Eastern Caribbean Currency Union
2007 Discussion on Common Policies of Member Countries: Staff Report; and Public Information Notice on the Executive Board Discussion

Over the last decade, the Eastern Caribbean Currency Union (ECCU) macroeconomic performance has deteriorated relative to the rest of the Caribbean. Tourism accounts for three-fifths of exports, and the import content of consumption and investment is high. The ECCB-operated quasi-currency board arrangement (CBA) has continued to deliver price and exchange rate stability. The region has strong social indicators, but poverty, health, and crime remain concerns. Despite the implementation of ambitious revenue reforms, limited progress has been made toward fiscal consolidation. Credit has continued to expand rapidly.

Abstract

Over the last decade, the Eastern Caribbean Currency Union (ECCU) macroeconomic performance has deteriorated relative to the rest of the Caribbean. Tourism accounts for three-fifths of exports, and the import content of consumption and investment is high. The ECCB-operated quasi-currency board arrangement (CBA) has continued to deliver price and exchange rate stability. The region has strong social indicators, but poverty, health, and crime remain concerns. Despite the implementation of ambitious revenue reforms, limited progress has been made toward fiscal consolidation. Credit has continued to expand rapidly.

I. Background and Social Setting

1. ECCU countries are small, open, tourism-dominated island economies that are highly vulnerable to external shocks and natural disasters (Figures 1 and 2). 1 Tourism accounts for three-fifths of exports, and the import content of consumption and investment is high. While the share of value added from agriculture has declined sharply in recent decades, crops (particularly bananas) remain important in supporting rural incomes.

Figure 1.
Figure 1.

ECCU: Key Characteristics

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Figure 2.
Figure 2.

ECCU: Overview

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: ECCB; World Bank; and Fund staff estimates.1/ Simple average of The Bahamas, Barbados, Belize, Dominican Republic, Guyana, Haiti, Jamaica, and Trinidad and Tobago.2/ A larger value indicates greater income inequality.

2. Over the last decade the ECCU’s macroeconomic performance has deteriorated relative to the rest of the Caribbean. Growth has declined since the mid-1990s, and debt levels increased substantially as fiscal deficits rose, partly as a result of many shocks, including natural disasters, the 2001 terrorist attacks, the erosion of trade preferences, and collapsing aid flows (Figure 3). Besides shocks, political cycles have also influenced national fiscal outcomes. Governments have repeatedly eased fiscal stances—chiefly through expansions of the civil service wage bill and increased capital spending—in the lead up to elections. 2

Figure 3.
Figure 3.

ECCU: External Environment, 1995–2006

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: World Bank, World Development Indicators; IMF, International Financial Statistics; IMF, World Economic Outlook; OECD, International Development Statistics; ECCB; and Fund staff calculations.
uA01fig01

The Caribbean: Relative Ranking on Macroeconomic Performance 1/

(Comparison of Average Performance during 1990–97 and 1998–06)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: World Economic Outlook; country authorities; and Fund staff calculations and projections.1/ The ranking is based on total public debt in 2006, absolute change in public debt from 1990–97 to 1998–2006; average overall fiscal balance from 1998–2006, absolute change in overall fiscal balance from 1990–97 to 1998–2006; average CPI inflation from 1998–2004, absolute change in CPI inflation from 1990–97 to 1998–2006; average real GDP growth from 1998–2006, and absolute change in real GDP growth from 1990–97 to 1998–2006. Countries are ranked from 1 to 14 in each category, with the best performer receiving the highest scores. The scores are then summed for each country, with equal weight to each category of macroeconomic performance. Finally, the summed-up scores are normalized so that the scores for all countries range from 1 to 100. Haiti is excluded from the comparison since the data on the primary balance in period 1990–97 are not available.

3. The ECCB-operated quasi-currency board arrangement (CBA) has continued to deliver price and exchange rate stability. The ECCB has kept lending to member jurisdictions well within statutory limits, and international reserve coverage is near 100 percent of demand liabilities (the legal floor is 60 percent). There have not been any exchange rate pressures, and inflation has been anchored around the U.S. rate.

4. The region has strong social indicators, but poverty, health and crime remain concerns. An entrenched tradition of democracy has nurtured a strong social commitment in the ECCU to public health, education and protecting the vulnerable. As a result, the ECCU countries rank high on the Human Development Index relative to their income levels. While most social indicators are comparable to the OECD average, the region suffers from high unemployment and emigration rates. In addition, there has been a rapid acceleration in the spread of diabetes and hypertension, with associated implications for health spending. One quarter of the region’s population lives in poverty, and crime is a growing problem.

ECCU: Social Indicators

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Sources: ECCB; Fund staff estimates and projections; United Nations, Human Development Report 2007/08; http://www.sdnp.org.gy/ghdr/BOX1.1.html; and the World Bank, WDI 2006.

Percentage of population living below each country’s locally-defined poverty line in 2000.

II. Recent Economic Developments and Near-Term Outlook

5. Growth was buoyant in 2006 (Table 1). Real GDP growth in the ECCU was close to 6 percent, the highest in more than 15 years, driven by construction, tourism, and financial services. Construction activity reflected significant expansions in hotel capacity, cricket stadia and supporting public infrastructure, in preparation for the Cricket World Cup (CWC) held in March–April 2007.

Table 1.

ECCU: Selected Economic and Financial Indicators, 2003–08

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

Excludes Anguilla and Montserrat. ECCU aggregates are calculated as weighted averages of individual country data; ratios to GDP are then calculated by dividing this sum by the aggregated GDP of the region.

