Eastern Caribbean Currency Union: Selected Issues
Author: International Monetary Fund
Publication Date:
27 Oct 2004
eISBN:
9781451811667
Language:
English
Keywords:
ISCR; CR; ECCU country; bank; ECCU government; balance-sheet data; credit growth; credit allocation; Commercial banks; Credit; Bank credit; Public sector; Loans; Caribbean
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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.

VI. The Role of the Banking Sector in the ECCU1

A. Introduction

1. Financial systems in the small, open economies of the Eastern Caribbean Currency Union (ECCU) are relatively deep, albeit inefficient, compared with other Latin American and Caribbean countries at a similar level of development. The average ratio of broad money to GDP, an indicator of the degree of monetization, increased from 80 percent at end-2000 to 92 percent at end-2002. Monetization in Antigua and Barbuda and St. Kitts and Nevis was more than double the levels in Argentina, Chile or Uruguay at end-2000, despite similar levels of GDP per capita (in purchasing power parity terms). However, despite the sharp decline in international and U.S. deposit rates since 2001, there has been limited interest rate flexibility in the ECCU. The spread between lending and deposit rates has averaged about 8 percent, which is relatively high for the degree of monetization (Lynch, 1996).

A06ufig5

Latin America and the Caribbean: M2/GDP and GDP Per Capita (PPP),2000

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A006

Source: World Development Indicators and Fund staff calculations.

2. Resource mobilization is mostly undertaken by onshore banks, near-banks (chiefly credit unions), and by the partly-funded national insurance systems (or social security boards in some countries). The latter two groups account for about 25 percent and 15 percent of total financial assets in the region, respectively. About 40 percent of the resources mobilized by the national insurance systems are invested in bank deposits, mainly in locally-owned banks, with the remainder fairly evenly divided among government securities, foreign investments, other local investments, and “other assets” (Van Beek et. al, 2000).

3. Despite their small size, each ECCU country has at least four banks, two or more of them part of a foreign-owned international banking group. Foreign-owned banks have over 55 percent of the union-wide market (measured by bank loans). The foreign banks are branches of banks based in Barbados, Canada, and Trinidad and Tobago. Of the locally- owned banks, four are fully or majority government-owned and account for 15 percent of the union-wide market.

4. This chapter examines the role of the banking sector in allocating financial resources within the ECCU, specifically its links to other sectors of the economy. The chapter uses banks’ balance-sheet data which has been compiled, although not necessarily verified, by the Eastern Caribbean Central Bank (ECCB). Section B examines the linkages of the banking sector with the real sector of the economy, including the magnitude and composition of banks’ credit allocations. Section C focuses on the links with the public sector, including the implications of large fiscal imbalances and high public sector debt for financial intermediation and risk. Section D draws a number of policy conclusions that could enhance the efficiency of financial intermediation in the ECCU.

B. Banking Sector Links to the Real Sector

5. Apart from foreign direct investments and other large projects, bank credit remains the main form of funding for the private sector. Capital markets in the region—the Regional Government Securities Market (RGSM) and the Eastern Caribbean Securities Exchange (ECSE)—are at an early stage of development, with few issues and small market capitalization (apart from a handful of government and public enterprise securities). Thus the private sector has to rely for additional capital on the domestic financial system—chiefly the banking system—as credit from nonbank financial institutions is mostly member-based and small in size. The small capital base of most domestic banks means that large projects, including foreign direct investments, cannot be funded by domestic banks without violating exposure limits. Therefore, such projects are typically financed either by foreign banks directly or through foreign branches operating in the region, which typically have better access to lower-cost funding.

6. Despite a reduction in the minimum saving deposit rate from 4 percent to 3 percent in September 2002, deposits with the banking sector have risen (Figure VI.1). Savings and time deposits contributed to most of the deposit growth, except in Antigua and Barbuda and St. Kitts and Nevis, where foreign currency deposits have played a bigger role than saving deposits. Nonresident deposits as a share of total deposits have increased somewhat in three ECCU countries since 1997, and on average they account for around 12 percent of total deposits at end-September 2003 (Figure VI.2).

Figure VI.1.
Figure VI.1.

ECCU: Private Sector Deposits and Credit, 1997-2003

(12-month percentage change)

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A006

Source: ECCB and Fund staff calculations.
Figure VI.2.
Figure VI.2.

ECCU: Non-Resident (NR) Deposits, 1996-2003 1/

(in percent)

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A006

Source: ECCB and Fund staff calculations.1/ End September figures for 2003.

7. In recent years, private sector credit growth has lagged behind deposit growth with a declining trend consistent with the sluggish level of economic activity (Figure VI.1). In Dominica, St. Kitts and Nevis, and St. Lucia, periods of negative credit growth occurred. Where there has been some positive credit growth, it was mostly explained by growth in loans to households, mainly housing related.

8. Personal loans account for on average half of the total bank loans, and, in four of the six ECCU countries, its importance in banks’ loan portfolios has increased since 1996 (Table VI.1).2 Personal loans principally comprise loans to finance the acquisition of property and other personal lending, which includes credit cards, travel, and education. Growth in other loans has increased particularly rapidly since 1996, most notably in Grenada and St. Lucia. Housing loans are backed by property with varying degree of coverage, and banks tend to hold these loans to maturity, although they have the option to sell their primary mortgages to the Eastern Caribbean Home Mortgage Bank.

