Eastern Caribbean Currency Union: Selected Issues

This Selected Issues paper analyzes macroeconomic fluctuations in the Eastern Caribbean Currency Union (ECCU). The paper describes data, along with the estimation technique used to ensure stationarity of the data. The empirical regularities of macroeconomic fluctuations in the ECCU are described, examining the relationship between a set of macroeconomic time series and domestic output, for each of the six IMF members of the ECCU. The paper also explores the determinants of macroeconomic volatility in the ECCU.

Abstract

This Selected Issues paper analyzes macroeconomic fluctuations in the Eastern Caribbean Currency Union (ECCU). The paper describes data, along with the estimation technique used to ensure stationarity of the data. The empirical regularities of macroeconomic fluctuations in the ECCU are described, examining the relationship between a set of macroeconomic time series and domestic output, for each of the six IMF members of the ECCU. The paper also explores the determinants of macroeconomic volatility in the ECCU.

II. Islands of Stability? Determinants of Macroeconomic Volatility in the ECCU1

A. Introduction

1. This chapter explores the determinants of macroeconomic volatility in the Eastern Caribbean Currency Union (ECCU). Considering their high degree of openness, dependence on tourism, and proneness to natural disasters, the ECCU economies are unusually exposed to external shocks. Nevertheless, the volatility of economic output in the ECCU has over the past decades been markedly lower than in other high-middle-income countries. This chapter finds that this relative stability is explained by fiscal policies and international capital flows that are less procyclical than typically is the case in other developing countries. The scope for continued stability could be ending, however, as high public debt may force outcomes to become more procyclical.

2. The literature on macroeconomic volatility would predict high output volatility in the ECCU; however, the evidence in the region does not support this hypothesis. A number of studies—including Acemoglu and Zilbotti (1997), Easterly and Kraay (2000), Easterly et al. (2000), and Pritchett (2000)—have sought to uncover the sources of economic volatility. Their findings suggest that output volatility is typically associated with a low level of income, lack of diversification, and high openness to trade. With the sum of imports and exports amounting to about 130 percent of GDP, tourism receipts accounting for about half of total exports of goods and services, and a high frequency of devastating hurricanes, one would expect the ECCU countries to be extremely volatile. Historically, however, the ECCU economies have been remarkably stable. Indeed, the analysis finds that the standard indicators of vulnerability identified in the literature suggest a level of real GDP volatility that is about twice as high as that actually observed. The exceptionally low volatility of the ECCU would therefore seem related to factors that are unique to the region.

3. The low level of output volatility in the ECCU has so far received little attention. There is a large literature on the special vulnerability of small island states (see Atkins et al., 2000) but most of the studies do not address the fact that the ECCU countries fail to fit into this picture in terms of their historical output volatility. Berezin et al. (2002)—in one of the few studies to mention this anomaly—suggest five causes: macroeconomic stability; absence of large-scale social conflicts; a declining role of agriculture; low correlation between sectors; and stable export earnings. This chapter builds on their work by exploring the causes of low output volatility and discusses possible implications.

4. The region’s reliance on tourism has contributed to the relative stability, but it does not appear to be the dominating determinant. Dependence on tourism has not created volatility as one could have expected, as it is an unusually stable industry. Indeed, despite the lack of diversification, the volatility of overall exports of goods and services is lower in the ECCU than in the average developing country. In addition, private capital inflows into the ECCU countries are predominantly in the form of comparatively stable foreign direct investments. Nevertheless, the impact of these two sources of stability appears limited, as estimates suggest that private sector volatility in the ECCU is relatively high.

5. A key source of stability in the ECCU has been the ability to pursue counter-cyclical policies. Contrary to the procyclical tendencies in developing countries documented by Kaminsky, Reinhart, and Végh (2004), fiscal policy and international capital flows in the ECCU countries are found to have been only mildly procyclical or even counter-cyclical. The absence of this “when it rains, it pours” syndrome helps explain why the effects of high external vulnerability have been so muted. A key reason for the ECCU countries’ ability to pursue counter-cyclical policy is that they have had relatively easy access to capital in good and bad times. This, in turn, may be related to the exceptional stability of the common quasi-currency board arrangement, with the Eastern Caribbean dollar pegged to the U.S. dollar since 1976 and to the pound sterling before that. Such an explanation would also be consistent with recent studies by Acemoglu et al. (2003) and Satyanath and Subramanian (2004) who argue that institutions are the fundamental determinants of economic outcomes, and that macroeconomic policies are symptoms rather than root causes of volatility. This may be a mixed blessing, however. If the monetary arrangement has provided easier access to capital it may also have contributed to the build-up of debt.2

