Public Information Notice No. 08/12

Public Information Notice: IMF Executive Board Concludes 2007 Discussion on Common Policies of Member Countries of the Eastern Caribbean Currency Union

February 7, 2008

On February 4, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the 2007 Discussion on Common Policies of Member Countries of the Eastern Caribbean Currency Union (ECCU).¹

Background

Economic activity in the ECCU remains robust, despite high oil prices and the ongoing erosion of European Union trade preferences. Real GDP growth was close to 6 percent in 2006, its strongest rate in more than 15 years, driven by tourism and construction ahead of the 2007 Cricket World Cup. Private construction activity remains the main driver of economic growth, which is expected to reach around 4 percent in 2007, despite disappointing tourism arrivals and the damage caused by Hurricane Dean in August 2007. With most economies operating close to their potential, rising food and energy import prices, and ongoing depreciation of the U.S. dollar, inflation has picked up and is likely to reach about 3¾ percent by end-2007, nearly twice the level of 2006.

Despite the implementation of ambitious revenue reforms, limited progress has been made towards fiscal consolidation. While stronger growth, administrative efforts, and tax

policy reforms (particularly the introduction of VATs) have improved tax revenues, a surge in capital spending associated with the Cricket World Cup led to a deterioration of fiscal balances in 2006. Revenues are likely to remain strong in 2007 yet expenditure pressures remain, and overall fiscal deficits are expected to average about 5 percent of GDP in 2007. Despite debt restructurings in several countries, public sector debt is projected at 102 percent of GDP at end-2007.

The financial system remains resilient, despite the recent global financial turbulence. Significant progress has been made in strengthening banking sector supervision, highlighted by the passage of the uniform Banking Act in all ECCU jurisdictions, strengthened off-site reporting by banks, and the issuance of new prudential guidelines. However, the rapidly-growing nonbank financial sector remains largely unsupervised, with a functioning single regulatory unit (SRU) established only in Grenada, and SRU-enabling legislation remains to be passed in other ECCU jurisdictions.

Prudential indicators suggest a modest strengthening of the financial sector, but vulnerabilities remain. Monetary aggregates continue to expand rapidly, with strong growth in credit to the private sector. Nonperforming loans (NPLs) of local banks continue their declining trend, and are close to the ECCB's prudential target of 5 percent (of total loans). However, provisioning has continued to fall, and exposures to government remain high, largely concentrated in some state-owned local banks.

The external current account deficit widened in 2006 to over 23 percent of GDP—financed mostly by foreign direct investment. In 2007 the current account deficit is expected to narrow, due to the slowing of Cricket World Cup-related imports. Gross international reserves continue to grow, with the reserve coverage of monetary demand liabilities now close to 100 percent—well above the central bank's legally-mandated floor of 60 percent. Since end-2001, the Eastern Caribbean dollar's real effective exchange rate has depreciated by almost 14 percent (up to September 2007), and is currently at its most depreciated level in almost 20 years.

Executive Board Assessment

Executive Directors welcomed the ECCU region's recent strong economic performance, characterized by robust growth and generally low inflation. Directors considered that a soft landing of the ECCU economy in the near term appears likely, while observing that the region continues to face significant challenges, notably a slowing world economy, a large public debt burden, high world energy and food prices, shrinking trade preferences and development assistance flows, and dependence on external private capital inflows. Against this background, Directors supported the focus on policies aimed at sustaining growth and building resilience, through enhancing competitiveness and economic diversification.

Directors considered that the quasi-currency board arrangement continues to serve the ECCU well by fostering price stability, despite recent price shocks arising from external factors. They observed that the level of the real exchange rate appears to be in line with fundamentals, but noted that there would be challenges in maintaining external competitiveness in the period ahead. While the real effective exchange rate has been depreciating, reflecting the ongoing depreciation of the U.S. dollar against major currencies, regional exports and the terms of trade have been deteriorating. Against this background, Directors highlighted the need to enhance ongoing efforts at structural reforms to bolster regional competitiveness and the sustainability of the exchange rate peg. Noting the national authorities' responses to cushion the impact of the recent inflationary pressures, Directors welcomed the Eastern Caribbean Central Bank's (ECCB) Monetary Council's intention to examine this issue further at a regional level.

Directors noted that the region's current account deficits are widening, although these have been financed largely by a sharp rise in foreign direct investment in the tourism sector. They, therefore, supported the authorities' intention to monitor closely current account developments to avoid the accumulation of unsustainable external liabilities and financing needs. Directors considered that, if a strong policy framework is pursued, current account imbalances would gradually decline to sustainable levels over the medium term.

Given the region's fixed exchange rate, very high debt levels, and vulnerability to natural disasters and other shocks, Directors underscored the need to accelerate fiscal consolidation. They encouraged the ECCU's national authorities to demonstrate a strong commitment to the Monetary Council of the ECCB's revised fiscal benchmarks through front-loaded and sustained reductions in debt ratios. Directors recommended that the Monetary Council's fiscal benchmarks be linked transparently to the implementation of national fiscal policies.

Directors commended the steps that have been taken to modernize tax systems throughout the region, and stressed that increased efforts be made to rationalize expenditures with a view to ensuring that the increased tax revenues translate into declines in public debt ratios. It would be important to avoid distortions in tax systems, including by avoiding exemptions to VATs and limiting the granting of tax concessions that have proven costly in terms of forgone revenue. Directors welcomed the ECCB Monetary Council's recent decision to establish a Public Expenditure Review Commission, and called for firm control over spending. In particular, they called for moderating new expenditure commitments, better prioritizing capital spending, and containing government wage bills through civil service reforms. The need to reform costly social security schemes in some countries was also noted.

Directors commended the progress made in enhancing the regulatory framework for the banking system and the financial sector more broadly. They recommended that efforts be continued to strengthen the risk-based supervisory framework for banks, and to focus onsite inspections on vulnerable banks to contain emerging risks. In view of the continuing rapid growth in private sector credit, Directors encouraged the authorities to ensure the credibility of the revised regulatory framework through effective enforcement. They also welcomed plans for enhanced supervision of the nonbank financial sector, and noted in particular the intention to establish single regulatory units in all ECCU jurisdictions.

Directors supported the renewed momentum towards economic integration. They noted that liberalizing capital and labor flows, as envisioned in the Organization of Eastern Caribbean States Economic Union Treaty, should play an important role in allowing the region to benefit more fully from globalization.

Directors welcomed the Union's stepped-up efforts to improve data quality. The ECCB has taken several initiatives to strengthen its statistical capacity, but data weaknesses remain a key constraint on effective policymaking and surveillance. Directors encouraged the national and regional authorities to bolster statistical practices and data management. They also reiterated the Fund's commitment to provide assistance in launching an integrated regional statistical system for the ECCU, which could help foster social consensus for key policy decisions.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.