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.

VII. Integration and Growth in the Eastern Caribbean1

A. Introduction

1. This chapter explores the extent and effects of regional and international integration of the ECCU countries.2 It reviews their basic integration strategy, achievements, and shortcomings. It focuses on various aspects of integration to show how, despite being fairly open economies, the ECCU countries are not fully integrated into the global economy. The chapter then explores empirically the contribution of integration to growth in the ECCU.

2. ECCU countries have developed behind a wall of high protection, combined with significant product and factor market rigidities. While this helped increase intra-regional trade to a limited extent, real income growth has significantly slowed in the past six years. The ECCU countries have developed uncompetitive production structures, and real wages have tended to increase more than productivity growth. The chapter draws on various aspects of the literature—with particular emphasis on factor market integration—to address one of the major policy challenges facing ECCU countries. The chapter takes a broad view of integration to encompass many aspects of liberalization of trade in goods and services and of factor markets, through regional and multilateral integration arrangements.

B. The Integration and Growth Literature

Traditional approach

3. There is general agreement among mainstream economists that international trade promotes growth and development. The general consensus can be characterized as follows. International trade leads to higher growth by reallocating scarce resources to those sectors in which a country has a comparative advantage, thereby increasing output and income levels through gains from specialization. Measures to improve trade, such as integration at the regional and international level, can, therefore, be expected to raise growth rates.

4. According to Haveman et al. (2001), there are three channels to increase growth through integration and trade. First, integration increases communication, thereby facilitating the transmission of technology. Second, integration leads to an increase in the size of the market, thus increasing gains from economies of scale. Finally, greater competition promotes research and development activities. Moreover, knowledge spillovers, which reduce duplication of research and development activities, are an increasing function of the volume of trade between countries.

5. Among others, Sachs and Warner (1995) document that trade and integration are major determinants of growth in poor countries. Using cross-country indicators of trade openness for over 100 developed and developing countries over a long period of time (about 40 years), and controlling for other policy variables, they show that the lack of economic convergence in income levels in most developing countries is explained by a closed trade regime. They also show that open economies usually successfully avoid balance of payments crises.

Recent developments and critique of the traditional approach

6. Much of the debate in recent years has been on whether the mere presence of trade, absent other factors, is a key ingredient in promoting growth. Recent literature (Frankel and Romer, 1999; Dollar and Kraay, 2004) focus on problems related to the potential endogeneity of trade and integration with other growth-raising reforms. They note that countries with liberal trade policies are likely to be those with other growth-inducing policies, such as those that promote physical and capital accumulation, as well as technological change. To counter the critique, these authors have attempted to use instrumental variables techniques to test whether trade by itself leads to higher growth or not.

7. The research on liberalization of trade in services has generally been less successful in demonstrating potential benefits of liberalization on growth. In a review of the literature on the subject, Whalley (2003) concludes that the studies are confusing and sometimes contradictory, and often fraught with serious methodological problems. Trade in services is typically subject to greater barriers than trade in goods—these include rights of establishment, rules of conduct, and competition rules. Whalley concludes that studies that typically find a strong impact on income and welfare suffer from biases resulting from misspecification of models. Models that assume no accompanying liberalization of factor markets typically find a weak impact on income and welfare. On the other hand, if liberalization of services extends to removing impediments to factor flows, especially foreign direct investment, then gains are usually large, but also uneven across countries.

8. In a fundamental critique of the trade and growth literature, Rodrik et al. (2004) argue that giving the “integration view” a central role in fostering economic convergence between poor and rich countries is erroneous. They argue that this approach focuses on superficial determinants of growth. In their view, it is necessary to answer the question why some societies manage to accumulate and innovate more rapidly than others. They organize their approach by looking at what they consider to be “deeper” determinants of growth. According to them, the three key ingredients (using various measures) are geography, integration, and institutions. In contrast to most of the prevailing literature, they find that the quality of institutions “trumps everything else.” They show that once institutions are controlled for, integration has no direct effect on incomes, while geography has at best weak direct effects. Their measure of institutional quality—property rights and the rule of law—is statistically significant, and their results are very robust to various statistical tests, including endogeneity between institutions and integration.3

Application to the ECCU

9. Regional integration, by promoting transparency and nondiscriminatory practices, can promote good institutions. Although Rodrik et al. (2004) are quick to point out that their study does not offer clear policy implications, it can be argued that good institutions, both local and regional, can help foster regional integration and growth. What does the literature tell us about the merits of pursuing regional integration, as a way of promoting trade, investment and growth, and good institution building. Does regional integration indeed lead to more trade in general? What about the evidence for the CARICOM region and the ECCU?

