Eastern Caribbean Currency Union: Selected Issues

This Selected Issues paper on the Eastern Caribbean Currency Union (ECCU) underlies key features of business cycles. To obtain new measures of classical and growth cycles, simple rules were applied to date turning points in the classical business cycle, and a recently developed frequency domain filter was used to estimate the growth cycle. At the regional level, the ECCU countries are facing two shocks, i.e., the depreciation of the U.S. dollar and the depreciation of the Dominican Republic’s peso. The countries of the ECCU have experienced modest erosion in their price and nonprice competitiveness.

Abstract

This Selected Issues paper on the Eastern Caribbean Currency Union (ECCU) underlies key features of business cycles. To obtain new measures of classical and growth cycles, simple rules were applied to date turning points in the classical business cycle, and a recently developed frequency domain filter was used to estimate the growth cycle. At the regional level, the ECCU countries are facing two shocks, i.e., the depreciation of the U.S. dollar and the depreciation of the Dominican Republic’s peso. The countries of the ECCU have experienced modest erosion in their price and nonprice competitiveness.

V. Public Debt Accumulation in the ECCU1

A. Introduction

1. Public debt has increased substantially in the Eastern Caribbean Currency Union (ECCU) since 1998. The average public debt to GDP ratio of the six Fund member countries of the ECCU has increased from about 60 percent in 1997 to over 100 percent in 2003. Some countries are already facing difficulties in servicing their debt—Antigua and Barbuda is running arrears, while Dominica is undertaking major tax reforms and attempting to restructure its public debt.2 For about a decade prior to 1998, public debt was high but stable at around 60 percent of GDP (Figures V.1 and V.2). A natural question suggested by these figures is to ask: What caused the sharp increase in the public debt to GDP ratio after 1998?

Figure V.l.
Figure V.l.

ECCU: Public Debt, 1980–2003 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A005

Sources: Country authorities; and Fund staff estimates.1/ Refers to the ECCU countries that are members of the IMF: Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines. For both total and external debt, the ECCU debt-to-GDP ratio is the simple average of the country-specific debt-to-GDP ratios.
Figure V.2.
Figure V.2.

ECCU: Public Debt, Total and External, 1980–2003

(Percent of GDP)

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A005

Total Debt: Thick LineExternal Debt: Thin LineSources: Country authorities; and Fund staff estimates.

2. A debt accounting exercise is used in this chapter to analyze the sources of the public debt build up in the ECCU. The chapter follows the methodology of Helbling, Mody, and Sahay (2003), HMS henceforth. In essence, the exercise decomposes the sources that contributed to the rise in the public debt to GDP ratio, and quantifies their contributions over time.

3. This chapter does not analyze whether the accumulation of public debt was an optimal response to policies and exogenous shocks. The issue of optimality is a very important and complex one and is beyond the scope of this chapter (see for instance, International Monetary Fund, 2003). However, the information provided in this chapter could be used to compare the implications of optimal debt models.

4. The rest of the chapter is organized as follows. Section B presents a formal description of the methodology used to decompose the rise of the public debt-to-GDP ratio. Section C presents the results of the debt decomposition. Section D focuses on developments in primary fiscal balances, a key contributor to the debt build-up. Section E concludes.

B. Decomposing Public Sector Debt Dynamics

5. Equation (1) describes the accumulation of public sector debt. For simplicity, and given that the nominal exchange rate in the ECCU has been fixed during the period under study, the equation measures all variables in U.S. dollars. Ft and Dt are, respectively, foreign and domestic public debt at the beginning of period t, while GBALt is the government’s primary fiscal balance during period t. GRANTSt represents the grant component of government revenue, which can be used to finance deficits without creating new debt. Since the EC dollar has had a hard peg (to the U.S. dollar) for nearly 30 years, it is assumed that the interest rate, it, is independent of the currency denomination of the debt. Additionally, since no distinction is being made between foreign and domestic debt, Bt will be used to denote the country’s total public debt. EVTt (event) denotes any event that does not appear in the fiscal accounts, but modifies the public debt at time t:3

(Ft+1Ft)+(Dt+1Dt)=GBALtGRANTSt+it(Ft+Dt)+EVTt.(1)