6. While the ECCU countries so far have been islands of stability, there are worrying signs that this might be ending. Fiscal balances have deteriorated sharply in the ECCU since the mid-1990s, and public debt has risen rapidly. With public debt to GDP ratios now among the highest in the world, governments will not likely be able to borrow to the extent they have in the past when faced with the next downturn. Such procyclical tendencies would lead to greater volatility and have detrimental consequences. Ramey and Ramey (1995), for example, find that higher output volatility leads to significantly lower economic growth. In addition, given risk aversion and a limited capacity to insure, volatility itself is associated with a welfare cost that may be very large in developing countries (Pallage and Robe, 2003; Cashin and Dyczewski, 2005).

7. The remainder of this chapter is organized as follows. Section B documents the features of the ECCU economies that make them vulnerable to external shocks. Section C compares the historical level of economic volatility in the ECCU with the rest of the world and seeks to identify the underlying determinants. Section D concludes.

B. Stylized Facts: High Vulnerability but Low Volatility

8. The ECCU countries share a number of structural features that make them exceptionally vulnerable to external shocks. Part of this exposure is related to their very small size—the combined annual GDP of the six Fund member countries is less than US$3 billion and the total population is just 570,000. The countries also share a number of other features that add to their vulnerability (Table II.1).3

Table II.1.

Selected Indicators of Exposure to Exogenous Shocks

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Sources: IMF, World Economic Outlook database; World Bank, World Development Indicators; EM-DAT; and Fund staff estimates.Note: The data on natural disasters refer to 1970-2002, all other are for 2000. Figures for country groups are unweighted averages.

9. The most visible vulnerability is the exposure to natural disasters. As documented in Rasmussen (2004), the ECCU countries face some of the highest frequencies of natural disasters in the world, primarily because of hurricanes but also due to earthquakes and volcanoes. Estimates of the costs of natural disasters are subject to considerable uncertainty, but available data suggest that the value of damage in the ECCU is equivalent to 2 percent of GDP per year on average. Some catastrophic events caused damage exceeding 100 percent of GDP, such as 1979 Hurricane David in Dominica, 1998 Hurricane Georges in St. Kitts and Nevis, and 2004 Hurricane Ivan in Grenada. Over the past three decades, the 12 most damaging disasters in the region were associated with a median 2.2 percentage point same-year decline in the growth rate of real GDP, which has clearly contributed to output volatility.

10. A second striking feature of the ECCU economies is their dependence on international trade. High openness renders countries vulnerable to volatile international markets and has been found to lead to high output volatility (Easterly and Kraay, 2000). In the ECCU countries the sum of exports and imports is very high at about 130 percent of GDP. Imports alone represent about 70 percent of GDP, reflecting the high dependence of the tourism sector and domestic markets on imported goods.

11. A third source of vulnerability is the lack of economic diversification. A concentrated production structure can be expected to lead to higher output volatility (Jansen (2004) and Mobarak (2004)). In the ECCU the large export sector is heavily dependent on tourism. In addition, a single agricultural crop typically dominates merchandise exports.

12. All the standard indicators of economic vulnerability would suggest that the ECCU economies are among the most vulnerable in the world. A number of studies have sought to synthesize the various variables in a composite vulnerability index, as exemplified in Table II.2. By this measure, all ECCU countries are among the top 30 of the 111 countries considered, with Antigua and Barbuda taking second place.4

Table II.2.

The Commonwealth Composite Vulnerability Index Rankings

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Source: Atkins and others (2000).Note: The composite index is a weighted average of the three variables, where export dependence is measured by exports of goods and services as a fraction of GDP, export diversification is given by the UNCTAD diversification index for merchandise exports, and vulnerability to natural disasters is given by the percent of population affected by disasters. The weights are given by the importance of these variables in determining output volatility. The sample has 111 countries. For each measure, the country deemed the most vulnerable is assigned a ranking of “1”.

13. The ECCU countries may also lack resilience to adverse events stemming from a low capacity to absorb shocks. Hausmann and Gavin (1996) find that inflexible exchange rate regimes contribute to higher macroeconomic volatility because of their inability to absorb real shocks. Thus, most of the adjustment must take place via changes in output. From this perspective, the ECCU’s fixed exchange rate regime would be a source of added volatility. Also contributing to low resilience is that even if some relative price movements take place, the responsiveness of tourism tends to be smaller than that of other exports.5 Consequently, countries would find it difficult to expand tourism to compensate for downturns in other parts of the economy. This general tendency may well be especially pronounced in the ECCU, where the dominant form of high-end tourism is widely considered price inelastic.

