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.
IV. Assessing Exchange Rate Competitiveness in the ECCU 1
1. The paper estimates the equilibrium real exchange rate in the tourism-driven ECCU economies, using three different approaches. First, the purchasing power parity (PPP) hypothesis is used to provide a benchmark to assess real exchange rates in the region. Second, a fundamentals-based equilibrium real exchange rate approach is used to explore sources of real exchange rate fluctuations in ECCU countries. Third, the macroeconomic balance approach is employed to examine whether the medium-term current account balance of the ECCU deviates from an estimated equilibrium current account position.
2. The PPP hypothesis is a common starting point when calculating the equilibrium real exchange rate. Panel unit root tests indicate that real exchange rates in the ECCU economies revert to a long-run constant, thereby lending support to the PPP hypothesis. The paper finds little evidence of overvaluation of the EC dollar, and the speed of adjustment toward equilibrium is faster than that typically found in the literature for fixed-exchange rate regimes. The PPP analysis provides a first benchmark for the analysis of the real exchange rate, but it explains only a limited portion of real exchange rate volatility and fails to explain turning points in the real exchange rate. Thus it is necessary to introduce a model that emphasizes the time-varying nature of the real exchange rate, whereby real factors (fundamentals) have a role in its determination.
3. There is a large empirical literature on the real determinants of the long-run real exchange rate. In the case of the tourism-dominated economies of the ECCU, the real exchange rate is expected to be driven by: tourism-based productivity differentials (which raise nontradable prices); higher terms of trade (appreciates the real exchange rate through wealth effects); higher government consumption (likely to appreciate the real exchange rate to the extent that it falls mostly on nontradables rather than tradables); and increased net foreign assets (which can in principle sustain a stronger real exchange rate). Figure 1 confirms the findings made by the PPP analysis: real exchange rates in the ECCU in general have experienced two periods of overvaluation, one in the early 1980s, and a second in the early 2000s. Based on data through end-2008, the ECCU real exchange rate is close to its most depreciated level in almost 20 years (reflecting the depreciation of the U.S. dollar against major currencies since 2002). Figure 2 demonstrates that the ECCU equilibrium real exchange rate has depreciated since 2000 as a result of a continuing accumulation of net foreign liabilities, increased government consumption spending, and the worsening terms of trade. A key finding is that the ECCU real exchange rate appears to be competitive: (i) there is little evidence of overvaluation of the EC dollar, as the ECCU real exchange rate is close to its equilibrium level; and (ii) movements in tourism-driven terms of trade and productivity are important determinants of the equilibrium real exchange rate.
4. Common arguments to claim an overvaluation of the EC dollar are the large current account imbalances in the region. The paper also makes use of the macroeconomic balance approach of the IMF's Consultative Group on Exchange Rate Issues (CGER) to assess real exchange rates in the ECCU. The macroeconomic balance approach calculates the difference between the current account (CA) balance projected over the medium term (2014) at the prevailing exchange rate, and an estimated equilibrium current account balance or norm. If the CA projected for the medium term exceeds (is close to) the estimated equilibrium CA or norm, there is evidence of exchange rate overvaluation (little evidence of overvaluation). Following the substantial CGER-based literature, key determinants of equilibrium current account balances in the Caribbean were found to be: fiscal balances (a fiscal surplus raises national saving and thereby increases the current account balance); oil balance (higher oil prices decrease the current account balance of oil-importing countries); relative income (at relatively low stages of development, increases in relative income would tend to improve a country's access to foreign capital and be negatively correlated with the current account balance); relative economic growth (stronger economic growth relative to trading partners is likely to be associated with a lower current account balance); foreign direct investment (FDI) and grants (higher FDI tends to affect the current account balance through increased imports).
5. The equilibrium current account deficit (the current account ‘norm’) is estimated at between 16–20 percent of GDP for the ECCU, for sample sets consisting of CARICOM-based and tourism-based economies (Figure 3). The staff's projected medium-term (2014) current account balance for the ECCU (20 percent of GDP) is close to the estimated level of the equilibrium current account. This implies that despite their high levels, the medium-term current account deficit—largely financed by private capital flows—appears sustainable. This also indicates that there is little evidence of overvaluation of the real exchange rate, as the medium-term current account balance is close to the current account norm. In addition, as shown in Figure 4, increased FDI and the growing oil trade imbalance have been the major contributors to the large ECCU current account imbalance.
6. While the ECCU current account imbalance is projected to remain above its estimated equilibrium level for an extended period, it is expected to decline over the medium term to a sustainable level. As tourist arrivals pick up and tourism-based investment opportunities in the ECCU decline over the medium term, private capital inflows and current account imbalances will narrow. Nonetheless, the region's high external imbalance, large public and external debt, and associated financing needs do pose risks that warrant careful monitoring and continued efforts at fiscal consolidation, to enhance debt sustainability, maintain competitiveness, and support the region's currency board arrangement.
Summary of IMF Working Paper WP/09/78, “Assessing Exchange Rate Competitiveness in the Eastern Caribbean Currency Union,” by Emilio Pineda, Paul Cashin, and Yan Sun.