Monetary Policy Frameworks to Cope with the Vulnerability

of Small StatesAnthony Birchwood

Presented at Conference “Sustaining Development in Small States in a Turbulent Global Economy”, July 6-7,

2009, Commonwealth Secretariat, London.

Introduction• Study is centred around the regional CARICOM block inclusive of

12 small open economies.• These countries possess a population of under 1 million in the main,

but Jamaica has a population of about 2.8 million, while Trinidad and Tobago have a population of about 1.3 million.

• Region depends largely on export led growth plus external capital flows.

• Exports of goods and services highly concentrated– Primary Service exporters

• Antigua and Barbuda, the Bahamas, Barbados, Dominica, Grenada, Montserrat, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines

– Primary commodity exporters: • Belize, Guyana, Jamaica and Trinidad and Tobago

External Current Account Performance of Caribbean Economies

• External current account worsened over time in the majority of cases.

• Deficits reached as high as 34.7% in ECCU, 25.6% in Guyana and Jamaica (21.9%).

• Widening of current account deficits in 2008 by as much as: Barbados (-3.5%); Belize (-1.6%); Guyana (-4.1%) Jamaica (-6.1%). Trinidad and Tobago recorded reduced surplus

1991-1999(%)

2000-2007(%)

2008(%)

Bahamas, The

(7.4) (9.3) (13.9)

Barbados 1.6 (7.8) (10.4)

Belize (2.1) (14.4) (5.6)

ECCU (14.2) (22.3) (34.7)

Guyana (10.3) (17.1) (25.6)

Jamaica (2.6) (10.0) (21.9)

Trinidad and Tobago

(1.2) 13.0

External Capital Inflows and impact on region

• Most of the regional economies historically depended on the strength of capital inflows to cushion the external current account deficits.

• External capital inflows in 2008 were unable to cushion the high deficits of the external current account of the CARICOM Countries.

• Spillover of what started as a financial crises in Wall Street resulted in a slowdown in regional economic growth:

o Two countries went into contraction – The Bahamas (-1.3%), Jamaica (-0.6%). Except for Trinidad and Tobago 3.6%) and Suriname (6.5%), the other territories recorded growth rates of under 2%. Most of these territories previously enjoyed rates of over 3%.

Ultimate goals of monetary policy in the CARICOM Economies

• Accumulation and preservation of external reserves to bolster the credibility of the exchange rate.– Investment of reserves in low risk assets– Debt financing.

• Stability of the financial sector– Supervisory framework

• Monetary Stability– Low inflation

• Economic Development– Direct controls over credit allocation

Foreign exchange constraint and exchange rate credibility in 2008

• External reserve adequacy– The regional economies recorded mixed

performances. Reserves declined in Barbados (15.7%), ECCU (0.7%) and Jamaica (5.8%) but it increased in the other territories.

– Outside of Trinidad and Tobago which recorded 9 months import cover, the various territories recorded less than 3 months import cover.

Threat to foreign exchange reserves arising from crises in 2008• Some economies had to draw down on reserves in 2008 following

adverse global events:– Non-agricultural prices fell by a third in the first quarter of 2009

compared to their June 2008 levels.– Downturn in Tourist arrivals: regional economies exhibited mixed

fortunes for 2008 with respect to the growth of arrivals. Effects are potentially devastating on those economies which registered declines as:

• Out of the most 20 tourism dependent countries in the world, 10 are from the Caribbean. Tourism accounted for almost 50% of GDP in these economies.

• Twin external current account and external capital account deficits.• Drying up of debt markets.

– Just over half of the CARICOM member countries (7/13) account for about a third of the most indebted countries in the world in terms of external debt to GDP.

– CARICOM countries have been borrowing in recent times from multilateral institutions such as the IDB and IMF.

Strength of Financial Sector• From inception banks exhibited a position of strength, been

adequately capitalised.– Financial institutions tried to adhere to international standards such as the

Basel.

• Little direct exposure of regional economies to risky financial products and toxic assets.

– Loans financed mainly by deposits given excess liquidity.– Major economic activities are financed by external banks, so that local

financial sector restricted to financing domestic activities and small scale export activities.

• Exposures, if any, would mainly be through foreign banks. Ownership of foreign banks are mainly with respect to Canadian banks and they have not yet shown signs of distress.

