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IDB notes T&T’s inflexible spending

Published: 
Sunday, June 15, 2014

T&T has the third highest inflexible expenditures in the Caribbean, according to the latest available Inter-American Development Bank Quarterly Bulletin (May 2014). Barbados has the highest, and Jamaica has the second highest. 

 

 

“Caribbean economies have a longstanding history of monetary rigidity that makes fiscal policy the principal tool,” the IDB said. All Caribbean countries follow monetary policy frameworks that are anchored to the US dollar. Furthermore, they have exchange rate arrangements that generally allow for little movement. 

 

According to the International Monetary Fund’s Exchange Arrangements and Exchange Restrictions Report (2013), The Bahamas and Barbados run conventional fixed exchange rate regimes, whereas Guyana, Suriname, and T&T, in practice keep the nominal rate relatively stable. Jamaica, with the most flexible arrangement, has a crawl-like arrangement. As a result of this inflexibility, the Caribbean region has relied on fiscal policies to manage the macroeconomy.

 

“The fiscal stance of the region’s economies over the past several years has deteriorated, and this trend is projected to continue,” the IDB said. Overall the region has experienced a declining primary balance on average since 2007 with the overall regional average standing at 0.2 per cent of gross domestic product (GDP), the IDB said. The primary balance is the difference between government’s revenue and its expenditure. but with debt service payments being excluded from spending. 

 

By 2015, the average primary balance for the region is expected to decline to -2.0 per cent of GDP, the IDB said. More broadly, the worsening of the primary balance is primarily driven by a slowdown in revenues and an expansion in largely inflexible public expenditures. A large part of the increase (about two thirds) in expenditure comes from inflexible items such as wages, salaries, and current transfers (See Figure 4 attached).

 

Moreover, the fiscal buffers have weakened for most countries in the Caribbean. In Figure 5, the countries represented by the arrows pointing northwest indicate a worsening situation: increasing debt-to-GDP ratio and deteriorating fiscal balance. On the contrary, the arrows going southeast reflect the opposite: an improvement. Of the six countries, only one—Guyana—shows an improving historical and projected trajectory. The other five show a worsening situation in both dimensions, or improvement in one and deterioration in the other.

 

External buffers that would serve as the first line of defense against a potential sudden stop or capital flight downside scenario also reveal a similar situation. Figure 6 is oriented such that the arrows going northeast indicate an improvement in the current account balance in percentage of GDP while alongside an increased reserve cover; arrows going southwest indicate the opposite. Except for Suriname, all other countries face an environment of potentially elevated risks with an increasingly vulnerable external position.

 

Fiscal and external sustainability are thus linked, in that fiscal policy would have to be the first line of response against a shock. The ability to respond depends not only on the primary balance, but also on the initial level of public debt. Figure 7 shows the required fiscal adjustment of the primary balance needed to maintain the public debt-to-GDP level at current rates. It also corroborates the fact that tourism-dependent economies have less fiscal room to maneuver. In this representation, Barbados needs the largest adjustment.

 

Jamaica needs a smaller adjustment; however, its debt levels are already very high, the IDB said. Macroeconomic instability significantly constrains Caribbean growth. With high debt-to-GDP ratios for tourism-dependent Caribbean countries and negative primary balances, adequate fiscal space is not available to effectively make use of countercyclical policies in the event of an external threat.

 

 

Can the Caribbean be ready?
“The short answer is yes,” the IDB said. “But it will be difficult for the Caribbean economies to effect the relevant changes without a deliberate and explicit push,” the Washington-headquartered multilateral added. The IDB said efforts need to be made in establishing macroeconomic policies, building new trade relationships, and boosting the private sector.

 

“External devaluation can be a good approach for countries where current account deficits have been persistent but may not be appropriate for Caribbean economies because of natural difficulties increasing demand for nontradables,” the IDB said.

 

The transmission mechanism for successful expansionary external devaluations works by lowering the real exchange rate, which boosts domestic demand for nontradables and production of tradables. If capacity is available, output will increase, exports would grow, and the overall economy would grow. 

 

However, in some economies such as those in the Caribbean, expenditure switching can prove to be difficult, the IDB said, (citing Worrell, 1986), and so an external devaluation can backfire by simply depressing real incomes (citing Krugman and Taylor, 1978). It can also have a negative effect on balance sheets of households and businesses by limiting their ability to borrow, making existing foreign-exchange debt more expensive to service and leading to pressures on the banking sector as a second-order effect.

 

Internal devaluation—which aims to lower labour costs without changing the value of the exchange rate—can be effective but requires a certain institutional setup that may be missing from several Caribbean economies, according to the IDB. Because governments do not have direct control over prices, the mechanism to conduct internal devaluation normally includes cutting the government wage bill with the expectation that private sector wages will be affected accordingly and eventually reduce producer prices. 

 

Among the factor cited by the IDB experience for successful internal devaluations are open economies with flexible labour markets. Without the right policy and institutional setup, the impact on producer prices can be limited. A fiscal devaluation can also be performed by implementing a tax reform aimed at reducing labour costs.

 

 

The transmission mechanism works in the same manner as an internal devaluation aimed at the wage bill, except that the source of lower costs is different. Caribbean tourism countries have made use of tax waivers to make the tourism sector more competitive. A modern approach is to reduce payroll taxes and increase value-added taxes because, with nominal wages fixed in the short run, this would reduce the unit labour costs.

 

Citing the International Monetary Fund, the IDB economists who authored the quarterly said “fiscal devaluations can have significant effects” and should be considered as a policy tool in the Caribbean. Deepening trade with new partners around the world—particularly developing middle-income countries—could help the Caribbean economies become less dependent on their historically significant developed trade partners such as the United States and Europe, the IDB said.

 

The IDB said another IDB paper simulates an exercise whereby Brazil is assumed to be the main trading partner for five of the Caribbean economies over 2008–18. This exercise revealed that Caribbean per capita income under such a scenario would have increased by more than US$300 in 2012 and would be US$600 higher by 2018 relative to the baseline.

 

“Boosting the private sector is a good way to achieve a balanced growth path that can be sustained over time while reducing the need to have large fiscal buffers and naturally create external buffers through increased exports,” the IDB said. “While the global economy has begun to pick up, high-impact, low-probability events could materialise. Two specific risks—unexpected increase of interest rates in the United States and a negative growth shock in China—can have repercussions for the Caribbean,” the IDB said.

 

The multilateral added: “The region’s economies are particularly vulnerable to external shocks given their history of exchange rate rigidity. At present, the economies do not have adequate fiscal or external buffers to sustain such an impact.” The IDB said that the Caribbean needs macroeconomic and structural policies that allow the region to “(a) develop resilience against such risks and (b) become stronger in the long run.”

 

The IDB said solutions include improving the macroeconomic policy frameworks given the uniqueness of Caribbean countries’ location, endowments, comparative advantages and smallness; engendering laissez faire economic growth; and expanding trading horizons to find “new neighbours.”