Includes errors and omissions.

ECCB’s foreign assets as a ratio of its demand liabilities.

ECCU: Selected Economic Indicators, 2003–08 1/

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Sources: Country authorities, and Fund staff estimates.

Excluding Anguilla and Montserrat.

6. Output is presently estimated to be above potential (Figure 4). In 2007, output is estimated to remain above trend in all countries, although the pace of economic activity is uneven—Antigua and Barbuda and St. Vincent and the Grenadines are expected to continue their strong performance, while growth in Dominica is expected to be minimal following the passage of Hurricane Dean. 3

Figure 4.
Figure 4.

ECCU: Central Government Actual and Structural Budget Balances, 2000–07 1/

(In percent of potential GDP)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: Country authorities; ECCB; and Fund staff estimates.1/ Actual balance is the overall balance (revenue and grants less expenditure), and is expressed as a percentage of actual output. Actual output is measured as gross domestic product (GDP) at factor cost.2/ The output gap is actual output less potential output, as a percent of potential output.3/ Structural balance is expressed as a percent of potential output. The structural balance is the budgetary position (overall balance) that would be observed if the level of actual output coincided with potential output.
uA01fig02

ECCU: Contribution to Real GDP Growth by Sector, 2001–06 1/

(In percent)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: ECCB; and Fund staff projections.1/ Excludes Anguilla and Montserrat.2/ Includes wholesale and retail trade, hotel and restaurant, air transport, and half of local transport.3/ Includes mining and quarrying.

7. Despite the CWC, tourism performance in 2007 has been weak. Notwithstanding strong tourism arrivals from Europe—partly reflecting the depreciation of the U.S. dollar (and thereby the EC dollar) against major currencies—U.S. and intra-Caribbean tourist arrivals have disappointed (Figure 5). This performance reflects CWC-related disruptions during the peak winter tourist season; more stringent rules on Caribbean travel for U.S. nationals; and problems with intra-regional airlift (¶24). 4

Figure 5.
Figure 5.

ECCU: Stayover Arrivals, 2005–07

(Annual percentage change)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: ECCB; and Fund staff calculations.
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ECCU: Output Gap, 1982–2007 1/

(In percent of potential GDP)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: ECCB; and Fund staff estimates and projections.1/ Data for 2007 are Fund staff projections.

8. Inflation has picked up. Rising world food prices, the depreciation of the U.S. dollar against major currencies, and the pass-through of higher world oil prices have put upward pressure on prices in the ECCU in 2007 (Figure 6 and Box 1). 5 Inflation is expected to reach 3¾ percent by end-2007, nearly twice the level at end-2006. The ECCB’s Monetary Council has established a working group to further investigate the inflationary pressures on a regional level, and CARICOM leaders have agreed on the elimination or reduction of the Common External Tariff on a selected group of items (by end-January, 2008). Individual countries have responded differently to rising price pressures, including by intensifying profit margin controls (Grenada, St. Kitts and Nevis), considering the provision of import duty concessions on food and other basic necessities (St. Kitts and Nevis), reducing taxes on certain products (Antigua and Barbuda, Dominica), providing limited subsidies to vulnerable groups (Grenada), and having national budgets absorb world price increases on petroleum products (St. Lucia).

Figure 6.
Figure 6.

ECCU: Inflation Developments, 2001–07

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: IMF, Direction of Trade Statistics; Haver; ECCB; and Fund staff calculations.1/ Tradables are defined to include food, alcoholic beverages and tobacco, fuel and light, clothing and footwear, and household and furniture equipment.2/ Nontradables are defined to include housing and utilities, transportation and communication, medical care and expenses, education, personal services, and miscellaneous.

9. For 2007–08, indications suggest a ‘soft landing’ of the ECCU economy. Growth is expected to reach around 4 percent in 2007—closer to estimated trend growth of 3¼ percent—reflecting continuing strength in private construction, and despite disappointing tourism arrivals. Activity is expected to moderate further in 2008, to just above trend, due to the slowing world economy and moderating construction activity. Growth is thus likely to remain above the 2¾ percent “stall speed” associated with past regional recessions.

uA01fig04

The forecast is for a soft landing, as growth is estimated to remain above the historical “stall speed” of 2¾ percent.

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

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

10. However, there are risks to this outlook. The upside potential from strong domestic demand due to the private construction boom is more than offset by downside risks as the turbulence in global financial markets may dampen consumption and tourism demand. In addition, construction activity may be affected by weaker expectations for real estate sales and tourism inflows. With oil import prices high, further dollar depreciation, and structural rigidities in the labor market, cost pressures could continue to elevate inflation.

11. Despite the implementation of ambitious revenue reforms, limited progress has been made towards fiscal consolidation (Table 2). Stronger growth and far-reaching tax reforms have improved tax revenues, benefiting from broader tax bases and better tax collections, especially the introduction of new VATs. 6 Nevertheless, a surge in capital spending associated with the CWC led to a deterioration of actual and structural fiscal balances in 2006 (Figure 4). In 2007–08, lower spending is projected to improve primary balances before grants, but declining aid flows and higher interest rates are likely to more than offset this improvement, leaving the ECCU-wide overall deficit at around 5 percent of GDP.

Table 2.

ECCU: Selected Central Government Indicators by Country, 2003–08 1/

(In percent of GDP)

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Sources: Country authorities; and Fund staff estimates.

Excludes Anguilla and Montserrat. Fiscal years for Dominica and St. Lucia.

Dominica’s primary balance is measured by below-the-line financing and may not equal the above-the-line definition.

