The ECCU debt carrying capacity: an empirical investigation of its debt evolution and debt limits

Economic Policy
Macroeconomics - Economic growth - Monetary Policy

The Eastern Caribbean Currency Union (ECCU) comprises of eight small, ‘open’ island states who share a common monetary policy underpinned by a fixed exchange rate regime to the US dollar. This arrangement has been maintained for 37 years and is credited with providing a stable macroeconomic platform for economic activity to take root. During this period however the countries of the Eastern Caribbean Currency Union have accumulated debts that are high and unsustainable by international standards. At the end of 2012, the average debt to GDP ratio for the Eastern Caribbean was estimated at 87.4 per cent (Figure 1). On a country basis, the six independent territories1  in the ECCU had debt ratios in excess of the 60 per cent target approved by the Monetary Council.

Figure 1: ECCU member countries Public Debt to GDP ratios as at end - 2012

ECCU Public Debt

The historic public debt to GDP performance in the ECCU illustrates several phases of public debt growth, the 2000 to 2004 period where the ECCU debt to GDP ratio grew from 68.7 percent in 2000 and peaked at 94.3 percent in 2004, subsequently declining to 75.7 percent by 2008 followed by an uptick in the post-2008 period to 87.4 percent by 2012 (Figure 2).

Figure 2: ECCU Public Debt Dynamics

ECCU Public Debt

Similarly, two key explanatory variables in the public debt dynamics for the ECCU are the primary balance and real economic growth. Consecutive primary deficits throughout the review period contributed in a large part to debt accumulation except for the period 2005-2007 when increases in real GDP growth offset the impact of primary deficit on the debt to GDP ratio. The decline in the public debt over the period 2005 to 2007 may be attributed to the increases in real GDP associated with the hosting of Cricket World Cup in 2007. The decline in economic activity in 2009, due in part to spillover effects associated with the global financial crisis led to increasing fiscal deficits and consequently rising public debt in the ECCU.

Of equal importance are the repeated economic shocks such as hurricanes and other natural disasters which plagued the ECCU member countries during the period 2000-2012 which resulted in increases in their public sector borrowing to rebuild public infrastructure, in part contributing to the prolonged period of primary deficits. The decomposition of the ECCU public debt showed that persistent primary deficits, low real GDP growth and other debt creating flows were the key contributors to the growth in public debt over the historical period.

In a recent paper we assessed the sustainability of the ECCU’s fiscal and debt performance through a decomposition of the historic public debt and calculating the debt limit or a sustainable debt carrying capacity for the region. The paper concluded with recommendations on corrective fiscal measures necessary to achieve sustainable levels.

The peculiarities of debt and fiscal dynamics in small open economies have been highlighted by works such as Sahay (2006), Samuel (2008) and Dohia (2008) who posit that the regions high debt is a consequence of deteriorating fiscal balances brought about by expenditure growth outpacing revenues and the negative impact of external shocks. It is instructive to note that this deterioration is observed throughout the global economy but is particularly acute in small economies, which have limited opportunities to gain economies of scale or scope and subsequently face high fixed cost of public sector operations, which often exacerbates and leads to rigidity in expenditures. The ECCU’s geographic location and high dependence on a few major trading partners (the United States and the United Kingdom) also lends itself to making the region prone to revenue shocks should economic or other circumstances (natural disasters) impact the tourism industry which is a key source of revenue and catalyst for growth.

The results of a series of empirical tests, Maximum Sustainable Debt (Ostry 2005), Crisis Debt level (Mendoza and Oviedo 2006) and Fiscal Response Functions (Bohn 2008), showed that the ECCU debt carrying capacity ranged between 35.0 to 59.0 per cent of GDP, lower than the internationally accepted 60.0 per cent Debt to GDP target. The finding is consistent with the work of Reinhart and Rogoff (2009) which suggested that debt to GDP burdens in excess of 40.0 per cent of GDP may be a drag on economic growth for some countries. As a result, the end-2012 ECCU’s Debt to GDP ratio of 87.4 per cent suggests that some members of the currency union are actually over borrowing. Improving fiscal and debt sustainability in the currency union is vital for its survival, continued financial stability and confidence in the fixed exchange rate regime.

The low debt carrying capacity for the ECCU was largely on account of its inability to generate large primary surpluses, within an environment of low real GDP growth performance and moderate to high real interest rates in some member countries.

The case for holistic structural reform is strengthened when one considers the fiscal adjustment necessary to achieve these optimal balances and the less stringent 60.0 per cent debt to GDP target by 2020 was shown to be large given both historical and future macroeconomic performance. The magnitude of these adjustments also suggested that they would require some combination of economic growth above historical averages in order to raise revenues and or significant cuts to expenditures to allow for favourable primary balances. The ability to attract and craft sustainable growth pursuits to allow for high economic growth within an environment of global uncertainty and risk aversion is difficult while simultaneously considering the opportunity cost of cutting expenditures and consequently eroding the regions social safety net. Another result which should be stressed is the volatility in the macroeconomic fundamentals of the ECCU. Applying a negative (1/2 standard deviation) shock to real GDP growth and primary balance, resulted in the ECCU debt carrying capacity reducing by half of the pre-crisis amount to 18.0 to 30.0 per cent of GDP.

Another key finding was that while several member countries exceeded the benchmarked debt carrying capacity for a number of years, there was no commensurate debt crisis. The results suggest that a key trigger point for a debt crisis reside with liquidity challenges such as the “bunching” of debt payments instead of long run solvency issues. This is a central point, as much emphasis has been place on debt to GDP targets as opposed to assessing the appropriateness of amortization schedules and the ability to meet rollover and other liquidity risk in any given time period. The results of the paper show that the fiscal adjustments necessary to achieve estimates of optimal debt levels or the much vaulted 60.0 per cent debt to GDP targets by 2020 appear onerous. The desirability and opportunity cost associated with achieving optimal targets although alluded to in the paper was not fully addressed but could form an interesting area for further investigation.

These developments logically lead to discussions about the need and importance of restructuring of debt portfolios given the magnitude of adjustments necessary to solve debt issues solely through fiscal means. Consequently a combination of efforts aimed at strengthening growth and improving fiscal balances while restructuring debt portfolios may prove most helpful in allowing small open economies to transition towards successful debt paths. Further to this diagnosis the paper recommends that increased scrutiny of the composition of debt without abstracting from the dangers associated with the absolute level of debt is important. Another recommendation from our paper is that awareness of the regions vulnerabilities and inherent high fixed cost should focus policy prescriptions towards enhancing the efficiency and allocation of government spending as opposed to simply cutting outlays to achieve better balances.

In conclusion the findings of the paper were consistent with other studies on debt and fiscal performance in small island states. Deteriorating fiscal balances and other debt creating flows were large contributors to debt growth over the review period with the level of debt being above optimal and prudent targets. The fiscal effort necessary to obtain prudent levels were seen as onerous and led to recommendations on a holistic reform program which includes debt restructuring.

1. Antigua and Barbuda, Dominica, Grenada, St Kitts and Nevis, Saint Lucia, and St Vincent and the Grenadines

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