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.
IV. Fiscal Policy in a Regional Currency Union1
A. Introduction
1. Currency unions with fixed exchange rates can induce mutually conflicting fiscal incentives. On the one hand, fiscal overspending by one country—reflecting countercyclical policies or fiscal slippages—has ramifications on the exchange rate stability for the entire union, thereby requiring utmost fiscal discipline by union members. Conversely, under some conditions, member governments can defer the costs of fiscal slippages to the future or share them with other members, which induces moral hazard behavior.
2. The existing theoretical literature has analyzed both of the above aspects in the relationship between fiscal incentives and exchange rate regimes. Earlier studies supported the traditional view that a fixed exchange rate is an effective policy for fiscal discipline, since fiscal profligacy is deterred by the risk of losses in foreign reserves or buildup of public debt resulting ultimately in a costly abandonment of the peg.2 However, country experiences with changes in fixed exchange rate regimes caused in part by fiscal deterioration (for example, the CFA franc zone in January 1994 and Argentina in December 2001) have questioned the conventional wisdom.3 In this regard, recent studies have shown that the conventional view can be overturned by explicit consideration of fiscal incentives induced by the exchange rate regime (Tornell and Velasco, 2000; Chari and Kehoe, 2004).
3. This chapter explores in detail the factors underlying fiscal policies in the Caribbean in general and the Eastern Caribbean Currency Union (ECCU) in particular. First, it draws on the recent theoretical literature and assesses the combined effect of a regional currency board on fiscal policies. Next, using annual data from 1983 to 2003, it estimates the factors influencing fiscal policies in 15 Caribbean countries, including the ECCU6, by recognizing explicitly the scope for free-riding under the Eastern Caribbean currency board arrangement (CBA).4
4. The main results of the chapter provide evidence in support of the presence of greater free-riding behavior in the ECCU relative to countries with other exchange rate regimes. The theoretical framework shows that under some conditions fiscal stances under a regional currency board can be associated with greater free-riding opportunities arising from the ability of governments to transfer the inflation costs of fiscal slippages to the future—given the fixed exchange rate—and dilute it across space to other member governments—given the currency union. This opportunity does not arise under a flexible exchange rate regime owing to the immediate inflationary impact of fiscal overspending. Stylized observations on the fiscal stances of 15 Caribbean countries show that the primary balances of the ECCU countries were the worst during 1990–2003, followed by countries with fixed pegs, while countries with flexible regimes were the best fiscal performers. Finally, empirical results confirm that fiscal policies of the ECCU countries during 1983–2003 were indeed characterized by greater free-riding behavior.
5. The rest of the chapter is organized in the following manner. Section B draws on the existing literature and provides insight on the impact of a regional currency-board on fiscal incentives from a political-economy perspective. Section C describes the institutional setup of the Eastern Caribbean Central Bank (ECCB) and the nature of fiscal policies in the ECCU, and Section D presents the empirical analysis. Section E concludes.
B. Fixed Exchange Rates, Currency Unions, and Fiscal Discipline
6. Tornell and Velasco (2000) show that fiscal discipline is not always maintained under a fixed exchange rate. The authors assume that a government can finance fiscal deficits by issuing debt for a temporary period, but eventually has to rely on the inflation tax (in the spirit of Krugman, 1979). Thus, different exchange rate regimes influence fiscal incentives differently, depending on when observable costs start to bite. Under a fixed exchange rate, observable costs will not materialize until inflation takes place at some time in the future. Conversely, under a flexible regime, inflation is observed in the present owing to the consequence of anticipated future inflation (in the spirit of Sargent and Wallace, 1981). If governments are shortsighted and dislike inflation, they spend more under fixed exchange rates, as they can postpone the costs of higher spending.
7. In a similar vein, Chari and Kehoe (2004) show that fiscal discipline is not unambiguously upheld under a currency union arrangement. In their model, the supranational central bank faces a tradeoff between the benefits of greater debt deflation and the output costs of higher inflation, and reneges on its commitment of low inflation when the benefits exceed the costs. Consequently, a government has the incentive to overspend given that the benefits of spending accrue solely to its own country while the inflation cost of higher fiscal deficits can be shared with other members of the union.
8. Thus, the combination of two monetary arrangements—a fixed exchange rate within a currency union—can indeed give rise to perverse fiscal incentives. Under the traditional setup, fixed rates and currency unions reinforce each other, making the monetary arrangement an ideal environment for fiscal discipline. However, considering also the elements of the alternative view, the scope for free-riding could be strengthened. Following Tornell and Velasco (2000) and Sun (2003), and assuming that: (i) there are no enforceable rules for fiscal deficits and no policy coordination between member governments; (ii) governments eventually rely on inflationary financing of fiscal deficits; (iii) governments are biased toward spending and are shortsighted, i.e., they discount the future more heavily than the present, then fiscal policies under a regional currency board can induce free-riding opportunities by allowing a member government to transmit costs of fiscal slippages to the future and to other member governments.5
9. The critical assumption supporting the above result is that persistent fiscal deficits eventually need to be financed by the inflation tax, possibly in the form of a currency or banking crisis.6 This assumption can be substantiated from both a theoretical and an empirical stand point. Theoretically, inflation is viewed as the outcome of the tradeoffs for the common central bank between benefits to fiscal accounts versus the costs of output decline. The benefits of inflation increase with increases in public debt until a threshold when it is optimal to inflate.7 Empirically, country experiences have proven that a currency crisis can take place even when the central bank had apparently neither the incentive nor the legal capacity to devalue (for example, in Argentina).8 Fears of fiscal insolvency usually spur self-fulfilling mechanisms, resulting in a widespread sudden plunge in the demand for government liabilities, including the currency.
