## 1. Fiscal Stances of Caribbean Countries, Average 1990–2004

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### Introduction: research question and scope
- Focus: relationship between exchange rate regimes and fiscal stances, specifically scope for moral hazard or “free-riding” behavior under fixed pegs, currency unions, fixed peg within a currency union (FPCU), and flexible regimes.
- Approach: develop a simple conceptual framework and conduct an empirical analysis for 15 Caribbean countries.
- Purpose: demonstrate that the exchange rate regime can have a very important bearing on fiscal discipline while abstracting from institutional factors.
- Empirical strategy: panel fixed-effects regression to control for unobservable heterogeneity and reduce simultaneity concerns by identifying specific channels of free-riding.

### Theoretical framework: environment, assumptions, and propositions
- Model environment and key assumptions:
  - Two-period model, perfect capital mobility, price flexibility; n identical countries; decentralized fiscal policy; no enforceable fiscal rules.
  - Fiscal dominance: common regional central bank eventually accommodates fiscal authorities and distributes seignorage revenue.
  - Households: constant endowment y, transfer g_i, can hold international bond f_i,t or nominal domestic currency M_i,t; transversality condition f_i,2 = m_i,2 = 0.
  - Governments are shortsighted (discount rate condition noted), private sector cannot create fiat money.
  - Central bank can commit to price stability in period 1 but may abandon commitment in period 2 and provide seignorage.
- Definitions of comparative spending measures (net present values) preserved exactly:
  - icflex g, : country with a flexible exchange rate regime (individual country).
  - cuflex g, : country in a currency union with a flexible exchange rate regime.
  - icfix g, : country with a fixed exchange rate regime (individual country).
  - cufix g, : country in a currency union with a fixed exchange rate regime (FPCU).
- Propositions:
  I. “Pure regional free-riding”: cuflex g, > icflex g, .
  II. “Pure intertemporal free-riding”: icfix g, > icflex g, .
  III. “Exacerbated free-riding”:
    - (a) cufix g, > icfix g, .
    - (b) cufix g, > cuflex g, .
- Selected analytical relations and exact expressions:
  - Under fixed exchange rates:
    - Money demand: ε− = r m0.
    - Solution for government spending in a currency union under fixed rates:
      - )1( )1()(' , 1, ε ε δ − += n r g u cufix i .  (equation (15))
    - If n =1:
      - )1( )1()(' , 1, ε ε δ − += r g u icfix i .  (equation (16))
    - Implication: using equation (13), icfix cufix gg , , > — Proposition III (a).
  - Under flexible exchange rates:
    - Identity: )1( 101 π − = m m (equation (17)); and εε/)1( 001 )1( − − += m r m m (equation (18)).
    - Combining first-order conditions yields:
      - Λ − += n r )1( )1( ε ε δ ψ  (equation (21)), with Λ defined explicitly.
    - Comparative implications preserved exactly:
      - )(' )1( )1( )1( )1()(' , 1, , 1, icflex i cuflex i gur n r gu = Λ − + < Λ − += ε ε δ ε ε δ .
      - Given ( )0ug′ < Æ icflex i cuflex i gg , 1, , 1, > — Proposition I.
      - Since 1 > Λ under assumptions, cuflex i cufix i gg , 1, , 1, > — Proposition III (b).
      - It is straightforward that , , ,1,1 ( ) (1)() (1) flex icfix ic ii ug r ug ε δ ε ′′ > += −  which implies icfix i g , 1, > icflex i g , 1, . Using equation (13), icfix g , > icflex g , — Proposition II.

### Conceptual implications emphasized
- Fixed exchange rates permit postponement of inflationary costs and hence intertemporal free riding by governments.
- Currency unions permit sharing of inflation costs across members and hence regional free riding.
- The combination (FPCU) can maximize scope for free riding by allowing transmission of inflation tax costs both across time and across countries.
- Flexible regimes limit such free-riding opportunities because inflationary impact is immediate and cannot be shared with other countries.
- Theoretical prediction: FPCU regimes are associated with exacerbated free-riding and worse fiscal outcomes relative to other regimes.

