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We are grateful to Tobias Rasmussen for his contributions at early stages of this paper and Paul Cashin for his insightful comments. Thanks are also due to Roberto Alvarez, Jingqing Chai, Pablo Druck, Robert Flood, Rishi Goyal, Arnold Harberger, Juan Manuel Jauregui, Amin Mati, Guy Meredith, Prachi Mishra, Garth Nicholls, Patrick Njoroge, Sanjaya Panth, Catherine Pattillo, David O. Robinson, Ratna Sahay, Garnett Samuel, Sebastian Sosa, Carlos Végh, Sir K. Dwight Venner, and Patricia Welsh-Haynes; seminar participants at the Eastern Caribbean Central Bank; the Caribbean Center for Monetary Studies; the IMF’s Western Hemisphere Department; and University of California at Los Angeles for helpful comments and suggestions. We are responsible for any errors and omissions.
The ECCU has one of only two FPCU in the world and hence can be analyzed relative to the other exchange rate regimes in the Caribbean. Besides the ECCU, the only other currently operating currency union with a fixed exchange rate regime is the CFA franc zone—comprising the West African Economic and Monetary Union (WAEMU) and the Central African Economic and Monetary Union (CEMAC)—time series data on which is sparse, and hence is not included in our empirical study.
In other words, economic policy is characterized by fiscal dominance, a feature more characteristic in developing countries. Conversely, policy making in developed countries is generally characterized by a systematic tendency for fiscal and monetary policy to counterbalance one another (see Debrun, 2000).
See Sun (2003), however, for an analysis of fiscal policies in a context of “fragmented policymaking,” that is, many fiscal authorities operating in a single country with a fixed exchange rate, which can be adapted to a multi-country setup. The author shows that if the punishment for abandonment of the peg is high enough, fixed exchange rates might induce more fiscal discipline and inflation may not occur.
Note that the only type of free-riding behavior under consideration is with respect to the burden of the inflation tax. Other forms of free-riding, e.g., higher future taxes or lower future social expenditure, are not considered here.
The model abstracts from other structural characteristics and institutional factors that also might be affecting fiscal performance under different exchange rate regimes.
Under this setup, while monetary policy is not able to precommit to stable prices, fiscal authorities are able to precommit to repay debt. The abstraction from sovereign default risk allows the model to focus on its objective of analyzing the differential consequences on fiscal behavior of different exchange rate regimes. However, even with sovereign default risk in the model, the results of the paper would hold as long as the inflation tax is part of the ultimate policy response to fiscal solvency.
The following transversality condition is imposed: fi,2=mi,2=0.
Note that i = r +π.
This assumption guarantees the economy operates in the upward-sloping side of the Laffer curve.
To simplify, the inability of the monetary authority to precommit is introduced mechanically, abstracting from explicit time inconsistency considerations. An important result derived from the latter strategy is in Sun (2003), who shows that if punishment associated with the abandonment of the peg is big enough, fixed exchange rates might induce more fiscal discipline.
The beneficial effects of inflation on public accounts are twofold. Tornell and Velasco (2000) stress seignorage revenues deriving from the devaluation, while Chari and Kehoe (2004) stress the deflation of debt in domestic currency.
In the context of high foreign currency debt, the threshold is likely to kick in after the foreign currency debt has been defaulted, as Rocha et al. (2002) show.
Reinhart (2002) shows that 85 percent of debt crisis are accompanied by currency crisis (and hence inflation), even though her definition of debt crisis does not include bailouts by international financial institutions (as in Manasse et al., 2003). Thus, the correlation between debt crisis and currency crisis could be even higher.
In the sample, the ECCU countries (Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines) maintained their FPCU regime through out the sample period. The Bahamas, Barbados, Belize and Suriname maintained conventional fixed peg regimes through out the sample period. Guyana maintained a fixed peg until 1989, Haiti until 1991, Jamaica until 1990 and Trinidad and Tobago until 1993. These countries abandoned their fixed peg regimes in favor of a variety of more flexible exchange rate regimes, including floats. The Dominican Republic maintained a crawling peg until 2002, when it adopted a floating exchange rate regime.
This result also has direct implications for the regression analysis presented in the next sub-section. In particular, even if there were any causality from fiscal performance to exchange rate regime choice, one would expect fixers to be associated with stronger fiscal balances, which is contrary to what is shown in Figure 1.
See Kaminsky, Reinhart, and Vegh (2004), and Rasmussen and Tolosa (2005). The higher influx of net capital inflows since the mid-1990s was unrelated to changes in capital account policies, as the region had eliminated most capital controls in the early 1980s (see IMF Annual Report on Exchange Arrangements and Exchange Restrictions, various issues).
Reinhart et al. (2003) find evidence that borrowing capacity is significantly related to default histories and the nature of macroeconomic volatilities.
Kufa and others (2004) show that fiscal policies in the ECCU have consistently worsened over time, increasing the risk of unsustainability of the public sector debt. Duttagupta and Tolosa (2005) show that the growth in fiscal spending in the ECCU during 1983–2004 generally surpassed GDP growth irrespective of the nature of the business cycle, implying that fiscal stances were influenced by other factors besides growth.
The country-specific, time-invariant factors also help proxy for “institutions” data for which is very poor in the Caribbean (e.g., fiscal transparency, characteristics of the budget process, independence of the Ministry of Finance over the Cabinet, the degree of expenditure control by the budget authority). See von Hagen and Harden (1996).
The reserve pooling agreement in the ECCB implies that no individual country reserves are allocated, but each member has unrestricted access to the common pool of reserves, as long as it has the domestic currency to make it effective (see Williams et al., 2005). Thus, the use of foreign reserves to determine the bailout capacity of the central bank from each member’s perspective appears reasonable.
To avoid endogeneity between some of the right-hand side explanatory variables (real GDP growth, trade openness, and foreign reserves) with the primary balance, one-year lagged values of the explanatory variables are used.
The data on natural disasters during the sample period was obtained from the “EM-DAT” database and comprised disasters including hurricanes, floods, drought, earthquakes, slides, famine, volcano, and mudslides (also see Rasmussen, 2004).
This result could have two implications: either, the increase in fiscal spending in response to a natural disaster was accompanied with at least the same increase in grant-financed fiscal revenue; or contrary to expectations, primary expenditure did not increase or was actually compressed during a disaster episode (column (b) provides some support for this argument).
Note that the primary spending only summarizes the expenditure side of fiscal stance and hence, is a relatively poor proxy of fiscal policy compared to the primary balance. In other words, a deterioration of fiscal stance is associated with an increase in primary expenditure, only if the former overshoots any increase in fiscal revenue.
These regression results are not presented here, but are available upon request.