C. Economic Volatility: Cross-Country Evidence

14. Surprisingly, the ECCU countries have been islands of stability in a volatile developing world. In other words, the high degree of vulnerability identified in the previous section, has not been associated with the high output volatility one would have expected. It is well documented that output volatility tends to be markedly higher in developing than in high-income countries (Agénor et al., 2000) and that small economies have experienced higher volatility than large economies (Easterly and Kraay, 2000). However, as Table II.3 indicates, the volatility of real GDP growth in the ECCU—as measured by the standard deviation over the past three decades—has on average been lower than in virtually all regions of the world. This finding is robust to alternative measures of volatility—for example, measured by the coefficient of variation (the standard deviation divided by the mean) or the fraction of years with growth below a certain threshold. Moreover, volatility in the ECCU has been on a declining trend since the mid-1980s. This section seeks to explain the reason for this remarkably low level of volatility.6

Table II.3.

Volatility of Real GDP, 1971-2003

(Annual percentage change)

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Sources: IMF, International Financial Statistics and World Economic Outlook database; ECCU country authorities; and Fund staff estimatesNote: Figures for country groups are simple averages, with the number of countries in parenthesis.
uA02fig01

ECCU: Real GDP, 1980–2003

Citation: IMF Staff Country Reports 2005, 305; 10.5089/9781451811681.002.A002

Source: ECCU country authorities.

15. The core variables that have been used to explain output volatility in cross-country regressions cannot account for the unusual stability in the ECCU. Table II.4 shows the results of regressing countries’ historical output volatility on a series of explanatory variables capturing potentially relevant characteristics of the economies, including measures of vulnerability discussed in the previous section. Regression 1 includes a core set of explanatory variables that have emerged in the literature on determinants of volatility: institutional quality; the degree of openness; the size of the economy; and average per capita income.7 It shows significant coefficients associated with each of these variables, with the signs of the first three as expected. Contrary to some previous findings (e.g., Jansen, 2004) and the simple correlation identified in Table II.3, the coefficient on per capita income is positive, suggesting that higher income does not lower volatility when controlling for the other variables. While these variables explain a sizable share of the cross-country variation in output volatility, the regression fails to explain the ECCU’s very low volatility, as reflected by the negative and highly significant coefficient for the ECCU dummy variable. Indeed, the magnitude of the coefficient on the ECCU dummy suggests that the region’s volatility has been only half of what the other variables imply. In contrast, the coefficient on the dummy variable for other small island developing states is much smaller and barely significant at the 10 percent level.

Table II.4.

Determinants of Output Volatility, 1971-2003

(Cross-country OLS regressions with the natural logarithm of the standard deviation of annual real GDP growth as the dependent variable)

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Sources: See the Annex.Notes: Figures in parentheses are standard deviations, and “*”, “**”, “***”, indicate significance at, respectively, the 10, 5, and 1 percent level. Variables denoted with a † are expressed in natural logarithms.

16. Other explanatory variables used in previous studies do not explain the puzzle. Regression 2 includes measures of terms of trade volatility, export concentration, exposure to natural disasters, and the importance of agriculture in the economy. None of these variables has significant coefficients, although the explanatory power of the regression increases and some of the previous coefficients lose their significance.8 Regression 3 introduces a series of regional dummies. Here the dummies for developing countries in Europe and Central Asia and the Middle East and North Africa are found to be statistically significant, reflecting those countries’ high volatility, while the other coefficients are broadly similar to those in Regression 1. In both regressions the coefficient on the ECCU dummy variable remains strongly negative. This shows that even a broad set of explanatory variables fail to account for the stability of the ECCU output, with Regressions 1–3 all pointing to predicted volatility about double the actual level.

17. Several other factors could explain the relative stability of the ECCU. Part of the explanation may be that the volatility of exports of goods and services has not been particularly high given the lack of diversification (Table II.5). This can be attributed to the relative stability of the large tourism industry and, to a lesser extent, the stable export prices afforded to agricultural exports under preferential trading arrangements. Another possible source of stability is that the ECCU nations have a large diaspora and receive substantial remittances (see Mishra, 2005) that could potentially help offset economic difficulties, although Cashin and Wang (2005) find that such transfers have tended to be procyclical. In addition, the countries receive exceptionally high levels of foreign direct investment, which are relatively stable in comparison to inflows of portfolio investment. Finally, the ECCU countries are highly monetized compared with other developing countries, which may have helped buffer adverse shocks.

Table II.5.

Selected Indicators

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Sources: IMF, World Economic Outlook database.Note: The data refer to 1971-2003, except for current transfers and FDI which are averages over 1995-2003.