### Empirical analysis: sample, stylized facts, and context
- Sample: 15 Caribbean countries over 1983–2004; fiscal stance data available from 1983 onward.
- Regime variation in the sample:
  - ECCU countries (Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines) maintained their FPCU regime throughout the sample period.
  - The Bahamas, Barbados, Belize and Suriname maintained conventional fixed peg regimes throughout the sample period.
  - Guyana: fixed peg until 1989; Haiti: until 1991; Jamaica: until 1990; Trinidad and Tobago: until 1993; these later moved to more flexible regimes.
  - Dominican Republic: crawling peg until 2002, then adopted a floating exchange rate regime.
- Stylized facts (primary balance, percent of GDP, average 1990–2004):
  - The six ECCU countries with a FPCU regime had the worst average primary deficit in the Caribbean during 1990–2004.
  - Countries with fixed or crawling peg regimes were intermediate.
  - Countries with various forms of flexible regimes — including floats — were the best fiscal performers in the sample.
- Drivers of ECCU deterioration:
  - Worsening government expenditures increased sharply during the 1990s.
  - Fiscal expenditure growth generally surpassed GDP growth irrespective of the nature of the business cycle.
  - The rise in primary expenditure over time exceeded the increase in fiscal revenue during the same period in every ECCU country.
  - The composition of primary spending did not change in a major way.
- Capital flows:
  - ECCU governments had access to foreign financing even when other emerging market countries faced a turnaround of net capital inflows.
  - Non-FDI capital inflows to the ECCU continued even during periods of low economic activity.
  - Possible contributing factors: good repayment record, relatively low GDP volatility, perceived lender-of-last-resort role of the currency union central bank, elimination of transaction costs with financial innovation over time.

### Empirical methodology and identification strategy
- Motivation: address unobserved heterogeneity and potential simultaneity in prior cross-section studies.
- Estimation strategies:
  - OLS regression with binary dummy variables for pegged and FPCU regimes as RHS variables.
  - Fixed effects (FE) panel regression with time-varying proxies representing intertemporal and regional free-riding.
- Estimated equation specification:
  - y_it = α + β x_it + γ z_it + v_t
    - y_it: primary fiscal balance (percent of GDP).
    - x_it: control variables (see Box 1).
    - z_it: regime dummies under OLS; group of three indicators representing proxies for intertemporal and regional free-riding under FE.
    - v_t: error term.
- Control variables (Box 1):
  - (i) Economic performance: annual real GDP growth rate.
  - (ii) Trade openness: sum of exports and imports of goods and services as a percentage of GDP.
  - (iii) Terms of trade: ratio of export price to import price, in dollars.
  - (iv) Dummy for an IMF program.
  - (v) Time dummies.

### Key fixed-effects estimation findings (preserve exact coefficients and p-values)
- Main FE findings (Table 2, column (b)):
  1. Intertemporal free-riding significantly influences fiscal policies in fixed peg and FPCU regimes.
     - Intertemporal free-riding in the ECCU: Proximity to election for countries under the ECCU = -0.60 (0.01)**.
     - Intertemporal free-riding under fixed pegs: Proximity to election for fixed peg regimes = -0.36 (0.10)*.
     - Proximity to election for flexible regimes = 0.03 (0.92) — no significant negative association.
  2. Regional free-riding affects fiscal policies under the FPCU:
     - Official foreign reserves (relative to reserve money) for ECCU countries = -0.13 (0.01)**.
     - Official foreign reserves for non-ECCU countries = 0.00 (0.71).
  3. Fiscal stances under the ECCU worsen as relative country size rises:
     - Dummy for ECCU * relative country size in ECCU = -0.76 (0.03)**.
  4. IMF programs associated with improved fiscal stances:
     - Dummy for IMF program = 1.34 (0.10)*.
- Selected OLS coefficients (Table 2, column (a)):
  - Dummy for FPCU regime: -5.84 (0.00)**.
  - Dummy for fixed peg regime: -5.32 (0.00)**.
- Other selected coefficients and model statistics (Table 2):
  - Real GDP growth: -0.10 (0.30) [OLS], 0.00 (0.98) [FE].
  - Terms of trade: 0.00 (0.90) [OLS], 0.00 (0.83) [FE].
  - Trade openness: 0.02 (0.37) [OLS], 0.02 (0.05)** [FE].
  - Number of observations: 256.
  - Number of countries: 15.
  - R-squared: 0.31 [OLS], 0.34 [FE].
  - Significance of the regression: F(30, 211) 3.69**.
  - Significance of country specific effects: F(14, 211) 12.05**.

### Robustness checks and alternative specifications
- Robustness tests (summary):
  - Natural disaster dummies added (Table 3, column (a)); most natural disasters did not adversely affect fiscal balances except Antigua and Barbuda (1995) and St. Vincent and the Grenadines (1992).
  - Five key free-riding results remain robust:
    - Intertemporal free-riding under both FPCU and fixed peg regimes.
    - Absence of intertemporal free-riding under flexible regimes.
    - Deterioration of fiscal stances with increase in ECCB bailout capacity.
    - Deterioration with increase in relative size of member country in ECCU.
    - Absence of regional free-riding in non-FPCU countries.
  - Additional controls tested with no systematic influence: availability of external financing proxy, world oil prices, world interest rates (three-month U.S. treasury bill rate), institutional development (real GDP per capita).
- Alternative dependent variables (Table 3):
  - Primary expenditure (percent of GDP) as alternative proxy:
    - Intertemporal free-riding and size-based regional free-riding under ECCU continue to hold.
    - Intertemporal free-riding under fixed exchange rate regimes does not hold when using primary expenditure.
    - Primary spending does not increase in response to reserve coverage at the ECCB.
  - Fiscal revenue as alternative proxy:
    - Increase in ECCB bailout capacity reduces fiscal revenues significantly — regional free-riding manifested through laxity in generating fiscal revenues.

