Abstract

Caribbean economies face high and rising debt-to-GDP ratios that jeopardize prospects for medium-term debt sustainability and growth. In 2011, the region’s overall public sector debt was estimated at about 70 percent of regional GDP (Figure 1.1). Interest payments on the existing debt stock in the most highly indebted countries with rising debt ratios are already in the range of 16 percent to 42 percent of total revenues. In addition, high amortization exposes some countries to considerable roll-over risk that could trigger a fiscal crisis.

Caribbean economies face high and rising debt-to-GDP ratios that jeopardize prospects for medium-term debt sustainability and growth. In 2011, the region’s overall public sector debt was estimated at about 70 percent of regional GDP (Figure 1.1). Interest payments on the existing debt stock in the most highly indebted countries with rising debt ratios are already in the range of 16 percent to 42 percent of total revenues. In addition, high amortization exposes some countries to considerable roll-over risk that could trigger a fiscal crisis.

Figure 1.1
Figure 1.1

The Caribbean: Total Government Debt, 1997–2011

(weighted average; percent of GDP)

Source: Author’s calculations.

Structural fiscal problems have resulted in a sizable accumulation of debt. Between 1997 and 2004, the average debt-to-GDP ratio in the region increased from 54 percent to 84 percent, driven mainly by deteriorating primary balances. Successive years of fiscal deficit, public enterprise borrowing, and off-balance-sheet spending, including financial sector bailouts, all contributed to high debt levels. Prior to the onset of the global crisis, moderate growth rates helped some countries to broadly stabilize and reduce their debt ratios, albeit at high levels.

The global financial crisis worsened the already high debt burdens in the Caribbean. The crisis and the subsequent slow recovery in advanced countries had a significant adverse effect on the Caribbean, undermining growth in the largely tourism-dependent economies and exposing balance sheet vulnerabilities built up over many years. These vulnerabilities originated from a strategy of increasing public spending to counteract declining trade performance, partly due to the erosion of trade preferences, and rebuilding costs after frequent natural disasters. As a result, the ratio of public debt to GDP increased by about 15 percentage points between 2008 and 2010 in tourism-dependent economies. By contrast, Caribbean commodity exporters rebounded rapidly after the crisis, buoyed by high commodity prices, and their debt ratios have stabilized at relatively low levels.

Past attempts at tackling high debt in the region have not yielded lasting gains. Several countries have made attempts at reducing debt, mainly through ad hoc restructuring or fiscal consolidation. Since most countries have not adopted comprehensive economic reforms to complement these adjustment efforts, the initial gains have not been sustained. Further, because of their middle-income status, the majority of the region’s nations have not been able to benefit from international debt relief. Moreover, only a few Caribbean countries still qualify for concessional borrowing at the World Bank. At the same time, their small size and geographical location makes them highly vulnerable to a host of frequent shocks, against which it is costly to insure. As a result, Caribbean economies have had a silent debt crisis for the past two decades, contributing to a high debt–low growth trap.

This book examines the challenges of fiscal consolidation and debt reduction in the Caribbean. It looks at the problem of high debt in the region, examines the reasons for this debt, and discusses policy options for improving debt sustainability, including fiscal consolidation. The book examines empirically the factors underlying global large debt reduction episodes to draw important policy lessons for the Caribbean. It also reviews the literature on successful fiscal consolidation experiences and provides an overview of past and current consolidation efforts in the Caribbean region.

More specifically, the book attempts to address the following questions:

  • What are the impacts of the global financial crisis on fiscal performance and debt levels in the Caribbean?

  • How large are fiscal multipliers in the region?

  • Has there been fiscal consolidation?

  • What policies are the region’s countries currently pursuing to reduce debt?

  • What are the challenges to fiscal consolidation?

  • Is there an optimal level of debt for the region?

  • What is the impact of fiscal consolidation on the current account in the region?

  • What lessons can these countries draw from successful fiscal consolidation and large debt reduction experiences around the world?

  • What is the impact of fiscal policy rules on fiscal performance in the region?

  • Is fiscal consolidation enough to significantly reduce the debt levels? What other policy options may be available?

In an environment where the level of public debt remains high, reducing public debt is crucial to reduce vulnerabilities. How then can the Caribbean countries lower their debt-to-GDP ratio? What factors explain the success of public debt reduction, and why are some countries able to reduce public debt to prudent levels faster than others? To answer these questions, this book analyzes past global large debt reduction episodes in order to yield relevant policy lessons for the Caribbean. The analyses show that major debt reductions are mainly driven by decisive and lasting fiscal consolidation efforts focused on reducing government expenditure. In addition, robust real GDP growth increases the likelihood of a major debt reduction because it helps countries grow their way out of indebtedness.

Since growth in the current environment is virtually nonexistent, significant fiscal consolidation is inevitable. Based on a survey of country experiences, fiscal consolidation based on expenditure reductions tends to be more effective than tax-based consolidations. However, for countries with large adjustment needs, fiscal consolidation may need to be a balanced combination of spending cuts and revenue increases (Baldacci, Gupta, Mulas-Granados, 2010). Given the already sizable public sector in Caribbean countries, most of the fiscal consolidation would have to be done by restraining spending while implementing measures to boost revenues. Fiscal consolidation needs to be complemented by a comprehensive strategy to reduce public debt, including tax policy reforms, improvements in the efficiency of government spending, containment of contingent liabilities, rationalization of the public sector, active debt management and debt restructuring, and growth-enhancing structural reforms.

The Social, Economic, and Political Context

This section briefly discusses the social, economic, and political setting of the Caribbean to identify the main constraints to macroeconomic policy making in the region. Knowledge of the setting within which macroeconomic policies will take place is essential in order to design and implement successful fiscal consolidation and debt reduction strategies.

The Caribbean enjoys a relatively high GDP per capita, well-developed social indicators, and a long history of political stability (see Table 1.1). The region performs relatively well on most social development indicators, even though unemployment and poverty levels are rising. Life expectancy, for instance, averages more than 75 years, higher than the average for middle-income countries. Significant progress has been made in reaching the objectives of the millennium development goals. Primary school enrollment is close to 100 percent, and the average tuberculosis detection rate has increased to close to 99 percent in the Eastern Caribbean Currency Union (ECCU). Additionally, the proportion of seats held by women in national parliaments in the Caribbean has increased significantly (Jack and Wendell, 2013).

