Abstract
This paper assesses the evolution of Eastern Caribbean Currency Union (ECCU) real exchange rates over time, and examines whether the region has lost competitiveness. The main finding is that there is little evidence of overvaluation of the Eastern Caribbean (EC) dollar. The relationship summarized above permits the calculation of equilibrium current account balances or norms. The financing of ECCU current account imbalances appears stable. This paper also provides evidence on the distinctive impact that tourism plays in the determination of the real exchange rate in tourism-driven economies.
II. Price Dynamics in the Eastern Caribbean Currency Union13
A. Introduction
1. ECCU member countries have generally enjoyed low inflation in the context of the regional quasi-currency board exchange rate arrangement, with a fixed peg with the U.S. dollar. The currency union is one of only two currency unions in the world with a fixed exchange rate.14 It is the only one in which member countries pool their foreign reserves; the convertibility of the common currency is fully self-supported; and the parity of the exchange rate has not been changed in more than three decades.
Inflation Rates, 1985–2006
(In percent)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: WEO; and Fund staff estimates.1/ Simple average of The Bahamas, Barbados, Belize, Dominican Republic, Guyana, Haiti, Jamaica, and Trinidad and Tobago.Inflation Rates, 1985–2006
(In percent)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: WEO; and Fund staff estimates.1/ Simple average of The Bahamas, Barbados, Belize, Dominican Republic, Guyana, Haiti, Jamaica, and Trinidad and Tobago.Inflation Rates, 1985–2006
(In percent)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: WEO; and Fund staff estimates.1/ Simple average of The Bahamas, Barbados, Belize, Dominican Republic, Guyana, Haiti, Jamaica, and Trinidad and Tobago.2. This chapter formally examines the influence of the ECCU exchange rate arrangement on price dynamics in the six Fund-member ECCU countries. First, given the longstanding fixed peg with the U.S. dollar, it examines to what extent the U.S. price level has helped anchor price movements in the ECCU countries. Second, it analyzes whether the currency union arrangement has promoted price convergence among the ECCU countries and led to greater real exchange rate stability. Answers to these questions help address whether price movements in ECCU countries are entirely imported or have some domestic policy content, and whether the ongoing process of economic integration within the ECCU would help promote greater price convergence.15
B. What is the Composition of CPI Baskets?
3. The ECCU countries have similar consumption patterns, but the weights of individual components of CPI baskets vary considerably across the countries (Table II.1). For instance, the item “food and beverages” has the largest weight in the relatively less-developed Windward Islands, accounting for 35–55 percent of the total CPI basket.16 Conversely, the components “housing” and “transportation and communication” carry more weight—in the order of 30–40 percent—in the relatively more-developed Leeward Islands.
ECCU: Current Composition of CPI Basket
T = tradables; N = nontradables.
ECCU: Current Composition of CPI Basket
| Category 1/ | Antigua and Barbuda | Dominica | Grenada | St. Kitts and Nevis | St. Lucia | St. Vincent and Grenadines | |
|---|---|---|---|---|---|---|---|
| All items | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | |
| Food | T | 214 | 329 | 368 | 281 | 468 | 536 |
| Alcoholic beverages and tobacco | T | 2 | 10 | 9 | 7 | 28 | 10 |
| Clothing and footwear | T | 111 | 82 | 98 | 93 | 65 | 98 |
| Housing | N | 218 | 112 | 102 | 130 | 135 | 30 |
| Fuel and light | T | 64 | 59 | 55 | 44 | 45 | 89 |
| Medical care & health expenses | N | 28 | 32 | 47 | 37 | 23 | 62 |
| Household furnishing | T | 126 | 94 | 95 | 141 | 58 | 69 |
| Transportation and communication | N | 154 | 194 | 157 | 193 | 63 | 10 |
| Education | N | 23 | 29 | 37 | 21 | - | 34 |
| Personal services | N | 43 | 43 | 16 | 20 | 32 | 34 |
| Miscellaneous | N | 18 | 18 | 18 | 34 | 83 | 30 |
| Memorandum items: | |||||||
| Tradables | T | 516 | 573 | 624 | 565 | 663 | 726 |
| Nontradables | N | 484 | 428 | 376 | 435 | 337 | 274 |
T = tradables; N = nontradables.
