Public Information Notice No. 05/118

Public Information Notice: IMF Executive Board Concludes Discussion on the Eastern Caribbean Currency Union Region

August 19, 2005

On July 13, 2005, the Executive Board of the International Monetary Fund (IMF) concluded its discussion on the Eastern Caribbean Currency Union.¹

Background

Economic growth has declined since the start of the 1990s as the region struggled to cope with a series of shocks. Growth declined from nearly 6 percent per annum in 1980-89 to less than 3 percent per annum in 1990-2004. Growth slowed with the erosion of trade preferences for traditional agricultural products (bananas and sugar), a sharp reduction in official development assistance, and the September 11 attack in 2001. Economic activity has accelerated since mid-2003—despite an active hurricane season in 2004—due to an acceleration of activity in the tourism and construction sectors. The impact of Hurricane Ivan on Grenada was severe, but because damage to other ECCU countries was limited, growth in the region was just above 3 percent compared to a pre-Ivan projection of 4 percent. Similar growth is expected in 2005.

Fiscal stances were relaxed in the second half of the 1990s in an attempt to raise growth rates, resulting in very high public debt levels in the region. As the economies slowed, public investments rose and the government was used as the employer of last resort. After a sharp adjustment in 2003, central government primary balances in the region improved modestly in 2004, but remained marginally in deficit for the region as a whole. This reflected significant strengthening in primary balances in both Antigua and Barbuda—as the new administration attempted to contain fiscal imbalances—and in Grenada—where public sector investment was curtailed sharply. Fiscal positions were eased in the rest of the region, notably in St. Kitts and Nevis. Public sector debt stocks have averaged more than 100 percent of GDP since end-2002.

The rebound in tourism helped to narrow the external current account deficit in 2004, but it remained large—at 17 percent of GDP—and financed mostly by foreign direct investment (FDI). In the past two years, tourist arrivals have increased sharply with the easing of the global security concerns, the rebound in growth in the world economy and the depreciation of the U.S. dollar against major currencies that has improved competitiveness in European markets. Imports continued to increase in relation to GDP, partly reflecting an increase in current transfers (largely to Grenada), which more than offset a modest decline in FDI flows. Gross international reserves of the Eastern Caribbean Central Bank (ECCB) have continued to rise, reaching US$632 million at end-2004, implying that the coverage of monetary demand liabilities has increased to 96 percent, well above the legally mandated floor of 60 percent.

Inflation has been stable and monetary aggregates have been expanding rapidly, reflecting continued growth in the demand for money and confidence in the banking system and the quasi-currency board arrangement (CBA). Broad money grew 9½ percent in 2003 and 13½ percent in 2004, but inflation remained at around 2 percent. The brisk growth of deposits and weak credit growth, particularly to the private sector, has left the banking system highly liquid. Capital markets have continued to develop, particularly the Regional Government Securities Market which has become a key regional market—only Antigua and Barbuda and Dominica have yet to place issues. The number of equities listed on the Eastern Caribbean Securities Exchange has continued to increase.

Executive Board Assessment

Directors observed that the ECCU region has been confronted with several challenges in the last decade, including the erosion of trade preferences in traditional agricultural exports, a decline in official development assistance, recurring natural disasters, and the September 11, 2001, shock to tourism, all of which contributed to a sharp decline in economic growth. The growth slowdown, combined with a relaxation in fiscal stances, has considerably weakened economic conditions and led to a rapid buildup of public debt. Directors noted that, while recent growth and fiscal outcomes have improved, economic policies have not strengthened sufficiently to place debt on a clearly downward path and ensure sustainable growth, and many structural rigidities and vulnerabilities remain.

Against this background, Directors called for strengthening fiscal consolidation, lowering the debt ratios, and ensuring the consistency of fiscal policies with the currency board arrangement, while undertaking reforms aimed at improving private-sector-led growth. These reforms should focus on improving the investment climate and competitiveness through lowering labor costs, providing for greater flexibility and integration of the labor and product markets, and reducing the role of the public sector. More generally, Directors called for intensified economic and financial integration, which would help provide the full benefits of a common currency area.

Directors noted the increasing determination among the authorities to tackle the region's difficult economic situation, including in recent electoral campaigns. They welcomed the step-up in outreach efforts by governments through town hall meetings, public policy debates, and press conferences. Directors recognized that the improved quality and depth of dialogue between staff and the authorities has helped instill greater public awareness of economic problems and attain public consensus on the need for fiscal and structural reforms, and they encouraged further efforts in this direction.

Directors noted the steps being taken by most countries to address their underlying macroeconomic imbalances. However, the recent easing of fiscal policies in some countries in anticipation of the elections and the 2007 World Cricket Cup was a setback, and Directors stressed that the authorities should take advantage of the favorable global growth outlook and step up the pace of fiscal reform. In this context, and expressing concern about the seriously high debt levels, Directors urged the authorities to strengthen fiscal institutions in order to facilitate fiscal consolidation. This should be achieved through expanded tax bases, better expenditure and public debt management, and well prioritized and effective public sector investment programs.

Directors underscored the importance of ensuring consistency between national fiscal policies and the regional quasi-currency board arrangement in order to preserve the exchange rate arrangement. They noted that protracted fiscal weaknesses could adversely affect confidence in the CBA and macroeconomic stability. In this regard, Directors urged that efforts be made by regional governments to achieve the fiscal benchmarks approved by the ECCB's Monetary Council. Directors considered that greater fiscal responsibility could be encouraged by the setting of interim annual fiscal targets, in association with broader dissemination of fiscal performance relative to the benchmarks in order to generate heightened discipline and public ownership of fiscal performance.

Directors noted that financial contagion risks are likely to rise as regional financial markets deepen, pointing to a need for continued efforts to strengthen financial sector supervision. In this regard, Directors urged the implementation of key measures identified by the regional Financial Sector Assessment Program, including an increase in the frequency of on-site bank inspections and the approval of amendments to the Uniform Banking Act at the national level. The regulatory and supervisory frameworks for the nonbank and insurance sectors should also be strengthened. Further, Directors underscored the importance of developing contingency plans by country authorities, in coordination with the ECCB, to prepare for unanticipated shocks and crises.

Directors noted that the region's high public debt levels limit the ability of ECCU governments to use fiscal policy to respond to external shocks, underscoring the need for measures to reduce the region's vulnerabilities. Directors urged the authorities to further enhance disaster mitigation and preparedness activities, and undertake greater investment in insurance of public assets and infrastructure, possibly through participation in regional insurance pooling arrangements.

Directors stressed the importance of boosting the competitiveness and growth potential of the region. They urged a fundamental change in the role of the public sector in the region, away from serving as employer of last resort and main engine of growth, to that of providing a supportive business environment to permit the private sector to flourish. Directors recommended that the investment climate be improved by deepening regional integration, removing labor market rigidities, revamping the regulatory framework, and attaining greater efficiencies through consolidation and provision of collective government services. Directors also emphasized that the region's distortionary, nontransparent, and costly tax concessions be reformed, and that a coordinated regional approach be adopted to avoid costly tax competition between islands. Also, in light of the high emigration rates of skilled labor from the region, Directors saw scope for tapping the Caribbean diaspora to support domestic private investment. Directors also recommended that distortions in financial markets, including the floor on the rate for savings deposits, should be gradually phased out to stimulate private sector credit and investment.

Directors welcomed the continued emphasis placed by the ECCB on strengthening the availability and quality of statistics in the region. They stressed that improvements in the coverage, quality, and timeliness of statistical data in all areas would facilitate better assessment of economic, social, and financial conditions, and enhance the quality of policymaking and public debate at all levels.