A Fiscal Insurance Scheme for the Eastern Caribbean Currency Union Laura dos Reis Intergovernmental Group of 24 (G-24) RES, 10 years September 17, 2004 Washington, D.C.

Fiscal Insurance Important instrument to respond to asymmetric shocks Reinforce the monetary union long-term sustainability

The Organization of the Eastern Caribbean States (OECS)

Volatility of TOT Shocks OECS Monetary Union is particularly vulnerable… Volatility of TOT Shocks Term of Trade shocks are defined as (trade/GDP)*(change in term of trade) Source: WDI-GDF, World Bank and terms of trade data are from the IMF.

Natural Disasters Frequency and Cost of natural disasters 1970-2000 1/ in 1988 Hurricane Gilbert caused an estimated US$1 billion of damage Source: World Bank (2002).

Natural Disasters Main Natural Disasters in OECS (1979-2000) 1/Damage is valued at the year of the event Source: World Bank (2002)c. and OFDA/CRED International Disaster Database (EM-DAT) 2002. Hurricane Lenny Recovery in the Eastern Caribbean.

…which have affected the regional growth performance and complicated the management of government finances OECS Selected Economic Indicators (as percent of GDP). Source: Eastern Caribbean Central Bank (ECCB).

Room for potential gains under a risk-sharing mechanism However, regional asymmetries provide scope for potential risk-sharing gains Low or negative correlation of economic fluctuations Aggregate output and fiscal revenues are less volatile than individual member’s volatility Room for potential gains under a risk-sharing mechanism

Correlation of Economic Fluctuations   Correlation Matrix of Cyclical Revenues (1981-2001) (*) 5 percent statistical significance level. Standard error in parenthesis. Source: Own calculations based on ECCB fiscal data. Correlations are calculated with the cyclical revenues in logarithms

OECS output less volatile than for member countries   GDP Growth and Volatility in OECS (in percent) Source: Own calculations based on data of the Eastern Caribbean Central Bank (ECCB).

Fiscal Revenues less volatile for OECS than for member countries Volatility in OECS Revenues (2) It does not include Dominica due to data unavailability for the period 1984-1992 Source: Own calculations based on the Eastern Caribbean Central Bank

Fiscal Insurance Proposal Basic Framework A buffer fund to be administered by a centralized fiscal authority or the regional central bank A Fiscal insurance scheme that covers for shortfalls in cyclical revenues owing to natural disasters and terms-of-trade shocks. The fiscal authority establishes the share of the shortfalls in revenues attributed to the shocks for each member The initial fund requirements for this coverage could be financed through regional savings, market financing or multilateral loans The payments to the fund can take the form of a flat premium or a credit line with charges

Fiscal Insurance Proposal Benefits Help accommodate asymmetric and country-specific shocks Reduction in regional volatility Long-term sustainability of the union: - Less incentives to leave the union - Better fiscal coordination. Limitations Incentives problems: -Moral Hazard -Common-pool

Simulation Exercise The centralized fiscal authority only covers for cyclical changes in fiscal revenues due to terms-of –trade shocks and natural disasters Monte Carlo simulation of fiscal revenues to test the performance of the insurance scheme for full and partial insurance coverage levels

Simulation Results: Initial OECS Buffer Funds Simulation for Full –and Partial- Insurance (100 50-year histories) /1The percentage of coverage is the number of histories the buffer fund is depleted out of a total of 100 histories. Note: “Bo/GDP” is the share of the initial period buffer fund over GDP trend.

Simulation Results: Initial OECS Buffer Funds OECS International Reserves (percentage of GDP) Source: IMF, International Financial Statistics (IFS) and World Economic Outlook (WEO) April 2004.

Simulation Results: Risk-Sharing Gains Self Insurance and Risk-Sharing: Simulation for Full –and Partial- Insurance (100 50-years histories)

Conclusions Volatility in fiscal accounts would be reduced if countries join a fiscal insurance arrangement Asymmetries in regional fluctuations of output and government revenues can lead to welfare gains. Fiscal Insurance would reinforce the countries’ commitment to the union. Partial Insurance can - Moderate incentive problems (i.e. moral hazard) - Easier to implement as it required lower initial resources Further steps to implement this policy - Institutional characteristics of the central fiscal authority. - Initial financing conditions. - Re-payment options: premium, credit line.