10. From a theoretical perspective, the economic effects of integration in the form of a trading bloc are, in fact, ambiguous, and can lead to trade diversion. Gunning (2002) shows that in a South-South trading bloc, poorer members will typically suffer from the loss of revenue, and may well see a shift in the concentration of production in the richer, more industrialized members. Richer members benefit from protection from imports from the rest of the world through a common external tariff (CET). A simple diagrammatic presentation from Gunning (2002) illustrates this point (see the Appendix).

11. Regional trading arrangements (RTAs) may well be the best way forward in as far as liberalization of services is concerned, according to Stephenson (2002). This has less to do with the intrinsic merits of RTAs, and more to do with the weaknesses of the General Agreement on Trade in Services (GATS). She shows that RTA agreements in services, including those of CARICOM, have surpassed those of the GATS in terms of delivering promotion of transparency and stability of agreements. While the GATS has a positive list approach for services to be liberalized, RTAs typically assume that all services will be liberalized with some exceptions (negative list). RTAs also usually have an explicit clause precluding the introduction of any new restrictions on services trade. She concludes that although in general the optimum level of liberalization is at the multilateral level in order to attract and accommodate investment from the most efficient service operators, the regional level may well be the most appropriate and realistic, given the practical limitations.

12. Most South-South RTAs have been found empirically to promote trade. Using a gravity model, Cernat (2003) shows empirically that RTAs are generally trade creating, with little trade diversion. For CARICOM, Egoumé-Bossogo and Mendis (2002)—also using the gravity model framework for the period 1980–99—find that CARICOM has promoted intra-CARICOM trade, as well as trade with the rest of the world. In other words, they find little evidence of trade diversion within CARICOM.

C. The ECCU Experience with Regional Integration and Growth

Objectives of regional integration in the Caribbean 4

13. Regional integration in CARICOM was initially viewed as a way to facilitate import substitution and industrialization at the regional level, after national opportunities were exhausted. Since the size of individual domestic markets was a major constraint to production (Demas, 1965, 1974), early efforts at integration focused on market integration—removing impediments to regional trade of manufactured and agricultural goods and widening the protected domestic market. The initially-high common external tariff (70 percent) was a deliberate effort to divert trade from third countries, since none of the CARICOM member countries would have been the least-cost producer of manufactured goods. The high tariffs were expected to have a secondary effect of encouraging FDI flows, as firms from third countries would establish branches behind the tariff walls to try to retain their markets. A second objective of regional integration was to exploit complementarities in the resources of the region through production integration (Brewster and Thomas, 1973; Blake, 1984).

14. Joint trade negotiations aimed at increasing bargaining power and therefore raising the terms of trade, while at the same time, CARICOM intended to pursue the provision of common services to benefit from scale economies (Demas, 1974). Andriamananjara and Schiff (1998), using theoretical analysis of bargaining power and high fixed costs of negotiating, have argued that CARICOM has been exceptionally successful in enhancing its bargaining power beyond its size and economic importance by concluding agreements such as the Lomé Convention, CBI, and CARIBCAN. The Lomé Convention and the successor Cotonou Agreement conferred higher export prices for Caribbean products. Similarly, high fixed costs of production have been used to justify the provision of common social services like tertiary education and some health services in CARICOM.

15. The ECCU countries participate in a series of concentric integration initiatives that cover a variety of areas (Box VII.1). The membership in the ECCU is almost identical to that of the Organization of Eastern Caribbean States (OECS), with the latter including the British Virgin Islands. All of the countries are members of CARICOM, a wider regional integration movement among the former British colonies in the Caribbean, along with Suriname and Haiti. The CARICOM countries are negotiating jointly for entry into the Free Trade of the Americas (FTAA), via the regional negotiating machinery (RNM). Similarly, the RNM is negotiating an economic partnership agreement with the European Union (EU) as part of the broader negotiations with the African, Caribbean, and Pacific countries (ACP) for a successor to the Cotonou Agreement. All of this takes place against the background of global liberalization under the auspices of the WTO.