10. Table IV.1 illustrates how fixed exchange rate regimes and currency unions can spread the burden of the inflation tax across time and space, and thereby induce fiscal incentives that are at odds with the conventional wisdom. Four cases are highlighted:
Allocation of the Inflation Tax Under Alternative Exchange Rate Regimes
Allocation of the Inflation Tax Under Alternative Exchange Rate Regimes
| Individual Country | Currency Union | |
|---|---|---|
| Flexible exchange rate regime |
Case I. “No free riding” Inflation tax borne by the country in the present |
Case II. “Regional free riding” Inflation tax borne by all countries in the union in the present |
| Fixed exchange rate regime | Case III. “Intertemporal free-riding” Inflation tax borne by the country in the future |
Case IV. “Intertemporal and Regional free-riding” Inflation tax borne by all countries in the union in the future |
Allocation of the Inflation Tax Under Alternative Exchange Rate Regimes
| Individual Country | Currency Union | |
|---|---|---|
| Flexible exchange rate regime |
Case I. “No free riding” Inflation tax borne by the country in the present |
Case II. “Regional free riding” Inflation tax borne by all countries in the union in the present |
| Fixed exchange rate regime | Case III. “Intertemporal free-riding” Inflation tax borne by the country in the future |
Case IV. “Intertemporal and Regional free-riding” Inflation tax borne by all countries in the union in the future |
Case I, represented by the upper left panel of Table IV.1, shows the situation when a country has a flexible exchange rate regime. Fiscal overspending would be translated into depreciation of the exchange rate and inflation in the same period as demand for money decreases in anticipation of future inflation. This is the benchmark case with no free riding in fiscal policy.9
Under Case II, a country is a member of a currency union that operates a flexible exchange rate. While fiscal overspending would generate costly present inflation, this is now shared with all union members. This case is labeled as “regional free-riding” since the costs of spending are diluted for the country undertaking fiscal expansion.
Under Case III, a country has a fixed exchange rate. In this case, future inflation does not lead to present inflation as the current exchange rate is fixed. Deferring the costs of the inflation tax amounts to free riding on future governments by spending today, a phenomenon that can be called “intertemporal free riding.”
Finally, under Case IV, the common currency of the union—adopted by all union members—is fixed vis-à-vis a major international currency. The outcome in this case follows naturally from the other three cases. Actual inflation or even the probability of higher inflation in the future has no consequences for money demand or inflation today, given the fixed exchange rate. Inflation is expected to take place in the future and the cost to be shared by future member governments, given the currency union. Thus, the inflationary costs of fiscal expansion are minimal at present—future governments end up bearing them and member governments end up sharing them. Consequently, incentives for fiscal slippages at present are the highest.
11. The scope for regional free-riding can intensify under certain conditions. The incentive to free-ride would increase with increases in the bailout capacity of the central bank—for example, proxied by the level of foreign reserves at the currency board—as perceived by member governments and/or their creditors. Even if governments do not expect to be directly bailed out by the central bank, the latter’s commitment to bail out the financial system from systemic crises reduces the urgency for governments to prepare for potential liquidity shortages in the banking system, and also benefits governments that have significant ownership in the banking system.
12. The incentive to free-ride intertemporally is related to internal political competition and turnover. The higher the competition for political leadership, the smaller the probability that the same political party will have control in the next term and the higher the incentive to delay the cost of fiscal expansion, in particular when elections are close.10
13. The operation of both moral hazard channels depends on the structure of capital markets as well. In well-developed markets, high debt would be discouraged by rising interest rates (Bayoumi et al., 1995). Conversely, countries face tight borrowing constraints in poorly developed markets owing to the structural scarcity of funds. Thus, the scope for fiscal overspending increases under some degree of capital market development, i.e., where capital is available and limited information leads to underestimation of sovereign risk.
C. Fiscal Policies in the Eastern Caribbean Currency Union
Institutional setup
14. The Eastern Caribbean Currency Bank (ECCB) operates like a currency board arrangement (CBA) at the regional level. It has full central bank functions such as issuing the common currency, managing a common pool of foreign exchange reserves for member countries, and maintaining monetary conditions conducive to growth, economic development, and financial system stability. The reserve pooling agreement implies that no individual country reserves are allocated, and although reserves are imputed to individual members, these are not a measure of the foreign reserves at a country’s disposal. At the same time, each member has unrestricted access to the common pool of reserves as long as it has the domestic currency to make it effective.