ECCU: Current Composition of CPI Basket
| Category 1/ | Antigua and Barbuda | Dominica | Grenada | St. Kitts and Nevis | St. Lucia | St. Vincent and Grenadines | |
|---|---|---|---|---|---|---|---|
| All items | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | 1,000 | |
| Food | T | 214 | 329 | 368 | 281 | 468 | 536 |
| Alcoholic beverages and tobacco | T | 2 | 10 | 9 | 7 | 28 | 10 |
| Clothing and footwear | T | 111 | 82 | 98 | 93 | 65 | 98 |
| Housing | N | 218 | 112 | 102 | 130 | 135 | 30 |
| Fuel and light | T | 64 | 59 | 55 | 44 | 45 | 89 |
| Medical care & health expenses | N | 28 | 32 | 47 | 37 | 23 | 62 |
| Household furnishing | T | 126 | 94 | 95 | 141 | 58 | 69 |
| Transportation and communication | N | 154 | 194 | 157 | 193 | 63 | 10 |
| Education | N | 23 | 29 | 37 | 21 | - | 34 |
| Personal services | N | 43 | 43 | 16 | 20 | 32 | 34 |
| Miscellaneous | N | 18 | 18 | 18 | 34 | 83 | 30 |
| Memorandum items: | |||||||
| Tradables | T | 516 | 573 | 624 | 565 | 663 | 726 |
| Nontradables | N | 484 | 428 | 376 | 435 | 337 | 274 |
T = tradables; N = nontradables.
4. Despite their small sizes and openness, the ECCU countries have a sizeable share of nontradables in their consumer baskets. While the classification of CPI components into tradables and nontradables is a subjective exercise, as a general rule of thumb all goods (usually imported) are classified as “tradable,” while services (usually domestically produced) are classified as “nontradables.”17 Generally speaking, the higher the income level of a country, the higher is the share of nontradables—with the share of nontradables ranging from over 25 percent in St. Vincent and the Grenadines to close to 50 percent in Antigua and Barbuda.
C. Impact of U.S. Price Movements
5. A close examination of the data—from 1990 to 2006—reveals two stylized facts:
Price indexes in the ECCU have generally moved closely with the U.S. price index (Figure II.1). Indeed, the ECCU countries have enjoyed remarkable price stability for decades—their average annual rate of inflation was about 3 percent during 1982–2006. Nevertheless, relative price indexes (i.e., bilateral real exchange rates) between individual ECCU countries and the U.S. do not appear to comove, suggesting that inflation in the ECCU is not entirely imported (Figure II.2).
Inflation volatility in the ECCU countries has been much higher than that of the U.S. (Figure II.3). As ECCU countries face more exogenous shocks in the context of a fixed nominal exchange rate, their domestic prices have to adjust more frequently to absorb the shocks.
ECCU: Consumer Price Index Movement, March 1990–December 2006
(Logarithmic scale, index September 1995=100)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Consumer Price Index Movement, March 1990–December 2006
(Logarithmic scale, index September 1995=100)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Consumer Price Index Movement, March 1990–December 2006
(Logarithmic scale, index September 1995=100)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.
ECCU: Relative Price Indexes with the United States, March 1990–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Relative Price Indexes with the United States, March 1990–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Relative Price Indexes with the United States, March 1990–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.
ECCU: Quarterly Inflation, March 1990–December 2006
(In percent)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Quarterly Inflation, March 1990–December 2006
(In percent)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Quarterly Inflation, March 1990–December 2006
(In percent)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.6. A formal econometric analysis confirms that while U.S. price stability has helped anchor price stability in the ECCU, inflation in the ECCU is not entirely imported. An error-correction model is used to formally establish the link between the ECCU and U.S. price levels. First, the price level in each ECCU country is found to cointegrate with the U.S. price level, suggesting a country-specific long-run equilibrium between the two series (Table II.2). However, for most countries and the ECCU as a whole, the cointegration coefficients are statistically significantly different from one. Panel unit root tests also confirm that relative price indexes between ECCU countries and the U.S. are nonstationary, suggesting that U.S. inflation does not translate one-to-one into ECCU inflation even in the long run. Second, short-run deviations are stationary in that a positive (negative) deviation from the equilibrium level reduces (increases) the rate of inflation, pushing the domestic price back to its equilibrium level. The speed of adjustment to equilibrium is quite fast, with an estimated half life of about eight months for the ECCU as a whole.
ECCU: Price Levels—Long-Run Equilibrium Relationships Dependent variable: Domestic price level 1/
All variables are in logarithms.
Coefficient on U.S. price level in cointegrating regression, with standard error in parentheses.
ECCU: Price Levels—Long-Run Equilibrium Relationships Dependent variable: Domestic price level 1/
| Country | Cointegration Equation 2/ |
|---|---|
| ECCU average | 0.785 |
| (−0.042) | |
| Antigua and Barbuda | 0.326 |
| (−0.089) | |
| Dominica | 0.679 |
| (−0.083) | |
| Grenada | 0.934 |
| (−0.074) | |
| St. Kitts and Nevis | 1.475 |
| (−0.291) | |
| St. Lucia | 0.965 |
| (−0.059) | |
| St. Vincent and the Grenadines | 0.704 |
| (−0.06) |
All variables are in logarithms.