Table VI.1.

ECCU: Commercial Banks’ Credit Allocation by Economic Activity

(in percent of total)

article image
Source: ECCB and Fund staff calculations.

9. Distributive trade and public administration are the second-largest recipients of bank credit, each receiving on average 10–11 percent of total bank loans (Table VI.1). Compared with end-1996, however, the relative importance of distributive trade has fallen in most ECCU countries, while that of public administration has increased, as ECCU governments have increased direct borrowing (i.e., bank loans and overdraft) from the banking systems.

10. Tourism and agriculture, two of the leading growth sectors in the region, receive relatively small shares of the banking system credit (Table VI.1). Excluding St. Lucia, where tourism accounted for a bigger share than public administration, ECCU countries had only about 5 percent of bank credit allocated to tourism as of end-2002. In four countries, the relative share of tourism credit has actually declined since 1996. Agriculture, vital to rural livelihoods in almost all of the ECCU countries, receives less than 2 percent of bank credit. A noticeable exception is St. Kitts and Nevis, where the large share in credit is accounted for by credit to the sugar company. While it varies with each country, it seems that the agriculture sector has relied on a mixture of self-financing, rural cooperatives, and government agriculture diversification programs (some of which are funded by the European Union).

C. Fiscal-Financial Linkages and Vulnerabilities

11. As public sector debt surged since the mid-1990s, banking systems’ gross exposures to the home country public sector built up quickly, and exceeded capital for locally-incorporated banks (Table VI.2). While these exposures have not grown unduly large relative to total bank assets—except in St. Kitts and Nevis where over half of banking system’s assets are loans and advances to the public sector—in all but two ECCU countries, the share of public sector exposures in total assets has doubled since 1996. Moreover, in all six ECCU countries, locally-incorporated banks have on aggregate gross exposures to government that exceed their total capital, and by a large margin in four countries. The majority of these exposures and their increases over the years are accounted for by government borrowing, except in St. Kitts and Nevis, where both the government and public enterprises have more than doubled their borrowings from the banking system since 1996.

Table VI.2.

ECCU: Commercial Banks’ Exposures to the Home Country Public Sector 1/

(in percent)

article image
Source: ECCB and Fund staff calculations.

End-September figures for 2003.

Credit includes treasury bills, other securities, and loans and advances.

For 1996, 1997 figures are used.

12. Banks’ investments in home government treasury bills may play a more important role, with the increasing use of the RGSM. Treasury bills amounted to 14 percent of total gross government credit as of end-September 2003, excluding St. Kitts and Nevis, where some banks routinely pool resources from their sister-branches in the region for securities investment, resulting in 72 percent of the total gross government credit taking the form of home government treasury bills. However, since the launch of the RGSM, in countries where treasury bills were issued in the RGSM, banks’ exposures to home country treasury bills have varied considerably, depending on the auction outcome. It is also more likely that banks increase their exposures to other ECCU countries’ governments through the RGSM, as an effort to place excess liquidity.

13. Public sector deposits—mostly by national insurance systems but, in some cases, by governments—are a key source of liquidity for banking systems (Table VI.2). Deposits by national insurance systems vary from 2.5 percent of total banking assets in Antigua and Barbuda to 35.8 percent in St. Kitts and Nevis. In Antigua and Barbuda, public enterprises are the main depositors in the banking system, amounting to 18 percent of the total banking assets. Deposits by the government are also important in St. Vincent and the Grenadines and in St. Kitts and Nevis, amounting to 15-16 percent of the total banking assets. However, some proportion (ranging from 15 percent to 40 percent) of government deposits with the banking systems are donor-financed project funds, whereby their use is linked to project execution. As a result, banks’ net exposures to the public sector range from a net debt in the case of St. Lucia and St. Vincent and the Grenadines, the two countries with the lowest debt burden, to a net credit of 23.1 percent of assets in the case of St. Kitts and Nevis, despite the large contribution from the social security board.

14. The funding linkage between banks and the public sector has implications for financial and fiscal risk management. The banking systems in the region fund on a gross basis about 20 to 35 percent of the public sector debt, although the contribution of banking systems’ financing to public sector debt has declined slightly recently, as governments made increasing recourse to external borrowing (Figure VI.3). A change in banks’ risk assessments of government financing or a bank failure resulting in loan recalls could create an interruption in financing of government deficits. On the other hand, if governments sharply draw down deposits, it might create a liquidity shortage for locally-incorporated banks. Isolated incidents may not be much of a concern, as foreign banks and/or the ECCB may provide the needed liquidity, but a systemic disconnection of such a link could be destabilizing.

Figure VI.3.
Figure VI.3.

ECCU: Banking System’s Financing of Public Debt, 1996-2003 1/

(in percent of total public debt)

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A006

Source: ECCB and Fund staff calculations.1/ End-September figures for 2003.

