Marion Williams: Central banking in a global context - promoting both
national and regional economic gains
Feature address by Dr Marion Williams, Governor of the Central Bank of Barbados, delivered
at the 35th Anniversary Conference of the Central Bank of Barbados, Bridgetown, 10 May
2007.
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Mr. Chairman
Members of the Board
Deputy Governors
Distinguished Panellists
Members of Management and Staff,
Distinguished Ladies and Gentlemen:
I am delighted to welcome you to the Central Bank and to the Frank Collymore Hall. Over the
years, the Bank has set itself the goal of promoting dialogue on topics of economic and
financial interest. Such an occasion as our 35th anniversary could not therefore pass unless
we staged such a dialogue on a topic of economic interest. We are delighted to welcome our
panelists Dr Trevor Farrell, formerly of the University of the West Indies at St. Augustine, Dr
Gregor Heinrich of the BIS and Dr Jose Blanco of the Latin American Monetary Council. My
presentation is intended to set the scene for later discussion by our panelists, some of whom
will share with us the integration experience in other jurisdictions.
Given the pace and momentum of global change, Central Banks in developing countries are
often unable to influence global forces. However it is important that we adopt our approaches
to accommodate to these forces of change.
The timing of the formation of the Caribbean Single Market & Economy (CSME), coming as it
does at the turn of the 21st century, is a time when our economies are now more exposed to
the opportunities and pressures of economic and financial integration than ever before. The
precise implications are continually unfolding, what we know is that the gains for the region
have the potential to be significant if our responses are regional rather than national and
sooner rather than later.
Let me focus first on a few global economic and financial developments which have
implications for Central Banks and for the region before turning to regional issues.
Integration of markets and economic growth
Compared to even a decade ago, world financial and product markets are significantly more
integrated. Cross-border flows of real and financial capital have also increased dramatically -
a reflection of the notable reduction in the degree of home bias in capital markets. Along with
the evolving pattern of cross-border flows, we have also seen profound increases in the
absolute size of current account balances in both industrial economies and emerging market
economies. A more integrated world economy brings with it the prospect of a more
productive, yet competitive world economy. The increase in the ties between national
financial systems as well as the greater sophistication of financial markets and financial
market instruments allow risks to be shared more broadly and capital to flow to where the
returns are expected to be the highest.
The recent spurt in integration has occurred during a sustained period of relatively strong and
steady growth on a global scale and of relatively stable and low inflation rates. These
improvements in outcomes have surfaced amidst a number of other important changes in the
environment, including significant technological progress and better economic policies steady
growth in Latin America and the Caribbean and more stable emerging economies particularly
in Latin America. But even without being able to assign precise shares to all the contributing
factors, we know that greater integration and openness are likely to have been particularly
important in the Caribbean case.
China through its Central Bank the National Bank of China has become the repository of vast
foreign exchange reserves principally in US Dollars. China is also competing with many of
the international lending agencies for the attention of many West African countries, where
access to less complicated loans are becoming attractive. Regional economic units are
looking to each other and to their central banks for balance of payments support rather than
to international institutions. Also private credit markets are now accessible to central banks
and to governments in a way which did not obtain in the past.
Economic modeling and monetary policy
All of these developments have impacted on the way in which central banks do business.
Many Central Banks in the region are therefore redesigning their policy responses, not only
in the context of global forces but in the context of adjusting to the fact of greater regional
economic and financial integration.
Our models however are pressed to catch up with the changes. Economic theory is most
comfortable with fully integrated systems in which prices and flows of goods and services
along with real and financial capital respond continuously and completely to market forces.
Significantly harder to capture in our models are those factors that do not fully, or quickly,
adjust to market incentives, or where those incentives are hidden. In the dynamic landscape
of the 21st Century, economic modeling has therefore become the subject of continuous
adjustment as relationships and responses on which these models are based, change more
frequently and become less standardized as national and regional flows, policies and
economic decisions accommodate to each other.
Yet in the world of risk management instruments it is expectations that are important and
margins of error have to be minute in order for financial markets to be efficient and avoid
major losses. This is a challenge for developing countries who need to manage risks but
have thin financial markets.
