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Maintaining independence

The Barbadian economy depends on foreign exchange to finance the variety of imports which support our standard of living. Because of this, it has been necessary to cut the fiscal deficit to reduce overall spending and spending on imports in the face of the slowdown in tourism and the international business and financial services sector. Fiscal restraint has helped to keep the external accounts in balance, and the foreign reserves of the Central Bank have been maintained at about the same level as at the onset of the crisis in 2008. This means that the exchange rate is secure, and the economic direction of the country remains firmly in the hands of Barbadians, both in the private sector and in Government. Going forward, the growth strategy focuses on private investment in the sectors that earn and save foreign exchange, supported by appropriate Government incentives and investment in infrastructure.

An important benefit of an adequate cushion of foreign exchange reserves is that it allows policy autonomy. In the wake of the Asian crisis of the mid-1990s, Asian economies determined to insulate themselves against future shocks by accumulating a buffer of foreign reserves, thereby ensuring that they could determine the right policy mix for themselves, in response to subsequent economic shocks. Barbados has been able to follow a similar path to policy autonomy, by maintaining a buffer of foreign reserves at an adequate level since the onset of the 2008 crisis.

What is more remarkable, we have done it in the face of economic contraction, whereas the Asian economies have had the benefit of economic growth, driven by abundant natural resources and domestic demand. Thanks to the foreign reserves buffer, Barbados may pursue appropriate policies, independently of analyses and prescriptions based on misperceptions of the Barbadian reality.

As is the case for small open economies everywhere, the Barbadian economy cannot sustain growth without an additional supply of foreign exchange. Small open economies need foreign exchange in order to grow, because they cannot produce the range of commodities needed to support modern lifestyles. In this, they are different from large economies, which have domestic substitutes for everything they need, at prices which ordinary people can afford.

The small open economy faces a “hard” foreign exchange limit, one which it cannot get around by altering its policy. A large country like Brazil does not face this foreign exchange limit. If the demand for Brazil’s exports or tourist services falls, the authorities may reduce the demand for imports by devaluing the real, the Brazilian currency, inducing consumers to switch from more expensive imports to affordable domestic substitutes.

However, all small economies are limited in the range of commodities they can produce at competitive prices. Their small size means that their human and material resources are fully employed in the production of just a handful of goods and services.2 In comparison, the consumption needs of a modern economy are very diverse. As a result, the policy of growing domestic production to substitute for imports that works for Brazil is not practical for Barbados. The proportion of imports for which there are Barbadian made substitutes available at competitive prices is trivial.

The foreign exchange constraint defines policy, in the short and long run. In the short run, policy must be to limit spending, so that the demand for imports does not exceed the expected foreign exchange inflow. In the longer term, growth must be led by investment in the sectors that earn and save foreign exchange.

In what follows, the following points are made:

* The Barbadian exchange rate is secure, protected by adequate foreign reserves, and as a result Barbados has the autonomy to pursue an appropriate home-grown economic policy;

* To maintain policy autonomy and sustain the foreign reserves buffer, spending on imports is contained by use of fiscal adjustment, to ensure that the demand for imports does not exceed the available foreign currency inflows;

* Reserves are monitored daily, and every month decisions are taken about the fiscal measures that may be needed to keep expenditure in line with foreign exchange inflows;

* The Government’s published medium-term strategy to balance the fiscal accounts, and bring down the ratio of debt to GDP, is front loaded, and is on track;

* The growth strategy is led by private investment in the foreign exchange sectors, supported by Government incentives and marketing and other services.

In addition, this paper makes an analysis of the “weaknesses” cited by Standard and Poor’s in their report of July 17, 2012.

The exchange rate is secure, and Barbados has policy independence

Foreign reserve levels have been maintained since the onset of the crisis in 2008, by a mix of judicious foreign borrowing and fiscal adjustment.

The demand for foreign exchange has been held down in line with the supply through the use of fiscal policy…

The Central Bank projects the expected supply of foreign exchange each year, and the expected expenditure, in the aggregate and on imports. Whenever the expected demand for foreign exchange is projected at a point … where the demand for foreign exchange exceeds the available supply, Government decides on action (through raising additional tax revenue or lowering government expenditure) to reduce the demand for foreign exchange…, where the demand matches the supply of foreign exchange.

Thereafter, the demand and supply of foreign exchange are monitored on a daily basis by the Central Bank and the Ministry of Finance and Economic Affairs. On days when the supply of foreign exchange exceeds the needs of buyers, the surplus is sold to Central Bank and the reserves increase. On days when the interbank market is in deficit, banks buy from the Central Bank, and reserves fall.

The Central Bank’s foreign reserves are therefore a barometer of the state of the foreign exchange market. The reserves are plotted on a chart which allows for comparison with the daily patterns of the previous four years, so that potential losses of reserves may be detected at an early stage, and corrective measures can be taken in good time.

In sum, the Ministry of Finance and Economic Affairs and the Central Bank of Barbados together anchor the exchange rate through fiscal adjustment, ensuring that foreign reserves remain adequate. Fiscal revenue and spending are calibrated and adjusted to keep foreign spending within the limits of available funding. The system is monitored daily, so that remedial action may be taken, should some portion of expected foreign exchange inflows fail to materialise. Unfortunately, the only option in case of a shortfall may be further fiscal cuts or additional taxes, when foreign borrowing conditions are unfavourable.

The medium-term fiscal strategy to reduce the ratio of debt to GDP is on track

The ratio of Government Debt to GDP is not especially high compared to other countries that have been adversely affected by the financial crisis, including industrial countries. On a net basis, taking account of all financial assets which Government holds with the private sector, the ratio is 57 per cent, and on a gross basis, ignoring these assets, it is 77 per cent.

Figure 4 shows how Barbados compares with a selection of industrial countries, and countries which are rated BB+ by S&P.

Figure 4.

Furthermore, the servicing of the external debt is not especially burdensome (see Figure 5). This is crucially important, because funds for debt service compete with imports for the available foreign exchange.

Nonetheless, Government has published a medium-term strategy to reduce the fiscal deficit, and bring down the ratio of debt to GDP. A lower ratio provides additional freedom in the choice of policy responses, including borrowing, in the event of future shocks. The fiscal adjustment strategy is slightly ahead of schedule, with a reduction in the deficit from 9.1 per cent of GDP in Fiscal Year 2010/11 to 4.6 per cent last Fiscal Year.

The fiscal strategy fits the economic circumstances. Fiscal policy does not need to be any tighter, because there has been no substantial loss of foreign reserves. However, the foreign balances and the fiscal outturn are under constant surveillance, with a view to taking appropriate early action should that become necessary.

The growth strategy focuses on the sectors that earn or save foreign exchange

Barbados is a private sector led economy: economic growth is driven by the investment decisions of forward-looking firms and individuals, seeking to exploit profitable opportunities. Government’s role is to support the private sector with incentives and an enabling environment, including the provision of efficient public services.

While investment in all sectors is needed, growth cannot be sustained unless there are additional foreign exchange inflows, sufficient for the additional import needs of consumers and producers. For this reason, growth is sustainable only when led by the foreign exchange sectors. The sectors which earn or save foreign exchange, or have the potential to do so, are tourism, international business and financial services, agriculture and agro-processing, and

Continued on page 33.

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