Recent developments in implementing stated objectives of integration

16. CARICOM does not have a good record of implementing the stated objectives. There has been some success in eliminating tariffs on goods originating within the region, reducing the level of the common external tariff, joint international negotiations, and the provision of common services. However, many of the initiatives remain on the books and are not yet implemented, such as rights of establishment, the free movement of capital, a regime for free trade in services, and a common currency (CARICOM, 2004). Meanwhile, free movement of labor is restricted to some very restrictive categories, such as university graduates, artists, and media workers. This has precluded firms from obtaining factors of production from lower-cost sources, especially in areas where there is a shortage of skills.

17. To address shortcomings, the original CARICOM treaty was amended by a series of protocols starting in the mid-1990s, but key limitations to integration remain. There are nine protocols, of which the most important deal with organizational structure and administration to help speed up implementation of decisions, rights of establishment and free movement of capital, competition policy, industrial policy, and disadvantaged regions. The full implementation of these protocols as well as the completion of the program for reducing the common external tariff from 5–45 percent to a range of 0–20 percent is scheduled for 2005 in the context of introducing the CARICOM Single Market and Economy (CSME) (see Table VII.1). Free movement of labor would still be confined to limited categories of workers, which have been expanded to include service providers who have to relocate to trade their services.

Preferential Trade Arrangements in Which ECCU Countries Participate

The ECCU countries participate in a series of concentric and sometimes overlapping trading arrangements, which accord them varying degrees of trade preferences (Figure VII.1). These agreements co-exist with the negotiations under the WTO for multilateral trade liberalization. The following is a brief description of the major preferential trading agreements of the ECCU countries.

The Organization of Eastern Caribbean States (OECS) is the tightest integration grouping of the ECCU. Created in 1981, it includes all 8 members of the ECCU and the British Virgin Islands. The major goals are promoting economic integration, managing a common currency via the ECCB, setting up a common judicial system via a joint supreme court, coordinating civil aviation activities and telecommunication services, and maintaining joint overseas missions. Discussions are underway for creating an economic union by 2006 with free movement of labor.

The Caribbean Community (CARICOM), established in 1973, originally included only English-speaking Caribbean countries, but was recently expanded to include Suriname and Haiti. It is essentially a common market for goods and capital, but without free movement of labor. It also provides a framework for common services in education, health, meteorology, and foreign policy. Goods originating within the region are generally (there are only a few exceptions) traded duty free. Although a common external tariff (CET) was established in 1975 with a maximum rate of 70 percent, it has not been fully harmonized because of delays in implementation. In 1993, the countries agreed on a three-year program to reduce the CET to the range of 0–20 percent, but to date some members have not fully complied. The integration process is marred by slow implementation of decisions, because there is no effective sanctioning mechanism (Girvan, 2004).

The 1973 Lomé Convention between the European Union (EU) and the African Caribbean and Pacific (ACP) countries, provided one-sided duty-free access into EU markets for goods which meet the rules of origin. The import of bananas, rice and sugar were governed by protocols, which conferred higher than world market prices for these products in line with the EU’s Common Agricultural Policy. Thus for the ECCU, Dominica, Grenada, St. Lucia, and St. Vincent and the Grenadines benefited from higher banana prices and St. Kitts and Nevis from higher sugar prices. Latin American banana producers successfully challenged the banana regime under the WTO, which has resulted in reforms that reduced the level of protection. A similar challenge to the sugar regime was upheld by the WTO in 2004. The Cotonou Agreement (2000) updated the Lomé Convention to be consistent with WTO policies, but the commodity protocols will continue, subject to periodic review. Negotiations are continuing for the eventual creation of reciprocal economic partnerships, which include reverse reciprocity of any preferences extended to third countries.

The Caribbean Basin Initiative (CBI), which began in 1984, also offers nonreciprocal duty-free access of some goods to the United States that meet the rules of origin and some other criteria. The CBI has not been as beneficial as Lomé, because of the initially narrow range of goods and the advent of NAFTA which later eroded the preferences. The list of goods was expanded in 2000 for 8 years, and this has partially reversed the erosion.

The benefits of CARIBCAN—which provides nonreciprocal duty-free access into Canada—are also constrained by the range of goods, uncertainty of duration, and NAFTA. The Free Trade Area of the Americas (FTAA) agreement, under negotiation, will allow all countries in the Western Hemisphere (excluding Cuba) to trade freely in goods and services. The ECCU countries have argued for special and differential treatment, in order to reduce the adjustment costs.

