Devaluation and Caribbean Economies

Brian FrancisBy Dr. Brian Francis

 

From time to time, countries all over the world, irrespective of physical sizes, resource endowments, and the types of economic institutions in place, are forced to make significant adjustments to economic policies and important prices to restore internal as well as external balance. Countries in the Caribbean have had their fair share of such experiences.

One of the principal prices in international economics is the exchange rate. The exchange rate is simply the price of one currency relative to that of another. In the case of the Eastern Caribbean dollar (XCD), for instance, the exchange rate with the United States dollar ($) stands at 1.00$ = 2.70 XCD. And that exchange rate has been fixed for several decades.

In recent times, some of the countries that have adopted the Eastern Caribbean dollar as their official currency have been experiencing tremendous economic difficulties as a result of limited economic growth, huge fiscal deficits, and mounting public debt. The natural outcomes have been defaults on debt service payments.

Responding to what Moody’s is now describing as a “debt crisis” in the member countries of the Eastern Caribbean Central Bank (ECCB), the rating agency has been extremely bold in its pronouncements, recommending that those countries should devalue their official currency within the next five years or adopt the United States dollar as their official currency.

The ECCB has been quick in its response, suggesting clearly that devaluation ought not to be a real option at this critical time in the countries’ economic life.




For the sake of clarity, devaluation is the term used to describe a reduction in the value of a country’s currency under a fixed exchange rate regime. In essence, this means that the direct exchange would increase.

The adoption of another country’s currency, as is being suggested by Moody’s, is what economists generally refer to as “dollarisation.” Typically, a country would consider devaluation when the deficit on the current account of the balance of payments become unsustainable and the net international reserves held by the Central Bank deteriorates to a level way below the required amounts to maintain the existing exchange rate parity.

Clearly, that is not the case in the Eastern Caribbean Currency Union and, therefore, the idea of a devaluation of the local currency makes absolutely no sense at this point. Why Moody’s chose to suggest a five-year horizon is even more baffling, unless of course the rating agency has information that is not available publicly.

At the more technical level, devaluation is often recommended as a strategy to influence relative prices in the traded versus non-traded sectors of the local economy. The main argument is that with devaluation, the country’s exports become much more attractive to the rest of the world, while imports get more expensive. Hence, the country is afforded an opportunity to increase its exports and reduce imports, resulting in an overall improvement in the balance of payments.

But, therein lies the problem for most countries in the Caribbean. Do our countries have the ability to really increase exports because they are now cheaper to the rest of the world? Is there sufficient domestic production capacity to replace imported commodities that are now more expensive as a result of devaluation?

In most Caribbean countries, the answers to both of these questions is no. Hence, devaluation is generally likely to do more harm than good and must therefore be avoided as much as possible!

 

(Dr. Brian Francis, the former Permanent Secretary in the local Ministry of Finance, is a Senior Lecturer in the Department of Economics at the Cave Hill Campus in Bridgetown, Barbados of the University of the West Indies)

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