Economic Stabilization in the Caribbean
Alvin D.L. Hilaire
Barbados, Guyana, Jamaica, and Trinidad and Tobago simultaneously tackled serious economic difficulties in the early 1990s. The results of their adjustment programs demonstrate that fiscal reform, supported by other policies, may be the key to achieving a sustainable recovery.
In the late 1980s and early 1990s, Barbados, Guyana, Jamaica, and Trinidad and Tobago were all wrestling with severe economic problems. During other difficult periods, each of these countries had been able to rely, to some extent, on its neighbors for support in the form of investment, export outlets, employment opportunities, or even direct government financing, but such support was lacking now that they all found themselves in dire economic straits.
These countries were similar in that they all had open economies, produced a relatively narrow range of products, and were members of a regional customs union, the Caribbean Community (CARICOM). But there were also important differences among them—including the types of products they specialized in, the extent of state involvement in productive activity, and the size of their outstanding debts—which determined their policy options.
As the 1980s drew to a close, Barbados's tourism and sugar sectors were depressed and its manufacturing sector was faltering, as exports to Trinidad and Tobago contracted. Growing government deficits—the result of rapid fiscal expansion—were financed at first by foreign borrowing and later by central bank credit. Rising unemployment created pressures for the government to provide jobs, and fiscal discipline became even more lax. The repercussions on the balance of payments were strong and direct: the external current account slipped into deficit; foreign exchange reserves plummeted; the specter of default on foreign loans loomed; and the exchange rate for the Barbados dollar, pegged to the U.S. dollar since 1976, came under threat.
Under a socialist model of development, in the 1970s Guyana nationalized virtually every foreign enterprise of any significance. It also erected an extensive system of price controls, trade restrictions, and foreign exchange rationing, which gave rise to smuggling and a parallel market for foreign exchange. However, many of the commercial activities controlled by the government proved to be highly unprofitable. The economy went into a deep recession, and the fiscal deficit spiraled out of control after oil prices soared in 1979-81 for the second time in a decade. The government turned to the central bank to finance its deficit, and balance of payments difficulties became even more intractable. By 1988, external payments arrears had mounted to more than $500 million.
The 1973-74 oil shock compounded Jamaica's fiscal and external imbalances, although the effects were initially dampened by windfall receipts from sugar exports and a new bauxite levy. As bauxite production was cut and aluminum prices softened, however, the government faced declining revenues and a soaring oil-import bill. Growing fiscal deficits were financed with central bank and external loans, and the underlying balance of payments situation weakened. Private investment dried up because of a lack of confidence in the government's populist program, and capital began to flee the country. By the mid-1970s, international reserves had run out. The government undertook major adjustment measures in the early 1980s, including sharply devaluing the currency and cutting public expenditure. Although such measures helped to restore confidence in the government's ability to manage the economy, they were inadequate to stabilize Jamaica's balance of payments.
Following large increases in oil prices in the 1970s, oil-exporting Trinidad and Tobago faced a classic "Dutch-disease" situation—that is, when a country focuses on the exploitation and export of a particular natural resource to the detriment of the rest of the economy. As government expenditure—initially restrained—picked up, prices of nontradables (such as real estate) rose sharply in relation to prices of imports and exports. The government invested in large projects in such sectors as steel and petrochemicals, with the explicit intention of reducing the country's dependence on oil. But by the time the oil boom was punctured in the early 1980s, the country had grown accustomed to a certain lifestyle, and necessary changes were delayed. Government and private consumption were slow to adjust, and fiscal deficits emerged. The collapse of real estate prices had repercussions throughout the economy, bringing down a number of financial enterprises. The large stock of foreign exchange reserves accumulated during the oil boom was depleted. Serious adjustment did not begin until the mid-1980s, when the government tightened import and exchange controls and devalued the currency.