### Selected robustness coefficients and statistics (Table 3, FE regressions)
- Dependent variable: primary balance (256 observations), primary expenditure (282 observations).
- Key coefficients (primary balance):
  - Intertemporal free-riding in the ECCU: -0.59 (0.03)**.
  - Intertemporal free-riding under fixed pegs: -0.44 (0.09)*.
  - Regional free-riding (ECCU reserves): -0.11 (0.03)**.
  - Dummy for ECCU * relative country size in ECCU: -0.79 (0.05)**.
- Key coefficients (primary expenditure):
  - Intertemporal free-riding in the ECCU: 0.62 (0.01)**.
  - Dummy for ECCU * relative country size in ECCU: 2.56 (0.00)**.
- Model statistics:
  - R-squared: 0.54 [primary balance], 0.33 [primary expenditure].
  - Significance of the regression: F(89, 152) = 2.03** [primary balance]; F(37,230)=3.59** [primary expenditure].
  - Significance of country specific effects: F(14, 152) = 9.22** [primary balance]; F(14,230)=42.74** [primary expenditure].

### Policy-relevant implications and conclusions
- Empirical confirmation (15 Caribbean countries, 1983–2004):
  - Free-riding most intense in countries with fixed pegs under currency unions (FPCU), followed by countries with fixed pegs; not evident under flexible exchange rate regimes.
- Policy recommendations emphasized:
  - Ensure consistency of fiscal policies with prevailing monetary arrangements.
  - Under flexible regimes, immediate inflationary consequences help contain fiscal overspending incentives.
  - Under fixed and FPCU regimes, mechanisms are needed to enforce fiscal discipline in absence of inflationary deterrence:
    - Demonstrate regional central bank’s unwillingness to yield to fiscal dominance or bail out members to boost credibility of commitment to exchange rate stability.
    - The practice by the Eastern Caribbean Central Bank of not bailing out governments facing intermittent debt servicing problems has helped establish credibility in the ECCU region.
    - Under fixed exchange rates, mechanisms such as an independent central bank that can build a strong reputation over time would eliminate scope for intertemporal free-riding.

*Source: _wp06119 - 1. Fiscal Stances of Caribbean Countries, Average 1990–2004 (IMF PDF).*

### 1. Fiscal Stances of Caribbean Countries, Average 1990–2004 ............................................18

### 1. Fiscal Stances of Caribbean Countries, Average 1990–2004

### Major sections
- 1. Fiscal Stances of Caribbean Countries, Average 1990–2004 ............................................18
- 2. Eastern Caribbean Currency Union: Nature of Fiscal Stance, 1990–2004........................19
- 3. Private Net Capital Inflows (Less FDI) .............................................................................20

### Box
- 1. Control Variables Used in the Regression .........................................................................22

### Tables
- 1. Allocation of the Inflation Tax Under Alternative Exchange Rate Regimes ....................15
- 2. Determinants of Fiscal Policy in the Caribbean 1983–2004 .............................................25
- 3. Determinants of Fiscal Policy in the Caribbean 1983–2004 .............................................28

### Appendices
- I. Some Extensions to the Theoretical Model .......................................................................30
- II.     Data     Resources...................................................................................................................32

*Source: _wp06119 - 1. Fiscal Stances of Caribbean Countries, Average 1990–2004 (IMF PDF).*

### References..............................................................................................................

### _wp06119 - References

### Introduction: research question and scope
- Focus: relationship between exchange rate regimes and fiscal stances, specifically scope for moral hazard or “free-riding” behavior under:
  - fixed pegs,
  - currency unions,
  - fixed peg within a currency union (FPCU),
  - flexible regimes.
- Approach: develop a simple conceptual framework and conduct an empirical analysis for 15 Caribbean countries.
- Purpose: demonstrate that the exchange rate regime can have a very important bearing on fiscal discipline while not disregarding other determinants (institutional factors are acknowledged but abstracted from).
- Key empirical strategy: panel fixed-effects regression to control for unobservable heterogeneity and reduce simultaneity concerns by identifying specific channels of free-riding.