Table 1.1

The Caribbean: Selected Social and Economic Indicators, 2012

article image
Sources: Bloomberg, L.P.; Caribbean Development Bank Country Poverty Assessments; IMF, World Economic Outlook database; International Labour Organization; World Bank, World Development Indicators; and authors’ calculations.

Latest available data.

Median ratings published by Moody’s, Standard and Poor’s, and Fitch Ratings.

The Caribbean includes The Bahamas, Barbados, Belize, Guyana, Jamaica, Suriname, Trinidad and Tobago, and the Eastern Caribbean Currency Union (ECCU). GDP and population are sums of individual countries. Real GDP growth and trade openness are simple averages.

ECCU includes Anguilla, Antigua and Barbuda, Dominica, Grenada, Montserrat, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines.

Despite this progress, poverty levels and unemployment, which are likely to have been exacerbated by the global financial crisis, remain stubbornly high. Country poverty assessment studies conducted by the Caribbean Development Bank show that the collapse of the sugar and banana industries has worsened poverty levels in rural communities even though the levels are not as high as in some urban communities (Jack and Wendell, 2013). Labor force survey data are limited in the Caribbean, but anecdotal evidence suggests that the unemployment rates increased during the global financial crisis.

Policy decision making in most Caribbean countries is guided by social partnership arrangements, under which the government, the private sector, and labor unions meet to discuss and agree on policies of national concern. As a result, the implementation of macroeconomic programs needs the support of all the major stakeholders in the economy. There are also other elements of the social fabric of the Caribbean that could help improve economic performance. Generally, greater social homogeneity and cohesion in a country lead to greater flexibility and decision-making efficiency and greater openness to change, resulting in greater gains for the country as a whole (Streeten, 1993). For instance, greater social homogeneity should enable adjustment to shocks to be more promptly handled because the shifting of adjustment onto other social groups is less feasible (Alesina and Drazen, 1991).

On the economic front, domestic markets in the Caribbean are small, so the level of domestic demand lies below the minimum efficient scale of output (Armstrong and others, 1993). Due to their small size, these countries are usually disadvantageous as locations for extensive industrial activities, especially those that could substantially raise growth. The small domestic market is less conducive for the development of indigenous technologies, limiting the growth of research and development, technical progress, and technology acquisition. In addition, a small domestic market does not allow competitive firms to emerge within the Caribbean because of the limited number of participants involved in any economic activity. As a result, prices of goods are generally higher in the Caribbean than in other regions (Armstrong and others, 1993). The relatively small population tends to make labor very scarce in the Caribbean. As a result, output in the region is usually enhanced through the accumulation of human or physical capital rather than through employment (Bhaduri, Mukherji, and Sengupta, 1982). The small size of domestic markets and the scarcity of labor tend to narrow the structure of domestic output, making these countries dependent on a small number of activities and hampering the potential to implement import substitution industrialization strategies. This leaves them exposed to exogenous shocks.

Exports and export markets are also narrow, due in part to the narrowness of their domestic production structures. The need for specialization tends to limit export-oriented domestic output to just a few products. Tourism and financial services are the main service sectors, normally complemented by an uncompetitive agricultural sector. Offshore financial services have become an important sector in the Caribbean due to their strategic location and enabling local laws. Highly liberalized financial systems based on lax regulatory standards or strong supervisory frameworks have been a major attraction in the emergence of the Caribbean as an offshore financial center. The export specialization of Caribbean countries renders them vulnerable to external shocks, and this vulnerability is worsened by the fact that reliance is on export markets in just a few countries (Armstrong and others, 1998).

The Caribbean continues to gain from its proximity to the U.S. market and historical ties to the United Kingdom in the areas of tourism and financial services. At the same time, this trade openness and these strong ties imply that global economic crises are easily transmitted to the Caribbean. The importance of tradable goods to these economies necessitates their pursuit of highly open trading regimes. Consequently, import barriers are less important in the Caribbean than in other regions (Selwyn, 1975). There is a substantial asymmetry between domestic production patterns and consumption in the Caribbean, making the proportion of imports in domestic consumption very high. This feature has led some researchers (see Worrel, 2012) to argue that currency devaluation may not be beneficial to the Caribbean.1

The small size of domestic economies, the negligible nontradable sector, and the fact that the development of nontraditional exports is hampered by domestic constraints rather than external obstacles have led many of these countries to adopt a fixed exchange rate regime (either soft or hard pegs). The bigger economies of the region have moved over time from soft to hard pegs. Barbados, The Bahamas, and Belize have hard pegs, while Guyana, Suriname and Trinidad and Tobago have opted for soft pegs. Jamaica, in principle, currently has a flexible exchange rate regime (ECLAC, 2003). Within the hard peg category, some countries have explicitly opted for a currency union. This is the case of the small economies of the Eastern Caribbean (Anguilla, Antigua and Barbuda, Dominica, Montserrat, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines), following the formation of the Eastern Caribbean Currency Union (ECCU) and the parallel creation of the Eastern Caribbean Central Bank in 1983.

The choice of exchange rate regime was also a direct consequence of the development model adopted by Caribbean economies following their political independence. The main features of the development model include the attraction of capital flows, fiscal incentives, protectionism, and the development of exports to the industrialized world. In most of the Caribbean, the exchange rate is a nominal anchor and thus an avenue to control costs and prices and import credibility (ECLAC, 2003). The fixed exchange rate regime combined with the hard foreign currency constraints makes fiscal policy the main tool of macroeconomic management.

Labor markets in the Caribbean are very rigid. Typically, the indigenous labor force tends to be highly protected, or custom makes it socially difficult for private sector managers to fire them. This creates an inflexible indigenous labor force, which tends to be employed mainly in central government, parastatals, or other relatively secure jobs (Imam, 2010). As a result, a large chunk of the indigenous population in the region is not employable by market standards, and there is high unemployment or underemployment. The public sector often then acts as the employer of last resort and the bureaucracy becomes overstaffed with poorly trained individuals (see also Rodrik, 1998).