Includes external arrears.

ECCU: Selected Fiscal Indicators, 2003–08 1/

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Sources: Country authorities; and Fund staff estimates.

Excluding Anguilla and Montserrat.

12. Debt levels and debt servicing costs remain large. Notwithstanding recent strong economic growth and debt restructurings and writedowns in several countries, public sector debt is expected to remain above 100 percent of regional GDP (Figure 3). Debt servicing absorbs a substantial portion of revenues in most countries—the exceptions being Dominica and Grenada, reflecting previous debt restructuring agreements with creditors. In addition, St. Vincent and the Grenadines benefited in 2007 from a debt write-off from Italy equivalent to about 10 percent of GDP. The high burden of debt servicing is limiting fiscal space for much-needed social and poverty-reduction spending.

ECCU: Selected Indicators of Debt Burden, 2004–08

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Sources: Country authorities; and Fund staff estimates.

Includes only external amortization.

For 2005, the debt service incorporates amortization in relation to debt relief received by Antigua and Barbuda from Italy.

13. Credit has continued to expand rapidly. Broad money has grown faster than nominal GDP, and banks have run down their net foreign assets (Figure 7 and Table 3). Private sector credit expansion has accelerated, reflecting increased lending to tourism, construction, and consumers. As construction activities wind down in 2008, credit growth is expected to return to more sustainable levels. Reserve coverage of demand liabilities rose to above 100 percent at end-September 2007.

Table 3.

ECCU: Monetary Survey, 2003–08

(In millions of Eastern Caribbean dollars)

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Sources: ECCB; and Fund staff estimates.

Includes the national insurance schemes.

Figure 7.
Figure 7.

ECCU: Monetary Developments, 2001–06

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: ECCB; and Fund staff calculations.1/ Includes interbank float, reserves held with the ECCB, and other unclassified assets.2/ Includes tourism, entertainment, and half of transport, distributive trade and professional services.3/ Excess reserves is defined as the excess of bank reserves (cash holdings and deposits of commercial banks with the ECCB) over required reserves. The current reserve requirement is 6 percent of deposits.

ECCU: Selected Monetary Indicators, 2003–08

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Source: ECCB.

Twelve-month change in percent of broad money at the beginning of the period.

14. Prudential indicators of the financial sector have strengthened (Figure 8 and Table 5). Nonperforming loans (NPLs) of local banks have continued to decline and are close to the ECCB’s prudential target (5 percent of total loans). However, provisioning has continued to fall, and the decline in the NPL ratio partly reflects the ongoing rapid credit expansion—raising the importance of effective financial sector supervision. Exposures to government remain high, and are concentrated in some state-owned local banks (Figure 9).

Table 4.

ECCU: Summary Balance of Payments, 2003–12

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Source: ECCB; and Fund staff estimates and projections.

Includes errors and omissions.

Table 5.

ECCU: Selected Vulnerability Indicators, 2003–08

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Sources: ECCB; and Fund staff estimates and projections.

Excludes Anguilla and Montserrat.

Defined as external current account deficit plus external amortization.

Figures for 2007, as at end-September.

Foreign assets as a percentage of demand liabilities.

Figure 8.
Figure 8.

ECCU: Banking System Vulnerabilities, 2002–07 1/

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: ECCB; and Fund staff calculations.1/ Prudential indicators are reported by commercial banks, with infrequent onsite verification by the ECCB.
Figure 9.
Figure 9.

ECCU: Decomposition of Commercial Banks’ Exposure to the Public Sector, 2004–07

(In percent of public sector exposure)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: ECCB; and Fund staff calculations.

ECCU Banking System: Financial Soundness Indicators, September 2007

(In percent)

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Source: ECCB.

Local banks.

Quarterly return.

15. The ECCB has strengthened banking sector supervision, but vulnerabilities remain. The uniform Banking Act has been implemented in all ECCU jurisdictions, offsite reporting and data verification have been strengthened, new prudential guidelines have been issued (on provisioning for government arrears, corporate governance, liquidity risk management, and related-party transactions) and corporate governance has been enhanced. Some progress has been made in establishing national single regulatory units (SRUs) for the supervision of nonbank financial institutions (NBFIs), but legislation providing for uniform regulation (of ECCU credit unions, money transfer institutions, and domestic insurance companies) has not yet been introduced in all ECCU jurisdictions. While several countries have enhanced supervision of their offshore financial sectors, there has been little progress in aligning the prudential regimes of offshore banks with those of domestic banks, as recommended by the 2004 FSAP. 7

16. The external current account deficit widened in 2005–06, accompanied by strong capital inflows (Figure 10 and Table 4). The increase in the deficit since 2004 has been driven by imports related to hotel construction and public capital expenditure for the CWC, rising energy imports, and disappointing tourism receipts. Hotel construction is financed mostly through FDI, and is expected to slow in the medium term as new tourism capacity comes online. CWC-related construction was financed largely through external grants. In 2007–08 the current account deficit is expected to narrow, due to slowing CWC-related imports. Gross international reserves are expected to continue to grow, reaching about US$770 million by end-2007 (over 4½ months of imports), with capital inflows (chiefly FDI flows) largely covering the current account deficit.

Figure 10.
Figure 10.

ECCU: Trade and Capital Account, 1996–2006

Large and worsening current account deficits are financed by surging FDI flows and transfers.

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: Country authorities; ECCB; and Fund staff estimates.1/ A positive (negative) number indicates borrowing from (lending to) foreigners.

