Event Transcript

Macroeconomic Options for Very Small Open Economies

DeLisle Worrell, Governor of Central Bank of

Peterson Institute for International Economics, Washington, DC April 17, 2014 Unedited transcript

Adam Posen: Good afternoon ladies and gentlemen. Welcome back to the Peterson Institute for Interna- tional Economics. Please continue to grab you lunch and come forward. It is my pleasure today to play preliminary host, at least, to DeLisle Worrell, Governor of the . People might ask why we are doing a talk from the Governor of the Central Bank of Barbados without recognizing both how special both DeLisle Worrell is, but most impor- tantly, how uniquely interesting the Barbados example is for monetary and fiscal policy.

We’re distributing, and we hope to make available in the website, the occasional paper for the Group of Thirty by DeLisle, Governor Worrell, “Policies for Stabilization and Growth in Small, Very Open Economies.” Both my predecessor Fred Bergsten, who was visiting scholar at the Central Bank of Barbados earlier this year, and Governor Worrell will explain more about that.

There are now, I believe, fifty countries with under a million people who are, by defini- tion, small, very open economies who in their sovereignty and independence have to cope with the world of capital markets and flows that we all face. And when we worry and we hear of a Brazil or an India complaining about the pressures from the outside, you can only imagine what must be the case for our neighbors in the Caribbean and elsewhere. And it has been very stimulating for us to have Fred Bergsten come back and report in detail on the principled approach that the Central Bank of Barbados and the overall economic policy making has taken in Barbados.

Pardon me, I’m a bit—still recovering from an illness and so Fred will be taking over the session momentarily. Just to recap, a number of people, including our own Anders Aslund have paid a lot of attention to the example of with its hard peg and its policies, and it’s very interesting and controversial to see Barbados, in a sense, taking that to an even fur- ther pitch as a disciplining measure and as a means of competitiveness.

Just a bit more about DeLisle Worrell. He was appointed Governor of the Central Bank of Barbados in November 2009. He was previously Executive Director of the Caribbean Center for Money and Finance, and for a long time of course worked for the International Monetary Fund in the Monetary and Capital Markets Department. We have many dis- tinguished alumni of the fund, including former and current Fellows of the Institute, who came out today to welcome DeLisle, and I am delighted to see you all here.

He also had previously served as Deputy Governor of the Central Bank of Barbados from 1990 to 1998, and as the bank’s Manager of the Research Department. I have read his G30 paper. I have not yet read, but I have on order, his book Small Economies, which combines the best of both worlds: small island reading and economics. He’s also a distin-

1 guished scholar holding Fellowships at the Smithsonian Institution, here at the Peterson Institute, Federal Reserve Board, Yale, Princeton, and of course, the legendary University of the .

I have—given the limits of my voice and of my experience, I will now turn over to Fred Bergsten who can give a more directed and personal introduction to the importance of what DeLisle Worrell, Governor of the Central Bank of Barbados, has to say. Fred?

C. Fred Bergsten: Thanks to Adam and thanks to DeLisle for joining us today. Adam has already given you DeLisle’s main CV items so I’ll just add a little color from my recent six weeks as the first Distinguished Visiting Fellow, as they called me, at the Central Bank of Barbados. You will note that I did that from the middle of January to the first of March. Since Barbados has, in my estimation, the best weather in the world, that was an apt time to take up the Fellow- ship that DeLisle and his colleagues had been so gracious as to offer.

My first experience on this trip to Barbados was quite revealing about DeLisle and the Cen- tral Bank. I arrived on Saturday, this was the middle of January, and the next day was the date of the Conference Finals in the National Football League playoffs. So I turned on the television to make sure I could watch those epic events, and lo and behold, when I turn on the television what I found immediately on the Caribbean channel to which I turned first, was DeLisle Worrell holding forth on the , what his policies were, and where it was going. Now this was primetime on a Sunday afternoon … and the Governor of the Central Bank—this is a quarterly event, I learned—was holding forth, instructing and educating his country on his economic policy.

Now this was obviously remarkable in two senses. First, to have in prime time an explana- tion of the economy, and he was presenting charts and data and going through the details. Just think: would we ever have that in the ? And you all know the answer. Secondly, this was the Governor of the Central Bank, and I can tell you he was not talking about M1 or swap agreements, or all the detailed arcana of monetary policy. He was talk- ing about fiscal policy, social policy, structural reforms, and all the key underlying elements of the economy that came home to individuals and were important for carrying out the program. Could you imagine the Governor of the Federal Reserve standing up on national television or anywhere else explicating fiscal policy, social reforms, labor issues, and the like? So this was remarkable. Both in terms of the efforts in Barbados to explain and reinforce the consensus on economic policy—which does exist there and is very strong and DeLisle will explain it—but also underlining the role of the Central bank.

Move forward to my time in the capital, ; and those of you who’ve been to Bar- bados know that physically, the one building that literally towers over the city, and there- fore the country, is the Central Bank. Everything else is very low-rise. The Central Bank by their standards is high-rise and it literally towers over Bridgetown. To me that was quite a metaphor. It was both figuratively and literally the towering influence over the city and thus the country. And as you listen to DeLisle today, you can be assured that you are listening to the most authoritative voice on economic policy in that country and its influence ranges out through the Caribbean widely as well.

I had the great privilege to meet with the Prime Minister, with the Minister of Finance while I was there, and I can tell you they were listening not to what I said, but what DeL-

2 isle said when he accompanied me to those visits. So his role in the country is really enor- mously impressive and critically important. Those of us who’ve worked in developing coun- tries a lot in our careers know that central banks are often the institution in a . They have the best expertise, the greatest credibility, the reputation for objectivity, analytical honesty and the like. I can tell you it is fully the case in Barbados. And DeLisle with a long career at the Central Bank that Adam explained, and his Governorships now for the last five years, exemplifies all that in spades.