Table VII.1:

Status of Implementation of Key Elements of the CARICOM Single Market and Economy 1/

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Source: CARICOM Secretariat website: www.caricom.org

CARICOM consist of 15 member countries, Antigua and Barbuda, Barbados, Belize, The Bahamas, Dominica, Grenada, Guyana, Haiti, Montserrat, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, Suriname and Trinidad and Tobago, but the revised Treaty does not apply to The Bahamas, Haiti, and Montserrat. Montserrat is awaiting entrustment from the U.K. and has been granted a two- year derogation on implementation.

Quantification of indicators of integration

Trade in goods

18. Regional integration resulted in the expansion of intra-regional trade in the early years. Intra-regional trade expanded rapidly during the late 1970s up to the early 1980s, and then declined significantly following the collapse of the CARICOM Multilateral Clearing Facility in 1981.5 Although the clearing facility was never revived, trade recovered during the 1990s as payment arrangements improved and foreign exchange constraints were relaxed. As noted earlier, Egoumé-Bossogo and Mendis (2002) showed that tariff reductions, although still incomplete (Table VII.2), in the context of regional integration had a positive impact on total and intra-regional trade in the 1990s. By contrast, membership of the WTO has had a negative impact on the total trade of the region, largely through the dismantling of preferential trading arrangements for banana and sugar exports. This evidence provides mixed reaction to integration—one positive and one negative—but this could be related to slow progress and short-run adjustment costs of dismantling protective trading arrangements.

Table VII.2.

Implementation of Tariff Reductions in CARICOM 1/

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Sources: CARICOM Secretariat; Itam et al 2000.

The Common external tariff has a special rate of 40 percent for selected agricultural products.

Belize was allowed to implement the schedule reductions with a two-year lag.

Haiti became a member of CARICOM in 2002.

Jamaica opted for an accelerated implementation schedule.

Suriname joined CARICOM in 1996.

19. The expansion of intra-regional trade within CARICOM also resulted in some diversification of the region’s production base. Petroleum products constitute about a third of intra-regional trade and hence dominate trade flows. Of the non-oil trade, processed food and agricultural products, which are the most protected, have the largest share, followed by manufactured products. The concentration of non-oil intra-regional trade on import substitution activities would seem to suggest more trade diversion, and would likely result in incentives that go against global integration (Krueger, 1999).

20. Intra-regional capital flows have been facilitated mainly through Trinidad-based financial groups, and, to a lesser extent, through cross-listing on the national stock exchanges. Trinidadian financial institutions have engaged in regional financial intermediation, mobilizing significant financial resources across the region through their insurance and investment arms, as well as recycling oil surpluses to finance significant investments in these economies.

Trinidad and Tobago: Geographic Exposure of Financial System Loans and Investments

(As of December 2004) 1/

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Source: Central Bank of Trinidad and Tobago (CBTT).

Geographical allocation of equity, loans and investment portfolio of commercial, merchant and investment banks, finance companies and trusts licensed by CBTT.

21. While the CARICOM integration initiative has increased intra-regional trade in goods, its impact on ECCU countries has been disappointing, particularly during the 1990s. During 1991–2003, the level of total exports of goods of ECCU countries remained virtually unchanged in nominal terms (Table VII.3), in part due to the increasing international competition in two key export products, bananas and sugar. At the same time, the available evidence seems to suggest the growth of trade-diverting integration as intra-ECCU exports increased from 9 to 17 percent of total exports.

Table VII.3.

Share of Exports of Goods of OECS Countries

(In millions of U.S. dollars)

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Source: IMF Direction of Trade Statistics.

In percent.

Product market restrictions

22. Apart from the common external tariff (CET), major product market distortions in the ECCU arise from the presence of nontariff barriers, monopolies, and state-owned enterprises. Some nontariff barriers have been retained in an effort to minimize the short-run impact on real income and unemployment, which would otherwise result from the closure of less efficient domestic firms.6 The special regime for the ECCU countries and Belize has also fostered inefficiencies and distortions.7 While most utilities are provided by monopolies, the telecommunications sector is currently being liberalized on a regional basis.8 A number of products, including basic food products and fuel, are imported by state-owned or state-licensed monopolies. The participation of the public sector in the economy varies across the countries and is most widespread in St. Kitts and Nevis where the sugar industry, electricity, and import of some basic foods are controlled by public enterprises, in addition to public sector participation in banking and telecommunications. As a result, there is some evidence that the average level of product mark-up and prices is quite high in the ECCU. While there is no data available for the ECCU countries, given their similarities with Barbados (McLean, 1981), a mark-up of 33–45 percent in the distributive sector seems likely.