### Empirical motivation and stylized facts
- Why the Caribbean sample:
  - Region contains a variety of exchange rate arrangements including an FPCU (Eastern Caribbean Currency Union, ECCU).
  - Developing-country context where fiscal dominance cannot be ruled out.
  - Relatively high political and institutional stability supports fixed-effects estimation.
  - High exposure to exogenous shocks (natural disasters, global shocks to tourism, erosion of trade preferences) helps distinguish fiscal responses to downturns from fiscal indiscipline.
- Empirical findings (summary):
  - Among the 15 Caribbean countries, fiscal outcomes: worst in FPCU countries, followed by fixed or crawling pegs, while flexible regimes were the best fiscal performers.
  - Regression analysis:
    - Fiscal policies under both FPCU and other pegged regimes suffer from “intertemporal” free riding arising from ability to postpone inflationary costs.
    - Fiscal performance under flexible regimes is not affected by intertemporal free riding.
    - Fiscal stances deteriorate with increasing systemic importance for countries with the FPCU regime.
    - Improved bailout capacity of the currency union central bank is associated with worsening fiscal outcomes under FPCU regimes; not the case for countries not in a currency union.
  - Results are robust to a number of sensitivity tests.

### Literature review: how prior work informs the analysis
- Traditional view: fixed exchange rates induce fiscal discipline because fiscal profligacy risks reserve losses or debt buildup, leading to costly abandonment of the peg.
- Contradictory empirical episodes: CFA franc zone (January 1994), Argentina (December 2001) challenged conventional wisdom.
- Alternative theoretical insights:
  - Tornell and Velasco (1995, 2000): governments can postpone inflationary costs under fixed exchange rates and thus may overspend if short-sighted.
  - Beetsma and Bovenberg (1999); Chari and Kehoe (2004): in a currency union, decentralized fiscal authorities may overspend because benefits accrue domestically while inflation costs can be shared.
- Combined implication: a fixed peg within a currency union (FPCU) can create perverse incentives and exacerbate free-riding, especially under:
  - no enforceable fiscal rules and no coordination among member governments;
  - governments eventually relying on inflationary financing;
  - governments biased toward spending and shortsighted (discount the future more heavily than the present).

### Conceptual framework: environment and assumptions
- Model environment:
  - Two-period model, perfect capital mobility, price flexibility.
  - n identical countries, identical individuals, decentralized fiscal policy, no enforceable fiscal rules.
  - Fiscal dominance: a common regional central bank eventually accommodates fiscal authorities and distributes seignorage revenue.
- Key assumptions and distortions:
  - Households: constant endowment y, transfer g_i, can hold international bond f_i,t or nominal domestic currency M_i,t; law of one price, unit international price (P = E).
  - Transversality condition: f_i,2 = m_i,2 = 0.
  - Governments care about transfers (α weight on own spending), are shortsighted (discount rate satisfies [] 11<+rδ ), and private sector cannot create fiat money.
  - Central bank can commit to price stability in period 1 but may abandon commitment in period 2 and provide seignorage to monetize deficits.
- Household problem: utility function (equation (4)) with parameters β (equal to world interest rate) and ε (between 0 and 1); first-order conditions (equations (5)–(7)); money demand (equation (8)).
- Aggregate solvency and budget constraints: aggregate government budget constraints given (equations (9)–(11)).

### Theoretical solutions and comparative propositions
- Definitions of comparative spending measures (net present values):
  - icflex g, : country with a flexible exchange rate regime (individual country).
  - cuflex g, : country in a currency union with a flexible exchange rate regime.
  - icfix g, : country with a fixed exchange rate regime (individual country).
  - cufix g, : country in a currency union with a fixed exchange rate regime (FPCU).
- Propositions to be proved:
  I. “Pure regional free-riding”: cuflex g, > icflex g, (akin to a “tragedy of commons”).
  II. “Pure intertemporal free-riding”: icfix g, > icflex g, .
  III. “Exacerbated free-riding”:
    - (a) cufix g, > icfix g, .
    - (b) cufix g, > cuflex g, .
- Key analytical results (selected equations and comparative relations preserved exactly as presented):
  - Under fixed exchange rates:
    - Money demand: ε− = r m0.
    - First-order conditions yield (equation (13)) and (equation (14)).
    - Solution for government spending in a currency union under fixed rates:
      - )1( )1()(' , 1, ε ε δ − += n r g u cufix i .  (equation (15))
    - If n =1: )1( )1()(' , 1, ε ε δ − += r g u icfix i .  (equation (16))
    - Implication: using equation (13), icfix cufix gg , , > — Proposition III (a).
  - Under flexible exchange rates:
    - Identity: )1( 101 π − = m m (equation (17)); and εε/)1( 001 )1( − − += m r m m (equation (18)).
    - First-order conditions include equations (19) and (20); combining yields:
      - Λ − += n r )1( )1( ε ε δ ψ  (equation (21)), with Λ defined explicitly.
    - Comparative implications:
      - )(' )1( )1( )1( )1()(' , 1, , 1, icflex i cuflex i gur n r gu = Λ − + < Λ − += ε ε δ ε ε δ .
      - Given ( )0ug′ < Æ icflex i cuflex i gg , 1, , 1, > — Proposition I.
      - Since 1 > Λ under assumptions, cuflex i cufix i gg , 1, , 1, > — Proposition III (b).
      - It is straightforward that , , ,1,1 ( ) (1)() (1) flex icfix ic ii ug r ug ε δ ε ′′ > += −  which implies icfix i g , 1, > icflex i g , 1, . Using equation (13), icfix g , > icflex g , — Proposition II.