• Possible Exposures could also have been through mutual funds and placements by private individuals who may have borrowed from the domestic financial sector. These may have been small however, relative to the overall financial sector.

Implementation of monetary policy in CARICOM

• Monetary frameworks in the region may be classified into two types: – Those which employed fixed exchange rates

• These countries mainly employed direct instruments.

– Those which moved off of fixed exchange rates.

• These countries are seeking to make a transition to the use of indirect instruments so that monetary policy would be more market based.

Monetary Instruments AdoptedBahamas, The (Fixed)

Barbados(Fixed)

Belize(Fixed)

ECCU(Fixed)

Guyana(Managed)

Jamaica(Managed)

T&T(Managed)

Moral Suasion

√ √ √ √ √ √ √

Bank Discount Rate

√ √ √ √

Selective Direct Credit Controls

√ √

Interest Rate Controls

√ √ √ √

Type of Security

√

Liquid Asset Ratio

√ √ √ √ √ √ √

Monetary Base/Money Supply

√ √ √

Open Market Operations

√ √ √ √

REPO Rate √ √

Direct transactions in FOREX

√ √

Liquid Asset RatioLiquidity Ratios Activity Level

Bahamas, The Statutory reserves: 5% Liquid Asset Ratio: 15% of demand deposits and 20% for savings and fixed deposits

Passive

Barbados Liquid assets ratio: 12% on securities and 5% on cash Moderate

Belize 10% across the board for average demand savings and time deposits.Secondary Reserves: 23% of approved liquid assets.

Moderate

ECCB 6% of deposit liabilities Passive

Guyana 12% of deposit liabilities Passive

Jamaica Increased Statutory Cash Reserve Requirement to 13% at December 3 2008. Active

Trinidad and Tobago

Increased to 17% by November 2008. Active

Ability of small states to conduct Monetary Policy Independent of Base Country

• Independent monetary policy is not actively used to fine-tune most Caribbean economies.– Countries using managed floats are more active in this

regard• These countries are currently seeking to develop money

markets.

• For most economies, the ability to influence bank liquidity is made difficult by the extent of foreign ownership of commercial banks.

• The fixed exchange rate regime militates against the staging of independent monetary policy.

Monetary policy dilemmas

• Fixed exchange rate countries sought to direct credit to achieve growth and development, but the disadvantage was that increases in credit poses the danger of deepening the current account deficits therefore militating against the maintenance of external reserves.

• Countries which used a managed float were reluctant to allow the exchange rate to depreciate to absorb economic shocks since depreciations brought attendant costs.

Inflation under alternative Exchange Rate Frameworks

• Countries with fixed exchange rates exhibited lower inflation rates.

• Results show the importance of the exchange rate anchor in the attainment of low inflation rates in regional economies.

• Exchange rate tend to depreciate if there is instability in the foreign exchange market. The depreciation tend to be associated with rising inflation.

• Consumers in Fixed exchange rate countries enjoy greater international purchasing power given – higher exchange rates and lower inflation.

Fixed Exchange Rate (Combined Average %)

Managed Float(Combined Average %)

1991-1999

2.6 16.5

2000-2007

2.6 7.2

The cost of maintaining fixed exchange rate

• Loss of monetary independence. Lack ability to use monetary policy to react to developments in the economy as domestic monetary policy is dominated by monetary policy in the base country (U.S.).

• Increases in credit was highly correlated with balance of payments deficits.– Pressure to build up activity levels without

creating BOP pressures.• More suited for countries that are

consistently maintaining adequate external reserves.

Guyana Exchange Rate

Jamaica Exchange Rate

Trinidad and Tobago Exchange

Costs of Managed Exchange Rate• Depreciation of the exchange rate is costly.

• It leads to rising inflation as countries import most inputs. Also, there are pressures to raise salaries as locals are priced out of the international market.

• It causes external debt to increase in local currency therefore causing increasing proportions of the national budget to be diverted to debt servicing.

– For example, after Jamaica succeeded in reducing debt in local currency by 20% in 2007, it then saw its debt converted to local currency increase in 2009, by 85%, partly on account of depreciations in the exchange rate.

• Depreciations generate further rounds of speculation against the rate, thus causing further depreciations.

• Depreciations encourage dollarization as domestic assets are now priced in US dollars.

