Pooling Fiscal Risk in the ECCU: Quantifying Savings of a Regional Fund for Stabilization and Investment

WP/21/191Pooling Fiscal Risk in the ECCU: Quantifying Savings of a Regional Fund for Stabilization and Investment by Alejandro Guerson IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. © 202 1 In ternatio na l Mon eta ry Fund WP/21/191IMF Working Paper Western Hemisphere Department Pooling Fiscal Risk in the ECCU: Quantitative Assessment of Savings with a Regional Stabilization Fund Prepared by Alejandro Guerson Authorized for distribution by Sònia Muñoz July 2021 Abstract This paper quantif ies the savings obtained from risk pooling with a Regional Stabilization Fund (RSF) for the Eastern Caribbean Currency Union. A Monte Carlo experiment is used to estimate the size of a RSF conditional on probabilities of depletion under specif ic saving-withdrawal rules. Results indicate that regional risk pooling requires about half of the saving amount relative to the sum of individual-country savings. In addition to reducing the amount of saving requirements for stabilization, the RSF can improve welfare by realocating government consumption savings during booms towards public investment during recessions, resulting in an increase of public investment in the range of 0.5-1.5 percent of GDP per year depending on the country, with positive growth dividends. Moreover, the RSF also reduces the dispersion of public debt outcomes in light of the cross-country cyclical synchronicity of output and revenue, thereby strengthening the stability of the regional currency board . JEL Classif ication Numbers: C6; G18; H6. Keywords: Natural disasters; ECCU; f iscal cycles; Monte Carlo experiment, debt sustainability, risk pooling. Author’s E-Mail Address: aguerson@imf.org. IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 3 I. INTRODUCTION________________________________________________________________________________________ 4 II. METHODOLOGY _______________________________________________________________________________________ 6 III. CALIBRATION ________________________________________________________________________________________10 IV. RESULTS ______________________________________________________________________________________________11 A. Pro-cyclicality of Government Spending ____________________________________________________________ 11 B. Regional Savings of Risk Pooling_____________________________________________________________________ 13 V. CONCLUDING REMARKS ___________________________________________________________________________15 REFERENCES _____________________________________________________________________________________________17 APPENDIX: NATIONAL SAVING FUND SI MULATIONS ____________________________________________18 4 I. INTRODUCTION Small island states in the Eastern Caribbean Currency Union (ECCU) exhibit signif icant volatility in output and government revenue. This volatility implies challenges to macroeconomic management and affect financial stability, fiscal discipline, external competitiveness and growth.1 Output volatility also results f rom low output diversif ication related to smallness: comparative advantage in a relatively narrow spectrum of sectors (mainly tourism) subject to global growth swings and dependence on key commodity imports, including oil and manufactured goods for investment and consumption. In addition, natural disasters (NDs), including tropical cyclones, earthquakes and volcanic eruptions, affect the region recurrently and impose signif icant losses of macroeconomic proportions, resulting in protracted increases in public debt (Acevedo, 2014).2 In a sample of Caribbean countries, Cantelmo, Melina and Papageorgiou (2019) find that the welfare loss from natural disasters are equivalent to a permanent decline in consumption of 1.6 percent of GDP. 1 See Rasmussen 2004; Noy 2009; Cavallo and Noy 2011; Cavallo, Galiani, Noy and Pantano 2013. 2 See for exa mple Cu mmin s a nd Mahu l (2009) for a presentation of natural disaster insurance and general principles for public intervention. 2345678020406080Damage and frequency of natural disasters in the ECCUDominicaSt. LuciaSt. Vincent and the GrenadinesSt. Kitts and NevisAntigua and BarbudaGrenadaAverage damage, in percent of GDPNumber of natural disasters 5 In addition, government spending in ECCU countries has been procyclical, compounding the supply-driven sources of volatility above. The text chart shows that the cyclical component of output has a strong positive correlation in most ECCU countries. The need