ECCU: Selected External Indicators, 2003–08

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Sources: ECCB; and Fund staff estimates.

The 2007 estimate is the realization at June 2007.

17. There is renewed momentum towards economic integration in the Eastern Caribbean region, while Caribbean-wide integration is proceeding more slowly. In May 2007, OECS member countries approved a draft Treaty for the establishment of an Economic Union (Box 2). 8 Progress in implementing the CARICOM Single Market and Economy (CSME) has been slow, and ECCU countries’ participation has been predicated on a US$250 million Regional Development Fund to support their development needs, which is not yet operational. 9

18. The region has maintained access to new financing, despite recent debt restructurings and debt write-downs. Governments have increasingly tapped commercial borrowing arranged by financial institutions in Trinidad and Tobago, as well as the ECCU Regional Government Securities Market (RGSM). 10 Bond placements on the RGSM have typically been oversubscribed at interest rates that have fluctuated in a very narrow range, with limited discrimination among countries, reflecting high levels of bank liquidity and the cash-flow surpluses of the region’s social security systems (Figure 11). 11 Debt restructurings (Dominica, Grenada) and write-downs (Antigua and Barbuda, St. Vincent and the Grenadines) have been described in the respective country staff reports.

Figure 11.
Figure 11.

ECCU: Markets for Equity and Government Securities

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: Eastern Caribbean Securities Exchange (ECSE); Regional Government Securities Market (RGSM); Caribbean Trade & Investment Report 2005; U. S. Federal Reserve; and Fund staff estimates.1/ Size of bubble indicates country GDP in millions of U.S. dollars.2/ Interest rates from RGSM auctions of St. Vincent and the Grenadines 91 day treasury bills. March-03, May-03, and Feb-06 rates are interpolated.3/ U. S. rate is the interest rate on 13-week treasury bills.

III. Policy Issues12 13

19. The ECCU countries have implemented many important policy initiatives in recent years, but challenges remain. The current, still favorable economic environment provides an opportunity for the region to address longstanding economic and social challenges and reduce vulnerabilities. Discussions with the national and regional authorities focused on three broad areas:

  • Enhancing growth prospects and maintaining competitiveness.
  • Ensuring a sound and dynamic financial system.
  • Reducing vulnerabilities.

A. Growth and Competitiveness

20. Discussions focused on the increasing dependence of the ECCU region on tourism, and the need for policies to ensure sustainable growth. The current economic expansion has been driven by construction to boost tourism capacity in many ECCU countries, at a time when the erosion of European Union trade preferences has weakened traditional exports. As a result, the ECCU is becoming increasingly dependent on tourism, but growth rates in travel receipts since the 1990s have been only about one-third of those in the 1980s, and have fallen below world growth rates (Figure 12).

Figure 12.
Figure 12.

Tourism Performance

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: Country authorities; ECCB; and Fund staff estimates. Note: Antigua and Barbuda (ATG), Aruba (ABW), Bahamas (BHS), Barbados (BRB), Cayman Islands (CYM), Croatia (HRV), Cyprus (CYP), Dominica (DMA), Dominican Republic (DOM), Grenada (GRD), Jamaica (JAM), Lebanon (LEB), Maldives (MDV), Malta (MLT), Montserrat (MSR), Netherlands Antilles (ANT), Puerto Rico (PRT), St. Kitts and Nevis (KNA), St. Lucia (LCA), St. Vincent and the Grenadines (VCT), Seychelles (SYC), Trinidad and Tobago (TTO), U.S. Virgin Islands (VIG), Vanuatu (VUT).1/ Grenada’s infrastructure was damaged in 2004 due to Hurricane Ivan.2/ The hassle factor captures cost, distance and time to arrive at destination (including to the actual resort/hotel). It is based on Fodor’s Caribbean 2007, with higher number indicating greater hassle factor.

21. Enhancing the ECCU’s growth potential is the region’s overarching challenge. The staff emphasized the need for reforms to lower the cost of doing business and raise the ECCU’s growth potential. The additional hotel room capacity being created could exert pressure on the older hotel stock, unless arrivals expand accordingly. The authorities acknowledged that tourism arrivals are sensitive to price competition, and were keen to enhance efficiency through improvements in the investment climate. 14 Staff suggested that the authorities address issues highlighted in the World Bank’s Doing Business Indicators 2008: the high cost of imports (arising from high trade barriers and weaknesses in customs administration); difficulties in accessing credit and credit information; weak contract enforcement; and the lack of flexibility in regional labor codes (Figure 13).

Figure 13.
Figure 13.

ECCU: Doing Business Indicators, 2007 1/

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: World Bank, 2008 Doing Business Indicators (2007); and Fund staff calculations. Note: Antigua and Barbuda (ATG), Bahamas (BHS), Barbados (BRB), Belize (BLZ), Dominica (DMA), Dominican Republic (DOM), Grenada (GRD), Guyana (GUY), Jamaica (JAM), St. Kitts and Nevis (KNA), St. Lucia (LCA), St. Vincent and the Grenadines (VCT), and Trinidad and Tobago (TTO).1/ Smaller numbers represent greater ease in doing business. The rankings are across 178 countries.

22. OECS Economic Union is at the center of the authorities’ growth strategy, and implementation will be key. The authorities believe that, building on a history of cooperation, the nascent Economic Union should enable the region to better compete within CARICOM, and also better prepare it for increasing globalization. The Economic Union Treaty envisages the creation of a single economic and financial space in the region, and strengthened functional cooperation in many areas, including joint diplomatic representation, provision of security services, tax and customs administration, utilities, transport, health, and education. Staff urged the authorities to accelerate the simplification and harmonization of the legislative and regulatory framework at the regional level, to help reduce transaction costs. The authorities agreed, and emphasized the importance of liberalizing labor movements, as this could yield significant benefits including better allocation and retention of skilled workers in the region.