6. Equation (2) below is obtained from equation (1), where the variables are expressed as shares of GDP. Let Zt denote the U.S. dollar denominated value of a country’s GDP. Thus, Zt = Yt*Pt, where Yt is the real GDP (measured in units of goods) and Pt is the U.S. dollar price index. Dividing both sides of equation (1) by Zt and rearranging terms, we obtain equation (2), where: bt+1=Bt+1Zt is the public debt to GDP ratio at the beginning of period t+1; gbalt is the primary balance (excluding grants) as a proportion of GDP; grantst is expressed as a proportion of GDP; and it is the interest rate. Real output growth and the growth of dollar denominated prices are denoted by Ŷt and P^t, respectively, while evtt denotes the value of events as a proportion of GDP:

bt+1bt=gbaltgrantst+itY^t(1+Y^t)(1+P^t)btP^t(1+P^t)bt+evtt.(2)

7. Note that the grants component of the primary balance (which is not a policy variable) differs from the nongrants component (which is a policy variable). Hence, in the remaining sections of this chapter the term “primary balance (excluding grants)” is used to refer to the nongrants component of the primary balance, while “primary balance (including grants)” is used to refer to the traditional primary balance concept.

C. Results of Debt Decomposition

8. The analysis is divided into two sub-periods, 1991-97 (when debt was stable) and 1998–2003 (when debt rose sharply).4 Figure V.3 illustrates that during the second sub-period, economic growth was slower and the fiscal accounts deteriorated sharply. The rise in fiscal deficits resulted from an increase in primary deficits (including grants) and higher interest payments (resulting from the larger stock of debt). While exports of goods and services do not directly affect equation (2), they are of critical importance for GDP and, as a consequence, are presented in Table V.1. Exports of goods and services declined substantially in all ECCU countries (with the exception of St. Kitts and Nevis), especially during 2001–02, when tourism-related activities contracted sharply following the terrorist attacks of September 11, 2001.

Figure V.3.
Figure V.3.

ECCU: Selected Macroeconomic Indicators

(Yearly Averages)

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A005

Sources: Country authorities; and Fund staff estimates.
Table V.1.

ECCU: Exports of Goods and Services

(Percent changes)

article image
Sources: WEO database; and Fund staff estimates.

9. Table V.2 presents the results obtained from estimating equation (2) for the ECCU. Public debt to GDP in the ECCU increased, on average, by 7.6 percent of GDP per year during the period 1998–2003, of which 2.7 percent of GDP is accounted for by the deterioration of fiscal primary balances (including grants) and 2.5 percent of GDP by the net effect of interest payments and output growth. Around 3.0 percent of GDP cannot be explained using the sources presented in equation (2).

Table V.2.

ECCU: Total Public Sector Debt Accumulation by Components

(Magnitudes are in percent of GDP, simple averages calculated from individual countries’ figures)

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Source: Authors’ calculations.Note: A positive sign means that the component contributed to an increase in the public debt to GDP ratio, while a negative sign means that it contributed to a decline of the public debt to GDP ratio.

Simple average of the country-specific debt-to-GDP ratios.

10. When comparing across the two sub-periods, the negative effect of the primary fiscal balance (including grants) is much larger than those originating from lower growth and higher interest payments (Table V.2). Of the 8.1 percent of GDP increase in the average public debt to GDP ratio across the two sub-periods, about 3.2 percent of GDP can be explained by the worsening of the primary fiscal balance (including grants), while the net effect of interest payments and output growth accounts for 1.2 percent of GDP, and the unexplained component accounts for about 2.2 percent of GDP. The price effect and the “events” category account for about 1.4 percent of GDP.

11. The unexplained component of the debt accumulation can be attributed to measurement errors in the fiscal accounts and the stock of public debt. To determine whether the unexplained component of the debt accumulation is driven by a particular country, Table V.3 presents the results of equation (2) for each country. The “unexplained” component is more important for Grenada, St. Kitts and Nevis, and St. Lucia. The positive sign of the “unexplained” component suggests that the actual increase in public debt is most likely underestimated—this result is consistent with the hypothesis of imperfect coverage in the fiscal accounts.

Table V.3.

ECCU: Importance of the “Unexplained Component” to Account for Public Sector Debt Accumulation

(Magnitudes are in percent of GDP)

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Source: Authors’ calculations.Note: A positive sign means that the component contributed to an increase in the public debt to GDP ratio, while a negative sign means that it contributed to a decline of the public debt to GDP ratio.