15. The ECCB regulations allow some departures from traditional CBAs, and as a result it is actually considered a quasi-CBA.11 The ECCB is required to maintain foreign exchange reserves to cover 60 percent of its demand liabilities, unlike most other currently existing CBAs that require full foreign exchange backing of the domestic currency (e.g., Hong Kong, Djibouti, and Lithuania). The ECCB can support the national fiscal authorities in several ways: by providing temporary advances (up to 5 percent of the government’s average annual revenue during the preceding three financial years); holding treasury bills (up to 10 percent of the government’s estimated revenue of that year); holding other securities (with varying limits according to the security); and servicing governments’ special deposit loans to financial institutions (Hendrickson et al., 2002; van Beek et al., 2003). The ECCB also has autonomy in determining discount and rediscount rates, reserve requirements and interest rate controls, such as the floor on the savings interest rate.
16. The CBA has been very stable so far, reflecting prudent policies by the ECCB. Despite its autonomy, the ECCB has rarely used the monetary policy tools at its disposal. Also, despite a lower requirement, the reserve backing of the CBA has been close to 95 percent, which has helped bolster the fixed exchange rate while giving the ECCB some scope to serve as a lender of last resort—at its discretion—for the banking system.
17. However, national fiscal policies in the ECCU have not been conducive to strengthening the CBA. Actual fiscal outcomes have increasingly deviated from the fiscal guidelines established by the ECCB in 1998, reflecting the fact that national fiscal policy decisions have been made independently of the CBA (Figure IV.1).12 Moreover, the rising foreign reserve coverage at the ECCB, combined with the discretion of the ECCB to provide liquidity support, could raise the perception of stronger bailout capability of the ECCB and induce further fiscal overspending by member governments and continued financing by their creditors. Thus, the scope for free-riding is clear, although whether this actually influences fiscal policies in the ECCU is an empirical question.
ECCU Countries: Compliance with Fiscal Guidelines, 1998–20031/
Citation: IMF Staff Country Reports 2005, 305; 10.5089/9781451811681.002.A004
Sources: Eastern Caribbean Currency Union member country authorities; and Fund staff estimates.1/ The four fiscal guidelines are: current balance (4-6 percent of GDP); overall balance (greater than -3 percent of GDP); total public sector debt (less than or equal to 60 percent of GDP); and debt service payments (less than 15 percent of current revenue).Stylized facts
18. Fiscal positions of the six ECCU countries were the worst among the 15 Caribbean countries in the sample. The ECCU countries had the largest average primary deficits during 1990–2003 (a sufficiently long period over which short-run determinants of fiscal policy can be expected to net out), followed by countries with fixed exchange rates (Figure IV.2).13 The countries with various forms of relatively more flexible regimes—including floats—were the best fiscal performers in the sample.
Fiscal Primary Balance Under Alternative Exchange Rate Regimes, average 1990–2003
(In percent of GDP)
Citation: IMF Staff Country Reports 2005, 305; 10.5089/9781451811681.002.A004
Sources: Country authorities; and authors’ calculations.19. The deterioration of primary balances in the ECCU was mainly due to a worsening in government expenditures, which increased sharply during the 1990s(Figure IV.3, Panel (a)).14 Fiscal expenditure growth generally surpassed GDP growth irrespective of the nature of the business cycle ((Panel (b)), suggesting that fiscal stances were influenced by other factors besides the growth slowdown. The rise in primary expenditure over time characterized every ECCU country, and in each case, exceeded the increase in fiscal revenue during the same period (Panel (c)). Also, the composition of primary spending did not change in a major way, implying that fiscal policies were not driven by a sharp rise in government preference towards a particular item (Panel (d)).
Eastern Caribbean Currency Union: Nature of Fiscal Stance, 1990–2003
Citation: IMF Staff Country Reports 2005, 305; 10.5089/9781451811681.002.A004
Sources: Eastern Caribbean Central Bank; ECCU member country authorities; and Fund staff estimates.20. The ECCU governments had access to foreign financing even when other emerging market countries faced a turnaround of net capital inflows (Figure IV.4). Also, unlike other developing countries, where capital flows are usually procyclical, non-FDI capital inflows continued to the ECCU countries even during periods of low economic activity.15 Possible reasons for their ability to borrow externally could be their good repayment record, relatively low GDP volatility, the perception that the ECCB would serve as a lender of last resort in the event of potential liquidity shortages faced by member governments, and the gradual elimination of transaction costs with financial innovation in capital markets over time.16
Private Net Capital Inflows (less FDI)
(In percent of GDP)
Citation: IMF Staff Country Reports 2005, 305; 10.5089/9781451811681.002.A004
Sources: Country authorities; and authors’ calculations.21. In sum, stylized facts underscore the need for a deeper analysis of the factors influencing fiscal policies in the ECCU. Average fiscal balances in the ECCU during the past two decades were much lower than in other Caribbean countries with more flexible exchange rate regimes. The fiscal deterioration was characterized by expenditure expansion across all member countries, with revenue remaining relatively stable. The large fiscal deficits were financed in part by borrowing from abroad during good and bad times, and even when financial flows were retracting from other emerging markets. These peculiarities highlight the importance of studying the nature of fiscal policies in the ECCU, and assessing in particular any evidence of moral hazard behavior under the regional CBA.