All four countries adopted market-oriented strategies to reduce state economic activity and stimulate the private sector. This was a major change for Guyana, and encouraging foreign investment became a pillar of its comprehensive economic recovery program. Guyana's debt overhang was so overwhelming that it also sought external debt relief. With a fixed exchange rate, Barbados concentrated on spending cuts, economy-wide income restraints, and diversification into offshore financial services. Trinidad and Tobago combined income restraint with expenditure-switching measures, using devaluations to compensate manufacturers for exposing them to import competition. Jamaica concentrated first on rapid trade and financial liberalization and then on lowering inflation through tight monetary management. All of the programs were supported by IMF arrangements.
Fiscal policy. Fiscal policy, a main component of the programs, was initially contractionary, as policymakers sought to reduce overall spending and foreign exchange needs. Subsequently, the countries undertook tax reforms designed to fortify government revenue while stimulating private sector activity by reducing the income tax burden.
Although the fiscal dimensions of adjustment were quite similar across countries, there were important differences in the programs' components. Initially, all of the countries emphasized reducing expenditure—particularly capital expenditure—rather than increasing revenue, because the former measure was easier to implement. They also reduced the number of public sector workers while taking different approaches to wages: Barbados and Trinidad and Tobago cut nominal wages, but Jamaica and Guyana, where public sector real wages were severely eroded by inflation, did not. All four divested state assets and used the returns to finance public sector operations and reduce debt. However, the divestment process was partially reversed in Jamaica in the late 1990s. Tax policy, for the most part, initially involved an increase in indirect tax rates and new taxes on income. Tax regimes were subsequently streamlined through the consolidation of indirect taxes into a value-added or consumption tax and the compression and lowering of direct tax rates.
Between 1987 and 1993, a strong fiscal effort was evident, as all countries reduced their public sector deficits in relation to GDP or eliminated them entirely (see table). Thereafter, public finances stabilized or improved in Barbados, Guyana, and Trinidad and Tobago. Jamaica's fiscal position deteriorated by more than 10 percent of GDP, however, and its earlier surplus turned into a sizable deficit as costly domestic debt expanded markedly. By 1999, as much as 45 percent of central government revenue in Jamaica was devoted to interest payments.
Monetary policy. Monetary policy was not central to the adjustment programs (except in Jamaica in the late 1990s), and it was focused on limiting central bank credit to the public sector. Nonetheless, monetary control did contribute in all countries to reducing inflation—in Guyana and Jamaica, from triple and double digits, respectively, to single digits (see chart). Central banks stopped micromanaging the distribution of credit within the private sector, and the four countries moved toward market-oriented instruments of monetary policy while maintaining reserve requirements. Only Barbados retained controls on interest rates.
Financial reforms. Financial sector problems eventually emerged in all of the countries—the worst were in Jamaica— prompting varying degrees of public sector support for restructuring.
In Trinidad and Tobago, the oil boom sparked tremendous growth of unregulated nonbank deposit takers. Although new legislation was enacted to cover nonbank institutions and deposit insurance was introduced in the 1980s, the economy remained weak, and several institutions had to be restructured after receiving liquidity support from the government. Higher prudential standards were finally adopted in 1993.
In Jamaica, financial and capital account liberalization, high inflation, and the availability of government instruments at attractive interest rates contributed to the surge of new financial entities in the early 1990s. Some packaged themselves to take advantage of differential reserve and other requirements (such as lower reserve requirements for nonbanks than for banks). A number of financial conglomerates were set up, linking insurance companies, commercial banks, merchant banks, and building societies, and related-party lending became pervasive. As tight monetary policy led to a dramatic decline in inflation and an increase in real interest rates, loan portfolios weakened. A large part of the financial system was in deep trouble by 1996-97. The government responded by guaranteeing all deposits and life insurance policies and setting up a resolution company that eventually took over most domestic financial institutions, several of which the state had divested less than a decade earlier. Legislation was amended in 1997 to improve financial sector supervision and restrict credit to related parties; Jamaica introduced deposit insurance the following year.