23. Tax concessions have eroded the corporate tax base across the Caribbean—preserving the integrity of the newly-introduced VATs is a key priority. 15 Governments in the region compete through generous tax concessions for foreign direct investment and employment. The authorities recognized that tax concessions have eroded their corporate tax bases. However, while they viewed a regional harmonization agreement—such as a voluntary code of conduct or a regional treaty on tax incentives—as potentially useful, in practice they saw it as not achievable and extremely difficult to enforce. The staff recommended that, in order to limit the distortionary impact from concessions, they be granted in a nondiscretionary and transparent manner, clearly identifying estimated costs and beneficiaries. The authorities agreed, pointing to ongoing initiatives in that direction in Antigua and Barbuda, Grenada, and St. Kitts and Nevis. They also broadly agreed on the need to limit concessions to investments and not extend them to consumables, ensuring the integrity of the new VATs being introduced in the region.

uA01fig06

Tax Competition in the Caribbean

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Source: Fund staff calculations, based on 2006 data for the ECCU, Suriname, and Haiti and 2003 data for others. The tax yield is revenue as a percent of GDP divided by the tax rate.
uA01fig07

Average Effective Tax Rate on Investment, 2005

(In percent)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: Country authorities; and Fund staff estimates.

24. Difficulties in intra-regional air travel have adversely affected tourism. The recent merger between the two regional airlines (LIAT and Caribbean Star) has created a near-monopoly on intra-Caribbean air transportation—air fares have risen sharply, while capacity has been scaled back. The merged airline now has a requirement to operate on a commercial basis, and is seeking efficiency gains to limit future capital injections from major shareholder governments (Antigua and Barbuda, St. Vincent and the Grenadines, and Barbados) and minimize operating costs. 16 The national authorities expressed a wide range of views on the best manner to operate a publicly-owned airline that is required to serve remote locations and unprofitable routes, but all agreed that intra-regional air transportation is an essential public good, vital for maintaining connectivity and facilitating intra-Caribbean trade and tourism.

uA01fig08

ECCU: Tourism Stay-Over Arrivals by Source Country or Region, 2000–06

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Source: ECCB.

25. Current account deficits in the ECCU are projected to remain above estimated equilibrium levels for an extended period, as the economies continue to adjust from agricultural to tourism-based economies. Using the macroeconomic balance approach, Fund staff estimate the equilibrium current account deficit (the current account ‘norm’) at between 9–15 percent of GDP, using sample sets consisting of tourism-based economies. Estimates based only on ECCU countries give a norm of about 20 percent of GDP, though this may overstate the equilibrium level as the estimation covers a period of rapid debt accumulation. 17 The recent increase in current account deficits reflects, in large part, preparations for the CWC and expanding tourism capacity as ECCU countries develop their tourism sectors. The size of future current account imbalances is expected to taper off in line with the decline in the construction of new resort facilities, though much of the decline is likely to occur after the end of the projection period. This implies that despite their apparent high levels, medium-term current account imbalances in the ECCU appear sustainable.

uA01fig09

ECCU: Current Account Deficit, Actual and Estimated Norms 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: ECCB; Fund staff estimates and projections; and Pineda and Cashin “Assessing Exchange Rate Competitiveness in the ECCU,” ECCU Selected Issues Chapter.1/ In computing the norms, medium-term values of the fiscal balance, oil-balance, output growth, and relative income are drawn from staff projections. Band is ±1 standard error of the prediction. ECCU sample includes only the 6 ECCU countries. CARICOM sample includes ECCU countries and The Bahamas, Barbados, Belize, and Jamaica. Full sample includes 21 tourism-dependent economies as defined by Bayoumi and others (2005).2/ Based on Fund staff estimates. Medium-term is 2012.

26. The structure of the financing of ECCU current account imbalances is stable. The large projected current account deficits are not expected to be financed by the accumulation of external sovereign debt (which has been declining in recent years) or by resources intermediated through domestic financial systems, but rather by private capital inflows (particularly FDI). Tourism sector investment, particularly for hotel construction, continues to be overwhelmingly financed by FDI. These tourism investments are often large in relation to the size of the ECCU economies. As tourism-based investment opportunities in the ECCU decline over the medium term, capital inflows and current account imbalances will narrow. While any adverse shift in investor sentiment may lead to a sharper than envisaged decline in foreign investment, so will the level of current account imbalances (given the high import content of construction activities), with only limited dislocation to the domestic economy.

27. The level of the real exchange rate appears to be appropriate, although there are challenges in maintaining external competitiveness. Staff analyses indicate that in the ECCU countries the actual real exchange rate is slightly below its equilibrium level, reflecting the depreciation of the U.S. dollar against major currencies. 18 Indeed, the real exchange rate—measured relative to either trade weighted, tourism competitors, or tourism source markets—is currently at its most depreciated level in almost 20 years (Figure 14). However, besides the real effective exchange rate, there are challenges in maintaining external competitiveness, as suggested by the weakening in regional exports, the ongoing deterioration in the terms of trade, and the recent decline in the ECCU’s share of Caribbean tourist (stayover) arrivals. In addition, given the ECCU’s large stocks of public and external debt, decisive fiscal consolidation is necessary to assist competitiveness, support debt sustainability, and underpin the EC dollar’s peg to the U.S. dollar. The authorities reiterated their strong commitment to the exchange rate peg and the currency union, noting that planned structural reforms (particularly increased flexibility of labor and product markets) should help generate efficiencies and enhance productivity to strengthen competitiveness.

