Directors concurred that the urgent challenge is fiscal consolidation. They emphasized that the currency union needs to be supported by consistent fiscal policies across all its members, buttressed by an appropriate institutional framework for policy coordination. Directors welcomed the authorities’ decision to translate the current debt target of 60 percent of GDP by 2020 into annual primary surplus targets, and stressed that implementation will be key. The required surpluses will vary by country, depending on the member’s initial conditions. Prioritizing public investment and implementing measures to enhance expenditure efficiency and contain current spending while protecting the poor and vulnerable will be important elements of the consolidation.

Directors underscored that safeguarding financial sector stability should be a critical undertaking, in view of the anticipated slow economic recovery and the large government exposures of some banks. Along with fiscal consolidation and reduced public financing through the banking system, enhanced crisis preparedness and preemptive resolution of weak indigenous banks will be important. The regulation and supervision of the nonbank financial sector will also need to be strengthened. Further progress should be made in enacting and harmonizing financial sector legislation and in setting up single regulatory units. Directors welcomed the announced steps to resolve BAICO. They encouraged the authorities to take a more decisive and stepped-up regional approach in the case of CLICO, in close cooperation with the home supervisory authorities. They stressed that any resolution strategy should minimize fiscal costs.

Directors agreed that the currency board arrangement has provided a strong anchor and continues to be an appropriate exchange rate regime. They noted the staff’s assessment that the REER appears broadly in line with current fundamentals. The needed fiscal adjustment, however, would require some depreciation of the equilibrium REER in the near term, implying an adjustment in relative prices in light of the currency peg. This will require restraint in real wage growth or even a reduction in nominal wages. Improving productivity and enhancing the business climate will be critical to maintaining competitiveness. Further strengthening regional integration will also be important.

Directors agreed that the views they expressed today will form part of their discussions in the context of the Article IV consultations for individual ECCU members that will take place until the next Board discussion of ECCU common policies.

Background

The ECCU region has been hard hit by the global economic downturn and is faced with a protracted recovery. Real regional Gross Domestic Product (GDP) contracted by 6 percent in 2009, reflecting a collapse in tourist arrivals and Foreign Direct Investment (FDI) financed construction activity. Continued weakness in private consumption and high rates of unemployment in the advanced economies has dampened prospects of a rapid recovery. Growth is expected to remain subdued in 2010 and recover only slowly in 2011. Inflation, which declined sharply to an average of 0.8 percent in 2009 reflecting the widening output gap and falling prices of imported food and energy, is expected to revert gradually to its long run average of about 2 percent, given the anchor of the currency peg. Risks to the outlook are tilted on the downside.

The overall fiscal deficit has increased sharply, while extremely high and rising regional public debt in the context of a regional currency board arrangement has exacerbated the region’s vulnerability to shocks. Recession-induced fiscal revenue losses, increases in public spending in most ECCU members aimed at mitigating the impact of the downturn, as well as higher debt servicing costs raised the region’s overall fiscal deficit to 8 percent of GDP in 2009 from 3.5 percent of GDP in 2008. The regional public debt jumped to above 100 percent of GDP at end 2009, from an average of 93 percent of GDP in 2006-08, reverting earlier gains in debt reduction. Reflecting in large part the fiscal adjustments envisaged under Fund-supported programs with Antigua and Barbuda and Grenada—the fiscal deficit for the region is projected to decline, but remain elevated at close to 4.5 percent of GDP for 2010–15, while public debt will stay above 100 percent of GDP through 2015.

Weaknesses in the ECCU financial sector have been aggravated by the contraction of economic activity in the region and the collapse of the Trinidad and Tobago-based CL Financial Group on insurance companies, BAICO and CLICO operating in the ECCU. Private sector credit growth slowed sharply in 2008–09 and liquidity in the ECCU banking system, particularly for some indigenous banks, tightened significantly. Non-performing loans (NPLs) increased to 9.6 percent of total loans as of June 2010 in the banking system, reflecting the deterioration of loan portfolios in tourism and mortgages. Some indigenous banks’ gross exposure to the government sector has been substantially, mirroring rising public sector debt in the ECCU. Despite high capital adequacy ratios, application of stricter classification for NPLs and provisioning might unveil further weaknesses

The external current account deficit is expected to narrow substantially to about 27 percent of GDP in 2009 from 37 percent of GDP in 2008. Lower imports more than offset the continued impact of lackluster tourism performance, reflecting largely the decline of FDI-financed construction-related imports and weak domestic demand. The current account deficit was financed predominately by FDI inflows, together with some public sector long-term loans and the drawdown of net foreign assets by commercial banks. The current account deficit in 2010 is projected to remain elevated at similar level to 2009, but to narrow in line with a gradual recovery in tourism receipts and fiscal consolidation over the medium term. The Eastern Caribbean Central Bank (ECCB) reserve coverage of demand liabilities declined below 100 percent in early 2009—averaged about 95 percent in the first half of 2010—but well above the central bank’s legally-mandated floor of 60 percent. The Real Effective Exchange Rate (REER) appears broadly in line with current fundamentals. However, the required fiscal adjustment going forward would be associated with a depreciation of the equilibrium REER and—given the currency peg—imply adjustments in relative prices.

The Eight-point Stabilization and Growth Program, signed by ECCU governments in December 2009, serves as the basis for a coordinated regional response to the economic downturn. It focuses on the implementation of a stabilization package covering financial programs, fiscal reforms, and debt management; a stimulus package with public sector investment programs and social and financial safety nets; and a more structural focused package, comprising the amalgamation of some indigenous banks and reform of the insurance sector. Driven in part by the fallout from the economic and financial crisis, the authorities stepped up their efforts to deepen regional integration by signing the Organization of Eastern Caribbean States (OECS) Economic Union Treaty. The new OECS Treaty, to be ratified by the respective member countries by January 2011, would pave the way for the free movement of people, goods, services, and capital among participating countries, and strengthen the institutional set up of a full-fledged economic and monetary union.