I. Introduction

1. Following more than a decade of relatively strong economic growth, the economy of the Netherlands Antilles entered a phase of stagnation during 1995-98, accompanied by a sharp increase in unemployment.¹ Adverse developments affecting the oil refinery and the offshore financial sector, and the hurricane in late 1995, which devastated the tourism infrastructure on Sint Maarten, are commonly seen as the main direct causes. Nonetheless, underlying fiscal imbalances and structural weaknesses of the economy also played a pertinent role. They undermined the economy’s flexibility to adjust to adverse real shocks. Given the undiversified nature of the economy and the adherence to a fixed exchange rate regime, this turned out to be detrimental to economic growth.

2. This paper explores four policy issues which are crucial for understanding the recent performance of the Antillean economy and which will need to be addressed to restore the prospect of durable economic growth:

• Fiscal policy. By the mid-1990s, fiscal policy had become quite expansionary, accommodating wage pressures in the budgetary sector against the background of a secular decline in offshore profit tax revenues. The ensuing large deficits could be financed only through recourse to arrears to the pension fund. Section II evaluates the efforts that have been made since 1996 to restore fiscal sustainability. It explains why these efforts have not met with success so far and outlines ways to address the underlying deficiencies.

• Public sector pension reforms. During the 1990s, the degree of capital funding of the pension system has been altered repeatedly and the civil servants’ pension fund has been abused to finance fiscal imbalances. Section III describes these pension reforms, their interaction with the government budget, and their implications for the actuarial soundness of the system. It suggests options for reform to restore the pension system’s viability.

• Monetary management. Monetary policy has borne the burden of safeguarding the fixed exchange rate system, which has served the Antillean economy well by contributing to low inflation. Direct controls, combined with capital controls, have been the preferred instruments of monetary control so far. They have not always been effective, however, and have hampered the efficient functioning of financial markets. In 1998, the central bank initiated a shift toward increased reliance on indirect instruments of monetary control, which culminated in the abolition of the ceiling on credit to the private sector for 1999. Section IV describes the monetary developments during the past two years and the shift in instruments. While it is too early to evaluate the effectiveness of the new instrument mix, it is noted that there is scope for improving the operation of the minimum reserve requirement. This could prove to be crucial for eliminating remaining excess liquidity.

• Labor market performance. Lack of flexibility in the labor market has limited the economy’s capacity to absorb adverse real shocks, and unemployment has remained high, even during periods of strong economic growth. Section V describes trends in employment, unemployment, and wages, and the main structural features of employment and unemployment. It presents a stylized quantitative assessment of the relation between employment and growth, and reviews the main institutional features of the Antillean labor market. It concludes that a restoration of confidence, investment, and economic growth will need to be accompanied by measures to promote labor market flexibility in order to lower unemployment.