The institutional framework governing industrial relations in the region varies from a model of statutory intervention, as observed in Trinidad and Tobago, to a voluntaristic model, as followed in Barbados (Downes, Mamingi, and Antoine, 2000). Across the region, there exist strong labor unions with significant membership in strategic sectors of the economy (Rama, 1995). Strong labor unions have emerged from the culture of trade unionism and the need to maintain labor and economic stability in order to propel economic development. Nevertheless, there are differences among the institutional frameworks within the region. For example, Jamaica and Trinidad and Tobago are known to have much more militant trade union movements than Barbados and Belize (Downes, Mamingi, and Antoine, 2000). In The Bahamas, Guyana, and Trinidad and Tobago, there are statutory provisions making all collective agreements legally enforceable, while in Barbados there is no such provision. There are no legal provisions for the recognition of trade unions in Barbados, Belize, and Guyana.

The political system in most of the Caribbean was inherited from the United Kingdom, a consequence of the region’s colonial history. This colonial legacy has served the Caribbean well, delivering stable democracies with relatively smooth transitions and high participation rates in national political affairs. However, concerns remain in many countries about the impact of this system on economic policy making and development, since the current system appears to worsen economic cycles and has resulted in a persistent increase in public debt levels in many countries (Jack and Samuel, 2013). Empirical evidence shows that good economic performance ahead of elections tends to increase the probability of success of the incumbent (Paldam, 1997). Jack and Samuel (2013) argue that most Caribbean governments tend to focus on short-term policy solutions, paying little attention to long-term planning that would promote sustained economic growth. Even though some recent attempts have been made to reform the political system, foster domestic electoral reform, and move toward greater regional political integration, these efforts have been largely unsuccessful.

The Dangers of High Debt Levels

High public debt raises the risk of a fiscal crisis and also imposes costs on the economy by keeping borrowing costs high, discouraging private investment, and constraining fiscal flexibility. Theoretically, high public debt is expected to reduce long-term economic growth through a number of channels:

  • Higher public debt crowds out private sector investment and lowers economic growth. It requires higher taxes to service the debt, which reduces investment and growth. Further increases in government expenditure financed by higher debt from already elevated levels are likely to be self-defeating, leading to lower long-term growth, as public sector debt crowds out private investment.

  • Higher debt can also increase roll-over risks. It is likely to increase the public sector borrowing requirement, because a higher debt ratio would require a larger share of GDP to service the debt and investors are likely both to demand higher interest rates and to switch to shorter maturities as the debt level increases. This directly increases the roll-over risk with the size and frequency with which the government needs to tap the debt market.

  • A higher public-debt-to-GDP ratio increases a country’s vulnerability to shocks. For example, higher interest rates and lower growth would have a larger impact on countries with higher debt ratios. An increasing interest rate raises the debt service burden and may hasten debt distress.

  • A high debt ratio reduces the space for policy flexibility, including the ability to respond to shocks. Countries that had a high debt ratio at the time of the global financial crisis were unable to respond with countercyclical fiscal policies due to the lack of fiscal space. Instead, many countries had to tighten their fiscal stance to stave off a financing crisis, thus pursuing procyclical policies.

Several empirical papers have documented a nonlinear relationship between public debt and growth, suggesting that public debt beyond certain levels can have negative effects on economic activity. A simple way of thinking about the relationship between public debt and growth is that once the debt-to-GDP ratio crosses a country-specific threshold, it increases the chances of a crisis and enhances volatility, thereby lowering growth (Gill and Pinto, 2005). Reinhart and Rogoff (2010) examine the relationship between public debt and GDP growth in advanced economies between 1946 and 2009. They find that whereas the link between growth and debt seems relatively weak at normal debt levels, the average growth rates for countries with public debt of over 90 percent of GDP are negative and substantially lower than countries with lower debt levels (see Figure 1.2). They highlight the existence of a nonlinear relationship between GDP growth and public debt with effects appearing at debt levels higher than 90 percent of GDP.

Figure 1.2
Figure 1.2

Median Real GDP Growth Associated With Various Public Debt Levels, 1790–2009

(20 advanced economies)

Source: Reinhart and Rogoff (2010).

Herndon, Ash, and Pollin (2013) replicate Reinhart and Rogoff (2010) and find that the latter’s coding errors, selective exclusion of available data, and unconventional weighting of summary statistics lead to serious errors that inaccurately represent the relationship between public debt and GDP growth in 20 advanced economies in the postwar period. They find that when properly calculated, the average real GDP growth rate for countries carrying public-debt-to-GDP ratios over 90 percent is actually 2.2 percent and not the −0.1 percent found by Reinhart and Rogoff. Overall, they provide evidence to contradict Reinhart and Rogoff’s claim that public debt of more than 90 percent of GDP consistently reduces GDP growth.

Using a novel empirical approach and an extensive dataset developed by the Fiscal Affairs Department of the IMF, Pescatori, Damiano, and John (forthcoming) document that countries with high levels of public debt do not systematically experience lower growth. In particular, they find no evidence of any particular debt threshold above which medium-term growth prospects are dramatically compromised. In addition, their results show that the debt trajectory can be as important as the debt level in explaining future growth, since countries with high but declining debt appear to grow equally as fast as countries with lower debt. While higher debt does not seem to unequivocally lower growth in their analysis, the authors find some evidence that higher debt may induce a higher degree of output volatility.

Boamah and Moore (2009) analyze the relationship between external debt, economic policies, and growth using data on 12 Caribbean countries over the period 1970 to 2000. Their results suggest that in the initial stages, as countries seek external resources to support domestic savings, external debt could have a positive impact on growth, particularly in countries with good policy environment. However, above a certain threshold, persistent high levels of debt can have a negative impact on growth, even when the policy environment is good. They argue that debt-to-GDP ratios above 63 percent for the group of countries studied would tend to have a negative influence on growth. They argue further that the estimated benchmark of 63 percent of GDP should be considered an upper bound as applied to countries with macroeconomic environments characterized by stable inflation, manageable fiscal deficits, and open trade regimes.

Greenidge and others (2012) address the use of threshold effects between public debt and economic growth in the Caribbean. Their results show that, at debt levels lower than 30 percent of GDP, increases in the debt-to-GDP ratio are associated with faster economic growth. However, the effect on growth diminishes rapidly as debt rises beyond 30 percent of GDP, and when it exceeds 55 percent of GDP debt becomes a drag on growth.

The conclusion from the literature is that the debt trajectory is equally important as the debt level in influencing economic growth. Even though there is no consensus on the impact of high debt on growth, there is some evidence that high debt levels may induce greater volatility of output.