D. Empirical Analysis
22. A fixed-effects panel model is used to examine the fiscal policy stance in 15 Caribbean countries during 1983–2003. This model allows one to assess the effect of competing factors—including specific channels of free-riding behavior under various exchange rate regimes—on fiscal policy after controlling for country-specific, time invariant factors (that can proxy for “institutions”).17 This approach reflects a marked difference from past studies, which focus on estimating the relationship between fiscal stance and exchange rate regimes in a cross-section set-up, without attempting to identify the channels through which different regimes can influence fiscal incentives (see Fatas and Rose, 2001; and Tornell and Velasco, 2000). The estimated equation has the following form:
where:
yit is a measure of fiscal stance of country i at time t, expressed as the primary fiscal balance (as a percent of nominal GDP). Since the primary balance is unaffected by interest payments, it serves as an appropriate indicator of fiscal policy stance;
xit comprises a number of control variables for country i at time t, the description of which (and their expected signs in the regression) is given in Box IV.1;
vt is the error term in the regression; and
zit is a group of three indicators that are used as proxies for moral hazard behavior reflecting regional and inter-temporal free riding behavior. These proxies are described in detail below.18
Control Variables Used in the Regression
(i) Economic performance, measured by the annual real GDP growth rate. A counter- (pro-) cyclical fiscal policy would imply an increase (decrease) in fiscal deficits during economic slumps and a corresponding decrease (increase) during an economic boom.
(ii) Trade openness, expressed as the sum of exports and imports of goods and services as a percentage of GDP, as a proxy for trade policies.
(iii) Terms of trade, measured by the ratio of export price to import price, in dollars. Improvement in the terms of trade would improve fiscal revenues, reduce the need for expansionary fiscal policy, and help improve the primary balance.
(iv) A dummy for an IMF program controls for the effect of existing IMF programs on the fiscal stance.
(v) Time dummies, to control for time specific events and also account for innovations in the financial markets over time that ease borrowing constraints for member governments.
23. Intertemporal free-riding is proxied by the closeness to election under alternative exchange rate regimes. Shortly before elections are held governments’ shortsightedness could increase; that is, the closer are elections, the more governments could spend to improve their chances of winning the elections. A fixed exchange rate regime would conveniently defer the costs of higher fiscal expenditure to the future, while under flexible exchange rates the costs would have to be paid upfront. Table IV.2 shows a negative (nonnegative) correlation between primary balances and closeness to election for the regional CBA (flexible regimes), although a more formal analysis is needed to establish any causal relationship reflected in the correlations.19
Simple Correlation Between Proximity to Elections and Primary Balances
Simple Correlation Between Proximity to Elections and Primary Balances
| Group | Number of Countries |
Observations | Correlation | ||
|---|---|---|---|---|---|
| Regional currency board | 6 | 123 | -0.16 | ||
| Of which | |||||
| Antigua and Barbuda | 21 | -0.15 | |||
| Dominica | 18 | -0.40 | |||
| Grenada | 21 | -0.13 | |||
| St. Kitts and Nevis | 21 | -0.08 | |||
| St. Lucia | 21 | -0.17 | |||
| St. Vincent and the Grenadines | 21 | -0.39 | |||
| Fixed peg regimes | 3 | 60 | 0.00 | ||
| Flexible regimes | 9 | 98 | 0.12 | ||
Simple Correlation Between Proximity to Elections and Primary Balances
| Group | Number of Countries |
Observations | Correlation | ||
|---|---|---|---|---|---|
| Regional currency board | 6 | 123 | -0.16 | ||
| Of which | |||||
| Antigua and Barbuda | 21 | -0.15 | |||
| Dominica | 18 | -0.40 | |||
| Grenada | 21 | -0.13 | |||
| St. Kitts and Nevis | 21 | -0.08 | |||
| St. Lucia | 21 | -0.17 | |||
| St. Vincent and the Grenadines | 21 | -0.39 | |||
| Fixed peg regimes | 3 | 60 | 0.00 | ||
| Flexible regimes | 9 | 98 | 0.12 | ||
24. Three variables are used to fully explore the impact of all exchange rate regimes on intertemporal free riding: (i) the product of the time remaining to the next election and a dummy for all ECCU countries (to capture the effect under the ECCU); (ii) the product of the time remaining to the next election and a dummy for countries that maintained fixed peg regimes (to capture the effect under these exchange rate regimes); and (iii) the time remaining to the next election in years for all regimes (to assess the effect under flexible regimes).20 In the presence of intertemporal free-riding, there would be a negative relationship between fiscal stance and proximity to election for all countries with fixed exchange rates, including the ECCU, and no such relationship for countries with flexible regimes.
25. Regional free-riding is proxied by the level of official foreign reserves relative to base money under different exchange rate regimes. While countries not belonging to the ECCU have access to external reserves at their central banks only, each ECCU country has access to the entire pool of foreign reserves at the ECCB. Two variables are used in the regression to explore the impact of all exchange rate regimes on regional free-riding: (i) the product of a dummy for all ECCU countries and the level of foreign reserves at the ECCB (as a percent of reserve money) that captures the effect under the CBA; and (ii) the level of foreign reserves under each of the other exchange rate regimes. In the presence of regional free-riding, the increase in foreign reserves at the ECCB would induce fiscal slippages, resulting in a worsening of fiscal balances in ECCU countries. In the non-ECCU countries, foreign reserves are not expected to have a negative bearing on fiscal stances.