18. Accounting for the factors noted in the previous paragraph still leaves unresolved questions. Regression 4 (Table II.4) introduces a series of variables related to the financial sector, and shows the M2-to-GDP ratio and the standard deviation of international financial flows entering with significant positive coefficients. However, after controlling for these factors, the coefficient on the ECCU dummy becomes even more negative. Regression 5 includes measures of the magnitude of service exports, international transfer receipts, and FDI to capture some of the other atypical features of ECCU economies. None of these variables has a significant impact on output volatility, although the coefficient on the ECCU dummy is slightly reduced.

19. The key reason for the relatively low volatility of output in the ECCU appears to have been the counter-cyclical fiscal policy pursued by national governments. Excluding the public sector’s contribution to GDP suggests that private sector output volatility has been relatively high in the ECCU (Table II.6).9 The high level of volatility in the private sector is what one would expect given the high level of vulnerability to external shocks identified in Section B. This suggests that the low level of overall volatility is a result of developments in the public sector.

Table II.6.

Indicators of Economic Volatility, 1984-2002

(Standard Deviations)

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Sources: IMF, International Financial Statistics and World Economic Outlook database; ECCU country Authorities; and Fund staff estimates.

Defined as the change in y -(l-g), where y is the index of real GDP and g is government expenditure as a share of GDP.

20. Fiscal policy in the ECCU has been relatively counter-cyclical. Government expenditure in developing countries tends to grow much faster in good times than in bad times (Table II.7). Except for Antigua and Barbuda, this tendency is mostly absent in the ECCU. Indeed, by this measure, fiscal policy in the ECCU has on average been almost as counter-cyclical as in high-income countries.10 The critical importance of fiscal policy is evident in Regression 6 (Table II.4), where the measure of fiscal procyclicality enters with a positive and strongly significant coefficient.11 This regression has the highest R-squared of the six, with the measures of institutional quality and openness being the only other variables associated with significant coefficients. Moreover, in this regression the coefficient on the ECCU dummy variable is substantially reduced and becomes statistically insignificant.

Table II.7.

Measures of Procyclicality

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Sources: Fund staff estimates for ECCU countries, 1983-2004; Kaminsky, Reinhart, and Végh (2004) for 104 other countries, 1960-2003.Note: Fiscal policy refers to the average annual growth in central government real expenditure. Capital flows refer the financial account balance in percent of GDP. In both cases, the index is computed as the difference between the average value in good times (real GDP growth above median) and the average value in bad times (real GDP growth below median). Higher values are thus associated with more procyclical developments.

21. An even more striking result is that international capital flows have been much more counter-cyclical in the ECCU countries than in other regions, including the high-income countries. Since public sector borrowing has driven a large part of capital inflows into the ECCU, the counter-cyclicality of international capital flows is to some extent the result of the low degree of procyclicality in fiscal policy. Both measures reflect that the ECCU governments have had unusually easy access to credit, allowing them to borrow in periods when other developing countries have typically been cut off. Importantly, Antigua and Barbuda, the one ECCU country that has been decidedly procyclical, is also the one which has been cut off from traditional international capital markets following defaults on its external debt dating back more than a decade (Table II.7).

22. The quasi-currency board arrangement is likely to have been an important contributor to output stability in the ECCU. Given that a counter-cyclical stance is a goal that governments typically aspire to but are often unable to achieve, the question arises as to why the ECCU countries have been less financially constrained than other developing countries. Although the cross-country regressions do not point to any significant effect from the exchange rate regime, the relatively counter-cyclical nature of fiscal policy and international capital flows in the ECCU could be related to the stability provided by the monetary arrangement.12 Having maintained a fixed exchange rate against the U.S. dollar for almost three decades, the system has undoubtedly contributed to keeping inflation and interest rates low and stable, and has facilitated the development of the deep financial systems. Indeed, there are very few other countries in the world that have maintained a fixed exchange rate for so long (the only other country with an equally impressive record in the Reinhart-Rogoff (2002) dataset on 110 countries is Panama).13 That the cross-country regressions do not detect a significant impact of the exchange arrangement may simply reflect that there are very few other countries that have managed to establish such enduring pegs. Also, while a fixed exchange rate may help provide access to credit and thereby facilitate the operation of counter-cyclical forces, the overall impact on output volatility is ambiguous, as the effect of reduced price flexibility identified by Hausmann and Gavin (1996) would work in the opposite direction. Another possible explanation is that, with the exception of Antigua and Barbuda, the countries have (until recently) by and large an excellent record of remaining current on sovereign borrowings, a factor that has been found to be an important determinant of a country’s borrowing capacity (Reinhart et al., 2003).