The Impact of the Global Financial Crisis on Public Debt

The Caribbean has a track record of high fiscal deficits, partly reflecting procyclical fiscal policies in good times. This has resulted in elevated levels of public-debt-to-GDP ratios since 1990. The predominant source of the budget imbalance is the central government, even though public enterprises have also contributed significantly to the debt buildup. The debt accumulation stems from countercyclical fiscal policy in bad times and procyclical fiscal policy during periods of economic boom. The net result is that debt accumulated during periods of weak growth is not offset in good times, resulting in higher levels of debt in the medium term (Egert, 2011).

The global financial crisis severely affected Caribbean countries, as spillovers from the United States and Europe led to a collapse of GDP growth and soaring debt levels. Debt rose from already elevated levels, and the crisis exposed balance sheet vulnerabilities that had built up over many years. These vulnerabilities originated from a strategy of increasing public spending to counteract declining trade performance, partly due to the erosion of trade preferences, and rebuilding costs after frequent natural disasters.

Chapter 2 of this book examines the impact of the global financial crisis on fiscal outcomes in the Caribbean. It analyzes fiscal performance in the region over the last 15 years to determine the nature of underlying fiscal problems and the extent of the impact that crisis has had on fiscal outcomes. Specifically, it examines whether the reaction of fiscal indicators during the crisis was different from what it was during previous downturns. The chapter also analyzes the factors that contributed to the debt accumulation during the financial crisis.

Fiscal performance in the region is analyzed by dividing the 15-year period into three distinctive sub-periods. The first period (1997–2002) was characterized by rising debt levels as the average debt-to-GDP ratio increased from 54 percent to 74 percent by the end of 2002. During the second period (2003–2007), debt declined by around 18 percentage points of GDP, while the third period (2008–2011) saw more debt accumulation, with the average rising to 70 percent of GDP. The debt buildup in the first period occurred in a relatively benign growth environment, with growth averaging 3.4 percent and the primary surplus close to 2½ percent.

The analyses show that Caribbean countries were severely affected by the global economic crisis due to negative spillovers from the United States and Europe. Tourism declined sharply, accompanied by declines in offshore activity and other services. Real GDP declined by 2.2 percentage points between 2008 and 2010. The global financial crisis impacted commodity exporting and tourism-intensive countries differently. On average, commodity exporters had higher growth during the last 15 years than countries more dependent on tourism (4 versus 2½ percent) and a better primary balance (3½ versus 2 percent of GDP). Many countries responded to the economic crisis by loosening fiscal policy, thereby increasing the debt-to-GDP ratio. In particular, governments generally raised spending in an effort to curb job losses and to stimulate the economy. Since buffers in the form of public sector savings were limited or nonexistent, they borrowed more to finance higher current spending.

Chapter 2 also analyzes the accumulation of public debt during the period of the financial crisis (2008–11) using an approach that decomposes the accumulation of government debt into different factors, including interest payments, the primary balance, inflation and exchange rate effects, and other exogenous events modifying public debt. The results show that the debt accumulation during the financial crisis period can be attributed to high interest payments and slow growth. On average, the debt-to-GDP ratio increased by 12.7 percentage points during 2008–11. This was driven mainly by high interest payments, which were responsible for about 90 percent of the debt buildup. The high contribution of interest payments was not due to higher interest rates, however, as these decreased on average from 5.2 percent (2004–07) to 4.6 percent (2008–11). Instead, this shows how the already high debt level elevates the debt burden even more. Low GDP growth and primary deficits also contributed to the debt accumulation. Residual encompassing factors, such as inflation, exchange rate changes, and other events changing public debt (e.g., debt restructuring), had a negative effect on the debt ratio.

The Current Profile of Public Debt in the Region

The public debt characteristics are heterogeneous, and in some cases they have increased macroeconomic vulnerabilities. While in general there has been a shift to domestic debt, there are important holdings of foreign currency debt, which leaves some countries exposed to exchange rate adjustments. In addition, some countries have increased their exposure to the local financial system and, with this, strengthened the link between fiscal sustainability and financial stability. Additional concerns arise from the exposure of some countries to floating rate debt and lower borrowing on concessional terms as well as, for some countries, shorter maturity profiles. These vulnerabilities increase the risk of a major fiscal crisis, given the high and increasing unsustainable debt ratios.

Chapter 3 reviews the region’s recent public debt profile and debt management practices. In particular, it assesses whether the structure of public debt offsets the high public-debt-to-GDP ratios and briefly discusses estimates of selected contingent fiscal liabilities and the institutional framework for debt management.

The largest component of Caribbean public debt is domestic debt, representing about 60 percent of the total, an increase from 39 percent in 2001 (see Figure 1.3). It is held mainly by the domestic financial systems in the form of medium- to long-term instruments. Social security schemes in some countries, including Barbados, are also important holders of government debt. Bonds remain the instrument of choice for most countries, but there are important differences. Domestic bonds represent about 52 percent of total public debt in the Caribbean and are more prevalent in The Bahamas, Barbados, Jamaica, and Trinidad and Tobago, representing over 50 percent of total debt. On the other hand, foreign bonds are more important in Belize and Grenada. In terms of currency composition, about 62 percent of total public debt is held in domestic currency. While large holdings of domestic debt may indicate that the so-called “original sin” problem may not exist, the experience in the Caribbean for some countries suggests that in some ways this large debt has actually increased the long-term vulnerability of the economy and has reduced the degree of policy freedom where it has not been effectively managed.

Figure 1.3
Figure 1.3

Composition of Public Debt, Caribbean Nations, 2011

(percent of GDP)

Sources: National authorities; and authors’ calculations.

Of the foreign currency debt, over 70 percent, on average, is held in U.S. dollars. For some countries, such as Belize and Grenada, the proportion is over 90 percent. Foreign currency debt also remains substantial in countries with high domestic debt, making them still vulnerable to exchange rate movements. The trend on concessionality of external debt appears to be mixed for the region as a whole. In particular, while the proportion of external concessional debt to total external debt has risen for most countries, the average grant element of new debt has risen for some and fallen for others, while the average grace period for new external debt commitments has declined for most countries.