Coefficient on U.S. price level in cointegrating regression, with standard error in parentheses.
ECCU: Price Levels—Long-Run Equilibrium Relationships Dependent variable: Domestic price level 1/
| Country | Cointegration Equation 2/ |
|---|---|
| ECCU average | 0.785 |
| (−0.042) | |
| Antigua and Barbuda | 0.326 |
| (−0.089) | |
| Dominica | 0.679 |
| (−0.083) | |
| Grenada | 0.934 |
| (−0.074) | |
| St. Kitts and Nevis | 1.475 |
| (−0.291) | |
| St. Lucia | 0.965 |
| (−0.059) | |
| St. Vincent and the Grenadines | 0.704 |
| (−0.06) |
All variables are in logarithms.
Coefficient on U.S. price level in cointegrating regression, with standard error in parentheses.
D. The Real Exchange Rate Within the ECCU18
7. The ECCU provides an interesting case study for analysis of the evolution of the real exchange rate. The literature on the real exchange rate has focused on either countries with different currencies or cities within the same country to which trade barriers or currency fluctuations do not apply. A currency union such as the ECCU is something in between these two polar cases. Nominal exchange rate variation, a standard factor underlying real exchange rate differences across countries, is not applicable in the ECCU countries, which share a common currency. However, many structural policies—related to trade barriers, factor market segmentation, and industry regulations—differ across the ECCU, making these countries less integrated than cities within the same country.
8. Absolute purchasing power parity (PPP) does not appear to hold within the ECCU. Figure II.4 depicts relative price indexes (i.e., the real exchange rate) using Antigua and Barbuda as the benchmark, and they do not appear to be stationary. Also, standard unit root tests confirm the nonstationarity of bilateral real exchange rates, regardless of the choice of benchmark country.
ECCU: Relative Prices with Antigua and Barbuda, March 1994–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Relative Prices with Antigua and Barbuda, March 1994–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Relative Prices with Antigua and Barbuda, March 1994–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.9. To understand the factors underlying the deviation from PPP, the roles of nontradables prices and transportation costs were examined, as suggested in the literature (Engle, 1993; Parsley and Wei, 1996; Engel and Rogers, 2001; and Cecchetti, Mark, and Sonora, 2002). The key results are as follows:
Deviation from PPP among ECCU countries reflects persistent price differences in nontradables rather than tradables (Figures II.5 and II.6). Relative price indexes are indeed stationary for most tradable goods, except for fuel and light. The latter possibly reflect the fact that, in the sample period under consideration, retail fuel prices were administered in most ECCU countries, except Dominica.19 As for nontradables (housing, transportation and communication, education, and health care), relative price indexes are nonstationary, implying that country-specific structural and policy differences may have resulted in persistent differences in the national price of these nontradables.
Barriers to trade such as transportation costs do not explain deviations from PPP. Geographical distance is used as a proxy for transportation costs and there is no evidence that deviation from PPP is larger for countries which are further apart. This result contrasts with other studies in the literature, and likely reflects the low level of intra-country trade within the ECCU.
ECCU: Relative Nontradable Prices with Antigua and Barbuda, March 1994–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Relative Nontradable Prices with Antigua and Barbuda, March 1994–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Relative Nontradable Prices with Antigua and Barbuda, March 1994–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.
ECCU: Relative Tradable Prices with Antigua and Barbuda, March 1994–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Relative Tradable Prices with Antigua and Barbuda, March 1994–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.ECCU: Relative Tradable Prices with Antigua and Barbuda, March 1994–December 2006
(Logarithmic difference)
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff estimates.10. For tradables, the speed of convergence to PPP is faster for those components with a larger composition of perishables. Among the three tradable CPI components, the half life of deviation from price parity is estimated at about 4 quarters for food and beverages, much faster than the 8–9 quarters estimated for household furnishing and clothing and footwear. Parsley and Wei (1996) also found that perishable goods converged to PPP faster than nonperishable goods, using price data for cities in the United States.
11. While price index (i.e., inflation) convergence among ECCU countries has increased for tradables, price indexes for nontradables appear to have become more dispersed (Figures II.7 and II.8). With the exception of fuel and light, price index dispersion of all other tradable CPI components has decreased during 1990–2006, with the decline being very pronounced for food and beverages. As for nontradables, however, the inflation dispersion of the housing and transportation and communication components has increased. Inflation dispersion of the recreation and education and health care components appears to have declined slightly. However, given their very small weights in the CPI basket, it would be safe to conclude that price indexes of nontradables have become more dispersed.