Figure 14.
Figure 14.

ECCU: External Competitiveness, 1990–2007

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: ECCB; Caribbean Tourism Organization; Country authorities; World Travel and Tourism Council; and Fund staff estimates.Note: Antigua and Barbuda (ATG), Barbados (BRB), Belize (BLZ), Dominica (DMA), Dominican Republic (DOM), Grenada (GRD), Jamaica (JAM), St. Kitts and Nevis (KNA), St. Lucia (LCA), and St. Vincent and the Grenadines (VCT).1/ An increase (decrease) indicates an appreciation (depreciation).2/ The sharp movements in the competitor-based real exchange rate in 2002–04 were largely driven by the Dominican Republic’s peso.3/ A value below 1 indicates that the country’s tourism sector is less productive than that of The Bahamas.
uA01fig10

ECCU: Actual and Equilibrium REER, 1979–2006 1/

(Index 2000=100)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: IMF, Information Notice System; and Pineda and Cashin, “Assessing Exchange Rate Competitiveness in the ECCU,” ECCU Selected Issues Chapter.1/ The shaded band around the equilibrium exchange rate represents ±1 standard error of the prediction.

28. Staff calculations suggest that the ECCU’s balance of payments position is consistent with external stability. As noted, there is no evidence that the exchange rate level is fundamentally misaligned. Based on available data (which are mainly for the public sector), the level and structure of capital flows appear sustainable: under current policies, external public debt is forecast to remain roughly constant (as a share of GDP) over the medium term (see Table 7 and the Appendix). Regarding private sector flows, following the recent increase in FDI, they are projected to decline over the medium term toward a sustainable trajectory (albeit beyond the period covered by the projections). Nevertheless, the high levels of current account imbalances, public debt and associated financing needs do pose risks that warrant careful monitoring and continued efforts at fiscal consolidation (Section III.C). The authorities view FDI—the dominant and historically stable source of external flows—as a sustainable and reliable source of capital flows. They agreed with the need to closely monitor private sector capital flows and asset positions, and to improve the statistical data in this and other areas. 19

Table 6.

ECCU: Creditor Composition of Public Debt at End-2006 1/

(Share of total)

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Sources: ECCB; and Fund staff estimates.

Excludes Anguilla and Montserrat.

Table 7.

ECCU: Change In Net Investment Position, 2000–06

(In percent of GDP)

article image
Source: ECCB.

B. Ensuring a Sound and Dynamic Financial System

29. The ECCU region remains relatively insulated from world capital markets, and has not been directly affected by the recent financial markets turmoil. 20 The region’s equity and bond markets are thin and illiquid—the U.S. subprime mortgage crisis and repricing of credit has not and is not likely to have a discernable impact. ECCU banks, on the other hand, are highly liquid, with limited interbank exposures—liquid assets are typically held in the form of large balances with foreign banks and foreign investments. The authorities did not view the risk of an impairment in the quality of foreign assets as significant, due to stringent prudential rules for portfolio investments by banks. Data limitations hamper an assessment of the impact on private and nonbank financial sectors.

30. Banking sector supervision has been strengthened significantly, but risks remain. Stress tests indicate that while prudential indicators have improved, some indigenous banks remain vulnerable (Box 3). Key risks include high government exposures, as well as credit risk, exacerbated by potential under-provisioning. These weaknesses appear to have persisted over time, emphasizing the need for enforcement of the ECCB’s strengthened regulatory powers. In this regard, resource constraints have adversely affected the frequency of the ECCB’s onsite bank inspections, and further progress needs to be made toward enhanced capacity building and the establishment of a comprehensive risk-based supervisory framework. The staff emphasized the need to use the risk-based supervisory framework to target onsite inspections at vulnerable banks. Another area where more progress is urgently needed relates to enhanced supervision of cross-border financial flows, given the growing integration of Caribbean financial markets. 21

31. Rapid credit expansion calls for heightened supervision to ensure that the longstanding resilience of the ECCU banking system is not compromised (Box 4). 22 Private sector credit has expanded rapidly in recent years, accompanied by sharp declines in NPL ratios as well as low loan provisioning levels (Table 5). As the experience in many other countries has shown, the improvement in prudential indicators may be largely temporary, reflecting growth in credit, unless there is an improvement in the underlying quality of loan portfolios. In the event that expectations of increasing tourist arrivals are not realized or real estate prices decline, the quality of bank assets could be impaired. The authorities considered this risk not to be significant on account of improved credit underwriting practices in the region’s banks, as well as the ECCB’s adoption of a prudential benchmark requiring NPL ratios not to exceed 5 percent. Moreover, the authorities did not expect the weaknesses in the U.S. housing market to translate into diminished demand for real estate in the ECCU, given the increasing number of European investors attracted to the region due to ongoing currency depreciation.

uA01fig11

ECCU: Banking Sector NPLs and Loan Loss Provisions, 1996–2007

(In percent of total loans)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: ECCB; and Fund staff calculations.

ECCU: Private Sector Credit

(Annual percentage change)

article image
Sources: ECCB; and Fund staff calculations.