So that is the background. As Adam said, this is not a set of issues that are important only to Barbados. There are about fifty countries in the world with populations of less than a million. There are a lot of countries who come close to that borderline so the universe of small open economies is actually quite important. It’s a lot of the total countries in the world, probably getting close to half of the total number of sovereign states in the world. And so when DeLisle speaks from the vantage point of Barbados, but more broadly, the role of small open economies, we have someone who speaks with great significance as well as experience.

The final point is, just to elaborate, Adam mentioned that DeLisle spent some time as a vis- iting fellow at this institute. It was in the late 1980s or early 1990s the he contributed the chapter on small economies to the book on Latin American adjustment that John William- son put together, which was actually the focal point for the development of the Washington Consensus. And so DeLisle played an important role in the evolution of that set of eco- nomic thinking and ideas which have later become both so important and so controversial.

So with all that, his lengthy background, to enable DeLisle to have at least a bite of lunch, it’s a great pleasure, particularly for me, to host him in a reciprocal way for the wonderful hosting he just did for me for six weeks at the Central Bank, but more importantly, to hear him on small open economies and how we should be thinking about their policies. Governor Worrell.

DeLisle Worrell: Thanks so much Fred for the introduction and for the opportunity to have this discussion with you. I want to say what a thrill it was for us to have Fred Bergsten as our first Distin- guished Visiting Fellow at the Central Bank. You guys sort of work with Fred all the time so you know his great accomplishments and what a tremendous contribution he has made, but for us in Barbados, to have the opportunity to sit with him and to learn from him and to hear for him to share the experiences of building this Institution to a world-class institu- tion was really an inspiration for us all, and we are really grateful to Fred for accepting our invitation.

I want to talk to you today about policies for stabilization and growth in very small open economies. On Sunday last the IMF Managing Director invited Central Bank Governors and Presidents attending the Spring Meetings to a day-long seminar on the topic, “Monetary Policy in the New Normal”. I attended that seminar along with colleagues and Central Bank Governors from many small economies in the Caribbean and elsewhere. I waited in vain for any hint during the discussion and commentary that the policies and prescriptions appli- cable to small economies might in any way differ from those applicable to large economies.

I was not surprised, of course; both the and the IMF now freely admit that size matters. And both institutions have set up working groups with the focus on the prob- lems of small size. However, while they concede the greater vulnerability of small states to

3 climate change and external shocks, neither institution recognizes that small economies do not have the range of macroeconomic instruments that are available to large economies. This is a major problem for policy makers in small countries like Barbados and , a country which was much in the news year before last. The international financial institu- tions, the rating agencies, and the international financial community expect all small econ- omies to adopt the same combination of flexible exchange rates and active monetary policy that is recommended for large economies.

When we choose, instead, to anchor the exchange rate and to manage aggregate demand through fiscal policy, we are accused of being masochistic. The reality is that we have no other choice. Another manifestation of the divergence of theory and reality on the exchange rates of small open economies is the long running debate between the IMF staff and small countries around the world on the management of the exchange rate.

I do not know whether a truce has now been reached, but in the decade I worked for the Fund, there were incessant arguments in countries from Ghana to about the extent of management of the exchange rate. The authorities always insisted that they had no exchange rate target, but the Fund was skeptical that the rate would remain unchanged in the absence of Central Bank guidance. The reality is that small countries in all these instances are doing the best they can.

Small open economies are different from large economies in that they face a foreign ex- change constraint that cannot be alleviated by depreciation of the exchange rate or by any other policies. This constraint affects monetary, fiscal, and exchange rate policy, fiscal sus- tainability and management, and patterns of economic growth. With respect to mon- etary, fiscal, and exchange rate policy, the most accessible framework for such economies is an exchange rate anchor, where the foreign currency market is balanced by managing aggre- gate demand using fiscal policy.

With respect to debt, the most sensitive indicators of fiscal sustainability are the ratio of ex- ternal debt service to foreign earnings and the rollover risk on foreign currency loans. With respect to growth, expansion in the small, open economy is sustainable only if led by the sec- tors that earn and save foreign exchange. That is going to be the burden of my presentation.

It is widely recognized that small states are very heavily impacted by the volatility of in- ternational prices of commodities and by uncertainties in international financial markets. What needs to be better appreciated, however, is that such countries have very limited po- tential to substitute for imports as a way of reducing their external vulnerability. Moreover, small economies with modern banking systems that are widely accessible, and that are host to regional and international conglomerates do not have an option to close the capital and financial account.

This is true even where local securities markets do not exist or are of trivial importance. And all economic agents, both firms and households, have alternatives to the banking system for effecting cross-border transfers. These avenues include transfer pricing, offset- ting transactions, the use of trade credit rather than domestic financing for working capital needs, exchange of services in kind, and informal transfers. These transactions are moti- vated by interest rate differentials, relative country risk premiums, and other factors more difficult to measure, such as the credibility of official policy.

4 The openness of small states, the ones that I refer to as small, very open economies, is therefore structural and may not be ameliorated by policy or strategy of any kind. There is a hard foreign exchange constraint that conditions all economic policy rather for the short- term stabilization or for medium to long-term sustainable growth. The small, very open economy is an economic engine that runs on foreign exchange. In the short run it must go conserve what is available, and in the medium and long run the economy accelerates as the inflow of foreign exchange increases.

I will argue that the simplest and most effective policy for stabilization of small emerging market economies is to anchor on a market-determined rate by means of adjusting aggre- gate demand, rather than price, using fiscal policy. Furthermore, sustained growth in the very open economy must be led by the sectors that earn or save foreign exchange. These are the sectors that produce tradable goods which may be sold at the ruling international com- petitive prices on world markets. Because economies of scale are universal in marketing, transport, financing and so forth, small economies find that they must concentrate available human and material resources in only a few tradables in which they may attain sufficient skill to be internationally competitive.

Growth is sustainable when the surplus of foreign exchange earned or saved in the tradable sectors is sufficient to meet the demand from producers of non-tradables and from consum- ers. What matters for growth prospects is the competitiveness of the tradable sectors. The national competitiveness indexes commonly used are misleading since they are based on an amalgam of domestic tradable and non-tradable prices. Both stabilization policies and growth prospects are therefore constrained by foreign exchange influence.