15. Weak domestic banking sectors potentially represent a substantial contingent fiscal liability to ECCU governments. 3 Resident private sector deposits in indigenous banks are around 50 percent of GDP, except in Grenada where they exceed 80 percent. The deposits of the national insurance systems, concentrated in the indigenous banks, particularly those which are government-owned, are substantial relative to their assets (e.g., deposits account for about half of the National Insurance Scheme assets in St. Vincent and the Grenadines). As such, the failure of an indigenous bank—particularly one that is government owned—could create a substantial fiscal obligation.

D. Policy Implications and Conclusions

16. Banking systems in the ECCU increasingly lend to households and the public sector, reflecting in part the sluggish activity in the private business sector. The weakness of private sector activities has persisted as a result of external shocks and negative shifts in the trade regime. It has also prompted ECCU governments to pursue countercyclical fiscal policy, which in turn draws greater bank resources into the public sector.

17. In addition to the lack of “bankable” business projects, structural weaknesses in ECCU banking systems have also contributed to the banks’ retrenchment in lending to the private business sector. These weaknesses include, among others: limitations in prudential capital calculations (which encourage lending to public sectors); weaknesses in risk management capabilities (witnessed by high nonperforming loans (NPLs));4 and legal impediments to prompt resolutions of bad loans.

18. Additional measures aimed at improving the institutional framework and reducing vulnerabilities are needed to enable ECCU banks to play a more efficient role in financial intermediation. These measures may include:

  • Strengthening banking supervision, including in particular strengthening capital adequacy requirements, applying a more rigorous risk-based program, and enhancing follow-up and enforcement of remedial action. Requirements for banks to account for sovereign risk in provisioning and capital adequacy calculations will help mitigate their vulnerability, given their large exposures to the government.

  • Improving risk management capabilities. The current concern for NPLs underscores the severity of the problems commercial banks face in credit risk management. Measures such as instituting a system of credit rating of clients and a network of information sharing among banks help improve loan quality and allow for a more efficient use of loan rates for risk management.

  • Establishing fair and expeditious legal procedures so as to create a debt repayment culture and to reduce the incidence of delinquency. In some ECCU countries, there exist legal impediments to the process of resolving bad assets. For example, where a court procedure requires three bidders for a foreclosed property, forestalling is created when a special-interest party bids prohibitively high.

  • Revisiting the present policy of a savings rate floor. A detailed study of the impact of the legislated floor on the savings rate is needed in order to weigh the possible positive effect on savings and deposit inflow against the possible negative effect on lending rates. While the evidence is mixed on whether the savings floor (at present 2 percentage points higher than the U.S. saving rate) has induced an inflow of nonresident deposits (Figure VI.2), the concern over the high cost of capital—real lending rates have been above 10 percent—warrants a closer study.

  • Deepening the regional financial market to facilitate the financing of large projects, while simultaneously strengthening supervision to guard against the risk of overly aggressive banking behavior. There is little banking integration in the ECCU region at present, although syndicated loans have begun to emerge. Given the presence of vigilant banking supervision, broadening the financing base of the region will help diversify risks beyond national borders.

References

  • Lynch, D., 1996, “Measuring Financial Sector Development: A Study of Selected Asia-Pacific Countries,” The Developing Economies, XXXIV-1, March 1996.

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  • Van Beek, F., J. Rosales, M. Zermeno, R. Randall, and J. Shepherd, 2000, The Eastern Caribbean Currency Union: Institutions, Performance, and Policy Issues, IMF Occasional Paper 195, International Monetary Fund, Washington DC.

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1

Prepared by Jingqing Chai.

2

Some personal loans are used for productive purposes, for example, a car loan with a partial use as taxi, or a mortgage loan with a partial rental use.

3

Banking sector risks appear concentrated in locally-incorporated banks. The ECCB has placed local banks accounting for about 40 percent of ECCU banking assets on its watch list.

4

NPL ratios are over 20 percent for many local banks, and may be even higher if government arrears are accounted for in some countries, such as Antigua and Barbuda.

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Cover IMF Staff Country Reports
Eastern Caribbean Currency Union: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 2004: Issue 335
Publisher:
International Monetary Fund
ISBN:
9781451811667
ISSN:
1934-7685
Pages:
160
DOI:
https://doi.org/10.5089/9781451811667.002
  • View in gallery

    Latin America and the Caribbean: M2/GDP and GDP Per Capita (PPP),2000

  • View in gallery

    ECCU: Private Sector Deposits and Credit, 1997-2003

    (12-month percentage change)

  • View in gallery

    ECCU: Non-Resident (NR) Deposits, 1996-2003 1/

    (in percent)

  • View in gallery

    ECCU: Banking System’s Financing of Public Debt, 1996-2003 1/

    (in percent of total public debt)

Latin America and the Caribbean: M2/GDP and GDP Per Capita (PPP),2000

ECCU: Private Sector Deposits and Credit, 1997-2003

(12-month percentage change)

ECCU: Non-Resident (NR) Deposits, 1996-2003 1/

(in percent)

ECCU: Banking System’s Financing of Public Debt, 1996-2003 1/

(in percent of total public debt)