### Implications highlighted by the model and empirical work
- Fixed exchange rates permit postponement of inflationary costs and hence intertemporal free riding by governments.
- Currency unions permit sharing of inflation costs across members and hence regional free riding.
- The combination (FPCU) can maximize scope for free riding by allowing transmission of inflation tax costs both across time and across countries.
- Flexible regimes limit such free-riding opportunities because inflationary impact is immediate and cannot be shared with other countries.
- Empirical evidence from the Caribbean sample corroborates the theoretical prediction that FPCU regimes are associated with exacerbated free-riding and worse fiscal outcomes relative to other regimes.

*Italicized source: _wp06119 - References (content excerpt provided)*

### Appendix I presents some interesting extensions to this simple model, which also has

### _wp06119 - Appendix I presents some interesting extensions to this simple model, which also has

### Summary of the Theoretical Results
- Table 1 frames how fixed exchange rate regimes and currency unions can spread the burden of the inflation tax across time and space, producing fiscal incentives that contrast with conventional wisdom.
- Four cases highlighted:
  - Case I (Flexible exchange rate, individual country): “No free riding” — inflation tax borne by the country in the present. Fiscal overspending → depreciation and inflation in the same period as money demand falls in anticipation of future inflation.
  - Case II (Flexible exchange rate, currency union): “Regional free riding” — inflation tax borne by all countries in the union in the present. Present inflationary cost of overspending is shared across union members, diluting the cost for the overspending country.
  - Case III (Fixed exchange rate, individual country): “Intertemporal free riding” — inflation tax borne by the country in the future. Fixed current exchange rate prevents present inflation; deferring inflationary costs shifts burden to future governments.
  - Case IV (Fixed peg under currency union, FPCU regime): “Intertemporal and regional free riding” — inflation tax borne by all countries in the union in the future. Present inflationary costs are minimal; future governments and union members share expected future inflationary costs, maximizing present incentives for fiscal slippage.

### Empirical Analysis — sample and context
- Sample: 15 Caribbean countries over 1983–2004.
- Rationale for sample start: lack of data on the fiscal stance prior to 1983.
- Caribbean exchange rate regime variation during sample: fixed pegs, various flexible regimes, and one of the only two “currency union cum fixed peg” regimes in the world.
- Specific regime facts in sample:
  - ECCU countries (Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines) maintained their FPCU regime throughout the sample period.
  - The Bahamas, Barbados, Belize and Suriname maintained conventional fixed peg regimes throughout the sample period.
  - Guyana maintained a fixed peg until 1989, Haiti until 1991, Jamaica until 1990 and Trinidad and Tobago until 1993; these countries later moved to more flexible regimes including floats.
  - The Dominican Republic maintained a crawling peg until 2002, when it adopted a floating exchange rate regime.

### Stylized Facts (empirical patterns)
- Fiscal performance by regime, average 1990–2004 (primary balance in percent of GDP):
  - The six ECCU countries with a FPCU regime had the worst average primary deficit in the Caribbean during 1990–2004.
  - Countries with fixed or crawling peg regimes were intermediate.
  - Countries with various forms of flexible regimes — including floats — were the best fiscal performers in the sample.
- Drivers of ECCU deterioration:
  - Worsening government expenditures that increased sharply during the 1990s (Figure 2, Panel (a)).
  - Fiscal expenditure growth generally surpassed GDP growth irrespective of the nature of the business cycle (Figure 2, Panel (b)).
  - The rise in primary expenditure over time exceeded the increase in fiscal revenue during the same period in every ECCU country (Figure 2, Panel (c)).
  - The composition of primary spending did not change in a major way (Figure 2, Panel (d)).
- Capital flows:
  - ECCU governments had access to foreign financing even when other emerging market countries faced a turnaround of net capital inflows (Figure 3).
  - Non-FDI capital inflows to the ECCU continued even during periods of low economic activity, contrary to the usual procyclicality of capital flows in developing countries.
  - Possible contributing factors to persistent external borrowing availability: good repayment record, relatively low GDP volatility, perceived lender-of-last-resort role of the currency union central bank, and elimination of transaction costs with financial innovation over time.