26. The relative size of a member country, reflecting its systemic importance in the ECCU, is used as an alternative proxy for regional free-riding. The relationship between this proxy and fiscal stance is ambiguous however. On the one hand, the more systemically important a country becomes, the greater could be the perceived prospects of being bailed out by the ECCB to maintain the stability of the CBA.21 One the other hand, the expectation of being bailed out could be seen to be higher if a country is small, since the associated costs are relatively small.
Results
27. Estimation results indicate that fiscal policies in the ECCU are significantly influenced by intertemporal free-riding, unlike countries with flexible regimes (Table IV.3).22 For the ECCU countries, fiscal stances worsen with closeness to the election period, reflecting that the cost of fiscal expansion is deferred to the future.23 This behavior is not observed for all exchange rate regimes, reflecting that the immediate inflationary consequences of fiscal expansion under flexible exchange rate regimes deters free-riding. The bottom panel of Table IV.3 shows that the total effect of intertemporal free-riding under the ECCU (given by the sum of the coefficients of (1) and (2)) is statistically significant.
Determinants of Fiscal Policy in the Caribbean, 1983-2003
Each coefficient represents the impact of a change in a given explanatory variable on the fiscal stance. The parentheses contain probability values. Results that are statistically significant at 5 percent and 10 percent are marked by “**” and “*” respectively.
Determinants of Fiscal Policy in the Caribbean, 1983-2003
| Fixed Effect Regression (Dependent Variable: Primary Fiscal Balance) Explanatory Variables |
Coefficients1/ |
|---|---|
| (1) Proximity to election (number of years to election) | 0.266 |
| (0.275) | |
| (2) Inter-temporal free-riding in the ECCU: Dummy for ECCU * proximity to election | -0.750 |
| (0.025)* | |
| (3) Inter-temporal free-riding under fixed peg regimes: Dummy for unilateral fixed peg | -0.078 |
| regimes * proximity to election | (0.843) |
| (4) Official foreign reserves (relative to reserve money) | 0.010 |
| (0.267) | |
| (5) Regional free-riding: Dummy for ECCU * official foreign reserves (relative to reserve | -0.103 |
| money) | (0.012)* |
| (6) Regional free-riding: Dummy for ECCU * relative country size in ECCU | -1.032 |
| (0.007)** | |
| (7) Real GDP growth | 0.120 |
| (0.085)* | |
| (8) Terms of trade | -0.004 |
| (0.836) | |
| (9) Trade openness | 0.010 |
| (0.509) | |
| (10) Dummy for IMF program | 1.230 |
| (0.094)* | |
| Number of observations | 272 |
| R-squared | 0.31 |
| Significance of the regression: F (29, 228) | 3.48** |
| Hypothesis Tests | |
| (i) Hypothesis: Total impact of intertemporal free-riding in the ECCU is insignificant: coefficient (1) + coefficient (2) = 0; value = 0.48, F (1, 228) = 4.60** | Rejected |
| (ii) Hypothesis: Total impact of regional free-riding (proxied by foreign reserves at the ECCB) in the ECCU is insignificant: coefficient (4) + coefficient (5) = 0; value = -0.093, F (1, 228) = 5.53** | Rejected |
| (iii) Hypothesis: Total impact of years after 1997 in deteriorating fiscal stance in the Caribbean is insignificant: value = -17.76, F (1, 228) = 6.49** | Rejected |
Each coefficient represents the impact of a change in a given explanatory variable on the fiscal stance. The parentheses contain probability values. Results that are statistically significant at 5 percent and 10 percent are marked by “**” and “*” respectively.
Determinants of Fiscal Policy in the Caribbean, 1983-2003
| Fixed Effect Regression (Dependent Variable: Primary Fiscal Balance) Explanatory Variables |
Coefficients1/ |
|---|---|
| (1) Proximity to election (number of years to election) | 0.266 |
| (0.275) | |
| (2) Inter-temporal free-riding in the ECCU: Dummy for ECCU * proximity to election | -0.750 |
| (0.025)* | |
| (3) Inter-temporal free-riding under fixed peg regimes: Dummy for unilateral fixed peg | -0.078 |
| regimes * proximity to election | (0.843) |
| (4) Official foreign reserves (relative to reserve money) | 0.010 |
| (0.267) | |
| (5) Regional free-riding: Dummy for ECCU * official foreign reserves (relative to reserve | -0.103 |
| money) | (0.012)* |
| (6) Regional free-riding: Dummy for ECCU * relative country size in ECCU | -1.032 |
| (0.007)** | |
| (7) Real GDP growth | 0.120 |
| (0.085)* | |
| (8) Terms of trade | -0.004 |
| (0.836) | |
| (9) Trade openness | 0.010 |
| (0.509) | |
| (10) Dummy for IMF program | 1.230 |
| (0.094)* | |
| Number of observations | 272 |
| R-squared | 0.31 |
| Significance of the regression: F (29, 228) | 3.48** |
| Hypothesis Tests | |
| (i) Hypothesis: Total impact of intertemporal free-riding in the ECCU is insignificant: coefficient (1) + coefficient (2) = 0; value = 0.48, F (1, 228) = 4.60** | Rejected |
| (ii) Hypothesis: Total impact of regional free-riding (proxied by foreign reserves at the ECCB) in the ECCU is insignificant: coefficient (4) + coefficient (5) = 0; value = -0.093, F (1, 228) = 5.53** | Rejected |
| (iii) Hypothesis: Total impact of years after 1997 in deteriorating fiscal stance in the Caribbean is insignificant: value = -17.76, F (1, 228) = 6.49** | Rejected |
Each coefficient represents the impact of a change in a given explanatory variable on the fiscal stance. The parentheses contain probability values. Results that are statistically significant at 5 percent and 10 percent are marked by “**” and “*” respectively.
