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June 14, 2013

The Caribbean: In search of lost competitiveness

Fri June 14, 2013

Over the past two decades, the Caribbean has experienced relatively low economic growth, particularly in its tourism-based countries, largely as a result of its increasing inability to compete in the global market. Many observers highlight the need for Caribbean countries to improve their economic competitiveness and in so doing, reduce their public debt burdens and raise the standard of living of their citizens.{{more}}

Governments basically have three main ways to improve competitiveness: (i) introduce structural reforms to boost both public and private investment and productivity; (ii) improve price competitiveness with fiscal measures that lower wage costs and increase labour productivity (internal devaluation); and (iii) allow a nominal currency devaluation to lower the international price of domestically produced goods (external devaluation). Caribbean governments need to determine which of these approaches would best increase their competitiveness.

Structural Reforms: These reforms – which have significant potential for creating longer-run economic payback – should focus on: (i) improving the effectiveness of public investment; (ii) improving the business environment and providing more efficient public services; (iii) increasing linkages between sectors with strong potential growth, e.g. tourism and geothermal energy, and other sectors; (iv) increasing efficiency in the product, labour, energy and financial markets; and (v) pursuing deeper regional integration to capitalize on economies of scale.

Internal or External Devaluation: The choice between the two remaining policy options requires careful consideration by each country within the Caribbean. The effectiveness of influencing competitiveness depends on a country’s economic characteristics and conditions. To analyze this, IMF staff has conducted studies that are calibrated for small open economies with high import propensities (i.e., like the tourist-based Caribbean countries). The main results are:

o Internal devaluation. There is evidence that measures that reduce government wage costs and bring domestic inflation below that of major trading partners boost competitiveness. For small states undertaking such measures, recent country experiences (Barbados, 1991; Hong Kong, 1997; and Argentina, 1998) support predictions that they will have a bigger improvement in their external current account than larger states, because of the high import content of cuts in government spending, while experiencing a smaller relative decline in domestic prices; and will have lower short-term losses in output from reduced demand, i.e., a smaller contractionary effect, than in larger economies.

o External devaluation. The IMF studies also suggest that economic conditions improve immediately following a devaluation for both large and small economies. However, the real depreciation of the exchange rate is lower in small states because domestic prices rise more, reflecting the larger import content of their consumption basket. Hence, the gains in output will be less in small states because of the smaller decline in relative costs. The studies also show that countries undergoing financial crises had smaller gains from devaluations.

For the Caribbean, the choice between internal and external devaluations is easier because some countries are already undertaking fiscal adjustments to improve their debt situation, and so aspects of internal devaluation are being implemented. For these countries, external devaluations can be pursued if additional adjustments are needed beyond what is feasible on the fiscal side. Structural reforms that boost competitiveness should be pursued vigorously, regardless of other policies. so that the Caribbean has a foundation for sustained economic growth and higher living standards over time.

Contributed by Wayne Mitchell