Abstract
The Eastern Caribbean Currency Union (ECCU) countries’ economies are heavily dependent on the United States for foreign direct investment, mainly in the tourism sector. The Selected Issues paper discusses economic development and policies of the ECCU. About one-third of the stayover tourists to the ECCU countries are from the United States., the top tourist-source country. The flow of remittances is also an important channel of influence, reflecting the significant proportion of Caribbean migrants living in the United States.
II. Optimal Reserves in the ECCU 1
1. This paper analyzes the adequacy of international reserves in the ECCU, using an optimization framework. Recent turbulence in global and Caribbean regional financial markets underscores the importance of reassessing the adequacy of international reserves held by the ECCB. With an open capital account and member countries highly susceptible to external shocks and natural disasters, the ECCB needs to maintain reserves to insure against current and capital account shocks. The ECCB is required by law to maintain international reserves to cover a minimum of 60 percent of its demand liabilities, and is often regarded as a quasi-currency board. In practice the ECCB maintains a reserve cover close to 100 percent of demand liabilities.
2. Gauged by traditional measures of reserve adequacy, the ECCB's holdings of international reserves appear to be in line with comparator countries. When compared with small, tourism-dependent economies, other currency unions and Caribbean countries, the ECCU indicators of reserve adequacy are found to be at the lower end of the range but close to the indicators for the comparators. In particular, the number of months of imports of goods and services held by the ECCB in international reserves averages around three, while most other comparator countries have reserves in excess of three months. Similarly, the ECCU countries have the lowest ratios of reserves to broad money and reserve money.
3. Using a self-insurance model, this paper finds that international reserves held by the ECCB are broadly adequate. The model is calibrated with parameters that have been used in a number of recent IMF studies of reserve adequacy. The results show that, historically, the ECCB's international reserves have been generally adequate for a variety of external current account and capital account shocks. However, the cushion of actual reserves over the optimal levels derived from the model has decreased over time. Moreover, the ECCB would be challenged in the event of moderate-to-severe deposit outflows.
4. International reserves are broadly adequate to cover current account shocks and natural disasters. Figure 1 shows that ECCU international reserves have been consistently above the optimal level needed to insure the region against potential current account shocks. Actual international reserves are larger than the amount required to withstand a shock equivalent to: (i) three months of imports; or (ii) a natural disaster of the average magnitude observed in the ECCU. In the event of a natural disaster with an impact on the current account of 10.8 percent of GDP and a probability of occurring of 10 percent, the optimal level of reserves is around 8.5 percent of GDP.
ECCU: Optimal Level of Reserves Given Different Shocks to the Current Account
(In percent of GDP)
Citation: IMF Staff Country Reports 2009, 176; 10.5089/9781451811742.002.A002
ECCU: Optimal Level of Reserves Given Different Shocks to the Current Account
(In percent of GDP)
Citation: IMF Staff Country Reports 2009, 176; 10.5089/9781451811742.002.A002
ECCU: Optimal Level of Reserves Given Different Shocks to the Current Account
(In percent of GDP)
Citation: IMF Staff Country Reports 2009, 176; 10.5089/9781451811742.002.A002
5. International reserves are also broadly adequate to cover some capital account shocks. The level of dollarization in the ECCU is moderate, with foreign currency deposits (mainly denominated in U.S. dollars) accounting for about 15 percent of total private sector deposits. The analysis shows that ECCB reserves are currently around the optimal size to insure the region against capital flight equivalent to the outflow of all short-term external debt plus foreign currency deposits. Actual reserves would also cover a shock equivalent to all demand liabilities, as expected with a quasi-currency board arrangement in place.
6. The ECCB would face challenges in responding to a scenario of a moderate to large deposit run. As shown in Figure 2, the ECCB holds reserves to withstand a shock equivalent to about 20 percent of total private sector deposits. However, the current level of reserves could prove to be an inadequate buffer against a heavy deposit outflow, although the presence of strong foreign banks may reduce the level of reserves required to insure against deposit outflows.
ECCU: Optimal Level of Reserves: Different Intensities of Bank Run
(In percent of GDP)
Citation: IMF Staff Country Reports 2009, 176; 10.5089/9781451811742.002.A002
ECCU: Optimal Level of Reserves: Different Intensities of Bank Run
(In percent of GDP)
Citation: IMF Staff Country Reports 2009, 176; 10.5089/9781451811742.002.A002
ECCU: Optimal Level of Reserves: Different Intensities of Bank Run
(In percent of GDP)
Citation: IMF Staff Country Reports 2009, 176; 10.5089/9781451811742.002.A002
7. Financial deepening over the last decade has reduced the cushion of actual international reserves over the optimal level required to withstand deposit outflows. The ECCB's operational rule of holding international reserves in excess of 80 percent of demand liabilities, while appealingly prudent, could systematically underinsure for deposit runs, because the deposit base has been growing at a much faster rate than demand liabilities. In fact, the income elasticity of broad money is estimated at 1.5 compared with an income elasticity of demand liabilities of about 1. Should this rule continue to be maintained, over time the level of international reserves would fall short of the optimal level. The projections in Figure 3 illustrate that even with full coverage of demand liabilities, in the next few years international reserves could fall below the level needed to cushion against a shock equivalent to 20 percent of total deposits.
ECCU: Optimal Level of Reserves: Different Intensities of Projected Bank Run
(In percent of GDP)
Citation: IMF Staff Country Reports 2009, 176; 10.5089/9781451811742.002.A002
Source: Authors' calculations.ECCU: Optimal Level of Reserves: Different Intensities of Projected Bank Run
(In percent of GDP)
Citation: IMF Staff Country Reports 2009, 176; 10.5089/9781451811742.002.A002
Source: Authors' calculations.ECCU: Optimal Level of Reserves: Different Intensities of Projected Bank Run
(In percent of GDP)
Citation: IMF Staff Country Reports 2009, 176; 10.5089/9781451811742.002.A002
Source: Authors' calculations.8. The constraints to monetary policy arising from a fixed exchange rate regime limit the ability of the ECCB to accumulate reserves. While the ECCB has a variety of monetary tools at its disposal, they are inherently limited because of the fixed exchange rate under the currency board arrangement. The most readily available tool is the rate of interest on fixed deposits that commercial banks hold with the ECCB, but raising this could imply quasi-fiscal losses for the ECCB since the rate that would be required to attract significant amounts of commercial bank fixed deposits might be higher than the central bank is earning on its foreign reserves. Retaining more of the central bank's profits could be another solution, but the accompanying build up in reserves is likely to be slow. Efforts by the central bank to strengthen the regulatory framework and to establish credit lines with international financial institutions (particularly other central banks) might also be useful to help insure against large adverse capital movements.
Summary of Working Paper, WP/09/77, “Optimal Reserves in the Eastern Caribbean Currency Union,” by Mario Dehesa, Emilio Pineda, and Wendell Samuel.