28. Fiscal policies under the ECCU are also affected by regional free-riding. Fiscal stances of the ECCU countries worsen with an increase in foreign reserves at the ECCB, consistent with the expectation of being bailed out rising with an increase in the reserve coverage at the ECCB. This effect is not observed for countries in the sample with other exchange rate regimes. The bottom panel of Table IV.3 shows that the total effect of this regional free-riding variable under the ECCU (given by the sum of the coefficients of (4) and (5)) is statistically significant.
29. The proxy for regional free-riding shows that fiscal stances worsen as the relative size of a member country in the ECCU rises, confirming that countries’ expectation of being bailed out rises with the increase in their systemic importance within the union.
30. The Caribbean countries—including the ECCU—also appear to have pursued countercyclical fiscal policies during the period under consideration. In other words, the worsening of fiscal stances in the ECCU during the 1990s also reflected adoption of expansionary fiscal policies in response to the growth slowdown.
31. Finally, the results confirm that fiscal policies in the Caribbean—including the ECCU countries—deteriorated significantly since the late-1990s. The hypothesis test at the bottom panel of Table IV.3 confirms the joint significance of the years after 1997 in adversely affecting fiscal stances. A possible explanation could be that with innovations in financial markets, Caribbean countries had better access to external financing, which exacerbated their fiscal positions.
32. To uncover the specific components of the fiscal balances in the ECCU that are more responsive to free-riding indicators, the regressions are re-estimated for just the ECCU countries. Table IV.4 reports the regression results using primary fiscal balance, primary spending and fiscal revenue (in percent of GDP) as alternative proxies for fiscal stance. The results indicate that fiscal primary spending increases with proximity to the election year (intertemporal free-riding), increases in relative size of the country in the ECCU (regional free-riding), and increases with the decline in real GDP growth (counter-cyclical fiscal behavior). Fiscal spending in the ECCU also increased with natural disaster shocks in 1992 and 1995.24 However, primary spending is not significantly affected by the increase in reserve coverage at the ECCB. Fiscal revenues fall with the increase in reserve coverage at the ECCB, implying that greater reserve coverage at the ECCB induces regional free-riding through an increase in governments’ laxity in generating fiscal revenues. Fiscal revenue is also negatively related to real GDP growth, possibly reflecting the fact that governments’ efforts to increase fiscal revenues suffer a setback during good growth years.25
Determinants of Fiscal Policy in the ECCU, 1983-2003
Determinants of Fiscal Policy in the ECCU, 1983-2003
| Dependent Variable | |||
|---|---|---|---|
| Fixed effect regression Explanatory variables |
(I)Primary balance |
(II)Primary expenditure |
(III)Fiscal revenue |
| (1)Inter-temporal free-riding: closeness to election year | -0.551 | 0.484 | -0.067 |
| (0.020)** | (0.063)* | (0.802) | |
| (2)Regional free-riding: Official foreign reserves (relative to | -0.111 | -0.089 | -0.200 |
| reserve money) at the ECCB | (0.048)* | (0.147) | (0.002)** |
| (3)Relative country size in ECCU | -1.236 | 3.438 | 2.220 |
| (0.003)** | (0.000)** | (0.000)** | |
| (4)Real GDP growth | 0.038 | -0.363 | -0.325 |
| (0.742) | (0.006)** | (0.016)** | |
| (5)Terms of trade | 0.049 | -0.019 | -0.597 |
| (0.169) | (0.007)** | (0.146) | |
| (6)Trade openness | 0.021 | 0.037 | 0.058 |
| (0.438) | (0.205) | (0.058)* | |
| (7)Hurricane Luis, Antigua and Barbuda, 1995 | -6.691 | 8.479 | 1.788 |
| (0.077)* | (0.043)* | (0.676) | |
| (8)Floods, St. Vincent and the Grenadines, 1992 | -7.800 | 9.100 | 1.300 |
| (0.024)** | (0.017)** | (0.738) | |
| Number of observations | 118 | 118 | 118 |
| Number of countries | 6 | 6 | 6 |
| R-squared | 0.56 | 0.61 | 0.48 |
| Significance of the entire regression F (26,86) | 4.22** | 5.11** | 3.01** |
| Significance of years after 1997 in deteriorating fiscal stance, F (l,86) | 5.55** | 3.46* | 0.07 |
Determinants of Fiscal Policy in the ECCU, 1983-2003
| Dependent Variable | |||
|---|---|---|---|
| Fixed effect regression Explanatory variables |
(I)Primary balance |
(II)Primary expenditure |
(III)Fiscal revenue |
| (1)Inter-temporal free-riding: closeness to election year | -0.551 | 0.484 | -0.067 |
| (0.020)** | (0.063)* | (0.802) | |
| (2)Regional free-riding: Official foreign reserves (relative to | -0.111 | -0.089 | -0.200 |
| reserve money) at the ECCB | (0.048)* | (0.147) | (0.002)** |
| (3)Relative country size in ECCU | -1.236 | 3.438 | 2.220 |