So, my first point. Openness is structural and the foreign exchange constraint is hard. The economies under consideration typically have an import propensity of fifty percent or more and the ratio of foreign exchange income and spending to GDP well in excess of one hundred percent. Earnings from exports of goods and services, together with foreign invest- ment and financial inflows, finance imports that reflect the full gamut of modern consump- tion and investment goods. Because the range of exports is very narrow, and the range of import is very wide, there is very little scope for import substitution.

What is more, exchange rate depreciation does not necessarily provide an incentive for higher exports. The depreciation leaves export prices unchanged in foreign currency terms, and therefore has no immediate effect on market prospects. Whether there is a later effect depends on the extent to which domestic producers of exports are able to reduce costs mea- sured in foreign currency. That, in turn, depends on the extent to which they use domestic rather than imported inputs, and the responsiveness of domestic input and factor prices to the exchange rate depreciation.

The defining characteristic of small, very open economies is the foreign exchange constraint and the fact that this constraint is largely unaffected by exchange rate changes. Some com- ments on monetary policy and the exchange rate: small, very open economies need an alternative to or monetary targeting with a flexible exchange rate—which is the standard recipe for stabilization policy—because both the domestic interest rate and the exchange rate are governed by short-term financial flows. Such an alternative is available in the form of a market-determined exchange rate anchor which is managed by containing ag- gregate spending, and therefore imports, through timely, forward-looking fiscal adjustment.

5 The advantages of this framework are that the predictability of the exchange rate is highly valued by economic agents and the ability to keep the rate unchanged over the long term lends credibility to economic policy. A second advantage is that the lack of exchange rate volatility has long been known to be a strong incentive to investment. Third, an exchange rate anchor is an effective anti-inflationary policy because it does not aggravate the effects of imported inflation.

Exchange rate targeting was, at one time, quite popular. Many countries attempted strate- gies ranging from unchanged rate to various degrees of floating. What my proposal shares with these strategies is the achievement of the target by means of intervention in the inter- bank by the Central Bank. What is added is the management of aggregate demand via fiscal policy as the means of equilibrating the market. In other words, the market is brought into equilibrium by manipulating the quantities, not the price.

And I have a figure here which illustrates what I mean. So on the horizontal axis you have aggregate spending. On the vertical axis you have foreign exchange demand, and the de- mand curve, as you would expect, increases as the spending increases. In the short run, your foreign exchange supply is constrained. You’re a small producer in a competitive mar- ket so you are constrained by your supply capacity, all right? So the supply is known. If you find yourself at point A, then in order to get back to a sustainable level, you have to reduce aggregate demand, because the market adjusts through the adjustment of quantities, which contrasts with the standard presentation.

This is a diagram which represents how the foreign exchange market is represented in the standard textbooks—this is [inaudible 00:26:29] text—where the adjustment of the ex- change rate shifts both the demand and supply curves because you’re operating in the price space, right? So this is the relationship between price changes and foreign exchange. In another paper I explained how if you take account of the inelasticity of substitution, these curves become horizontal and vertical, and therefore you are unable to demonstrate equilib- rium in this diagram. So this is the applicable diagram for small, very open economies. It’s a fixed-price market rather than a flex-price market.

A brief comment on fiscal sustainability and debt management: the foreign exchange con- straint also informs the way in which the deficit is financed. In particular, the extent of foreign currency financing. The servicing of the foreign debt should be kept within limits that the foreign exchange market agents consider acceptable and the maturities of foreign liabilities should be timed to be within the limits of acceptable rollover risk. The govern- ment debt profile of a small, very open economy becomes unsustainable when either of these is conditions is violated, even when the fiscal strategy is thought to be sustainable on other grounds. And if anyone is interested I can expand on that in the question period, but I want to move quickly to the question of competitiveness and growth.

The foreign exchange constraint, and the fact that it cannot be relieved by exchange rate depreciation, limits the overall growth rate of the small, very open economy in the medium term to the maximum that can be supported by the foreign exchange surpluses of the trad- able sectors. All production in the small, very open economy has a high import content, both tradables and non-tradables. The non-tradables, which earn no foreign exchange use the tradables surplus of foreign exchange over their own needs and the needs of consumers to buy imported goods. If that surplus is reduced for a year or two, it may be possible to

6 finance the difference by foreign borrowing or running down reserves, but eventually the growth of non-tradables will slow down if the tradable foreign surplus is not restored.

The foreign exchange constraint on growth may not be alleviated by an exchange rate de- preciation because of the low substitutability of non-tradables for tradables. The depreca- tion makes imports more expensive without creating any avenue for an increase in income either in the production of tradables or non-tradables, and therefore, fewer imports can be afforded. For the small producer in a competitive market, increasing your competitiveness is not about price. Your supply price has no effect on the market or on the amount you may sell. If you are able to produce profitably at the international price, you may sell your entire output. If you are unable to do so, you can sell nothing.

In the real world, competitiveness is a multidimensional concept. The most authoritative measure of global competitiveness appears in the annual Global Competitiveness Report, published by the World Economic Forum. Its list of factors determining competitiveness is grouped under twelve headings: institutions, infrastructure, macroeconomic environment, health, education, goods market efficiency, labor market efficiency, financial market devel- opment, technological readiness, market size, business sophistication, and innovation.

The picture that I have on the screen is how Barbados stacks up against tis peers in the Global Competitiveness Report for 2013-2014. It’s a picture which shows that Barbados, by and large, outcompetes its peers in most dimensions, and this is a picture which con- trasts with what you will see in the IMF Staff Report for the 2013 Article IV Consultation because, in that report, competitiveness is measured simply by the standard real effective exchange rate. It doesn’t represent the reality.

This is the reality: small states are different. Small, very open economies are more vulner- able to external shocks than larger economies simply because the external transactions coef- ficients are so much larger on both the current and capital and financial accounts. Small states may build resilience to excess volatility and achieve levels of economic performance comparable to larger, less vulnerable economies, but building resilience comes at a cost. These issues have been thoroughly investigated by the World Bank, Commonwealth Secre- tariat, and the University of in a number of studies.