Financial market segmentation in the ECCU

23. Despite sharing a common currency for most of their recent history, monetary and financial integration is far from complete. Legal and regulatory restrictions that deter the free flow of capital have led to fragmentation of the financial sector, as evidenced by large interest rate differentials between the countries (Table VII.4). Regulatory barriers like Alien Land Holding licenses and differential tax polices such as withholding taxes on nonresidents, as well as limits to the enforceability of contracts across territories, have essentially created a collection of mini financial systems within the currency union (World Bank, 1998). Prime lending rates can differ by more than 300 basis points, with greater variance between other lending rates. Such differentials in interest rates as well as asymmetric liquidity across countries and institutions imply that financial resources are not efficiently utilized, thereby dampening growth potential.

Table VII.4.

Interest Rates in Selected OECS Countries, end-2003

(In percent)

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Source: Eastern Caribbean Central Bank.

24. The fragmentation of the financial system results in higher operating costs because of the absence of economies of scale, and it also diminishes the capacity of the financial system to help spread risks. The Eastern Caribbean Central Bank has, in recent years, created a number of regional institutions to reduce the fragmentation of the financial system. A regional government securities market (RGSM) has been established to facilitate the issuance and secondary market trading in government securities, as well as an over-the-counter exchange for equities (Eastern Caribbean Securities Exchange). However, the government securities market still does not cover all territories (Antigua and Barbuda and Dominica have not met the criteria), and only 5 of a possible 30 public companies are listed on the stock exchange.

25. The external capital account has been progressively liberalized. Current transactions were free of restrictions since the 1970s, and an already liberal regime of capital controls was reformed in 1996, requiring authorization only for transactions over US$90,000.9 The limit was progressively raised until it was eliminated in 2003. However, the legal and regulatory barriers identified above also curtail the benefits of a more open capital account, yet also spare the countries some of the negative effects of volatile short-term capital flows.

Characteristics of ECCU labor markets

26. There is a relatively high level of wage inflexibility in the ECCU countries for several reasons. First, wages are determined mainly by collective bargaining agreements. With strong unions, wages are determined more by bargaining strength and political pressures, rather than productivity growth. These wage settlements result in relatively higher production costs, which affect the international competitiveness of production (ABT Associates, 1998). The level of unionization ranges from 12 percent in St. Vincent and the Grenadines to 33 percent in St. Kitts and Nevis (Table VII.5). Second, public sector wage agreements exert a very strong influence on wages in the private sector, given the relative size of government employment, which averages about 21 percent of the work force in the ECCU. Thus, in the private sector the wage determination process results in a distribution of rents between employers and workers similar to that described in Blanchard and Giavazzi (2003). Third, minimum wage laws and high reservation wages also add to wage inflexibility. All ECCU countries have enacted minimum wage laws for different categories of workers (Table VII.5). Finally, migration of high-skilled workers and inflows of remittances also push up the reservation wage of the relatively lower skilled workers who remain in the region and who prefer to remain unemployed because they receive significant income from remittances (see Mishra, 2005).

Table VII.5.

Labor Market Policies and Institutions in Selected Caribbean Countries

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Sources: Rama (1995); International Labour Organization (ILO); and Fund staff estimates.

The LMR index, sometimes called the worker protection index, is a numerical measure based on a number of labor market polices which protect workers, such as restrictions on hiring and firing, paid leave, maternity leave, and severance payments.

27. Wage rigidities are further reinforced by employment rigidities resulting from limited labor mobility and high severance costs. However, despite shortages in many skills, there is rigorous implementation of work permit requirements. Thus, while there is significant migration of workers from the ECCU to third countries, there is relatively limited movement of labor among them (Guengant, 1993). In the absence of unemployment insurance, severance regulations provide the only redundancy benefits. Nonetheless, they create barriers in hiring and firing workers, resulting in limited employer flexibility, the replacement of permanent workers with casual or contract workers, increased labor cost, and lower employment (ABT Associates, 1998). Other nonwage costs that increase labor market rigidity include social security payments in all ECCU countries introduced during the 1970s, and education and social services levies in Antigua and Barbuda and St. Kitts and Nevis (Table VII.5).

