Front Matter

Front Matter Page

© 2008 International Monetary Fund

March 2008

IMF Country Report No. 08/96

Eastern Caribbean Currency Union: Selected Issues

This Selected Issues paper for the Eastern Caribbean Currency Union (ECCU) was prepared by a staff team of the International Monetary Fund as background documentation for the periodic regional surveillance of the ECCU. It is based on the information available at the time it was completed on January 9, 2008. The views expressed in this document are those of the staff team and do not necessarily reflect the views of the governments of the ECCU or the Executive Board of the IMF.

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Front Matter Page



Selected Issues

Prepared by Paul Cashin, Mario Dehesa, Pablo Druck, Rupa Duttagupta, Hunter Monroe, Nkunde Mwase, Koffie Nassar, Emilio Pineda, Yan Sun, and Evridiki Tsounta (all WHD)

Approved by the Western Hemisphere Department

January 9, 2008


  • Executive Summary

  • I. Assessing Exchange Rate Competitiveness in the Eastern Caribbean Currency Union

    • A. Introduction

    • B. Evolution of the Real Exchange Rate in the ECCU

    • C. Equilibrium Real Exchange Rate

    • D. Macroeconomic Balance Approach

    • E. Conclusions

Executive Summary

The analytical work associated with the Eastern Caribbean Currency Union (ECCU) 2007 Discussion on Common Policies continues the staff’s work on defining the policy agenda to help the region strengthen macroeconomic stability and reduce vulnerability.

The ECCU countries share a common currency, the EC dollar, which has been pegged to the U.S. dollar at the same rate for more than three decades.1 The first two chapters examine the impact of the peg on the region’s external competitiveness and price dynamics, respectively. Chapter I: Assessing Exchange Rate Competitiveness in the ECCU finds little evidence of overvaluation of the EC dollar. Real exchange rates appear to be currently close to their equilibrium levels, following a period of overvaluation in the late 1990s and early 2000s. Key determinants of the equilibrium real exchange rate include government consumption, terms of trade, and tourism-driven productivity differentials. Furthermore, despite their apparent high levels, medium-term current account deficits in the region appear sustainable. Chapter II: Price Dynamics in the ECCU shows that U.S. price stability has helped anchor prices in the ECCU. Inflation in the ECCU is not entirely imported from the U.S., and so has some domestic policy content. In addition, purchasing power parity does not hold within the ECCU owing to increasing price dispersion of nontradables, despite a decline in price dispersion of tradables over the last two decades.

Under the present quasi-currency board arrangement, the Eastern Caribbean Central Bank (ECCB) has a very limited role as lender of last resort (LOLR). Chapter III: The ECCB: Challenges to an Effective Lender of Last Resort analyzes the challenges for the ECCB to be an effective LOLR as part of a modern banking crisis resolution framework. The main results from a theoretical model of the ECCB’s institutional arrangement are that the majority of currency union members may veto emergency lending in the case of a member-specific shock, as such lending may endanger the stability of the currency board (by lowering the central bank’s international reserves, thus raising devaluation risk). However, in the presence of contagion across member countries, all currency union members have a vested interest in liquidity supply from the central bank. A key policy recommendation is that currency union members need a stronger fiscal position to continue to access international financial markets and sustain the exchange rate peg.

The ECCU has never experienced a systemic banking crisis, despite being exposed to numerous exogenous shocks. Chapter IV: How Vulnerable is the Eastern Caribbean Currency Union to a Banking Crisis? examines the factors underpinning the resilience of ECCU banks, using a relatively novel statistical technique (binary classification tree). The results indicate that the banking system has been sheltered from major triggers of banking crises—excessive inflation and nominal depreciation—thanks to the stability provided by the quasi-currency board arrangement. Other precursors to banking crises—poor profitability, highly-dollarized liabilities, and low liquidity—have also not been major concerns in the ECCU thus far. However, rising dollarization and declining liquidity in some ECCU countries imply that bank stability should not be taken for granted, and the banking system should continue to be monitored carefully.