D. Worsening of the Fiscal Accounts: Why?

12. in this section, an examination is made of the changes in government revenues and expenditures and of the incidence of natural disasters in the region, in order to shed some light on the question—why did the ECCU’s fiscal accounts worsen in recent years? This question is motivated by the importance that fiscal primary deficits have in explaining the public debt build-up in ECCU countries. As is demonstrated below, the worsening of the fiscal accounts is driven by changes in government expenditures, which, in most cases, are driven by government current expenditures. Additionally, with the exception of St. Kitts and Nevis, the incidence of natural disasters does not look very different in the sub-period of public debt accumulation (1998–2003) vis-à-vis the sub-period of public debt stability (1991–97). As a consequence, the picture that emerges in this section is that the increase in government deficits in the region was to a large extent a decision made by the governments themselves, and not one that emanated from exogenously-caused natural disasters.

13. The results indicate that as GDP growth decelerated in 1998–2003, countercyclical policies were pursued with vigor. When shocks are permanent, as some have been, pursuing countercyclical policies is not optimal. Regarding the transitory shocks that ECCU economies faced, an argument can be made to smooth the path of national consumption. However, such a policy needs to be balanced by higher public savings in good times, otherwise rising public debt in the medium term will become unavoidable.

Central Government—Revenues and Expenditures

14. This section focuses on the behavior of the central government, given that, as mentioned above, there is lack of data on the consolidated public sector for three of the six countries. Despite the reduced coverage that use of this narrow definition of government produces, the use of a homogeneous definition of government does have the advantage of enabling a more accurate comparison of fiscal issues across countries.

15. Government expenditures as a share of GDP increased substantially during the period of public debt accumulation, while government revenues were stable (Figure V.4). Only in the case of St. Lucia is there observed an important decline in government revenues.

Figure V.4.
Figure V.4.

ECCU: Central Government Revenues and Expenditures

(Percent of GDP)

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A005

Sources: Country authorities; and Fund staff estimates.

16. increases in current expenditures were a factor behind the increase in central government spending in five of the six ECCU countries (Figure V.5). The exception is Grenada, where the increase in government expenditure seems to be associated with higher capital expenditures. Two countries, Dominica and St. Kitts and Nevis, witnessed an increase in both current and capital expenditures. In the case of St. Kitts and Nevis, the higher capital expenditure was likely associated with public reconstruction projects caused by the impact of natural disasters (see below). Importantly, noninterest expenditures is the most dynamic component, and main driving force, underpinning the behavior of current expenditures (Figure V.6). In addition, and consistent with the sharp increase in public debt, interest expenditures have been rising steadily for most countries.

Figure V.5.
Figure V.5.

ECCU: Composition of Central Government Expenditures

(Percent of GDP)

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A005

Sources: Country authorities; and Fund staff estimates.
Figure V.6.
Figure V.6.

ECCU: Current Expenditures of the Central Government: Interest Versus Noninterest

(Percent of GDP)

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A005

Sources: Country authorities; and Fund staff estimates.

Did Natural Disasters Play a Role?

17. Given that ECCU countries rank among the most prone to natural disasters in the world (see Chapter II of this paper), it is reasonable to examine whether the large increase in public debt may be associated with a jump in the incidence of natural disasters. Natural disasters affecting ECCU countries during the period 1990–2002 are chronicled in Table V.4.5 6

Table V.4.

Natural Disasters in ECCU Countries, 1990–2002

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Source: International Monetary Fund (2004).Notes: Natural Disasters are here defined as events due to natural causes that caused 10 or more fatalities, affected 100 or more people, or resulted in a call for international assistance or the declaration of a state of emergency.

18. Based on the number of people affected, only St. Kitts and Nevis seems to have had a higher incidence of natural disasters in the sub-period 1998–2003. In addition, this country has been affected by three large natural disasters since 1995. Therefore, it is not surprising that the public debt increase in this country started earlier than in the other countries (see Figure V.2), and that both current and capital government expenditures have increased steadily since 1995 (see Figure V.5).

19. Clearly, natural disasters have an impact on both fiscal revenues and expenditure, and ultimately on the path of public debt accumulation. However, with the exception of St. Kitts and Nevis, for most ECCU countries the incidence of natural disasters during 1998–2003 (the period of debt accumulation) does not seem to be greatly different from the incidence observed during the period 1991–97 (the period of stable debt stocks). Accordingly, there is little evidence to support the thesis that the sharp increase in the public debt to GDP ratio in the latter sub-period is associated with an increased incidence of natural disasters.