Debt management in Caribbean economies is currently undergoing a slow transition from a relatively weak framework and practices to more internationally recognized standards. Using the World Bank’s Debt Management Performance Assessment (DeMPA) framework, the region on average does not rank very well. Regarding the institutional frameworks, the legal framework for issuing and managing debt is very fragmented, apart from Jamaica and Suriname, which have a single debt management law. Debt is issued using several pieces of legislation, often targeted at a specific purpose. In addition, in many countries the coordination mechanism between debt management and the requirements for sustainability of fiscal and monetary policies is either limited or very weak.

The region lags behind on other debt management indicators as well. In particular, the government debt markets are fragmented and very inefficient, which prevents effective price discovery. Further, most borrowing activities are generally not supported by appropriate loan evaluation, which impacts negatively on fiscal and debt sustainability.

How Can the Region’s High Public Debt be Reduced?

How can the Caribbean countries lower their debt-to-GDP ratios? What factors explain the success of public debt reduction, and why are some countries able to reduce public debt to prudent levels faster than others? Chapter 4 of this book examines these important policy questions. It examines the factors explaining the success of global public debt reduction and draws lessons for the Caribbean.

Throughout this book, a “large” debt reduction episode is defined as one in which the debt-to-GDP ratio declines by at least 15 percentage points. Using this definition, about 206 episodes of large debt reductions around the world were recorded between 1970 and 2009.

  • About 100 of the debt reduction episodes (48 percent) were achieved through debt restructuring or default.

  • About 107 of the debt reduction episodes (52 percent) were achieved through higher GDP growth, higher inflation, or fiscal consolidation.

  • Of the debt reduction episodes achieved through fiscal consolidation, about 25 percent were preceded or accompanied by the existence of fiscal rules.

  • Most of the large debt reduction episodes lasted over a relatively long period, ranging from 4 years in Panama to 18 years in Australia. The average duration of large debt reduction episodes achieved through fiscal consolidation was about 7 years.

To examine the determinant of large debt reduction, the chapter uses a dataset spanning more than three decades for a large sample of developed and developing economies. The analysis uses a panel data set of about 160 countries to estimate the probability that a large debt reduction will be initiated using the logit regression approach. The dependent variable is the probability of a large debt reduction. The explanatory variables are measures of fiscal consolidation, macroeconomic variables, and political and institutional variables, and fiscal rules. Simple comparative analysis shows that countries that experienced a large debt reduction were on average able to achieve a higher GDP growth and larger primary surpluses and were more likely to have fiscal rules than countries that did not experience a large debt reduction.

The result of the econometric analysis shows that global large debt reductions are associated with robust economic growth, decisive and lasting fiscal consolidation, and a favorable external environment characterized by strong global growth. Fiscal rules are positively associated with a higher probability of debt reduction because they increase fiscal discipline and the credibility of fiscal policy and they help secure the gains of fiscal consolidation. The initial level of debt and debt servicing cost appears to play a disciplinary role by enhancing the incentives of governments to consolidate aggressively. The results are robust to alternative estimation methodologies and alternative thresholds for identifying large debt reduction episodes. The chapter concludes that future large debt reduction programs in the Caribbean need to be based on credible fiscal plans to increase primary balances, fiscal rules to enhance fiscal credibility, and structural reforms to promote growth.

What Caribbean Countries Can Learn From Successful Fiscal Consolidation Elsewhere

Governments facing high debt levels and seeking to undertake fiscal consolidation often confront a number of interrelated questions. What promotes a successful fiscal consolidation? How large should the adjustment be, and how quickly should it occur? Should one adjust now or later, and what are the consequences of postponing adjustment? Should one cut expenditures, raise revenues. or do both? Which components of expenditures or revenues should one adjust, and does the composition of adjustment really matter? Would the adjustment be self-defeating? Is there a political price for fiscal adjustment?

Chapter 5 attempts to answer many of these questions that policymakers may have in their quest for prudent fiscal consolidation strategies. The chapter uses two main approaches. First, it undertakes a comprehensive survey of a large body of mostly empirical literature on fiscal consolidation, covering industrial, emerging markets, and developing economies. Second, it explores specific country experiences with fiscal consolidation dating back to the 1990s, examining 25 cases studies, consisting of 14 advanced economies, 8 emerging markets, and 3 developing economies, including Barbados and Jamaica. It focuses on the prevailing economic and political conditions preceding fiscal consolidation, the various measures adopted, the composition of the adjustments, and the resulting achievements. The goal of the analysis is to draw useful lessons on the determinants of a successful fiscal consolidation.

The findings from this analysis indicate that fiscal consolidation is generally associated with low economic growth although that there are few cases where fiscal consolidation can be expansionary in the short term. Expansionary fiscal consolidation operates through wealth effects on consumption and credibility effects on the interest rate. An alternative channel of expansionary adjustment emphasizes supply-side considerations through effects on labor cost and competitiveness. Fiscal consolidation must be understood as part of a credible plan designed to permanently reduce government deficit and therefore future tax liabilities.

The main lessons for Caribbean countries from both country experiences and the empirical literature may be summed up as follows:

  • It is easier to build a broad consensus about the need for fiscal consolidation in difficult times. Fiscal consolidations were initiated during periods of economic recession, or at early stages of a recovery, which are often characterized by macroeconomic imbalances in the form of worsening fiscal deficits, high debt levels, current account deficits, high unemployment, and high inflation.

  • Significant fiscal consolidations were initiated by new governments. In particular, about three-quarters of the episodes in advanced countries were started by new governments, many with an explicit mandate for fiscal consolidation.

  • Fiscal consolidation based on expenditure reductions have tended to be more effective than tax-based consolidations. A probable reason is that expenditure measures reflect greater commitment, make substantial consolidation more feasible, and can lead to efficiency gains.

  • The composition of the adjustments as mixtures of revenue and expenditure measures varied, with many countries leaning toward expenditure-based reductions. Expenditure measures accounted for an 85 percent improvement in fiscal balances in Canada and Finland and a 75 percent improvement in the Netherlands, Sweden, and the United Kingdom.

  • In several successful episodes, spending cuts adopted to reduce deficits were associated with economic expansions rather than recessions. The more successful expenditure-based consolidations focused on cuts in transfers and wages, the so-called politically sensitive budget items.