| (0.003)** | (0.000)** | (0.000)** | |
| (4)Real GDP growth | 0.038 | -0.363 | -0.325 |
| (0.742) | (0.006)** | (0.016)** | |
| (5)Terms of trade | 0.049 | -0.019 | -0.597 |
| (0.169) | (0.007)** | (0.146) | |
| (6)Trade openness | 0.021 | 0.037 | 0.058 |
| (0.438) | (0.205) | (0.058)* | |
| (7)Hurricane Luis, Antigua and Barbuda, 1995 | -6.691 | 8.479 | 1.788 |
| (0.077)* | (0.043)* | (0.676) | |
| (8)Floods, St. Vincent and the Grenadines, 1992 | -7.800 | 9.100 | 1.300 |
| (0.024)** | (0.017)** | (0.738) | |
| Number of observations | 118 | 118 | 118 |
| Number of countries | 6 | 6 | 6 |
| R-squared | 0.56 | 0.61 | 0.48 |
| Significance of the entire regression F (26,86) | 4.22** | 5.11** | 3.01** |
| Significance of years after 1997 in deteriorating fiscal stance, F (l,86) | 5.55** | 3.46* | 0.07 |
Robustness
33. Robustness tests by including additional explanatory variables in the regressions confirm the existence of regional and intertemporal free riding. These included: (i) total private sector capital flows from industrial countries to emerging market economies (to assess whether the evolution of fiscal stances was a mere reflection of greater availability of external financing); (ii) world oil prices (to analyze the impact of oil price shocks on the fiscal stance); (iii) world interest rates (proxied by the three-month U.S. treasury bill rate, to see whether world monetary conditions affected capital flows to the region); and (iv) real GDP per capita (to proxy for the level of institutional development). These variables did not have any systematic or significant influence on fiscal policy, and did not affect the significance of the proxies for free-riding in the original regression. They were eventually dropped from the regression.
34. Finally, the estimation results were also tested for structural breaks and none were found. A Chow (1960) test was performed to identify structural breaks in fiscal policy stance during the mid-1990s and was rejected at the 5 percent level of significance. This result supports the view that moral hazard behavior was always present in the fiscal stances of ECCU countries, and was not a result of any major structural change in fiscal policies in the last decade.
E. Conclusion
35. Fiscal policies in ECCU countries became more expansionary over time and in comparison with other Caribbean countries. Primary balances in ECCU countries have been persistently deteriorating since the early 1990s—reflecting rapid expenditure growth and sluggish revenues—and actual fiscal outcomes have progressively diverged from the fiscal guidelines established by the ECCB’s Monetary Council in 1998. In a sample of 15 Caribbean countries during 1990–2003, the fiscal imbalances of ECCU countries were the highest, followed by countries with fixed peg regimes. Countries with more flexible regimes were the best fiscal performers.
36. This chapter found evidence in support of the presence of free-riding fiscal behavior by ECCU member countries. Contrary to the expectation that the regional CBA would restrain fiscal slippages of union members, fiscal discipline appears to have weakened given the scope for free-riding on member countries and over time. Specifically, the costs of fiscal overspending are spread across time (intertemporally) given the fixity of the exchange rate regime, and across space (regionally) to member countries, given the currency union. Expansionary fiscal policies are also reflected in a negative relationship between fiscal revenues-to-GDP and real GDP growth—indicating insufficient efforts to generate revenue in periods of high growth—although fiscal spending is countercyclical.
37. These findings underscore the need to ensure the consistency of fiscal policies with the regional CBA. Possible options include improving the effectiveness of the Monetary Council’s fiscal guidelines by enforcing them at the regional or national levels. Further analysis is needed to find effective incentive mechanisms that discipline individual country behavior and would support the stability of the CBA. Regional free-riding could be discouraged by clearly demonstrating that the ECCB will not bailout members—either directly by financing fiscal deficits, or indirectly by bailing out banking systems in individual countries. In this regard, the current practice by the ECCB of not bailing out governments facing intermittent debt servicing problems (as in Antigua and Barbuda during several years and Dominica in 2002) has helped establish the credibility of the ECCB. Finally, consideration should also be given to whether more fiscal policy coordination at the regional level—for example, by adopting a common approach towards eliminating costly fiscal incentives to investors, or allowing greater transmission of world oil price changes to domestic prices—would help attain greater fiscal discipline in the region.