28. ECCU wage levels are consequently quite high, denoting the presence of considerable wage premia. Using the only detailed data for an ECCU country (St. Lucia) available only for 2001, it is evident that the wage levels are much higher than in comparable Caribbean and Latin American countries (Table VII.6). Indeed, in one category—hotels and restaurants—the average wage was even higher than in Canada. A different metric, comparing the wage levels with the per capita gross national income, confirms this pattern. Unlike in most developing countries but similar to North America, wages in the ECCU countries are much higher than the average per capita national income level. Moreover, wage growth accelerated during the period when GDP growth was low, indicating a rising wage-productivity gap. At the same time, the regional unemployment rate has remained high, at over 20 percent. The high rate of migration to the U.S., Canada, and the U.K. has somewhat reduced the pressures on the labor market.10

Table VII.6.

International Wage Comparisons (2001)

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Source: ILO, World Bank World Development Indicators, Statistical Institute of Jamaica, and Central Statistical Office, Trinidad and Tobago, and authors’ calculations.

PPP, in current international U.S. dollars.

For St. Lucia, Gross National Disposal Income data (GNP plus remittances transfers) figures are used. GNP number computed on basis of ratio of GDP to GNP provided in Penn World Tables 6.1.

Data for 2000.

Data for 1999.

uA07fig01

ECCU: Average Annual Wage per Worker

Citation: IMF Staff Country Reports 2005, 305; 10.5089/9781451811681.002.A007

Source: Country authorities.

D. Modeling the Contribution of Integration to Growth in the ECCU

Basic model and data

29. The main objective of the model developed here is to analyze the relative contribution of various measures of integration to real GDP growth over time in ECCU countries, as well as in other Caribbean states. The model does not attempt to answer the question whether integration causes growth; to do this a much wider cross-section of data and a robust set of instrumental variables would be required, which have not been possible to construct for this exercise. Given the preponderance of trade in services such as tourism for the countries in our sample (see for example, Table VII.7a&b for the ECCU)—for which there is no direction of trade data—the traditional gravity model can also not be used to analyze this question.11 Even if the direction of trade in services data were available, it is still problematic to use a gravity model for tourism, which is driven more by factors such as “sea, sun, and sand,” and less by distance and relative size.12

Table VII.7a.

ECCU: External Services Receipts

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Sources: Eastern Caribbean Central Bank; and Fund staff estimates.
Table VII.7b.

ECCU: External Services Payments

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Sources: Eastern Caribbean Central Bank; and Fund staff estimates.

30. The aim of this section is, therefore, simply to explore the contribution of integration to growth over time, controlling for exogenous factors and domestic policy changes.13 The following general equation is estimated:

git=α0+βTit+γEit+θPit+ϵit(1)

where:

git: real GDP growth for country i during time t;

Tit: a vector of international integration variables;

Eit: a vector of exogenous variables;

Pit: a vector of domestic policy variables; and

it: the random disturbance term.

Box VII.2 gives a more detailed description of the model and data used.

The Estimated Model and Data

The actual model estimated for the ECCU countries and then for 14 Caribbean countries, Bolivia and Costa Rica is:

git=α0+βIτit+β2OPENit+β3FDIit+γI(ΔTOT)it+γ2(ΔFDEM)it+γ3XGROit+θIGCBit+θ2PINVit+ϵit(2)

The data used in the model are annual observations for the 16 countries in our sample for the period 1980–2003. The data are largely derived from the IMF’s World Economic Outlook database and the IFS. In several instances with missing data, secondary sources such as IMF country reports are also used. The following is a description of the various variables:

Growth

g: the real growth rate of the GDP (in domestic currency terms).

International integration variables (T)

τ: the effective duty rate, calculated as the ratio between customs duties and surcharges and imports of goods. This variable is a good proxy of what the countries have effectively done to reduce barriers to trade (see Senhadji and Ginting, 2004).1/ It is expected that the sign of the coefficient for this variable would be negative, i.e., the higher the effective trade taxes, the lower will be the growth.

OPEN: the openness index is calculated as the ratio of (exports+imports of goods and services) to current nominal GDP. Openness is expected to have a positive impact on growth.

FDI: the ratio of FDI (in U.S. dollars) to GDP (converted at current exchange rates). FDI is expected to have a positive impact on growth.

Exogenous variables (E)

TOT: terms of trade index. Changes in terms of trade could have either a positive or negative impact on growth, depending on whether they are positive or negative.