### Related empirical literature noted in the text
- Sahay (2005): ECCU countries among the most highly indebted emerging market economies; most public debt increase accounted for by deterioration in primary balances.
- Alberola and Molina (2004): In a sample of 32 emerging market economies, countries with fixed exchange rates during 1990–2001 were worse fiscal performers compared to those with flexible regimes.
- Tornell and Velasco (2000): In a sample of African countries, those with the CFA Franc FPCU regimes had higher fiscal deficits than those with flexible regimes.
- Kufa and others (2004); Duttagupta and Tolosa (2005): Fiscal policies in the ECCU consistently worsened over time; growth in fiscal spending in the ECCU during 1983–2004 generally surpassed GDP growth irrespective of the nature of the business cycle.

### Estimation Results — methodology overview
- Motivation: improve over past cross-section studies by addressing unobserved heterogeneity and potential simultaneity.
- Panel data approach advantages:
  - Fixed effects (FE) estimation accounts for country-specific, time-invariant characteristics (proxying for institutions where data are poor).
  - Identifying time-varying proxies for intertemporal and regional free-riding helps avoid simultaneity by targeting mechanisms rather than regressing fiscal performance directly on regime dummies.
- Two estimation strategies employed:
  - OLS regression with binary dummy variables for pegged and FPCU regimes as RHS variables — assesses association between fiscal stances and regimes but retains weaknesses of past cross-section approaches.
  - FE regression with specific time-varying proxies representing intertemporal and regional free-riding — aims to address both unobserved heterogeneity and simultaneity concerns.
- Estimated equation specification:
  - y_it = α + β x_it + γ z_it + v_t
    - y_it: primary fiscal balance (percent of GDP) — measure of fiscal stance.
    - x_it: control variables for country i at time t (see Box 1 in source for descriptions and expected signs).
    - v_t: error term.
    - z_it: under OLS, regime dummies for pegged and FPCU regimes; under FE, group of three indicators representing proxies for intertemporal and regional free-riding.

*Source: _wp06119 - Appendix I presents some interesting extensions to this simple model, which also has*

### Box 1. Control Variables Used in the Regression

### Box 1. Control Variables Used in the Regression

### Control variables included in the regression
- (i) Economic performance: annual real GDP growth rate.  
- (ii) Trade openness: sum of exports and imports of goods and services as a percentage of GDP (proxy for trade policies).  
- (iii) Terms of trade: ratio of export price to import price, in dollars.  
  - Rationale: Improvement in the terms of trade would improve fiscal revenues, reduce the need for expansionary fiscal policy, and help improve the primary balance.  
- (iv) Dummy for an IMF program: controls for the effect of existing IMF programs on the fiscal stance.  
- (v) Time dummies: control for time-specific events and account for innovations in the financial markets over time that ease borrowing constraints for member governments.

- Note: The data sources of all the indicators are documented in Appendix II.

### Proxies and variables for intertemporal free-riding
- Conceptual premise:
  - Governments become more shortsighted near elections; fixed or pegged exchange rate regimes can postpone the costs of fiscal overspending to the future, while flexible regimes require paying costs upfront.
  - Prediction: tendency to free-ride is inversely related to time to election under fixed regimes; no such relationship under flexible regimes.
- Variables used to explore impact across exchange rate regimes:
  - (i) Product of time remaining to next election and a dummy for all ECCU countries (captures effect under the ECCU).  
  - (ii) Product of time remaining to next election and a dummy for countries that maintained fixed peg regimes (captures effect under fixed pegs).  
  - (iii) Time remaining to the next election in years for all other regimes (assesses effect under flexible regimes).

### Proxies and variables for regional free-riding
- Rationale:
  - ECCU members have access to the entire pool of foreign reserves at the Eastern Caribbean Central Bank (ECCB); non-union countries only have access to their central bank reserves.
  - Prediction: increases in ECCB foreign reserves would induce fiscal slippages in ECCU countries (worsening of fiscal balances); no negative effect expected for non-ECCU countries.
- Variables used:
  - (i) Product of a dummy for all ECCU countries and level of foreign reserves at the ECCB (as percent of reserve money) — captures effect under the quasi currency board arrangement.  
  - (ii) Level of foreign reserves for all other exchange rate regimes.

- Alternative proxy:
  - Relative size of an ECCU member country (systemic importance) as an alternative proxy for regional free-riding.
  - Theoretical ambiguity: larger systemic importance can increase perceived bailout prospects (raising free-riding) but a small country may also be more likely to be bailed out because the cost is relatively small.