The small, very open economies are also more limited than large economies in what they can do in response to an economic shock. There is little scope for countercyclical fiscal pol- icy unless it can be financed by prudent foreign borrowing. Therefore, in contrast to large economies, small, very open economies have no way to respond to a shock that reduces output other than to absorb the loss of real income.

A third important distinction of small, very open economies has to do with the policy framework. A market-determined exchange rate anchor has proved to be a simple, credible, and effective framework for stabilization policy that delivers what is possible: equilibrium of external payments and the avoidance of balance of payments crises, and does not pretend to deliver what is not possible: growth in the face of declining demand for exports of goods and services or containment of imported inflation.

So, my conclusion. Small, very open economies are different from large economies in that they face a foreign exchange constraint that cannot be alleviated by depreciation of the real

7 exchange rate or other policies. With respect to monetary, fiscal, and exchange rate policies, the most accessible framework for such economies is an exchange rate anchor, where the foreign currency market is balanced by managing aggregate demand using fiscal policy. I also argue that expansion in the very small, open economy is sustainable only if led by the sectors that earn or save foreign exchange. Thank you.

C. Fred Bergsten: DeLisle, thank you very much for a very clear exposition of your economic and policy model for Barbados and very small, open economies. Before we open to the group, let me ask you the sort of first question that immediately comes to mind. How has the model been performing? How have you done? How has the Caribbean more broadly done? What’s been the result of your application of the strategy?

DeLisle Worrell: Right. I think that the strategy has served us well. It’s very striking that if you compare the performance of the countries of the Caribbean that have maintained an unchanged exchange rate peg over their entire existence with those where there has been exchange rate deprecation—and I use, as my measure, the , which I think is the most comprehensive sort of measure of quality of life in countries—those countries that have maintained an unchanged peg are clearly ahead of the pack. And again, you know, I have a picture, which unfortunately I don’t have with me, but, again, is in one of my publi- cations on our website where I show that very clearly.

C. Fred Bergsten: Okay. Relative to those competitors, but let me push you a little further. In the world econ- omy of the last few years we’ve basically had two groups. We’ve had the high-income tra- ditional advanced countries—Western Europe, , United States—and growing pretty slowly, one, two percent, maybe a little more now for the US. We’ve had the emerging and developing economies which have been growing much faster, five, six percent. The Carib- bean is usually included along with Latin America, and so one might think, “Well, Latin America and the Caribbean, that’s in the faster growing group.” As I observed it, from my recent visit, the Caribbean has actually been growing much more slowly and more akin to the high-income OECD countries.

Now do you regard that as kind of an inevitable result of your trade linkages, your financial linkages? Or is something out of kilter that has kept the Caribbean form showing the same rapid growth path as much of the rest of the developing world?

DeLisle Worrell: I want to frame the question a little differently, Fred, because I think the growth has to be related to your starting point, and if your starting point is at a relatively advanced level, then it doesn’t matter so much if you grow slowly or if you don’t grow at all for a little while. So, for example, Japan had, what? Over a decade of no growth at all, but it is still about the third richest country in the world. And similarly, the Caribbean start so far ahead of Latin America that, by and large—and there are one or two exceptions—even without, you know, we still had, in terms of quality of life in a couple of the Caribbean countries, including my own, is comparable an advanced country.

So that, again, reverting to the category set up by the Human Development Report, we are in the “Very High” development category. All the other Caribbean countries, except for and , are in the “Highly Developed Country” category. In a sense, the coun- tries within the Caribbean that are actually matching the growth of Latin America are the ones at the bottom of the scale, including Guyana—I’m not so sure about Haiti—because they are mainly commodity-based producers.

8 C. Fred Bergsten: Just so the audience knows, per capita income in Barbados is about $15,000, so it is pretty high up the scale compared with other developing countries, DeLisle makes the comparison with Japan. I’ve labeled Japan for some time—two decades, really—as high-level stagnation.

DeLisle Worrell: It’s not a bad place to be.

C. Fred Bergsten: DeLisle doesn’t like the term necessarily but, as he says, not a bad place to be. Though I have one other question on your model and then we open it up. It almost sounds like you’re saying the lack of options for a very small, open economy, the need to maintain a rigidly fixed exchange rate and all that, does it raise the question of why a very small open economy should even have its own currency?

DeLisle Worrell: It does. And I would say that one of the things that I mentioned about having your own currency is that if you keep it pegged, it lends a lot of credibility to economic policy, and it actually is a strong motivator for adopting tough and appropriate measures as have been necessary. So one of the reasons that we have been able, in Barbados in the current circum- stances, to maintain a focus on the competitiveness of our tradable sectors and the way of achieving that competitiveness through structural changes, through increased competitive- ness, through improvements in product quality, through better marketing, and through all the other dimensions which will, in practice, yield results, is because we have our own currency and people are motivated to ensure that the peg remains in place. If you lose that, then you’re better off with being part of a currency union and using one of the major trans- actions currency.

C. Fred Bergsten: Okay. Let me open up the floor to questions of your former colleagues. And first in the queue, Morris Goldstein and then one over here, and then several over here. A lot of ques- tions. Okay. Mics coming around, we have a standing mic in the back. Please introduce yourself and then fire away.

Morris Goldstein: I’m Morris Goldstein from Peterson. Governor, thank you for such a comprehensive and interesting presentation. I had, in a sense, a two part question. One of the issues that’s come up with hard pegs in all variety of economies is that once the public thinks they’re credible, they tend to borrow a lot in foreign currency, and a problem often arises because the bor- rowing is in non-tradable industries that don’t earn foreign exchange, like housing, because they get—they sometimes get a lower interest rate by borrowing in a foreign currency.