32. The rapidly-growing nonbank financial sector remains largely unsupervised. Some insurance companies are reportedly offering high interest rates on time deposits, and assets of credit unions have been growing rapidly. All countries are planning to establish single regulatory units (SRU) for the nonbank financial sector, but so far Grenada is the only Fund-member country to have done so. The authorities shared the staff’s view that establishing SRUs is a priority, and are committed to accelerate the passage of the enabling legislation, and ensure staffing by adequately-trained personnel.

uA01fig12

ECCU: Growth Rates in Financial Sector Assets, 1998–2006

(In percent)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: Caribbean Confederation of Credit Unions; Eastern Caribbean Central Bank; and World Council of Credit Unions.1/ Growth rates for 1998 and 2000 have been interpolated from the data.

33. Increasing dollarization in deposits will require enhanced risk management by banks. Dollarization has increased following the suspension of ECCU exchange and capital controls in 2004, leading to a decline in commercial banks’ coverage of liquid foreign currency liabilities. Thus, the observed increase in dollarization should not be indicative of a lack of confidence in the local currency. Nevertheless, the staff pointed out that given the growing cross-border flows as a result of liberalization and increased regional integration, the ECCB would need to develop guidelines to ensure that banks manage well the associated exposures and risks.

ECCU: Coverage of Liquid Foreign Currency Liabilities

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Source: ECCB.

Data refer to end-September.

34. The prudent management of reserve coverage by the ECCB has served the region well. Staff and the authorities agreed that conducting an active monetary policy could dilute reserve coverage, limit the ECCB’s potential lender of last resort capacity, and undermine the hard-earned credibility of the EC dollar’s currency peg. 23 In this regard, operating like a traditional currency board arrangement (involving minimal lending to member governments and rising foreign reserve coverage), as the ECCB has done since the early 1990s, has helped in maintaining exchange rate and price stability, and in limiting any potential systemic impact during past episodes of banking sector stress. Staff enquired about plans to augment reserve coverage, as the ECCB’s potential lender of last resort capacity is limited by the amount of reserves in excess of the minimum 60 percent requirement for backing of demand liabilities. 24 The ECCB viewed the current level of reserve coverage as broadly adequate for the purposes of its potential lender-of-last-resort role, noting that the banking system was dominated by large foreign banks, with limited systemic risk from local banks. The ECCB also pointed to the forgone investment costs associated with a further expansion of reserves, and explained that the authorities would examine other options for resolving bank stress and building depositor confidence, prior to stepping in as a lender of last resort.

uA01fig13

Foreign Reserve Coverage of Monetary Liabilities, 2005

(In percent)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: Country authorities; and Fund staff calculations.
uA01fig14

ECCU: Optimal Level of Reserves Given Different Shocks

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Source: Fund staff calculations.

35. There is scope to improve the efficiency and effectiveness of regional capital markets. Improvements in the legal and regulatory infrastructure of regional markets have the potential to reduce the cost of capital for borrowers and provide better risk allocations for investors. While the RGSM helps lower the costs of funds for member governments, trading on the Eastern Caribbean Securities Exchange (ECSE) is thin (Figure 11). Key areas for strengthening capital markets include:

  • Disclosure requirements. Firms listing on the ECSE are required to report financial results only once a year, which contributes to information asymmetry and risk for market participants.
  • Credit information and legal infrastructure. The World Bank’s Doing Business Indicators 2008 point to the lack of public or private credit registries and bureaus. Reforms are also needed to ease foreclosure laws and expand markets for collateral.
  • Cost of capital. Steps to lower the cost of capital would include increased competition in the financial sector leading to a reduction in banking spreads, and the removal of the deposit floor in the banking sector.
  • Listing requirements and transaction costs. Minimum capital requirements for listing on the ECSE are the highest in the Caribbean. Transaction costs and bid-ask spreads are also very high, deterring trading activity and contributing to thinness in the market.
  • Alien land holding restrictions. In ECCU jurisdictions, licenses are required for nonresidents to purchase shares in companies that own land. There is a move to exempt shares purchased on the ECSE from these requirements, but legislation remains to be approved in four countries.
  • Credit ratings. Caribbean capital markets are largely dominated by sovereign debt securities, yet many do not carry any credit ratings. Credit ratings for sovereigns (including through a regional ratings agency) could help establish pricing benchmarks and yield curves for local capital markets. 25

C. Reducing Vulnerabilities

36. While the medium-term outlook for the ECCU region appears favorable, it remains vulnerable to exogenous shocks. Growth is expected to remain above potential and moderate in the medium term as construction activity winds down. In addition, under current policies, fiscal consolidation is expected to be limited and public debt levels will increase slightly. Major vulnerabilities include: high public debt; further erosion of trade preferences; the region’s exposure to natural disasters; population ageing; reliance on high-priced energy imports; and dependence on tourism.

Fiscal imbalances and debt sustainability

37. A fundamental overhaul of government expenditures is needed to achieve fiscal sustainability and preserve the stability of the currency union. Sustained weakness in fiscal performance has led to high levels of indebtedness, potentially undermining the stability of the currency union. While revenue measures are being undertaken in many ECCU countries—in particular, introduction of VATs, market-valuation based property taxes, flexible fuel pricing, and strengthened tax administration—expenditures are also rising, limiting progress with fiscal consolidation (Figure 15).

Figure 15.
Figure 15.

ECCU: Fiscal Expenditure

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: World Economic Outlook; World Health Organization; World Development Indicators; and Fund staff calculations.1/ The straight line indicates the relative efficiency frontier. The distance from the frontier indicates the degree of inefficiency of that country’s spending. The sample consists of mostly Caribbean and Latin American countries and some small island economies in the Mediterranean.