In Barbados and Guyana, financial sector problems—limited to the poor performance of state banks active in the rice, sugar, and tourism sectors—were less severe. These two countries also considerably strengthened banking legislation and supervision, but in calmer financial environments.
Balance of payments difficulties. Policymakers also focused on the external current and capital accounts, in light of the need to reduce external imbalances. Trade was liberalized, with quantitative restrictions being phased out and replaced by temporarily higher import duties. This marked a major change from policies pursued before 1990, when Caribbean countries responded to balance of payments difficulties by tightening quantitative restrictions. The roots of this change of attitude lay in the adoption of a medium-term perspective emphasizing efficiency in a liberalized trading environment, influenced, no doubt, by the opening of trade worldwide. The liberalization of the external current account preceded the opening of the capital account in Jamaica, Guyana, and Trinidad and Tobago, which formally abolished all exchange controls and fully liberalized their external capital accounts.
Exchange rates. The four countries adopted different exchange rate policies. Barbados's steadfast adherence to a fixed exchange rate was given formal expression in successive "protocols" among the government, business, and labor leaders that laid the basis for economy-wide wage restraint. Jamaica and Guyana moved from fixed to floating exchange rates through a variety of arrangements; Jamaica held regular foreign exchange auctions, while Guyana adopted a "cambio" market arrangement by merging official market transactions with a large parallel market. The result was a substantial depreciation of the countries' currencies. Trinidad and Tobago switched abruptly from a fixed to a flexible exchange rate in 1993.
Outcomes and lessons
Although the four countries adopted similar strategies, there were differences in the timing of measures, public sector wage policies, the relative importance of monetary policy, and the choice of exchange rate regime. The programs initially resulted in a reduction of macroeconomic imbalances, but the resumption of sustainable growth was not achieved in all cases.
Barbados's currency experienced intense pressure in 1990-91, but sharp fiscal adjustment, accompanied by economy-wide wage restraint, helped restore balance both externally and internally. International reserves rose, the external debt-to-GDP ratio declined, and growth was restored in a low-inflation setting. Choosing a somewhat different path, Trinidad and Tobago also emerged from the recession with low inflation. Immediately after the currency was allowed to float in 1993, it depreciated vis-à-vis the U.S. dollar, from TT$4.20 to TT$5.75. It eventually settled at TT$6.30 to the U.S. dollar, supported by limited central bank intervention in the foreign exchange market.
Jamaica's most impressive accomplishment was to reduce inflation to less than 10 percent by 1997 from over 50 percent five years earlier. However, the trade-off was slow growth, as the high real interest rates that accompanied tight monetary policy depressed output. Jamaica did achieve some measure of external balance nonetheless, as reserves were built up and the external debt burden declined. With its extremely heavy debt burden, Guyana faced the most formidable constraints. However, with considerable debt forgiveness (including under the IMF and World Bank's Heavily Indebted Poor Countries (HIPC) Initiative), its external debt has fallen, and healthy foreign investment inflows helped improve the external accounts. Inflation dropped significantly, but a commendable growth performance was temporarily set back in 1998, and by the end of the decade the economy was still smaller than it had been in the early 1970s.
The lessons learned from these experiences can be valuable for future stabilization efforts:
Although each country had its own, independent stabilization program, it was influenced by the experiences of the other three countries, as well as by policy measures attached to multilateral loans and by trade commitments under CARICOM. Enhanced labor and capital mobility in the Caribbean, currently being proposed under CARICOM, would soften the impact of future economic shocks on individual countries by allowing labor and capital to move more easily around the region. Moreover, the common legacy of the recent stabilization programs includes less complicated tax systems, more liberal trade regimes, and stronger financial legislation, all of which, in the absence of major policy reversals, have given the countries the muscle to deal with the inevitable challenges to come.
This article is based on Alvin Hilaire, 2000, "Caribbean Approaches to Economic Stabilization," IMF Working Paper 00/73 (Washington: International Monetary Fund).