  • The empirical literature also finds that cuts in transfer programs and government wage expenditures are more effective than capital expenditure cuts. Adjustments that lasted longer were driven by reductions in wages and transfers. and cuts in wages, transfers and subsidies contributed about 86 percent on average to successful cases.

  • Frontloaded adjustments emphasized revenue measures, while gradual adjustments relied on cuts in primary current spending. In advanced countries, gradual adjustments were more successful and sometimes extended up to a decade, for example in Finland, Sweden, and Spain. This reflects efforts to anchor policy objectives within a medium-term framework with a credible commitment to adopted strategies.

  • Successful revenue measures focused on broadening the tax base and making reforms to simplify tax administration and reduce the tax burden. Base broadening measures were common in countries with more developed revenue administrations and longer period of implementation. In some cases, tax reforms resulted in tax buoyancy and higher revenues over the medium term. Revenue-based adjustment was sustained when the revenue-to-GDP ratio was low.

  • Adjustment efforts were also enhanced by broad political consensus and public support. The presence of an external political or economic anchor influenced fiscal adjustment, especially in Europe in the 1990s, where the need to achieve membership in the European Monetary Union was the motivating factor. In that context, the introduction of a broad medium-term strategy was important in mobilizing public support.

Fiscal Sustainability and Natural Debt Limits in the Region

The high debt levels in the region impose a high cost on Caribbean economies and put at risk the social and development gains made over the last 50 years. Consequently, many of the countries are implementing measures to consolidate government finances and reduce public debt. The question then is what public-debt-to-GDP ratio should these economies adjust to, taking into consideration their stage of development and vulnerability to shocks, and what is the appropriate speed of adjustment to that targeted debt-to-GDP ratio?

While theory offers little or no guidance on these matters, before the global crisis some Caribbean countries adopted a 60 percent ratio, and most considered a 60 percent ratio as a safe medium-term public debt target. Yet many countries have encountered fiscal and debt distress and are unlikely to meet these medium-term targets without ambitious adjustments. Against this background, it would appear that a total rethinking of fiscal sustainability and safe debt limits for all Caribbean economies is required.

Chapter 6 reviews different concepts of debt sustainability and seeks to determine the optimal debt levels for the region’s economies. In particular, it addresses three important policy-related issues. First, it delineates the key aspects of the different approaches to measure fiscal sustainability and public debt limits. Second, it measures the sustainability of fiscal policy and the extent of over- or under-borrowing by the public sector over the last two decades. And third, the chapter derives, through illustrative scenarios, debt benchmarks using reasonable assumptions about growth and interest rate shocks for Caribbean economies.

Overall, the results suggest that most of these economies are pursuing unsustainable fiscal policies and have over-borrowed relative to their calibrated debt limits. Several sensitivity analyses have shown their high vulnerability to negative shocks from interest rates and contingent liabilities, but they have also shown that higher growth and fiscal consolidation could lead the way back to sustainable paths. Consequently, these countries will need to adopt ambitious fiscal adjustment or other debt reduction strategies over the medium term to reduce the drag of high public debt on economic activity.

Several important implications for policy follow from these insights. In particular, policy needs to refocus on reducing public debt to sustainable levels. Moreover, those sustainable levels are likely to be different for each country, given countries’ differing growth prospects and volatility of revenues and spending. Further, public debt policy needs to target a debt ratio in normal times that would not create financing difficulties in the presence of negative economic shocks. Finally, Caribbean governments need to develop a comprehensive framework to fully account for all public debt obligations, including contingent fiscal liabilities. This is important to fully determine debt sustainability.

Fiscal Consolidation Experiences

Countries in the Caribbean have undertaken fiscal consolidation at various times with the primary objective of putting the debt-to-GDP ratio on a sustainable downward trajectory. Yet public debt levels in most of the countries remain high today, suggesting that past and ongoing fiscal consolidation efforts have not yielded durable benefits. A question that immediately comes to mind is why are public debts levels not falling as one would expect? Would it be connected with the Caribbean approach to fiscal consolidation, country–specific circumstances, or some challenges unique to the region? What are the characteristics of fiscal consolidation in the region, and how different are they from other nations’ experiences around the world?

Chapter 7 takes a broad look at the Caribbean experience with fiscal consolidation, covering a sample of 14 countries, including 6 that have been part of a currency union, over three decades (1980–2011). The chapter’s aim is to provide useful insights into the nature of fiscal consolidation across the region and the possible implications for policy. In addition, it assesses current fiscal consolidation efforts in case studies of Barbados, Jamaica, and St. Kitts and Nevis. Further, it identifies a number of challenges to successful fiscal consolidation.

The analysis in this chapter finds that fiscal consolidation efforts in the Caribbean have been slow but steady. A number of countries have embarked on fiscal consolidation to put their debt-to-GDP ratio on a sustainable downward path and improve external stability. Recently, the emphasis has been on maintaining social stability and mitigating the impact of the global financial crisis. Since 2008, they have adopted various tax and expenditure measures to reduce the fiscal deficit. In most of the region, the emphasis has been on raising revenues as opposed to spending cuts. However, in countries with IMF-supported programs, expenditure controls by the central government have been an important aspect of the fiscal consolidation strategy, in addition to reducing losses in public enterprises. In a small number of countries where spending has been restrained, countries have preferred to reduce capital spending rather than current spending. In some countries, including Antigua and Barbuda, Jamaica, and St. Kitts and Nevis, fiscal consolidation has also been accompanied by debt restructuring.

Despite these ongoing fiscal consolidation efforts, countries in the region are generating much lower primary fiscal surpluses than is needed to reduce the debt-to-GDP ratios. Debt sustainability analysis suggests that stabilizing these ratios at 2011 levels would require adjustments of about 1 percent of GDP for the average Caribbean country. If those adjustments were to come mainly from spending cuts, this would translate into large real spending cuts for a number of countries.

As mentioned earlier, common challenges to fiscal consolidation in the region include high levels of public debt, fiscal rigidity, high exposures to global economic conditions, and natural disasters. The high levels of public debt that many countries have has put pressure on expenditure by increasing the interest payment burden, and this could limit their ability to access additional financing. In many countries, fiscal expenditures are mostly committed to wages, interest payments, and social security, limiting the flexibility of fiscal adjustment. The region is highly exposed to global economic conditions through tourism and commodity prices, which pose risks to continuous implementation of a sustainable fiscal program. The Caribbean region is also prone to frequent natural disasters, such as hurricanes, tropical storms, and floods, whose social and economic impacts can be catastrophic.

