1. Monetary Policy Frameworks
to Cope with the Vulnerability
of Small States
Anthony Birchwood
Presented at Conference “Sustaining Development in
Small States in a Turbulent Global Economy”, July 6-7,
2009, Commonwealth Secretariat, London.
2. 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
3. External Current Account Performance of
Caribbean Economies
• External current account 1991-1 2000-2 2008
worsened over time in the 999 007 (%)
majority of cases. (%) (%)
Bahamas, (7.4) (9.3) (13.9)
• Deficits reached as high as The
34.7% in ECCU, 25.6% in Barbados
Guyana and Jamaica (21.9%). 1.6 (7.8) (10.4)
Belize (2.1) (14.4) (5.6)
• Widening of current account
deficits in 2008 by as much as: ECCU (14.2) (22.3) (34.7)
Barbados (-3.5%); Belize
Guyana (10.3) (17.1) (25.6)
(-1.6%); Guyana (-4.1%)
Jamaica (-6.1%). Trinidad and
Jamaica (2.6) (10.0) (21.9)
Tobago recorded reduced
surplus
Trinidad (1.2) 13.0
and
Tobago
4. 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%.
5. 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
6. 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.
7. 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.
8. 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.
9. 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.
10. Monetary Instruments Adopted
Bahamas, Barbados Belize ECCU Guyana Jamaica T&T
The (Fixed) (Fixed) (Fixed) (Fixed) (Managed) (Managed) (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
11. Liquid Asset Ratio
Liquidity Ratios Activity Level
Statutory reserves: 5%
Bahamas, The Liquid Asset Ratio: 15% of demand
Passive
deposits and 20% for savings and fixed
deposits
Liquid assets ratio: 12% on securities and
Barbados 5% on cash
Moderate
10% across the board for average demand
Belize savings and time deposits.
Moderate
Secondary Reserves: 23% of approved
liquid assets.
6% of deposit liabilities
ECCB Passive
12% of deposit liabilities
Guyana Passive
Increased Statutory Cash Reserve
Jamaica Requirement to 13% at December 3 2008.
Active
Increased to 17% by November 2008.
Trinidad and Active
Tobago
12. 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.
13. 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.
14. Inflation under alternative Exchange
Rate Frameworks
• Countries with fixed exchange
rates exhibited lower inflation
rates. Fixed Managed
• Results show the importance Exchange Float
of the exchange rate anchor in (Combined
the attainment of low inflation Rate Average %)
(Combined
rates in regional economies. Average %)
• Exchange rate tend to
depreciate if there is instability 1991-1 2.6 16.5
in the foreign exchange 999
market. The depreciation tend
to be associated with rising
inflation.
• Consumers in Fixed exchange 2000-2 2.6 7.2
rate countries enjoy greater 007
international purchasing power
given – higher exchange rates
and lower inflation.
15. 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.
19. 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.
20. 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.
21. Money Multiplier for Managed Floats
• Money Multipliers were unstable, admitting a unit
root.
22. 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.
23. 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.
24. Credit Growth and GDP Growth
(% ) The Bahamas (% ) Barbados (% ) Belize
16 25 18
14 16
20
14
12
15 12
10
10
8 10
8
6
5 6
4
4
0
2 2
0 -5 0
2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007
Growth in T otal Loans Growth in total Loans Growth in T otal Loans
Growth in Business Loans Growth in Business Loans Growth in Business Loans
GDP Growth GDP Growth GDP Growth
Infl ati on Infl ati on Infl ati on
(% ) ECCU (% ) Guyana (% ) Jamaica
24 15 60
10
20 50
5
16 40
0
12 30
-5
8 20
-10
4 -15 10
0 -20 0
2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007
Growth in T otal Loans Growth in T otal Loans Growth in T otal Loans
Growth in Business Loans GDP Growth Growth in Business Loans
GDP Growth Infl ati on GDP Growth
Infl ati on Infl ati on
(% ) Trinidad and Tobago
35
30
25
20
15
10
5
0
2002 2003 2004 2005 2006 2007
Growth in T otal Loans
Growth in Business Loans
GDP Growth
Infl ati on
• Credit growth amplified GDP growth in most
economies.
25. Loans and External Current
20
Correlation: -0.76 (0.14) 25
Correlation: -0.88** (0.02) 20
10
Correlation: -0.19 (0.72)
20 15
0 15 10
10 5
-10
0
5
-20
-5
0
-30 -10
-5
-15
-40
-10
-20
-50
2002 2003 2004 2005 2006 2007 -15 -25
2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007
Bahamas, The External Current Account Balance
Barbados External Current Account Belize External Current Account
Gr o wth i n l o an s
Gr o wth i n L o an s Gr o wth i n L o an s
20 20 60
Correlation: -0.77* (0.08) Correlation: 0.91** (0.01) Correlation: -0.41 (0.42)
50
10
10
40
0
30
0
-10 20
-10 10
-20
0
-20
-30
-10
-40 -30 -20
2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007 2002 2003 2004 2005 2006 2007
ECCU External Current Account Guyana External Current Account Jamai ca Exter n al C u r r en t Acco u n t
Gr o wth in L o an s Gr o wth i n L o an s Gr o wth i n L o an s
35
Correlation: 0.72 (0.11)
30
25
20
15
10
5
0
2002 2003 2004 2005 2006 2007
TT Exter n al Cu r r en t Acco u n t
Gr o wth i n L o an s
• 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.
26. 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.