FDEM: index of final demand in industrial countries. Changes in this variable are expected to be positively correlated with growth in our sample.

XGRO: growth of exports of good and services (in U.S. dollars).

Domestic policy variables (P)

GCB: central government overall balance-to-GDP ratio. The sign of the coefficient is a matter of empirical investigation. In the short run, a deficit may increase if it results from an expansionary fiscal policy; in the long run, deficits probably have a negative impact.

PINV: public investment to GDP ratio. The sign of the coefficient could be positive or negative, i.e., investment in such things as infrastructure can be growth inducing. On the other hand, public investment, to the extent that it leads to crowding out of the private sector or if the quality of the investment is inferior, could also have a negative impact on growth.

1/ A more satisfactory approach would be to construct a trade liberalization index over time, which could also comprise nontariff barriers, and could also cover services. However, it is virtually impossible to construct such an index, as there is a lack of time series data.

Empirical results

31. The basic regression results suggest that while some integration effort variables are important, the international economic environment plays a greater role in explaining growth in the ECCU (Table VII.8).14 The latter is consistent with the findings in Cashin and Wang (2005). The main integration effort variable, the effective tariff rate, is highly significant with the correct sign, but openness is insignificant. Openness is possibly insignificant due to threshold effects, i.e., due to the initial very high level of openness among ECCU countries, the marginal gain from further openness is negligible. Of the three international economic variables, proxied by income in the industrial countries, growth in exports, and changes in the terms of trade, the first two have the strongest effects. Changes in the terms of trade have a negative effect on growth, while foreign direct investment was insignificant. The domestic policy variables were generally insignificant—except in two specifications at the 10 percent significance level; the government capital expenditure variable has a negative sign, suggesting that government expenditure was either counter cyclical or ineffective.

Table VII.8.

Regression Results for Real GDP Growth Equation (OECS) 1/

Estimated equation: git = α0 + βTit + γEit + ΘPit + εit

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Source: Authors’ calculations.

Bracketed numbers are the t-statistics.

Wald statistic is reported in the row for the F-statistic.

32. When the basic regressions were augmented by including the remaining Caribbean countries in the sample, the results were broadly similar to the ECCU, but, additionally, openness, foreign direct investment and the domestic policy variables become significant in most cases (Table VII.9). Growth in industrial countries, export growth, and changes in the terms of trade remain the most significant variables, while FDI becomes a significant explanatory variable for the region as a whole. Openness and the effective tariff rate are both significant in the random effects model, the relevant model for the Caribbean panel. The domestic policy variables also become significant in the augmented panel.

Table VII.9.

Regression Results for Real GDP Growth Equation

(Caribbean, Bolivia, and Costa Rica) 1/

Estimated equation: git = α0 + βTit + γEit + ΘPit + εit

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Source: Authors’ calculations.

Bracketed numbers are the t-statistics.

Wald statistic is reported in the row for the F-statistic.

33. Re-estimating the growth equation to take account of spillover effects of integration yields a dramatically better fit with largely stable coefficients. The panel GLS estimator using cross-section weights along the lines of seemingly unrelated regression (SUR) model takes account of spillovers in the context of an integration movement. The method also corrects for cross-section heteroscedasticity. In the case of the ECCU, the parameter estimates remain largely the same but the adjusted R2 rises from about 0.40 to 0.48. Similarly, for the Caribbean panel, the coefficients of the growth in industrial countries, export growth and terms of trade are very stable but the R2 rises from about 0.30 to about 0.88. The increase in the explanatory power of the equation seems to suggest that there are some contemporaneous spillover effects that may be due to regional integration, and that such effects are larger for the wider Caribbean than for the ECCU.

E. Concluding Remarks

34. Efforts at regional integration in the ECCU have met with limited success in promoting trade and growth in recent years, but the potential for leveraging regional initiatives to do so remains high. ECCU countries currently face considerable challenges: economic growth since the 1990s has slowed dramatically, and public debt has risen to very high levels in most countries. Unemployment and wage levels are high compared to countries at a similar level of development. Given the currency board arrangement, exchange rate policy cannot be used to increase competitiveness or to respond to real shocks such as natural disasters.15 There have been many regional initiatives, particularly in the provision of common services, which have been relatively successful, including a common judiciary, joint external representation in the OECS, university education, and epidemiological services in CARICOM. However, more can be done even in this area, for example, through better coordination of security and customs services and the granting of tax incentives.