D. Concluding Remarks

23. Despite the high frequency of real shocks, the volatility of output in ECCU countries has been surprisingly low. The exceptionally low volatility has been associated with the fact that fiscal policy has been markedly less procyclical than in other developing countries. The ability to borrow as a result of a good record of debt repayments in most countries, and the stability of the monetary system, are two important factors that have allowed ECCU countries to pursue counter-cyclical policies.

24. Cross-country experience shows that counter-cyclical fiscal policy is one of the main drivers of low economic volatility. The analysis indicates that the cyclicality of government expenditure is a key determinant of output volatility. High output volatility is also strongly linked to low institutional quality, and there is partial evidence of a positive impact from openness, small size of the economy, high per capita income, and a high degree of monetization. Several of these variables may be interrelated and it is therefore difficult to pinpoint their individual significance. It is clear, however, that the counter-cyclical fiscal policy pursued by ECCU countries have helped dampen what would otherwise have been a much higher level of volatility.

25. Future stability of the ECCU economies will depend on the continued capacity to pursue fiscal policies that are markedly less procyclical than in other developing countries. If public debt continues to rise and borrowing limits are reached, expenditure reductions in downturns may become inevitable, thereby contributing to greater output volatility. Debt distress is already evident in Antigua and Barbuda, Dominica, and Grenada, indicating that it will be difficult to pursue expansionary fiscal policies in the near future.

ANNEX: Data Sources

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1

Prepared by Tobias Rasmussen and Guillermo Tolosa.

2

See Duttagupta and Tolosa (2005) for a discussion of the moral hazard problem inherent in the monetary arrangement.

3

In this chapter, ECCU6 denotes the six Fund-member countries of the ECCU.

4

Other vulnerability indices have been produced by Briguglio (1992, 1993, 1995, 1997) and Crowards (1998 and 2000). These other indices also consider transport costs and dependence on strategic imports as sources of vulnerability, and the general conclusion is that small island states tend to be more economically vulnerable than other groups of countries.

5

See Pain and Van Welsum (2004) and references therein for a discussion on the relatively low price elasticity of tourism and other services in comparison with merchandise trade.

6

See World Bank (2003) for additional background on growth and volatility in the ECCU. This study presents data showing that consumption volatility in the region has been higher than output volatility and also relatively high in comparison to other countries. However, data on consumption levels in the ECCU is weak, and the high degree of consumption volatility may reflect a measurement problem.

7

See the Annex for a detailed description of the data sources and definitions. The measure of institutional quality is an index of regulatory quality developed by the World Bank that captures the incidence of market-unfriendly policies and perceptions of the burdens imposed by excessive regulation.

8

Others have found these variables to have a significant impact on volatility. For example, Atkins et al. (2000) find a positive impact from susceptibility to natural disasters and export concentration; Easterly and Kraay (2000) find a positive impact from terms of trade volatility; and Fiaschi and Lavezzi (2003) find a negative impact from the size of the agricultural sector. Some of these differences in results may reflect different estimation periods and data sources, but they may also reflect that those studies fail to include important control variables.

9

Fiscal data for the ECCU is only available since 1983. However, the pattern of output volatility is broadly the same in the post-1983 period as in the 1971–2003 period considered earlier.

10

The applied measures of cyclicality are from Kaminsky, Reinhart, and Végh (2004).

11

There is a possibility that fiscal policy procyclicality, at least in part, depends on output volatility rather than the other way around, which would impair the statistical properties of the regression. Nevertheless, it seems likely that fiscal policy would depend more on the root causes of volatility, such as the size and openness of the economy. Also, similar endogeneity issues present themselves with respect to several of the other variables, notably the measure of institutional quality. Other studies have attempted to correct for potential endogeneity problems by using instrumental variable techniques (e.g., Acemoglu et al. (2003) and Satyanath and Subramanian (2004)) but still find that institutions have an important impact on volatility.

12

The Reinhart-Rogoff (2002) measure of exchange rate flexibility takes values on a scale of 1 to 15, with 1 indicating regimes with no separate legal tender. The ECCU countries all receive 2s (for preannounced peg or currency board arrangement) throughout the 1940–2001 sample period. See the Annex for additional details.

13

Among IMF member countries, there are seven countries aside from the ECCU that have managed to maintain an exchange rate relative to the U.S. dollar that never varied by more than 1 percent since 1980 on a year-average basis (Bahamas, Bahrain, Barbados, Belize, Djibouti, Panama, and Qatar). However, as with the Reinhart-Rogoff (2002) index, a dummy variable for these countries is not associated with a significant coefficient in the cross-country-regression analysis.