At the same time traditional armour of central banking is also subject to continual adjustment.
New relations and responses have the potential to alter the incentives of businesses and
investors, and change the accustomed rate and direction of flow of goods, services, labour
and capital. The lesson here is that in this era of liberalization of capital flows, central banks
have to be nimble and quick in their responses, less bound by theory and more by
pragmatism in doing what is in the interest of the economy they serve.
The pace of progress is in the direction of more openness to capital flows and the ability to
adjust to this openness, will depend in part on the pace at which countries are able to
strengthen the resilience of the domestic financial system and set in place the broader
institutional framework, including real time information systems and regulatory regimes that
are vital for open economies. In this regard, in almost every central bank in the world bank
supervision departments are growing and new risk management techniques are being
developed.
Higher reserves
Globalization of markets and greater openness has led to the holding of higher levels of
foreign exchange reserves by most countries across the globe. Indeed as cross-border
transactions grow there is a worldwide trend towards higher levels of official reserves in most
emerging markets. This is not simply the consequence of a desire for a greater financial
cushion against external vulnerability, but reflects the increasing level of interaction of
national economies with the regional and global economies. In addition many central banks
are increasingly diversifying the currencies of their foreign reserves holdings.
Collective responses
Another global trend among regional groupings is a trend towards the establishment of
regional foreign exchange pools. The 1997 the financial crisis in East Asia was a wake-up
call to governments of developing countries that financial markets and institutions must be
sufficiently prepared to manage globalised capital flows, before there was full market
liberalisation. Specifically, in South East Asia, financial institutions had to be reformed and
restructured, capital markets broadened and deepened, and supervision and regulatory
standards upgraded. Most importantly the regional response that followed encouraged
governments to consider establishing regional financial facilities in that region. As a result,
the Chang Mai initiative by South East Asian countries was established as a buffer which
offered greater and quick foreign exchange access. Today, a collective response drawing on
that regional integration initiative would be possible as apposed to the individual country
responses witnessed in 1997. This example of repositioning of South East Asia is of
significant import for Central Banks in other regional arrangements and other regional
groupings are considering the establishment of such pools.
At the same time, globalization and the reliance on the market and the decline in
discretionary monetary policy has limited the policy tools of central banks. Domestic
monetary policies of national central banks now face the money flows from international
sources which have the potential for making domestic policy less effective. At the same time
the wide disparity in interest rates and inflation rates across the globe is narrowing.
Inflation and monetary policy
While central banks in this region have multiple goals of ensuring financial stability, executing
monetary policy and helping to develop a stable economic and financial environments, price
changes and inflation control have not been a major issue as it has been seen in Latin
America in the 1970s and 1980s. Also, in the developed world inflation targeting is an
important objective of Central Banks. Indeed, noted economist Ken Rogoff and others have
pointed out that to the extent that globalisation increases the degree of competition, it can
reduce the "inflationary bias" or, to put it differently, it can strengthen the anti-inflation
credibility of a central bank. By promoting greater price flexibility, competition lowers gains in
the short-run to output from an unanticipated inflation. The improved credibility of the central
bank's commitment to keep inflation low and stable should, in turn, allow it to deliver better
inflation outcomes with fewer short-run costs to what many may consider as political
objectives of economic growth and employment.
It is however often not quite clear whether the successful control of inflation has been a result
of inflation targeting policies or of competition from South East Asia, China and India and
other developing countries which has driven prices down.
However, in the Caribbean inflation targeting has not been the major goal of monetary policy
up to now, but rather a subsidiary goal. And this has been largely because much of our
inflation has been imported. However, high oil prices, the more rapid growth of regional
economies in recent years, coupled with expansionary fiscal policies and demand pressures
of expansion of some regional economies, has brought the spectre of inflation more to the
fore. This has been so more in the rapidly growing economies elsewhere in the Caribbean,
but countries like ourselves have not been exempt. While the monetary policy levers for
control of inflation may be limited, the fact is, inflation control is likely to become a more
central part of both policy making than before if oil prices remain high. This however may
have less to do with regional Central Banks adopting inflation targeting as a goal and more
with the goal of ensuring that monetary and other policies do not contribute to the imported
component of inflation over which we are aware is beyond our control, if we adopt
counterbalancing monetary and fiscal policies. Here the trade-off is usually to sacrifice some
growth for lower inflation. This is not a win- win situation.