35. The theoretical and empirical work reviewed above suggests that integration has a positive effect on growth. Increases in market size, the transmission of technology and greater competition, all of which raise the efficiency of the economy, are among the key benefits of integration. For trade in services, in which the Caribbean has some competitive advantage, RTAs are more likely facilitate liberalization. In the case of CARICOM, the positive effects of integration may have been limited by the slow progress in implementing the agreements, including the reduction in the common external tariff and the adoption of initiatives to complete the single market and economy, particularly those related to trade in services and free movement of labor.

36. The empirical investigation finds that growth in the Caribbean is strongly influenced by growth in industrial countries, export growth, and changes in the terms of trade. The openness of the economies is also an important factor, but there are probably threshold effects, given the region’s already high level of openness. At the same time there is strong evidence that a reduction in the overall effective tariff (a proxy for trade reforms and international integration) is good for growth.16 Foreign direct investment and domestic policy variables (government capital spending and the central government balance) also appear to be statistically significant determinants of growth in the Caribbean.

37. Given the current trend in dismantling preferential access to the EU markets under the sugar and banana regimes, further integration of the ECCU economies into the global economy is inevitable. The theoretical literature and empirical evidence reviewed suggest that product and labor market deregulation would have a positive impact on employment and growth in the long run. However, there could be short-run costs related to lower nominal wages resulting from the elimination of protection-induced rents, which could be partially mitigated by possible declines in product prices.17 Since net benefits of integration are likely to be positive, particularly if they are implemented effectively, the ECCU countries should move quickly toward implementing the required reforms. Delaying this process would only postpone the benefits and make it harder to achieve a consensus for reform (DeRosa, 2000). The countries should also press forward with liberalization of the regime of trade in services under the CARICOM agreement and the free movement of labor and other labor market reforms under the initiative for economic union among the ECCU countries. They should use integration at the regional level as a stepping stone to greater international integration, with the latter yielding significantly more benefits, given the dependence of the ECCU countries’ growth rates on demand in industrial countries.

Figure VII.1
Figure VII.1

Regional Integration Groupings in the Caribbean

Citation: IMF Staff Country Reports 2005, 305; 10.5089/9781451811681.002.A007

Figure VII.2.
Figure VII.2.

Indicators of Economic Integration for Selected Caribbean Countries and Other Countries

Citation: IMF Staff Country Reports 2005, 305; 10.5089/9781451811681.002.A007

Sources: IMF, World Economic Outlook; and Fund Staff estimates.1/ For the period 1980–2003.
Figure VII.3.
Figure VII.3.

ECCU: Real GDP Growth and its Determinants

Citation: IMF Staff Country Reports 2005, 305; 10.5089/9781451811681.002.A007

Source: Authors’ calculations.

APPENDIX Economic Effects of Creating a Trading Bloc

Suppose two countries A (poorer) and B (richer) form a trade bloc. They can import from the rest of the world (W) which faces zero marginal costs to supply the bloc, i.e., a horizontal supply curve, SW. Country B has an upward slopping supply curve, SB. If A imposes import tariff t on all countries, this has the effect of moving the supply curves upwards for both suppliers by the amount of the tax. At the equilibrium point E, the supply is HG from B and GE from W. If the tariff is removed for B, B can supply an additional GF (or Q1Q2), thereby leading to a trade diversion. Under constant marginal costs for W, country A suffers from tariff loss, without a commensurate gain in consumer surplus. Gunning argues that most trade blocs, e.g., those in Africa, are pursued mostly for political reasons, and that it is usually more economically beneficial to undertake a unilateral lowering of tariffs.

Appendix Figure VII.1
Appendix Figure VII.1

Effects of Creating a Trade Bloc

Citation: IMF Staff Country Reports 2005, 305; 10.5089/9781451811681.002.A007

Source: Gunning (2002)

The question that arises is whether there is a case for a South-South regional trade area (RTA). Are RTAs a distraction from the more economically desirable multilateral trade agreements? Schiff (2002) argues that in general, it is best for RTAs to sign agreements with bigger countries or blocs in order to fully benefit from the benefits of integration. He does point to a number of advantages of RTAs. First, in the area of regional public goods (security, transportation, the environment), it makes sense to have regional cooperation. Second, an RTA is better able to negotiate with bigger countries or other RTAs by pooling their resources.

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