• Credit rating agencies can potentially create further instability in foreign exchange markets. – This was the case for Jamaica, where adverse credit ratings caused

countries exporting to that country to demand payment in cash rather than extend a line of credit. Thus, this created a surge in demand for foreign exchange and contributed to instability in the FOREX market.

Money Multiplier for fixed exchange rate Countries

• Money Multipliers unstable in the longrun, admitting a unit root.– Instability triggered by financial innovations, changes in financial composition and fiscal

expenditures.

• Lack of predictable relationship between money supply and commercial bank reserves.

Money Multiplier for Managed Floats

• Money Multipliers were unstable, admitting a unit root.

Causal Relationship between Inflation and Growth of M1 for the period 1988-2008.

• Narrow money supply was not a consistent predictor of inflation across countries.

• It was a predictor only across a minority of countries.

Causal Relationship between Inflation and Growth of M2 for the period 1988-2008.

• Greater empirical regularity with respect to broad money supply been a predictor of inflation, compared to M1.

Credit Growth and GDP Growth

0

2

4

6

8

10

12

14

16

2002 2003 2004 2005 2006 2007

Growth in Total LoansGrowth in Business LoansGDP GrowthInflation

(%)

-5

0

5

10

15

20

25

2002 2003 2004 2005 2006 2007

Growth in total LoansGrowth in Business LoansGDP GrowthInflation

0

2

4

6

8

10

12

14

16

18

2002 2003 2004 2005 2006 2007

Growth in Total LoansGrowth in Business LoansGDP GrowthInflation

0

4

8

12

16

20

24

2002 2003 2004 2005 2006 2007

Growth in Total LoansGrowth in Business LoansGDP GrowthInflation

-20

-15

-10

-5

0

5

10

15

2002 2003 2004 2005 2006 2007

Growth in Total LoansGDP GrowthInflation

0

10

20

30

40

50

60

2002 2003 2004 2005 2006 2007

Growth in Total LoansGrowth in Business LoansGDP GrowthInflation

0

5

10

15

20

25

30

35

2002 2003 2004 2005 2006 2007

Growth in Total LoansGrowth in Business LoansGDP GrowthInflation

The Bahamas Barbados Belize(%) (%)

ECCU(%) Guyana(%) Jamaica(%)

Trinidad and Tobago(%)

• Credit growth amplified GDP growth in most economies.

Loans and External Current

-50

-40

-30

-20

-10

0

10

20

2002 2003 2004 2005 2006 2007

Bahamas, The External Current Account BalanceGrowth in loans

Correlation: -0.76 (0.14)

-25

-20

-15

-10

-5

0

5

10

15

20

2002 2003 2004 2005 2006 2007

Belize External Current AccountGrowth in Loans

-40

-30

-20

-10

0

10

20

2002 2003 2004 2005 2006 2007

ECCU External Current Account Growth in Loans

-30

-20

-10

0

10

20

2002 2003 2004 2005 2006 2007

Guyana External Current AccountGrowth in Loans

-20

-10

0

10

20

30

40

50

60

2002 2003 2004 2005 2006 2007

Jamaica External Current AccountGrowth in Loans

0

5

10

15

20

25

30

35

2002 2003 2004 2005 2006 2007

TT External Current AccountGrowth in Loans

-15

-10

-5

0

5

10

15

20

25

2002 2003 2004 2005 2006 2007

Barbados External Current AccountGrowth in Loans

Correlation: -0.19 (0.72)Correlation: -0.88** (0.02)

Correlation: -0.77* (0.08) Correlation: -0.41 (0.42)Correlation: 0.91** (0.01)

Correlation: 0.72 (0.11)

• Lending lead to widening of deficit in most of the regional economies.

• This evoked tightening of monetary policy in many cases as central banks sought to get a grip on the BOP.

Concluding Remarks• The evidence has shown the usefulness of the exchange

rate anchor as a means of achieving low inflation rates.• For countries which exercised a managed float, the

exchange rate tend to be on a depreciating trend once there is instability in the foreign exchange market. This has socioeconomic implications such as the inducement of poverty.

• Monetary policy in these small states must be complemented by adequate foreign exchange earning capacity for it to be credible.

• Need for a new model of monetary policy that takes into account the instability of the foreign exchange market.

• Monetary Policy in small states is likely to be dominated by Fiscal Policy in reaction to fall outs in the global economy.