E. Conclusions

20. This chapter contained an analysis of the dominant sources of the accumulation of public debt in ECCU countries since 1998. The analysis concentrated on determining what underpinned the rise in the public debt to GDP ratio during 1998–2003 vis-à-vis 1991–97 (a period of stability in the public debt to GDP ratio).

21. The main conclusions are:

  • The worsening of fiscal primary balances (both including and excluding grants) is the major source of accumulation of public debt. Of an increase in the public debt to GDP ratio of 8.1 percent of GDP per year during the period 1998–2003 with respect to the period 1991–97, the fiscal primary balance (including grants) explains 3.2 percent of GDP. The effect that accounts for the impact of higher interest expenses and lower growth accounts for 1.2 percent of GDP; about 2.2 percent of GDP remains unexplained.

  • For some countries there is a large unexplained component that in general indicates that the sources of accumulation underestimate the actual increase in public debt. Measurement error may be behind this problem, especially those countries for which fiscal accounts do not consider public enterprises.

  • In most countries, the worsening of the fiscal accounts was driven by an increase in current expenditures. Higher capital expenditures were a factor behind the worsening of the fiscal accounts only in Grenada and St. Kitts and Nevis. The share of fiscal revenues to GDP did not display significant change in any of the countries during the period of debt accumulation (1998-2003). Only in St. Lucia has there been a decline in the share of central government revenues to GDP.

  • The more frequent incidence of natural disasters does not seem to be the reason behind the deterioration of most countries’ fiscal accounts. More specifically, only St. Kitts and Nevis has been significantly more affected by natural disasters during the period of public debt accumulation vis-à-vis the period of public debt stability.

  • The analysis also identified that at the same time public debt was accumulating, there was a decline in economic growth in the region. This suggests that the larger primary fiscal deficits may have been a policy response to the region’s adverse economic conditions (among them, the decline of the banana and sugar industries, high levels of unemployment, and the impact on tourism of the terrorist attacks of September 11, 2001).

External Crisis: Early Warning System Analysis for the ECCU

A recent approach to assessing external sustainability is to develop a systematic empirical framework for predicting currency and balance of payments crises (a so-called “early warning system”) using economic and financial indicators that provide a timely indication of the potential vulnerability of a country’s balance of payments position. Early warning system models can be a useful adjunct to the IMF’s traditional surveillance process, as such an objective approach avoids country-specific biases in the evaluation of the potential for crises. The predictability of currency and balance of payments crises has been examined in a number of recent papers (see Berg and Pattillo, 1999), and in this appendix an extension of the IMF’s Developing Country Studies (DCSD) model is applied to the ECCU.

The modeling approach used is as follows. A multivariate probit model is estimated on monthly data for a panel of 35 developing economies over the period 1970:1-2000:7. 1 The dependent variable in the model takes a value of one if there is a balance of payments crisis within the next 24 months, and zero otherwise. A crisis is defined to have occurred when an “exchange market pressure” index (calculated as a weighted average of monthly real exchange rate depreciations and monthly percentage declines in reserves) exceeds its country-specific mean by more than three standard deviations. The independent variables in the early warning system model include: real exchange rate overvaluation relative to trend; current account deficit as a percentage of GDP; foreign exchange reserve losses; export growth; and the ratio of external debt to foreign exchange reserves.2 The probability of a crisis is found to increase when the real exchange rate is overvalued relative to trend, reserve growth and export growth are low, and the ratios of the current account deficit to GDP and external debt to reserves are high. The estimated coefficients from the model can then be used to generate predictions in the form of the probability of a crisis occurring in any one country during the next 24 months, given the current values of the explanatory variables.3 Predicted probabilities above a certain threshold (typically taken in the literature as either 25 or 50 percent) indicate that the model is signaling the likelihood of a crisis (assuming unchanged policies) within the next 24 months.4 In effect, the signaling of an imminent crisis is tantamount to the model indicating that under unchanged policies, the path of external imbalances is unsustainable. Of course, a crisis may not eventuate if appropriate policy actions are taken to address the underlying economic problems.

The estimated crisis probability for the six ECCU countries (as a whole) peaked in late-1997 and again in late-1999 (see Appendix Figure V.1). However, since mid-2000 the ECCU crisis probability has remained relatively low at around 10 percent. It should be noted, however, that the figure for the Union as a whole masks significant differences in crisis probability across individual countries.