Despite these challenges, there is a need to reorient fiscal policy in the region, given that debt levels are high. There is currently no fiscal space that can be used, as in the past, to boost economic growth. Rather, the countries need to adjust to lower their debt ratios. Fiscal multipliers in the Caribbean are quite low (see Chapter 8), suggesting that any negative impact fiscal consolidation might have on growth would be smaller than in countries outside the region. Caribbean countries can learn from successful fiscal consolidation in other regions to guide their current efforts.

The Size of Fiscal Multipliers in the Region

The recent global financial crisis has drawn renewed attention to the effectiveness of fiscal policy, as many countries implemented fiscal stimulus measures to boost economic activity. The effectiveness of fiscal policy is often assessed by the size of fiscal multipliers, which measure a change in output caused by an exogenous change in government spending or tax revenue. Chapter 8 of this book estimates fiscal multipliers for the Caribbean using quarterly data for 14 countries in the region and investigates key determinants of the size of the multipliers.

Different multipliers are used in the literature, depending on the timeframe considered. The most frequently used measure is the impact multiplier, which is defined as ΔYt/ΔGt, where ΔYt is a change in output and ΔGt is a change in government expenditure in period t. It measures the increase in output generated by each additional dollar in government spending in period t. Another frequently used notion is the cumulative multiplier, which is defined as i=0NΔYt+j/j=0NΔGt+j. Since fiscal stimulus packages can only be implemented over time and there may be lags in the economy’s response, the cumulative multiplier may be more accurate in capturing the impact of fiscal policy.

The analysis shows that the estimated fiscal multipliers in the Caribbean are modest, consistent with evidence from existing empirical studies (for example, Guy and Belgrave, 2012). The impact multiplier of government spending is 0.13 and the cumulative multiplier is 0.53 after 24 quarters. The tax multiplier is 0.51 on impact and is 0.62 after 24 quarters. The modest size of fiscal multipliers can be attributed to the high levels of trade openness and public debt in the Caribbean. The authors of this chapter find that the “leakages” through imports are actually positive and statistically significant in the region. In addition, they find that the cumulative spending multiplier is essentially zero in the subgroup of high-public-debt countries, while it is 0.77 and statistically significant in the subgroup of low-public-debt countries.

Interpreting these fiscal multipliers requires caution, because they do not constitute a deep structural parameter. Instead, they consist of policy reactions and structural parameters. That is, the fiscal multipliers depend on various factors that can differ case by case, such as the fiscal policy instrument, its duration, its associated fiscal adjustments, the stance of monetary policy, and country-specific circumstances. Therefore, fiscal multipliers are best interpreted as empirical summaries of average reactions of output following exogenous changes in government spending or tax revenue.

Debt Restructuring Experiences

Many academics and policymakers in the Caribbean are of the view that fiscal consolidation might not be enough to reduce public debt in the region, since high primary surpluses need to be run over a long period of time. Chapter 9 reviews selected Caribbean restructuring cases and explores the scope for debt restructuring in the region. In particular, the chapter examines three interrelated policy questions. First, the chapter delineates the case for public debt restructuring, and outlines the history of resolving debt overhang in emerging-market and low-income economies. Second, it reviews the experience of selected past debt restructuring cases in the Caribbean and draws lessons from them. And third, it assesses the scope for additional traditional debt restructuring in Caribbean economies.

Overall, the results suggest that, while a number of Caribbean countries have pursued debt restructuring over the past 25 years, the relief secured has not been sufficient, by itself, to restore long-term fiscal and debt sustainability. Moreover, the changing structure of public debt in the Caribbean necessitates more innovative debt restructuring strategies to reduce public debt without instigating a financial crisis. Finally, credible macroeconomic frameworks are needed to lock in the fiscal space achieved through debt restructuring.

The recent experience with debt restructurings in the Caribbean provides helpful guidance as to what can be done. It confirms the importance of close coordination with creditors to design a menu of options carefully calibrated to deliver optimal results given the policy constraints in each country. It also underscores the importance of effectively communicating the government’s economic policy and strategy. However, the structure of the Caribbean debt, a large share of which is held by the domestic financial system, imposes limitations on the scope for traditional debt restructuring.

The author of chapter 9 takes the view that the IMF could help to catalyze additional external resources to assist the region in its adjustment efforts. Greater reliance on external rather than domestic financing would reduce borrowing costs and free up resources from the domestic banking system to lend to the private sector, which would help finance growth.2 These strategies would have to be buttressed with carefully calibrated policies to raise production and productivity in key export sectors.

Several policy implications can be drawn from these insights. First, there is a need for a holistic economic strategy over the medium term, one that is anchored in debt sustainability. Second, nontraditional debt reduction and restructuring strategies are likely to have a key role in restoring fiscal sustainability, given the structure of the region’s debt. Third, policy reforms, which lock in the gains of debt relief for future generations, would be essential to avoid a repeat of unsustainable fiscal policies.

Fiscal Policy and the Current Account

The extent to which fiscal adjustment can lead to predictable development in the current account remains controversial. There are two competing views. The traditional view argues that changes in fiscal policy are associated with changes in the current account through a number of channels. This view is challenged by the Ricardian equivalence principle, which states that an increase in budget deficit (through reduced taxes) will be offset by increases in private saving, insofar as the private sector fully discounts the future tax liabilities associated with financing the fiscal deficit, and therefore it does not affect the current account balance.

Chapter 10 examines the empirical link between fiscal policy and the current account, focusing on microstates, which are defined as countries with populations of less than 2 million between 1970 and 2009. The chapter employs panel regression and panel vector autoregression (VAR) to estimate the impact of fiscal policy on the current account. The main challenge in the empirical literature is how to measure fiscal policy in a way that reflects deliberate policy decisions and not simply the impact of business cycle fluctuations. The conventional approach to addressing this problem is to use the cyclically adjusted fiscal data to identify deliberate changes in fiscal policy. The presumption is that cyclically adjusted changes in the fiscal balance reflect decisions by policymakers to adjust tax rates and expenditure levels. The IMF (2010) uses an alternative approach, based on identifying changes in fiscal policy directly from historical records. While that approach could be superior to the conventional approach, this book follows the conventional approach because of the difficulties in constructing exogenous fiscal policy measures from historical records in microstates.