### Key regression results (summary of estimation findings)
- Methodology: OLS and Fixed Effects (FE) regressions for primary balance (in percent of GDP), sample: 15 countries, 1983–2004.
- OLS result highlights (Table 2, column (a)):
  - Dummy for FPCU regime: -5.84 (probability value (0.00)**)  
  - Dummy for fixed peg regime: -5.32 (0.00)**  
  - Conclusion: After controls, fiscal stances appear worse in countries with fixed peg and FPCU regimes.
- Fixed effects results (Table 2, column (b)): five main findings
  1. Intertemporal free-riding significantly influences fiscal policies in fixed peg and FPCU regimes.  
     - Intertemporal free-riding in the ECCU: Proximity to election for countries under the ECCU = -0.60 (0.01)**  
     - Intertemporal free-riding under fixed pegs: Proximity to election for fixed peg regimes = -0.36 (0.10)*  
     - Proximity to election for flexible regimes = 0.03 (0.92) — no significant negative association.
  2. No negative association between fiscal stances and proximity to election under flexible regimes.
  3. Regional free-riding affects fiscal policies under the FPCU: ECCU fiscal stances worsen with increases in ECCB foreign reserves.  
     - Regional free-riding: Official foreign reserves (relative to reserve money) for ECCU countries = -0.13 (0.01)**  
     - Official foreign reserves for non-ECCU countries = 0.00 (0.71) — not negative.
  4. Fiscal stances under the ECCU worsen as relative country size rises.  
     - Regional free-riding: Dummy for ECCU * relative country size in ECCU = -0.76 (0.03)**  
  5. IMF programs associated with improved fiscal stances: Dummy for IMF program = 1.34 (0.10)* (positive relationship between primary balance and prevalence of an IMF program).

- Time effects and sample-wide deterioration:
  - Several time dummies from 1998–2004 are individually significant in worsening fiscal balances; hypothesis test confirms joint significance of years after 1998 in adversely affecting fiscal stances: F(1, 211) 4.48**.
  - Interpretation: innovations in financial markets improved access to external financing, exacerbating fiscal imbalances.

### Selected coefficients and statistics from Table 2 (Dependent variable: primary balance in percent of GDP)
- (1) Dummy for FPCU regime: -5.84 (0.00)**  [OLS column (a)]
- (2) Dummy for fixed peg regime: -5.32 (0.00)**  [OLS column (a)]
- (3) Proximity to election (flexible regimes): 0.03 (0.92)  [FE column (b)]
- (4) Intertemporal free-riding in the ECCU: -0.60 (0.01)**  [FE column (b)]
- (5) Intertemporal free-riding under fixed pegs: -0.36 (0.10)*  [FE column (b)]
- (6) Official foreign reserves (non-ECCU): 0.00 (0.71)  [FE column (b)]
- (7) Regional free-riding (ECCU reserves): -0.13 (0.01)**  [FE column (b)]
- (8) Dummy for ECCU * relative country size in ECCU: -0.76 (0.03)**  [FE column (b)]
- (9) Real GDP growth: -0.10 (0.30) [OLS], 0.00 (0.98) [FE]
- (10) Terms of trade: 0.00 (0.90) [OLS], 0.00 (0.83) [FE]
- (11) Trade openness: 0.02 (0.37) [OLS], 0.02 (0.05)** [FE]
- (12) Dummy for IMF program: -0.02 (0.97) [OLS], 1.34 (0.10)* [FE]
- Time dummies: selected significant coefficients displayed; examples include year 1985: -4.37 (0.02)**; year 2002: -5.83 (0.00)** (coefficients for the statistically significant time dummies are presented only).
- Number of observations: 256  
- Number of countries: 15  
- R-squared: 0.31 [OLS], 0.34 [FE]  
- Significance of the regression: F(30, 211) 3.69**  
- Significance of country specific effects: F(14, 211) 12.05**

Notes on interpretation:
- Each coefficient represents the impact of a change in a given explanatory variable on the fiscal stance in percentage points. The parentheses contain probability values. Results statistically significant at 5 percent and 10 percent are marked by “**” and “*” respectively.
- To avoid endogeneity between some explanatory variables (real GDP growth, trade openness, and foreign reserves) and the primary balance, one-year lagged values of the explanatory variables are used.