Figure V.l.
Figure V.l.

Appendix ECCU: Contribution of Variables to DCSD Crisis Probabilities 1/

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A005

1/ The probability of a currency crisis over the next 24 months, estimated using the Fund’s DCSD model of Berg and Patillo (1999).

References

  • Berg, A., and C. Pattillo, 1999, “Predicting Currency Crises: The Indicators Approach and an Alternative,Journal of International Money and Finance, Vol. 18, pp. 56186.

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  • Helbling, T., A. Mody, and R. Sahay, 2003, “Debt Accumulation in the CIS-7 Countries: Bad Luck, Bad Policies, or Bad Advice,” (unpublished manuscript, International Monetary Fund, Washington, DC).

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  • International Monetary Fund, 2003, “Public Debt in Emerging Markets: Is It Too High?,” in World Economic Outlook (September 2003), International Monetary Fund, Washington, DC.

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  • International Monetary Fund, 2004, “Natural Disasters and the Macroeconomic Implications,” in Eastern Caribbean Currency Union: Selected Issues, Chapter II.

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1

Prepared by Pedro Rodriguez and Paul Cashin.

2

The accumulation of public debt during the second half of the 1990s has also affected the probability of an external crisis in ECCU countries. See the Appendix for an assessment of the vulnerability of the ECCU.

3

Four events have been identified: Antigua and Barbuda had a reduction in the value of its arrears in 1997 equivalent to 13.1 percent of GDP; the government of Grenada borrowed an amount equivalent to 11.4 percent of GDP to extinguish lease arrangements that had not been previously included as debt; public enterprises in St. Kitts and Nevis increased their debt by 8.8 percent of GDP in 1997 (not included in our fiscal accounts since only central government data is available for this country); and the government in St. Vincent and the Grenadines took over private debt in 1999 (for an amount equivalent to 17.5 percent of GDP).

4

Data on public sector debt, government fiscal balance, interest payments, public debt, and real GDP growth were obtained from ECCU country authorities, while those on natural disasters are from the EM-DAT database compiled by the Centre for Research on the Epidemiology of Disasters (see also IMF, 2004). Data on public debt corresponds to the public sector for all countries, but the coverage of the fiscal data varies across countries, since consolidated public sector data was only available for Antigua and Barbuda, St. Lucia, and St. Vincent and the Grenadines.

5

We include 1990 because natural disasters in the region usually occur in the second part of the year, and, as a result, they may have affected the public debt accumulation process of 1991.

6

Natural disasters are defined here as events due to natural causes that caused 10 or more fatalities, affected 100 or more people, or resulted in a call for international assistance or the declaration of a state of emergency.

1

The countries include the six IMF members of the ECCU (Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines), the ECCU as a whole, and four non-ECCU Caribbean countries (Barbados, Guyana, Jamaica, and Trinidad and Tobago).

2

Data are taken from: real bilateral exchange rate, external reserves, current account, gross domestic product, and exports (IMF, IFS); external debt (Bank for International Settlements, Eastern Caribbean Central Bank, and IMF staff). For each of the ECCU countries and for the Union as a whole, the total external reserves of the Union are used in the calculations of the model.

3

The coefficients from the probit model and the updated independent variables are used to generate out-of-sample predicted probabilities of crisis for the period 2000:8–2003:10.

4

The threshold probability for an alarm that minimizes a loss function equal to the weighted sum of false alarms (as a share of total tranquil periods) and missed crises (as a share of total pre-crisis periods) is 18 percent for the 35 country sample used in this study.

Eastern Caribbean Currency Union: Selected Issues
Author: International Monetary Fund
  • View in gallery

    ECCU: Public Debt, 1980–2003 1/

    (Percent of GDP)

  • View in gallery

    ECCU: Public Debt, Total and External, 1980–2003

    (Percent of GDP)

  • View in gallery

    ECCU: Selected Macroeconomic Indicators

    (Yearly Averages)

  • View in gallery

    ECCU: Central Government Revenues and Expenditures

    (Percent of GDP)

  • View in gallery

    ECCU: Composition of Central Government Expenditures

    (Percent of GDP)

  • View in gallery

    ECCU: Current Expenditures of the Central Government: Interest Versus Noninterest

    (Percent of GDP)

  • View in gallery

    Appendix ECCU: Contribution of Variables to DCSD Crisis Probabilities 1/