38. The ECCB’s revised fiscal benchmarks have yet to be made operational. In mid-2006 the ECCB’s Monetary Council agreed to a revised system of fiscal benchmarks that places increased emphasis on integrating annual budget objectives with the medium-term goal of reducing public debt to 60 percent of GDP by 2020. However, national authorities have yet to take decisive ownership of the revised benchmarks as key guideposts for national fiscal policies. They expressed little desire for an enforcement mechanism based on economic sanctions to assist in achieving the benchmarks, with a clear preference for peer review and enhanced transparency. The staff encouraged the authorities to establish appropriately ambitious, yet achievable, annual budget targets set within multiyear macroeconomic frameworks, consistent with the revised ECCU benchmarks. The targets should be published and allow for adverse shocks by aiming for stronger fiscal consolidation in periods of above-average growth.

39. The ECCB Monetary Council’s recent decision to establish a Public Expenditure Commission is a welcome step, and can help forge regional consensus on expenditure priorities and the role of government. Analogous to the positive experience with the earlier OECS Tax Reform Commission, a broad social dialogue should help establish expenditure priorities consistent with available fiscal resources and the overarching importance of fiscal prudence. Staff noted that the Commission could usefully examine: the optimal role of government, scope for civil service reform and privatization; instruments to better target social safety nets; and ways to better prioritize capital spending with optimal utilization of grant financing and strengthening of PSIP processes. Regional provision of government services could be an important source of efficiency gains, as envisaged under the OECS Economic Union, provided there are corresponding economies in government services at the national level.

40. The authorities expressed concern that fiscal adjustment alone would be inadequate to ensure debt sustainability in the region. Several of the national authorities perceived the magnitude of fiscal adjustment required to achieve the ECCB benchmarks as daunting, and perhaps not socially feasible. They explained that while many fiscal measures had been undertaken, vulnerabilities to natural disasters, trade preference erosion, and infrastructure requirements had created social and capital spending needs that could not be deferred. To address the debt situation, they considered that the region would need to formulate debt strategies, seek assistance from debt advisors to conduct comprehensive reviews and management of their debt stock, as well as tap debt relief wherever possible.

Ageing and social spending

41. Ensuring adequate health care coverage will require a multi-pronged and innovative approach to contain costs and manage outcomes (Figure 16). Due to rapid population ageing and changing lifestyles, the incidence of non-communicable diseases (such as heart disease, diabetes, and hypertension) is rising in the ECCU. The region’s health care systems are largely publicly financed, and although there are pressures to move towards universal health care, the authorities are concerned about the fiscal costs this may entail. 26 They are considering a multi-pronged approach, including promoting healthier lifestyles; improving preventive primary and secondary health care; and regional sharing arrangements in the provision of tertiary and capital-intensive medicine, in order to exploit economies of scale. Alternative financing options being considered for higher healthcare spending include an increase in the VAT rate, as well as private insurance and well-targeted user fees. 27

Figure 16.
Figure 16.

ECCU: Cost of Treating Diabetes, 2000–30 1/

(In Percent of GDP) (Cost of treating diabetes could increase significantly in some ECCU countries.)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: Caribbean Commision on Health and Development (2005); and Fund staff calculations.
uA01fig15

ECCU: Age-adjusted Total Death Rates by Cause, 2003

(Per 100,000 population)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Source: World Health Organization.

42. Action is needed to ensure the sustainability of social security systems. Governments in the region have used social security funds as a captive source of financing (at below market rates of interest), which has exacerbated the impact of rapid population ageing and high emigration. As a consequence, social security systems have large unfunded liabilities, and their reserve assets are projected to be depleted soon in several countries. 28 Parametric adjustments to social security schemes (increasing the retirement age and contribution rates, changing the benefits formulae), as well as greater international portfolio diversification of scheme assets, are essential to ensure the long-term viability of social security. Staff were encouraged by reforms already enacted in Dominica and St. Lucia, and those under active consideration by other governments (such as St. Vincent and the Grenadines). The current political momentum should be used to enact the necessary reforms as soon as possible, as well as to address the issue of noncontributory double pensions for civil servants in some ECCU countries. Staff also welcomed the ECCB Monetary Council’s establishment of a Social Security Commission, to spearhead work on this important issue.

ECCU: Projected Year of Pension Fund Reserve Asset Depletion

article image
Sources: Actuarial reviews; financial statements; and Fund staff estimates.

This projection assumes constant emigration at historical levels.

uA01fig16

ECCU: Net Implicit Pension Fund Debt, 2006

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 094; 10.5089/9781451811711.002.A001

Sources: Actuarial reviews; financial statements; and Fund staff estimates.

Financing issues

43. The high debt and debt servicing burdens of ECCU countries make them vulnerable to a tightening in global liquidity conditions. Enhanced debt management capacities could help in managing such vulnerabilities. Staff pointed out that ECCU governments have increasingly borrowed on commercial terms in Trinidad and Tobago and other CARICOM countries (Table 6). Interest rate spreads for such borrowing have not followed the decline of emerging market spreads in recent years, probably reflecting the region’s elevated debt levels as well as the impact of debt restructurings. As global liquidity conditions tighten and world interest rates rise, it may become more difficult and burdensome for ECCU governments to borrow commercially. The authorities agreed that rising interest rates could pose a challenge in an already difficult fiscal situation. They emphasized the need for Fund technical assistance to enhance debt management capacity—as planned for St. Lucia and St. Kitts and Nevis—to improve cash flow budgeting, extend debt maturities, and replace more expensive debt with cheaper debt.