Devaluation: An option for the Caribbean?

 

^{Photo courtesy of Wikimedia Commons, User Barry Haynes}

The Caribbean has long been plagued by low growth, high unemployment, burdensome fiscal deficits, debt, and a high susceptibility to global shocks. Notwithstanding an economic history that is characterized by interventions by the International Monetary Fund (IMF) and the World Bank (WB) that many historians and nationals alike would rather not reminisce about. More recently, Jamaica has struck an accord with the IMF to stabilize much of its economy with a dose of structural reforms and austerity. On such shaky grounds, the economic outlook for much of the Caribbean, including the commodity juggernauts, remains well short of the feel-good-vibes synonymous with the region.

What is clear is that there is a much deeper problem that has blighted the Caribbean, and it’s one that manifests itself as the inability to penetrate and openly compete on the world market – competitiveness! Whether it’s Guyanese sugar, or the white-sandy beaches of Barbados and The Bahamas, the ability to sell products, be it tourist-based or commodities, at low costs to maximize profits is paramount for growth and economic prosperity of a region dotted by small market economies.

However, being small is no excuse! Measuring competitiveness as the current account of the balance of payments illustrates a telling tale of ‘the Caribbean living beyond its means.’ With the exception of Trinidad and Tobago (thanks to black gold we know as oil), the region’s economies are characterized by excesses consumption beyond their domestic production. We see this when there is (i) excess of imports over exports, (ii) excess of domestic spending and investment over what is produced, and (iii) excess of domestic private and public investment over domestic savings. These trends are even more worrying as the Caribbean is being left behind by its direct small market competitors or rest of small economies (ROSE) as they turn the corner and make significant strides. So what can be done to reign in loose purse strings and improve productivity in the Caribbean? While productivity speaks to a microeconomic problem, tackling sector-by-sector reforms maybe too long. Thus, a policy with far-reaching and explicit effects such as devaluation may be the bitter medicine that is needed. Yes, DEVALUATION!

It’s no surprise that ‘devaluation’ is generally met with immense fear and speculation. Financial markets see it as a sign of weakness and a potent threat to balance sheets rife with foreign currency, denominated assets and liabilities; while policymakers, more often than not, shy away from even discussions on the issue fearing populist backlash because of its effects throughout the economic ladder. Like most parts of the world, the Caribbean and their policymakers are also haunted by these fears from such a bitter policy prescription. But much knowledge could be gained by tinkering (reading the fine print) as there is much more to devaluation than just ‘tanking a currency.’

If perennial current account deficits are unsustainable and competitiveness is low, devaluing the exchange rate may be a viable option, better known as external devaluation. This expenditure-switching policy will increase the price of imports and make exports cheaper; domestic demand for imports will fall and foreign demand for exports will increase and therefore the current account will improve (once the Marshall-Lerner condition holds), and the economy will grow. However, it is argued that expenditure cannot be switched from tradable goods to nontradable goods in countries such as those in the Caribbean. Therefore, real exchange rate evaluation only depresses real income. Worse, devaluation could result in stagflation, i.e. reduce economic growth and increase inflation.

While external devaluation may erode the gains of a pegged exchange rate prevalent in most Caribbean countries, an alternative policy that can be considered is internal devaluation which aims at reducing production costs, particularly labor, through deflation. Since governments do not directly control aggregate prices, cutting public sector wages places downward pressure on private sector wages and ultimately domestic prices. Lower domestic prices means greater external competiveness, however, the political and socio-economic backlash from lower wages that ultimately lead to greater unemployment poses a colossal policy dilemma.

The third policy variant entails fiscal tax adjustments that directly lower labor cost reduction without wage cuts – fiscal devaluation. This option was first discussed by Keynes in the context of the gold standard, when countries could not devalue their currencies. The modern version of this policy recommendation is to reduce payroll taxes and increase value-added taxes. This in effect will reduce unit labor costs improving competitiveness, while the higher value-added tax is levied on domestic consumption, including imports, and thus, reduce the current account deficit as foreign demand for exports increases and domestic demand for imports falls.

While devaluation is no cure-all, as there is a cadre of infrastructural, energy and transport deficiencies in the region that this policy measure cannot fix, it may represent an interim measure to cede the Caribbean’s slide. Thus, if we accept that a sustained deficit of the current account of the balance of payments is a problem, then policymakers have to consider these policy options for reducing the deficit and a measure to improve overall competiveness.

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