### Robustness tests (summary)
- Additional control variables:
  - Natural disaster dummies (years when a natural disaster hit a country) were added (Table 3, column (a)). Some natural disaster dummies had a positive effect on fiscal balance; the only disasters that adversely affected fiscal balances were Antigua and Barbuda (1995), and St. Vincent and the Grenadines (1992).
  - The five key results on free-riding remain robust: presence of intertemporal free-riding under both FPCU and fixed peg regimes; absence of intertemporal free-riding under flexible regimes; deterioration of fiscal stances with increase in ECCB bailout capacity; deterioration with increase in relative size of member country in ECCU; absence of regional free-riding in non-FPCU countries.
- Other controls added (no systematic/significant influence):
  - Availability of external financing (proxied by total private sector capital flows from industrial countries to emerging market economies).  
  - World oil prices.  
  - World interest rates (proxied by the three-month U.S. treasury bill rate).  
  - Institutional development (proxied by real GDP per capita).
- Alternative proxies for fiscal stance:
  - Primary expenditure (percent of GDP) used as alternative proxy (Table 3, column (b)):
    - Intertemporal free-riding and size-based regional free-riding under the ECCU continue to hold.
    - Intertemporal free-riding under fixed exchange rate regimes does not hold when using primary expenditure.
    - Primary spending does not increase in response to reserve coverage at the ECCB.
  - Using fiscal revenue as alternative proxy: increase in ECCB bailout capacity reduces fiscal revenues significantly — regional free-riding is manifested through laxity in generating fiscal revenues. Fiscal policies under non-FPCU regimes are not affected by regional free-riding.

### Selected coefficients and statistics from Table 3 (Fixed Effect Regression)
- Dependent variables: (a) primary balance, (b) primary expenditure
- Key coefficients (FE regressions):
  - Proximity to election (flexible regimes): -0.10 (0.98) [primary balance]; 0.22 (0.46) [primary expenditure]
  - Intertemporal free-riding in the ECCU: -0.59 (0.03)** [primary balance]; 0.62 (0.01)** [primary expenditure]
  - Intertemporal free-riding under fixed pegs: -0.44 (0.09)* [primary balance]; -0.07 (0.75) [primary expenditure]
  - Official foreign reserves (non-ECCU): 0.01 (0.93) [primary balance]; -0.01 (0.14) [primary expenditure]
  - Regional free-riding (ECCU reserves): -0.11 (0.03)** [primary balance]; -0.06 (0.18) [primary expenditure]
  - Dummy for ECCU * relative country size in ECCU: -0.79 (0.05)** [primary balance]; 2.56 (0.00)** [primary expenditure]
  - Natural disasters with selected significant effects:
    - Antigua and Barbuda, 1995: -6.39 (0.08)* [primary balance]; 11.40 (0.00)** [primary expenditure]
    - St. Kitts and Nevis, 1987: 8.85 (0.02)** [primary balance]; -6.49 (0.09)* [primary expenditure]
    - St. Lucia, 1987: 7.76 (0.04)** [primary balance]; -1.04 (0.78) [primary expenditure]
    - St. Vincent and the Grenadines, 1992: -5.48 (0.09)* [primary balance]; 0.61 (0.87) [primary expenditure]
- Number of observations: 256 [primary balance], 282 [primary expenditure]  
- Number of countries: 15  
- R-squared: 0.54 [primary balance], 0.33 [primary expenditure]  
- Significance of the regression: F(89, 152) = 2.03** [primary balance]; F(37,230)=3.59** [primary expenditure]  
- Significance of country specific effects: F(14, 152) = 9.22** [primary balance]; F(14,230)=42.74** [primary expenditure]

### Policy-relevant implications and conclusions (as presented)
- Fixed pegs and FPCUs create greater scope for fiscal free-riding because costs of fiscal profligacy can be deferred across time (intertemporal) or across members (regional).  
- Empirical confirmation (15 Caribbean countries, 1983–2004):
  - Free-riding most intense in countries with fixed pegs under currency unions, followed by countries with fixed pegs; not evident under flexible exchange rate regimes.
- Policy recommendations emphasized:
  - Ensure consistency of fiscal policies with prevailing monetary arrangements.
  - Under flexible regimes, immediate inflationary consequences help contain fiscal overspending incentives.
  - Under fixed and FPCU regimes, mechanisms are needed to enforce fiscal discipline in absence of inflationary deterrence:
    - Demonstrate regional central bank’s unwillingness to yield to fiscal dominance or bail out members (directly or indirectly) to boost credibility of commitment to exchange rate stability.
    - The practice by the Eastern Caribbean Central Bank of not bailing out governments facing intermittent debt servicing problems has helped establish credibility in the ECCU region.
    - Under fixed exchange rates, mechanisms such as an independent central bank that can build a strong reputation over time would eliminate scope for intertemporal free-riding.

*Source: Authors’ calculations, Box 1. Control Variables Used in the Regression (excerpt).*

### REFERENCES

### _wp06119 - REFERENCES

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### Monetary unions, exchange rate regimes, and fiscal discipline
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### Sovereign debt, crises, and creditworthiness
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### Caribbean, Eastern Caribbean Currency Union (ECCU), and regional studies
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*Source: _wp06119 - REFERENCES*

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