And then if you get a negative shock, you then have a problem if in fact the exchange rate then does have to be changed, you face very high servicing cost. So I wondered how you handle the issue, particularly with non-tradables in Barbados. Second of all, you mentioned the strategy of Barbados to manage aggregate demand with fiscal policy, since in a sense, monetary policy is already spoken for in terms of what needs to be done to maintain the peg. And I take it that you have considerable flexibility to use that. Again, in at least a non- trivial set of cases, countries can’t use that flexibility on fiscal policy because they have fiscal debt sustainability problems.

So I wondered, again, what it is about Barbados that lead you to think that you’ll be able to maintain that discipline or have been able to maintain that discipline whereby some other economies—including, I think, some in your region—have had more difficulty with that.

9 DeLisle Worrell: Thanks Morris. On the foreign exchange borrowing, that is, you know, as you say, an im- portant issue, and could create considerable vulnerability. The way we deal with that is through capital control, so that domestic institutions, even if they’re branches or subsidiar- ies of foreign institutions … if they want to engage in borrowings in foreign currency, then they need to apply to us. And we would not normally grant that permission unless you are earning in foreign currency.

And we have found that that has been easy to police, because, you know, your inspectors go into the banks, and if they see credits on the account which is in foreign currency which we have not approved, then that can be easily disallowed. So unless you have, you know, big problem with foreign informal markets and people not using the banking system, then that is a tractable concern.

On the fiscal sustainability, I’m working with a number of colleagues within the region on the whole notion of, “When does the fiscal become unsustainable?” because I think that the answer really depends on the foreign exchange constraint. So the key to managing in our case is ensuring that you observe the balance of foreign exchange in the fiscal policy as well.

You see, I think where it appears that you don’t have fiscal space in much of the debate is be- cause fiscal space is not defined in terms of the foreign exchange. And I would argue that in a number of Caribbean countries in the current circumstances which are thought not to have a fiscal space—in fact Barbados is thought not to have fiscal space, if you read the Staff Report of the Article IV, they will say that we don’t have fiscal space—and they’re wrong. We know we have fiscal space because there’s no pressure from the fiscal on our balance of payments.

C. Fred Bergsten: I would just reinforce DeLilse’s answer to both questions by noting something that I heard him say frequently when I was in Barbados, but he didn’t say it today, which is: the great bulk of the Barbados public debt is domestically owned. Essentially, they owe it to them- selves. This is the point that the Japanese have always made in defending themselves against charges of unsustainability. Though their debt ratios are very high—Barbados is high on some standards, nothing like Japan—but a very small percentage, as I remember, is exter- nally owned. So that adds to your fiscal space potential, and I would presume that’s one of the things you had in mind.

[inaudible 00:48:56]?

Speaker 1: Well, thank you very much Governor. It’s a pleasure to see you again, a pleasure to hear strong defense of fixed rates. You were doing that ten years ago, you’re still doing it.

I have a question that really follows on from what Morris had raised. You make this very good distinction between small, open economies and larger economies. The former should be treated differently from the latter. You know, within the small, open economies, there are differences too. And I think that one of the differences, what Fred pointed out, is be- tween the rich small open economies, which have foreign exchange reserves and the poor small open economies that don’t. So you in Barbados—actually the per capita income is $16,000—you’re sitting there with your high per capita income, you’ve had close to a bil- lion dollars in reserves.

Your situation to maintain the peg is much different, is much easier, than a country that I once worked on, the , where, you know, you had reserves that were something

10 like $20 million in total and you had a huge external imbalance. What could the country do in that case? So there you have a difference in the type of exchange rate regime the two countries might follow. It’s worth thinking about. I’m not quite sure but it’s worth thinking about, making that distinction.

One of the problems with what you say and the exchange rate targeting is of course you’re vulnerable to a speculative attack. I mean that’s been the standard thing. In your case, if you hold the rate as you did—when you were losing reserves last year, for example—you held the rate and you used up part of your foreign exchange reserves, but in addition, as you have maintained today, you used fiscal policy in fact.

So here I would say that—somewhat different point from Morris—fiscal policy became counter-speculative, rather than countercyclical, and I think I worry about [inaudible 00:51:30] because, you know, to be able to suddenly reverse track, tighten fiscal policy, be- cause you are facing a foreign exchange problem, is disruptive for the economy. So I know there’s not one specific question here for you, it’s some thoughts and, you know, anything you wish to address in that, I’d appreciate. Thank you.

DeLisle Worrell: Thanks very much [inaudible 00:51:52]. You know, that’s the practical policy maker speak- ing. You know, it’s always a question of adjustment. The term you just coined is actually quite accurate, you know, it’s counter-speculative. In our case, it was pointing in the right direction. So we already had in place a medium-term program for fiscal adjustment, which was intended to bring the fiscal deficit down. So in a sense, we simply front-loaded that and as the fund team itself admitted to an excessive extent, all right? So in the extant case of Barbados last year, the overkill, in a sense, on the fiscal was, in a sense, still taking us in the right direction.

As you rightly said, what motivated it was to knock out speculation against the currency, to make sure that the speculators were going to lose in the long run. The issue of inadequacy of foreign exchange reserves, it … I think you have to look at it differently. The underly- ing situation is: you have to manage our economies by, as I say, driving the external sector, driving the sector that earns foreign exchange. So in the case of Maldives, the answer to the problem really, is to find ways of increasing the capacity of the or whatever other foreign exchange earnings sector there is. And I’m saying that Maldives is small and there- fore they cannot make that expansion on a sustainable basis on the basis of reducing their prices. And that’s why the exchange rate is not a useful tool.

C. Fred Bergsten: [Inaudible 00:54:29] corrected me on one point, so I’m going to correct him on one point. When you said that Barbados had high reserves—and you mentioned a billion dollars— even when it had the billion dollars, that struck me as pretty modest. DeLisle, with this kind of omnipotence he has in determining economic thinking in Barbados, has among other things, convinced everybody that the precisely correct target for the foreign exchange reserves is the equivalent of fifteen weeks of imports, if I remember correctly. Fifteen weeks. That’s pretty precise, and it’s also not very high.