ECCU: Inflation Dispersion of Tradables, 1990–2006
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff calculations.Note: Inflation dispersion is measured as the standard deviation of inflation across ECCU countries.ECCU: Inflation Dispersion of Tradables, 1990–2006
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff calculations.Note: Inflation dispersion is measured as the standard deviation of inflation across ECCU countries.ECCU: Inflation Dispersion of Tradables, 1990–2006
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff calculations.Note: Inflation dispersion is measured as the standard deviation of inflation across ECCU countries.
ECCU: Inflation Dispersion of Nontradables, 1990–2006
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff calculations.Note: Inflation dispersion is measured as the standard deviation of inflation across ECCU countries.ECCU: Inflation Dispersion of Nontradables, 1990–2006
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff calculations.Note: Inflation dispersion is measured as the standard deviation of inflation across ECCU countries.ECCU: Inflation Dispersion of Nontradables, 1990–2006
Citation: IMF Staff Country Reports 2008, 096; 10.5089/9781451811728.002.A002
Sources: ECCB; and Fund staff calculations.Note: Inflation dispersion is measured as the standard deviation of inflation across ECCU countries.E. Concluding Remarks
12. The findings of this chapter suggest that domestic policies and structural differences could have a persistent impact on prices in the ECCU. First, U.S. price stability has helped anchor price stability in the ECCU. However, inflation in the ECCU is not entirely imported from the U.S. Second, purchasing power parity does not hold within the ECCU due to the persistent price dispersion of nontradables, which has increased despite a decline of price dispersion in tradables in recent decades. Thus, policy differences—related to the labor market and trade barriers—as well as differences in structural characteristics appear to have played a role in maintaining persistent inflation differences across ECCU countries. Looking ahead, these differences should decline over time as labor market segmentation and trade distortions are gradually removed, in the context of greater economic integration among ECCU countries.
References
Cecchetti, S.G., N.C., Mark, and R.J. Sonora, 2002, “Price Index Convergence Among United States Cities,” International Economic Review, Vol. 43,pp. 1081–99.
Engel, C., and J.H. Rogers, 1996, “How Wide Is the Border?”, American Economic Review, Vol. 86, pp. 1112–25.
Engel, C., and J.H. Rogers, 2001, “Violating the Law of One Price: Should We Make a Federal Case Out of It?” Journal of Money, Credit and Banking, Vol. 33, pp. 1–15.
Engel, C., 1993, “Real Exchange Rates and Relative Prices: An Empirical Investigation,” Journal of Monetary Economics, Vol. 32, pp. 35–50.
Parsley, D.C., and S. Wei, 1996, “Convergence to the Law of One Price Without Trade Barriers or Currency Fluctuations,” The Quarterly Journal of Economics, Vol. 111, pp. 1211–36.
Sarno, L., and M.P. Taylor, 2002, “Purchasing Power Parity and the Real Exchange Rate,” IMF Staff Papers, Vol. 49, pp. 65–105.
Rogers, J.H., 2007, “Monetary Union, Price Level Convergence, and Inflation: How Close Is Europe to the USA?” Journal of Monetary Economics, Vol. 54, pp. 785–96.
Prepared by Yan Sun and Rupa Duttagupta.
The other currency union is formed by the CFA franc zone consolidating the two economic unions in Africa—West African Economic and Monetary Union (WAEMU) and the Economic and Monetary Community of Central Africa (CEMAC). While the ECCU fixed exchange rate is supported by a quasi-currency board arrangement—in that the Eastern Caribbean Central Bank needs to cover only 60 percent of its domestic liabilities with foreign reserves—in actuality it operates like a full fledged currency board with almost full coverage of demand liabilities.
The ECCU region is moving toward an Organization of Eastern Caribbean States (OECS) Economic Union. A draft Treaty was approved by OECS member countries in May 2007.
Windward Island countries are Dominica, Grenada, St. Lucia, and St. Vincent and the Grenadines. Leeward Island countries are Antigua and Barbuda and St. Kitts and Nevis.
One caveat is that the production of nontradables would include tradable inputs, which we are unable to take into account in the absence of more disaggregated data on the price indexes in ECCU CPI baskets.
This chapter uses “real exchange rate stability” and “purchasing power parity (PPP)” interchangeably, as the real exchange rate may be viewed as a measure of the deviation from PPP. See Sarno and Taylor (2002) for a literature survey on the real exchange rate and PPP.
Dominica has allowed full pass through from world oil prices to domestic retail fuel prices since late 2003. Grenada and St. Kitts and Nevis liberalized the determination of retail gasoline prices in late 2006.