Panel regression results show that a percentage-point improvement in the fiscal balance improves the current account balance by 0.4 percentage points of GDP (similar to the coefficient of 0.34 found for the global sample). The real effective exchange rate has no significant impact on the current account in microstates, but in the global sample the coefficient is significant. Panel VAR results show that an increase in government consumption results in real exchange appreciation, but the effect on the current account after an initial deterioration dies out quicker in microstates in contrast to the global sample, where the deterioration remains for extended periods. The results imply that fiscal policy has little effect on the current account in microstates beyond its direct impact on imports. Overall, the results suggest that the weak relative price effect makes fiscal adjustment much more difficult in microstates.

Fiscal Policy Rules and Fiscal Performance

Several governments across the world have adopted fiscal policy rules, especially against the backdrop of worsening fiscal performance and rising debt levels. Recently, following the global financial crisis, fiscal rules have been advocated to support fiscal consolidation efforts and to ensure long-term sustainability of government finances. Chapter 11 of this book analyzes empirically the impacts of fiscal rules on fiscal performance in microstates, with a focus on the Caribbean, where fiscal consolidation has been a major challenge. Broadly, the chapter addresses three questions. Are there fiscal rules in microstates in general and the Caribbean in particular? If the answer is yes, what types of rules exist and what are their characteristics? And finally, is the existence of fiscal rules in microstates associated with improved fiscal performance?

The author of this chapter finds ample evidence of the existence of fiscal rules in microstates. In total, 17 countries—equivalent to 40 percent of the sample—have fiscal rules. The rules are relatively new, about two decades old. Although the institutional coverage slightly favors the central government, the rules in place aim to address fiscal and debt sustainability concerns. Budget balance and debt rules constitute 90 percent of all the fiscal rules. Most debt rules constrain the public-debt-to-GDP ratio to 70 percent or less.

The author estimates a fiscal policy reaction function for a panel of 40 micro-states using annual data for 1970–2009. Similar to Debrun and Kumar (2007), and Debrun and others (2008), he characterizes fiscal policy as a response of the cyclically adjusted primary balance (CAPB) to fiscal rules, controlling for other determinants of fiscal policy, including measures of institutional quality and temporary events such as natural disaster. Empirical results show that the presence of fiscal rules in microstates significantly influences fiscal performance. Chapter 11 suggests that by increasing the discipline and credibility of fiscal policy, fiscal rules tend to bolster fiscal consolidation efforts and lower high debt levels in micro-states, including the Caribbean countries.

Reducing Public Debt in the Caribbean: A New Agenda

Chapter 12 concludes the analysis in this book with an agenda for moving the region forward, drawing on the previous discussion of preceding chapters and the accompanying empirical analyses. While a survey of current policies through the Caribbean suggests that there is plenty of work yet to do on the fiscal sustainability agenda, the fact of a lack of economic recovery in the presence of high debt for many countries has called attention to a time for action. While each country will need to tailor its specific strategy, the chapter outlines some key elements that should be part of any medium term framework that countries in the region may consider adopting. Already, some countries are responding by selecting some elements and putting them in place to meet their debt reduction targets (including difficult and complex new institutional arrangements, for example Jamaica and its proposals for a new fiscal rule).

The chapter argues that robust growth and fiscal consolidation are needed to reduce the high debt in the region. However, since growth in the region is virtually nonexistent, significant fiscal consolidation is inevitable. Views differ regarding the most appropriate route to follow in the current environment given that the need to reduce debt comes in a difficult environment of fragile growth. Based on a survey of country experiences, fiscal consolidation based on expenditure reductions tend to be more effective than tax-based consolidations. However, for countries with large adjustment needs, fiscal consolidation may need to be a balanced combination of spending cuts and revenue increases (Baldacci, Gupta, and Mulas-Granados, 2010). Given the already sizable public sector, most of the fiscal consolidation would have to be done by restraining spending while implementing measures to boost revenues. Better control of the public wage bill, an increase in public sector efficiency, and transfer spending are obvious targets to reduce spending. On the revenue side there is significant potential for reducing tax expenditure, eliminating distortions, and broadening the tax base.

Fiscal consolidation in the Caribbean needs to be credible in order to anchor market expectations about fiscal sustainability (Baldacci, Gupta, and Mulas-Granados, 2010). It is essential to strengthen the fiscal framework by adopting fiscal rules and establishing independent fiscal agencies to guide the budget process and improve fiscal transparency. In the adjustment process, it is imperative to protect the poor. To that effect, social safety nets and well-targeted programs need to be enhanced while reducing or eliminating general subsidies. Targeting subsidies and transfers would also help improve the overall efficiency of nonproductive spending.

The chapter argues that fiscal consolidation is necessary, but may not be sufficient to bring down debt levels, as high primary surpluses would have to be maintained over a relatively long period to have a lasting impact on debt. The very highly indebted Caribbean countries would also need to reduce the net present value of the outstanding debt stock to levels that provide fiscal space and room for countries to resume their growth. The region needs a broad and sustained package of reforms to reduce debt ratios to more manageable levels and strengthen economic resilience. Reforms should signal a new commitment to credible and sound macroeconomic policies. These should include tax policy reforms, public sector rationalization, measures to improve fiscal discipline and credibility, active debt management, containment of contingent liabilities, active privatization programs, and structural reforms to boost growth and improve competitiveness.

In conclusion, this books shows that there is a new agenda waiting to be adopted and implemented. Policymakers and policy advisors in the Caribbean countries, which will face complex challenges in the years ahead, can benefit by learning from successful fiscal strategies around the world, which this book intends to illuminate.

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1

Assessing the impact of devaluation on Caribbean economies is beyond the scope of this book.

2

This, of course, would also need to be managed within a fully articulated debt management strategy that takes into account the cost-risk trade-off. An important risk from foreign borrowing that must be managed is the foreign exchange risk.

Tackling Fiscal and Debt Challenges
  • View in gallery

    The Caribbean: Total Government Debt, 1997–2011

    (weighted average; percent of GDP)

  • View in gallery

    Median Real GDP Growth Associated With Various Public Debt Levels, 1790–2009

    (20 advanced economies)

  • View in gallery

    Composition of Public Debt, Caribbean Nations, 2011

    (percent of GDP)