So I said to DeLisle, “If you’re going to run this very tight ship and you’re going to, you know, adjust everything to the exchange rate, maintain the peg, don’t you want higher reserves? Most of the countries in the world piling up reserves to beat the band, self-insur-

11 ance, all that, is the order of the day.” DeLisle says, “No.” Why don’t you explain that? Be- cause that’s a very interesting and very different point.

DeLisle Worrell: Because reserves are a loan to the United States, in our case, you know? Why would we want to lend reserves to the United States?

C. Fred Bergsten: Okay, right, fair point, but don’t you feel a little thin and vulnerable?

DeLisle Worrell: No, because you see, I think that markets respond to their understanding of fundamentals. And so the reason why I am very vocal on these matters is that I have to have market agents understand that what is fundamental to our economy is what I’ve been talking about. That the economy runs on foreign exchange, so you have to balance what goes out and what comes in. Reserves are just your lubricant for the friction between the timing of what comes in or what comes out. So you don’t really need any reserves at all, and there have been decades when we operated with only eight weeks of reserves and nobody noticed. So people have to understand that reserves are not what you run the economy on. What you run the economy on are inflows.

C. Fred Bergsten: Question over here, and then we’ll come over here.

Peter Bakvis: Yes, thank you. My name is Peter Bakvis, I’m with the International Trade Union Confedera- tion. Leroy Trotman, whom I’m sure you know, Governor, was our President a few years ago.

Just a short question. Theoretically, one way to diminish the constraint of a currency would be to share it more broadly among a larger number of economies, and I’d like to ask you, what is the state of the debate, if there is any, about developing a Caribbean currency unit? Thank you.

DeLisle Worrell: Yeah, absolutely. You see, what we have failed to achieve within the Caribbean is a con- sensus on the approach to exchange rate management, which I have been advocating. And so, the largest economies, in terms of dollar size in the economy, have now all experienced exchange rate depreciation, and Trinidad being the largest. So I think that puts the idea of a regional currency beyond the reach of possibility, because those of us who have maintained pegs are not going to go back to a situation where those pegs are under threat.

And because of the confidence issue, the countries that have already—the currencies that have been depreciated are unable to commit to a new level for the peg. So, unfortunately, even though from a point of view of transactions and the pooling of reserves, you know, a common Caribbean currency would be ideal, I think that that is now no longer practical.

C. Fred Bergsten: Question in the middle.

Cullen Hendrix: Good afternoon Governor, my name is Cullen Hendrix. I’m here at the Peterson Institute and also the Korbel School for International Studies at the University of Denver.

Roughly in the last decade, prices for most globally traded commodities have more than doubled and volatility has been high as well, and I just wanted to hear some of your thoughts on some of the challenges and opportunities that the price increase and those price fluctuations have put on the table for an economy that’s both an exporter and a large-

12 scale importer of these commodities. Thank you.

DeLisle Worrell: Right. There are some difference among the Caribbean as far as that is concerned. So Trini- dad is the biggest mineral exporter, we have a bit of minerals but not enough to export. Commodities, and Guyana are commodity exporters.

The thing that has been the biggest challenge for all of us is the volatility and the unpredict- ability of the prices. And that has been a challenge both for the exporters as well as for the commodity importers. Beyond that, the additional challenge for the importers has been that it has forced us, really, to have higher levels of reserves than we otherwise might need, because we’re—a big price increase may force us to cut back on spending in order to econo- mize at a given level foreign exchange inflows at any particular point in time.

So over time, I think that that has resulted in higher levels of reserves on average, and as I say, Fred mentioned that in Barbados we have about 15 weeks. We are on the low side. Most of our neighbors and colleagues are higher than that and I think part of the reason why they are is because of the difficulty of coming to terms with the unpredictability of commodity prices.

C. Fred Bergsten: Richard?

Richard Feinberg: Richard Feinberg, University of California, San Diego. Governor, I’d like to take you now to talk a little bit about the issues of growth. You mentioned small economies, just a few sectors, and the secret is productivity increases. So my question is: what is the role, if any, of public sector institutions (1) in selecting those sectors, and (2) in increasing their productivity.

DeLisle Worrell: Right. I’m not a big fan of the public sector leading the way as far as, you know, sort of new opportunities. Where it has worked in my experience is when the public sector is perceptive enough to see which private sector initiatives are actually showing potential, and to back those as opposed to others, because there is always a range of things that people are trying to do.

You know, entrepreneurship is really not in short supply in the Caribbean at any rate, but only a limited number of those things actually have the potential and they’re usually related to things that we are already doing, so that they are refinements in the area of agriculture products that we already produce. So the rum industry is a good example of that. Or spe- cialist areas within tourism, the Caribbean festivals, carnivals and related festivals, music industry, those sorts of things.

And I think that the government has an important role in not only providing fiscal incen- tives, which is the traditional thing, but also targeted support for a private initiative to ex- pand markets and to realize new avenues. So things like IT and developing your IT founda- tion and stuff like that, can be very important in facilitating those kinds of developments. And now I’ve forgotten the second part of your question ….

The other aspect is government business facilitation. That’s sort of providing efficient public services related to things like immigration policy, related to things like licensing, financial supervision. Those kinds of things become very important in terms of support for competi- tiveness in the private sector.

13 C. Fred Bergsten: Bill?

William Cline: Bill Cline here at the Institute. It’s delightful to have you here. It does seem to me that tourism in particular has been shown to be responsive to the real exchange rate. I mean, people in the US can decide to go a different island if your island gets too expensive. Now I appreciate the credibility that’s built up by maintaining a fixed exchange rate for a long period of time, but one can imagine the prices could still get out of whack, and so then you have to be very capable of having domestic price flexibility to make the correction.

And my impression is that both the external deficit and the fiscal deficit have been on the order of 10% of GDP so that there is a correction to be made. And on the fiscal sustain- ability, I don’t think the key is domestic or foreign, it’s whether you have to pay a high in- terest rate. Japan gets away with it because it pays a low interest rate, mainly domestic. So, I think, always looking at whether the primary surplus compares favorably with the interest rate minus the gross rate is very key. So one is not necessarily home free if you’re borrowing domestically. So I just wonder if any of these observations resonate with you.