While world tourism has been rising sharply, the ECCU region’s share has declined. Chapter V: Tourism Demand in Small-Island Economies finds that tourism flows in the ECCU are sensitive to real exchange rate movements, hotel capacity, crime, and adverse exogenous shocks, including those emanating from source (tourism-originating) countries. These findings suggest that improved competitiveness, price stability, enhanced law enforcement, and tourism-source diversification could boost tourism flows to the region.

Motivated by the concern that corporate income tax (CIT) competition may have eroded the tax base in the Caribbean, Chapter VI: Corporate Income Tax Competition in the Caribbean calculates average effective tax rates to measure the impact of CIT competition, including the widespread use of tax holidays, on the tax base of 15 countries. The results not only confirm the erosion of the tax base, but also demonstrate the need to remove tax holidays, if recent tax policy initiatives (such as accelerated depreciation, loss carry-forward provisions, and tax harmonization) are to be effective. These findings suggest that the authorities should either avoid granting CIT holidays or rely more on other taxes (including consumption taxes) in order to broaden the tax base in the ECCU.

The demographic transition now underway in the ECCU is rapid compared with international experience, with emigration playing a particularly large role. As a result, ECCU pension funds’ expenditure is projected to exceed contributions by over 6 percent of GDP by 2060, requiring significant reforms to place pension schemes on a sustainable path. Chapter VII: Can the ECCU Afford to Grow Old? describes and quantifies several factors which could magnify the challenge of pension reform. First, for some ECCU countries, continued emigration at historical rates would considerably advance the projected date at which pension scheme assets are depleted. Second, there is a significant risk that assets will underperform, given the large exposures to the highly-leveraged public sector. Third, portfolio diversification away from the public sector could be complicated by age-related pressure for greater central government health spending.

Facing increasing health care costs and related equity concerns, many countries in the Caribbean are considering a move toward universal health care. Chapter VIII: Financing Universal Health Care: Lessons for the Eastern Caribbean and Beyond compares two main financing options (general taxation and payroll contributions) for universal health care in the ECCU, with an emphasis on the need to ensure financial sustainability given emerging demographic pressures and the epidemiological transition for chronic diseases. The study finds there is no “one-size-fits-all” solution to universal health care financing—public policy largely depends on the country’s economic, cultural, institutional, demographic, and epidemiological characteristics, as well as political economy considerations.


  • II. Price Dynamics in the Eastern Caribbean Currency Union

    • A. Introduction

    • B. What is the Composition of CPI Baskets?

    • C. Impact of U.S. Price Movements

    • D. The Real Exchange Rate Within the ECCU

    • E. Concluding Remarks

  • III. The ECCB: Challenges to an Effective Lender of Last Resort

    • A. Introduction

    • B. The LOLR Facility and its Monetary Effects

    • C. The ECCB Institutional Architecture

    • D. The Model

    • E. Conclusions

  • IV. How Vulnerable is the Eastern Caribbean Currency Union to a Banking Crisis?

    • A. Introduction

    • B. Empirical Literature and Methodology

    • C. Data

    • D. Empirical Results

    • E. Conclusion

  • V. Tourism Demand in Small-Island Economies

    • A. Introduction

    • B. Factors Affecting Tourism Flows

    • C. Conclusions

  • VI. Corporate Income Tax Competition in the Caribbean

    • A. Introduction

    • B. Background and Motivation

    • C. Related Literature

    • D. Developments in Statutory Corporate Income Tax Rates and Bases

    • E. Evolution of Effective Tax Rates

    • F. Concluding Remarks

  • VII. Can the ECCU Afford to Grow Old?

    • A. Introduction

    • B. Emigration and Sustainability

    • C. Asset Returns and Portfolio Allocation

    • D. Other Age-Related Spending

    • E. Policy Recommendations

  • VIII. Financing Universal Health Care: Lessons for the Eastern Caribbean and Beyond

    • A. Introduction

    • B. Financing Options for Universal Health Care

    • C. General Taxation Versus Wage Contributions

    • D. Preconditions for Successfully Financing Universal Health Care

    • E. Conclusions