ANNEX: Data Sources
Fiscal stance proxies.(i) Primary balance divided by nominal GDP: For the ECCU countries, data for primary balance and GDP during 1983–1990 was obtained from the Eastern Caribbean Central Bank (ECCB), while data after 1990 was obtained from IMF, Western Hemisphere Department. For the non-ECCU countries data was obtained from the IMF’s World Economic Outlook (WEO) (series GCBXI for primary balance, and series NGDP for nominal GDP). For Haiti, in the absence of data on primary balance, fiscal stance was proxied by overall balance (WEO, series GGB). (ii) Primary expenditure, divided by nominal GDP: For the ECCU countries, the primary expenditure series before 1990 was obtained from the ECCB, while that after 1990 was from the Western Hemisphere Department, desk data. For the non-ECCU countries, the data was obtained from WEO (series GCENL).
De facto exchange rate regime. Reinhart-Rogoff (2002) classification of exchange rate regimes and the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions, various issues.
Gross domestic product. For ECCU countries from IMF, Western Hemisphere Department. For the rest of the Caribbean countries from WEO (series W_NGDP_R).
Election dates. From Database of Political Institutions, World Bank.
ECCB foreign reserves coverage was measured by the ratio of foreign assets at the ECCB in terms of reserve money (lines 1L. DZF and 14…ZF in IMF’s International Financial Statistics, IFS). Nominal exchange rate between EC$ and US$ (series AE.ZF in IFS) was used to convert foreign assets of the ECCB in US$ to that in EC$.
Terms of trade. WEO, Series W_TT.
Openness. Defined as the sum of exports and imports of goods and services, divided by nominal gross domestic product. For ECCU countries, these series were obtained from the IFS, series codes 90C..ZF… (exports), 98C..ZF… (imports) and 99B..ZF… (nominal GDP). For rest of Caribbean, the series were obtained from WEO: WEO W_NX (exports), W_NM (imports) and W_NGDP (nominal GDP).
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Prepared by Rupa Duttagupta and Guillermo Tolosa.
Besides the ECCU, the only other currently operating currency union with a fixed exchange rate regime is the CFA franc zone, which comprises the West African Economic and Monetary Union (WAEMU) and the Central African Economic and Monetary Union (CEMAC). The Euro Area, while also representing a currency union, is different from the ECCU and the CFA zone in that the common currency in the union freely floats against all other major international currencies.
The sample comprises the ECCU6—Antigua and Barbuda, Dominica, Grenada, St. Lucia, St. Kitts and Nevis, and St. Vincent and Grenadines—and 9 other Caribbean countries including, The Bahamas, Barbados, Belize, Dominican Republic, Guyana, Haiti, Jamaica, Suriname, and Trinidad and Tobago.
See Duttagupta and Tolosa (2005) for the detailed algebraic analysis.
Abstracting from relative prices, inflation and devaluation are equivalent. In addition, a jump in the price level is also considered inflation for the purposes at hand.
The beneficial effects of inflation on public accounts are twofold: Tornell and Velasco (2000) stress the seignorage deriving from the devaluation, while Chari and Kehoe (2004) stress the deflation of debt in domestic currency.
Reinhart (2002) finds that 85 percent of all debt crises are accompanied by currency crises.
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 controls, are not considered here.
Intertemporal free-riding is also linked with the cost of realignment of the peg—the higher the cost, the lower the probability of free-riding intertemporally (see Sun, 2003).
Henceforth, the quasi-currency board arrangement will be referred to as the CBA for the sake of simplicity.
However, the existence of fiscal rules per se may not be enough to induce fiscal discipline (as confirmed by the recent experience in the Euro Area).
In the sample of 15 countries, the ECCU countries maintained a regional currency board, while The Bahamas, Barbados and Belize maintained conventional fixed peg regimes through out the sample period. Other countries maintained a variety of exchange rate regimes during the sample period, including floats and intermediate exchange rate regimes.
Sahay (2005) analyzes the public debt dynamics of a sample of 15 Caribbean countries and finds that the ECCU countries are among the highest for emerging market economies. In addition, most of the increase in public debt is accounted for by a deterioration in primary balances.
See Kaminsky et al. (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.
Data for institutional variables that are usually cited in the literature—for example, 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 (von Hagen and Harden, 1996)—are very poor for the Caribbean.
The data sources of all the indicators are documented in the Annex.
Note however, the correlation between primary balance and proximity to elections for fixed peg regimes, while expected to be negative, is negligible.
The group of fixed peg regimes comprises countries which maintained fixed pegs during the entire sample period, with negligible adjustment in the exchange rate level (i.e., less than 1 percent). While it would also be interesting to single out the effect of pure floating regimes on fiscal policy, no country maintained a float during the entire sample period.
See Wildasin (1997) for a similar argument. For instance, the countries that violated the Stability and Growth Pact in Europe were its largest members, France and Germany.
To avoid endogeneity between some of the right-hand side explanatory variables (real GDP growth, trade openness, foreign reserves) with the primary balance, one-year lagged values of the explanatory variables are used.
While the same result also holds for countries with fixed peg regimes, the effect is not statistically significant.
The data for natural disasters were taken from Rasmussen (2004). To save degrees of freedom, each dummy was added individually to the regression (in Column II), and accepted only if its coefficient was significant at the 10 percent level.
This result also supports the perception that the sectors responsible for high growth in the region (e.g., tourism) are under taxed, resulting in sluggish fiscal revenue growth even in times of robust economic recovery.