DeLisle Worrell: Yes. On the tourism responsiveness, you know, I think it’s the price, not the exchange rate. To be competitive in tourism you have to be selling at the right price for the quality of tourism that you’re selling. So you’re absolutely right that if there is a cheaper product of the same quality then you have got to find a strategy which accommodates to that. It is either that you lift your quality so that you move into—that, to me, is the winning strat- egy—so that you move into a bracket which corresponds to the price you are able to sell at, or you will have to look to produce a different product; a product which is off lower quality which matches the price of the competition.

It is never about altering the price and keeping the quality constant, so that is the issue. So when you look at tourist products, you have to ask yourself, “Is your competition—the product that you are looking at, you sell it at a lower price—is it the same product? Is it a product of equivalent quality?” If it is then I have a problem. The way to deal with that is to ensure that it is not. That’s why I say that for countries like Barbados in tourism, it is all about quality. It is all about productivity.

And, you know, we start with an advantage because we have always been known as a quality destination, as an aspirational destination. So we just have to make sure that we keep the quality of our services at a level which stays ahead of the competition. And that is the basis of our strategy.

On the issue of the domestic debt, it is true that it is easier to manage the fiscal if your interest rates are very low or if they are almost non-existent as they were in the case of Japan. In any case, it’s domestic debt, so it really doesn’t matter what the interest rate is because it is owed to residents of the country. So it is a matter of income redistribution. The taxpayers are sur- rendering a larger part of their income than perhaps they should to the holders, but if, as was for many years the case in Jamaica, the taxpayers are happy with that—they seem to be because they kept electing governments who persisted with the policy—then, you know, it’s not for you or me or for any other economies to tell them that they are not to do it.

C. Fred Bergsten: On that first question that Bill raised, DeLisle will recall that I raised exactly the same question when I was in Barbados because many studies have shown that tourism is a very

14 price-elastic sector, including responsive exchange rates. As I further enjoyed my Barbados experience, I came upon a fact that made a big difference. And to put it crudely, Barbados tourism caters largely to the 1%, not the 99%. Meaning that the type of tourist exports that Barbados prospers from is really not so very price-elastic.

Some people even argue—I had some people argue to me in Barbados, people in the hotel industry, that there’s a backward bending demand curve. The quality point carried to the extreme, if you lowered prices, it might look like the place was cheapening down and you might lose some of your high income [inaudible 01:11:01] who are the main source of the tourist income in Barbados. Now that gets to the growth question, because then you raise the issue of volume, and do you want twenty more Hiltons, say, down on the South coast that would bring in tour groups with bigger volumes of income? And I have to say there some uncertainty about that in Barbados.

Do you want that on the grounds that it would kind of disturb and distort the high qual- ity pattern that has been your model in the past and has succeeded to the extent of the high-income but maybe not much growth? I think part of the analytical answer is that the distribution of demand is not what a generalized empirical study show when we look across the range of tourists choosing whether to go to , or Jamaica, or Barbados, or whether to go to or pre-Euro, when there was a huge, huge shift whenever those exchange rates shifted.

Lee Branstetter: Thanks. Lee Branstetter, Carnegie Mellon University and recently Peterson Institute. Gov- ernor Worrell, you’ve done a very good job of arguing that there’s a category of economies to which the conventional policy wisdom doesn’t apply, right? You haven’t challenged that conventional wisdom for large economies. You’ve suggested that there’s a dividing line and past that line, economists like the international financial institutions, think-tankers, need to recognize that a different model applies. Where do we draw the line, right? Can you give us any guidelines for thinking about the size, openness, parameter space where the conven- tional policy wisdom is no longer operative? Because it seems like to operationalize your argument, we really need to think about that. Thank you.

DeLisle Worrell: Thanks, very good question, and it’s one that we are thinking of actually doing some work on. I think it relates to the extent of diversification of your export commodities. So that’s what we’re going to be focusing on. So if you are only able to achieve internationally com- petitive size in a half a dozen different commodities, you can’t do substitution, right? That, basically, is the essence of my argument … that the relative price is only going to yield you space for additional growth if you can switch domestic production from foreigners to lo- cals. So stay tuned, we’re yeah ….

C. Fred Bergsten: Well in traditionalized economics the Marshall-Lerner condition has been a key variable. If the sum of the elasticities of your export and import demand exceeds one, then an ex- change rate change will be effective in generating positive adjustment. If not, then no, and the [inaudible 01:14:25] case holds. So one way to go about it would be to calculate Mar- shall-Lerner numbers for different countries—that’s been done, some controversy about how effective it can be—but I would recommend that as one of the variables you look at, as we try to answer that very good question.

We’ve got time for just one or two more. There’s one right here that’s been waiting, and then one over here, and maybe we’ll end with that.

15 Ali Mansoor: Hi I’m Ali Mansoor, I’ve just joined the African Department at the IMF after eight years as Financial Secretary in , so I’d like to offer slightly different perspective. First I want to say that the income in Barbados is about twice that in Mauritius, so certainly what they’ve done has worked very well for them and I want to have that as a qualifier. In Mauri- tius, we’ve run things relatively well with the opposite policy. And I think it’s linked to your question also and it’s linked to the answer the Governor gave.

In Mauritius we have very aggressively pursued economic diversification as a way to be more resilient and I think that the prescriptions which are being given here may be more suitable if you say, “Look, we have a good situation, we don’t worry too much about growth,” and the Governor almost said that, although he didn’t quite, and maybe if we had $16,000 instead of $9,000 we’d say the same. If you are trying to diversify and grow, we’ve found that a flexible exchange rate has been a very key component.

