IMF Working Paper confirms Caribbean countries highly exposed to external factors
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WASHINGTON-CMC–An International Monetary Fund (IMF) Working Paper has confirmed that Caribbean countries are highly exposed to external factors.

Using data from 1980-2017, the paper, “The Caribbean and Its Linkages with the World: A GVAR Model Approach,” says that a fall in oil prices and an increase in the US gross domestic product (GDP), as examples, have a “positive and large impact” on most Caribbean countries after controlling for financial variables, exchange rate fluctuations and overall price changes.

The paper uses a Global Vector Auto-regressive (GVAR) model tailored for the Caribbean region, which includes its major trading partners, representing altogether around 60 percent of the global economy.

“We provide stylized facts of the main interrelations between the Caribbean region and the rest of the world, and then we quantify the impact of external shocks on Caribbean countries through the application of two case studies: A change in the international price of oil, and an increase in the US GDP,” say the authors Mauricio Vargas and Daniela Hess.

“The results from the model help to disentangle effects from various channels that interact at the same time, such as flows of tourists, trade of goods, and changes in economic conditions in the largest economies of the globe,” they add.  The report says that global spillovers are a central element in international economics and that Caribbean countries are “as acutely exposed to them as many others.”

It says that production and trade in goods and services, and financial flows depend not only on internal market supply and demand forces but also on competitiveness and world growth.

During the past decades, the paper notes that many small and large countries have leaned towards trade openness and financial liberalization, stating that some evidence suggests that this might benefit their economies. Notwithstanding, the paper says a strong degree of integration poses additional risks to small open economies that may suffer disproportionately from shifting economic conditions in the largest economies of the globe, “as they are less able to diversify away from the sectors in which they have comparative advantages.”

“That is the case for most Caribbean countries, which are highly internationally integrated, especially through tourism flows – a sector often hit hard by downturns in larger economies,” the paper says. To quantify the strength of macroeconomic linkages between Caribbean countries and the rest of the world, the paper introduces a Caribbean-tailored GVAR model.

The IMF GVAR model features 45 developing, emerging market and advanced economies, of which 15 are Caribbean. The analysis focuses on specific spillovers for Caribbean countries, such as the effect of an expansionary policy in the United States or an oil price drop. The paper says one of the main advantages of implementing a GVAR model to assess macroeconomic impacts of external shocks is that “it allows to internalise second round effects that are usually considered as exogenous or static in less sophisticated models.”  The IMF Working Paper says measuring linkages between different regions of the globe is a challenge.

However, it says the GVAR methodology “shows itself to be useful to condense large amounts of information in a way that permits researchers to isolate global shocks or country-specific shocks and gauge their impact across the board.” “Given its size and large dependence of external markets, the Caribbean region is particularly sensitive to policy changes or shocks in large trading partners, such as the US, Canada, or the UK (United Kingdom),” the paper says.

While most of the Caribbean countries can be classified as tourism dependent, it says a few others are also affected by external conditions “due to the significant size of their trade in goods.”

The paper notes that Trinidad and Tobago recently terminated its refining operations and is currently shifting from oil to gas production, “which will likely change some of the impacts estimated in this paper.” According to the paper, the GVAR model suggests that an oil price shock might negatively affect important Easter Caribbean Currency Union (ECCU) trading partners that are oil exporters, such the UK, Canada and Trinidad and Tobago, “while an initial negative effect on GDP followed by a recovery in the medium term would be expected in the US.”

“Overall, and given their condition as oil importers, our findings reveal that most ECCU economies would expect a positive impact on their GDP,” the authors say, adding that those results coincide with the outcome from the recent drop in oil prices in 2014. The paper also finds “a strong impact from an expansionary policy” in the US on most Caribbean economies.

Simulated by a positive shock on the domestic GDP of the US, the paper says an expansionary policy would strongly affect tourism-dependent economies while having mixed effects on the set of Caribbean goods exporters. “The results are not surprising given the relevance of US tourist flows for the region and contribute to confirming results from country-specific models while taking into account a richer set of interactions,” the paper says. “External shocks represent a large source of uncertainty and volatility to small states and structural policies might help to downgrade their impact,” it adds.

While the questions raised in the paper are not new to IMF’s Staff Reports and research papers, the Working Paper says the GVAR methodology represents an alternative way to tackle them in a more integrated fashion while including second round effects from the dynamics of trading partners.

The paper says that the observed large impact of external factors suggest that Caribbean countries may benefit from preventive measures, such as increasing competitiveness, diversifying their economies and reducing their dependence on critical commodities and services, namely, oil-based energy and tourism.

“These policies might reduce exposure to external imbalances and, at the same time, promote economic growth,” the paper says. It says the GVAR methodology is capable of providing responses to a broad range of questions, stating that the model represents “a promising avenue for empirical analysis and could be expanded to include more countries or idiosyncratic variables for particular countries.”

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