual acts governing offshore institutions in the member countries to make them consistent with Article 41 of the ECCB’s charter, which gives it the power, effected through the Monetary Council, to regulate the licensing and monitor the operations of offshore financial institutions; harmonization of the large exposure clause in the UBA and the prudential guidelines (see above); an amendment to the UBA to allow the ECCB to execute formal memorandums of understanding with the home offices of foreign branch banks regarding supervision of the branches; an amendment to empower the ECCB to introduce additional prudential regulations; and making explicit the terms of its provision as a lender of last resort to the commercial banks.

There is also an ongoing effort to alleviate some of the legal impediments faced by banks seeking to make claims in the judicial system, which is often backlogged. A joint initiative (of the ECCB, the World Bank, the OECS Secretariat, the Caribbean Law Institute, and the U.S. AID) is under way to introduce, in each territory, alternative dispute regulation mechanisms, such as local judicial review agencies to expedite the recovery of delinquent assets.

External Policy

The key elements of the trade policy agenda are advancing trade liberalization and promoting competitiveness and export diversification. Governments face the challenge of curtailing remaining nontariff barriers and completing agreed reductions in the maximum tariff rates under the common external tariff of CARICOM. All countries but Antigua and Barbuda implemented the second stage, reducing the CET to 30 percent during 1995–97, but by early 1999 only Dominica, Grenada, and St. Vincent and the Grenadines had carried out the third stage (originally planned for implementation in the first half of 1997) that lowered the maximum tariff to 25 percent. By the same date only St. Vincent and the Grenadines had implemented the last stage of the agreement reducing the CET to 20 percent (originally planned for implementation in the first half of 1998). Grenada and St. Lucia implemented the last stage in January 2000.

Stabex Grants to the Windward Islands

The European Union (EU) has been providing grants to the Windward Island countries (Dominica, Grenada, St. Lucia, and St. Vincent and the Grenadines) since the late 1980s to compensate for losses in banana export earnings (also nutmeg and cocoa in the case of Grenada) from bad weather and adverse market conditions. For each year in which there are export losses, the EU sets a Stabex allocation for each affected country and subsequently negotiates its uses with the authorities. Thus, allocations usually become available with a lag of two to three years and actual drawdowns depend on project implementation. For the Windward Islands, these Stabex allocations have become an important source of assistance amounting to ECU 169.7 million for the eight allocation years 1990–97. Of this total allocation Dominica has been assigned ECU 37.1 million, Grenada ECU 15.6 million, St. Lucia ECU 57.1 million, and St. Vincent and the Grenadines ECU 59.9 million.

Stabex grants had been used mainly to support the banana industry until the EU and the authorities of the different countries concluded the Framework of Mutual Obligations (FMO) governing the use of the 1995 Stabex allocation. The FMOs had two main features: (i) the introduction of macroeconomic conditionality for the disbursement of the funds; and (ii) a marked increase in the share of Stabex resources allocated to human resource development, economic diversification, and poverty alleviation.

In 1998 the EU and the authorities advanced the negotiations on the FMOs governing the use of the 1996 and 1997 Stabex allocations. The agreements for 1996’97 amounted to ECU 38 million to be disbursed in three annual tranches beginning in 1999. The release of each of the tranches was linked to meeting targets on public sector saving, on agreed levels of expenditure on health and education (consistent with the countries’ public sector investment program), as well as on satisfactory implementation of the projects financed by previously released tranches. The agreements for Dominica, Grenada, and St. Lucia also envisage progress on the implementation of the common external tariff under the CARICOM Agreement.

The ECCB has continued to take steps to liberalize exchange controls applied to capital and non-trade current transactions. The indicative limit on foreign exchange purchases was increased in October 1997 to EC$250,000 per person per year, from EC$100,000. Purchases of foreign exchange in amounts above this limit require approval from the finance ministries, but all bona fide requests are routinely approved. The ECCB intends to continue the gradual phasing out of exchange controls.42

Efforts are under way to enhance the competitiveness of the banana industry. In preparation for the changes to the EU banana regime expected to take place in 2000, and with the technical and financial assistance of the EU (see Box 8), the Windward Islands started the implementation of a three-year banana recovery plan in 1998. The cornerstone of the plan is a new pricing policy involving a premium for higher quality fruit and a guaranteed price to farmers. The consensus view among stakeholders was that production had decreased largely because of reduced grower confidence in the future of the industry and inadequate prices to the grower for premium quality fruit. The average cost of production had been estimated at 30–68 EC cents per pound, depending on the farmer’s efficiency (see Table 17). It was assumed that prices in the range of 36–48 EC cents would provide an incentive to most farmers to increase production to levels that would cut the cost of dead freight to a minimum, increase the price that the associations receive for the fruit, and allow them to keep the price to farmers within that range without an increase in the associations’ debts (see Table 18).

In the longer term, increased emphasis is to be placed upon drainage and irrigation, with up to 2,270 acres to be supplied with drainage and 4,700 acres to be brought under irrigation over the three-year plan. Other elements of the plan include a publicity campaign to improve the profile of the sector and to encourage reinvestment, the restructuring of both local and external industry debts and enhanced extension services to improve farm management capacity. The plan is dependent upon financial commitments from the donors, the marketing and shipping joint venture of WIBDECO/FYFFES, and the banana growers associations. Partly due to this plan and to the initiatives taken earlier to improve irrigation and product quality, banana production and exports showed some pickup in 1998.

National authorities in the region think that to promote economic diversification it is essential to improve infrastructure and education, and to control costs. For this purpose, priority is given to those projects in the public sector investment program geared to improving the infrastructure for tourism and basic and vocational education. Success in diversification requires wage restraint in the public sector to avoid sparking demands for higher wages in the private sector, and maintaining a liberal policy regarding inflows of foreign labor. There is also awareness that regulatory policies need to be strengthened to avoid the cross subsidization of residential users of water and electricity by commercial users, and to bring the cost of international telecommunications and of handling cargo through the ports in certain countries to competitive levels. In this connection, it is encouraging that the sole provider of telecommunications services in the region has agreed to negotiations to revise its arrangements.43

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