Moreover, not only has it been crucial in terms of attracting new activity, but we also have been very subject to a lot of shocks. Maybe Barbados has had less shocks than we have, but if you face a lot of shocks, very difficult to hold a fixed exchange rate. And we did try—we all inherited the same British system, and we did try for a long time to run fixed exchange rates—but economic development and diversification only came about with a much more flexible exchange rate policy. Now I’m not making an argument here that every small coun- try should adopt a flexible exchange rate policy, but I am saying that the universe is richer and perhaps in answering the questions which you just posed, we also need to look at insti- tutional arrangements.

One of the reasons a flexible exchange rate policy was important in Mauritius is the institu- tional arrangements in the labor market. We have, not only fairly rigid wages, but we even have almost money illusion. People like to get a nominal pay award and then you use the nominal exchange rate to keep the real exchange rate constant, which is basically what the Central Bank has tried to do. And in periods of shock, shock is not only prices, we had huge shocks in recent years—we also cater to the 1%, essentially from Europe—but because of the shocks in Europe we had huge shocks even amongst the 1%, which has forced us to diversify the market. And again, the exchange rate policy has been a crucial component of that.

C. Fred Bergsten: What’s your population in Mauritius?

Ali Mansoor: 1.3 million. So we are a small state.

C. Fred Bergsten: I don’t know. I’m going to ask DeLisle to answer that. That’s four times bigger than Barba- dos, which has a population of under 300,000. And so differences in scale even at that level may have something to do with the scope for diversification.

Ali Mansoor: I would argue though that you need to look at economic size, not population and in terms of economic size, if you go back to 1968 when we had independence, we were very small, we were a very low income country; at that time population was only 600,000. And look at Singa- pore. Singapore today has five million but part of it having five million is because of its diver- sification strategy. And today, as Tom Friedman says, “The world is flat. Talent is global.” Small economies are not condemned to remain small in population if they have the right policies.

C. Fred Bergsten: What was the population of Singapore at independence, does anybody know?

16 Ali Mansoor: About 1.5 million, maybe even less. I know that when they really started their push they had about one and a half to two million, and today they have probably about 40% foreign- ers in the 5 million population. And it’s not that they sought to get people, it’s that they were open for business as a platform for the world, and part of that means you allow talent to come from wherever you need it. And before you know it, you have a lot of talent.

C. Fred Bergsten: The type of diversification I suggested when I was in Barbados was not intersectoral, but intrasectoral. Within the tourism sector, thinking about if they wanted more growth, thinking about broadening from the 1% to a broader variety which would be more price- sensitive and I particularly directed attention to the coming tsunami, as I called it, of Chi- nese tourists, which are going to just inundate the world over the next ten to twenty years. I mean we’re talking here about billions of tourists, and mega hundred billions of dollars of tourist spending.

Just think what happened in Japan after they liberalized the exchange controls, let the ex- change rate go up, and had the rapid growth for thirty years. Just remember the waves of Japanese tourists and is a country that’s ten times bigger. This is going to be massive. Now, does Barbados want to put up twenty Hiltons and attract Chinese tourist groups? If they did, they can make a lot of money, in my judgment, but they may not want it, for the reason I said before. That’s the kind of diversification that might be thought about.

Now DeLisle, you get the final answer. I’m sorry were out of time.

DeLisle Worrell Thanks for the comment on Mauritius. You know, as everybody recognizes there is a lot of specificity to individual country performance. And one of the things that is different is where Barbados sits in relations to the United States, compared to where Mauritius is. Mauritius does not have a close neighbor that is a reserve currency, the world’s reserve cur- rency … and that makes all the difference.

You also mentioned your institutional arrangements. Our institutional arrangements are different from yours. We have a very strong social partnership so that, you know, that is what helps to facilitate the kind of dialog that Fred mentioned that I conduct in public, that Fred mentioned at the outset. Everybody is reading from the same page when we ad- dress economic policy because we are able through the social partnership to show realities and to achieve an understanding by everybody of the way forward. So when the Fund Mission visited for the Article IV Consultation, we had a new head of the group. And one of the things that she said to me that impressed her was that nowhere in the economy was there any support for the notion of an exchange rate adjustment.

So there are certain things that sort of are a result of the circumstances and the history and economic and also geographical circumstances of the country. The other factor that is mate- rial is the extent of financial integration. Again, partly because of our geographical proxim- ity, but also because of migration links over many years and the closeness of the association. There is now a virtual, sort of free financial integration between the Caribbean and North America.

There are certain things like foreign currency holdings of deposits in formal financial insti- tutions which one can control, but in terms of the flows back and forth, and in terms of the store of value that is the norm for the economy. So everybody in Barbados, everybody in

17 the Caribbean—and I would say it’s probably true for Central America as well—takes their value from the US dollar.

C. Fred Bergsten: In closing I would like to underline this next-to-last point DeLisle made. Of all the things that impressed me during my visit to Barbados, what impressed me the most was this rock- solid domestic consensus in support of the current economic strategy. Barbados is a vibrant democracy; everything is debated. The nature of the fiscal adjustment is debated every day by the social partners very aggressively, “You’re laying off too many people.” “You’re putting off too many over here, it should be over there.” “You’re supporting the right or wrong projects.” It’s very vibrant, hotly debated, but there is zero, repeat, zero dissent on the basic strategy.

That’s true in universities—I spoke at the University of West Indies—the academics are not challenging it, though they challenge almost everything else. The think-tanks are not challenging it. I met with the Prime Minister, the Minister of Finance, you would think that they, under the political gun, on the implementation of the strategy might be cast- ing around for some alternative. Not so. So it is quite impressive, amazing in a sense, that there is that degree of domestic consensus. The IMF team certainly accepts that and I think would forward with its recommendation on that basis.

So that’s remarkable. It augurs well for continued success, and a great deal of it has to do with the persuasiveness and analytical acumen of Governor Worrell. I want to thank him again for joining us, again for having hosted me, but particularly now for coming to us here at the Institute again. The doors here are always open to you. We look forward to staying in close touch, and some of my colleagues might even like to spend the winter in Barbados as well, and you have to keep them in mind too. Thanks very much for joining us. Wonderful work.

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