As economies become more integrated, external factors can have a stronger impact on the
movements of some prices. Rapid demand growth, commodity price volatility, and the
influence of a broad range of global and regional conditions on wages can all trigger large
changes in relative prices. So central bankers have to be careful not to focus too narrowly on
one particular measure, or indeed in our context to allow it to be thought that the Central
Bank can control inflation. Having said that, some central banks in developing markets of
Latin America have adopted inflation targeting. There may however be measures which can
be taken in terms of controlling money creation which can help to dampen inflation. However
the levers for control do not all rest with central banks.
Interest rates were always important but external interest rates are becoming more important
in the design of monetary policy by central banks. If the prevailing patterns of capital flows
were to exert downward pressure on interest rates and upward pressure on other asset
prices, they would contribute to more expansionary financial conditions than would otherwise
be the case. When this happens, it can mask the effect of other forces that might otherwise
have exhibited themselves in risk premia or higher interest rates.
As the conduct of monetary policy becomes more challenging it also obliges policymakers to
devote more care to the process of understanding how the changes at the global level affect
the balance between opportunity, risk and uncertainty, so that we have the flexibility to
respond efficiently and in a timely manner to any crisis to the extent that domestic policies
will allow.
Transmission mechanism
Also, our understanding of the transmission mechanism of monetary policy, with respect to
cross border markets will become increasingly important in the globalized world Already, the
BIS is tracking global flows and probably has access to more comprehensive data on cross
border financial flows in the Caribbean than we do on the region with respect to our regional
neighbour's data.
Regional
I will now turn to the regional focus. In the Caribbean context, the efficacy of monetary policy
can be reduced as a result of long lags and the inability to control the money supply directly.
As a result, monetary policy has often played a largely supportive role to fiscal policy.
However, a single market and the opening of capital accounts will reduce the effectiveness of
traditional monetary policy prior to implementation of a single currency and while market
instruments will help to influence outcomes they will tend to operate at the margin and will
tend to be more effective in tight liquidity situations and costly for the central bank in excess
liquidity situations, as a couple of our neighbours can attest.
A common currency
Key among the policy choices for monetary implementation in the region will be a common
currency. The proposal for a single economic space for the Caribbean region is not new. It
has been suggested from time to time over the last few decades in one form or another, as
part of promoting regional economic cooperation.
A common currency represents the ultimate in the economic integration of states and is
normally the product of a currency union. It is a zone of countries or a region, where a single
currency circulates, a single monetary authority or central bank operates, a single exchange
rate policy prevails and the single monetary authority often maintains a common pool of
reserves. The literature identifies the following as key deciding factors for a currency union:
openness, high intra-union trade, a high degree of product diversification, similarity in
industrial structures, high correlation in economic activities, similar inflation rates, flexibility in
wages and prices and factor mobility.
There are many compelling reasons in favour of a common Caribbean currency. Currently,
the overwhelming majority of regional trade is conducted using the US dollar which fetches
vastly different values against the various regional currencies, whether fixed or floating. If we
do nothing the numeraire currency will be the US Dollar - by default. A single currency for
the region would lead to elimination of transaction costs and of volatility in exchange rates
among members of the regional grouping.
Just as a common language promotes communication among people, a common currency
could promote trade and investment among countries in the region. These benefits will have
to be weighed against the likely costs that have to be incurred by the region. These would
involve the costs of discontinuing their own independent currencies by replacing with the
common currency, and the loss of seigniorage revenue from printing their own currencies.
The gains from a currency union, which are in terms of increased efficiency, arise primarily
from two sources. The first is that a common currency eliminates transaction costs usually
incurred when trade and investment transactions need currency conversion. Secondly, a
common currency eliminates risk from the uncertainty associated with the differences in
exchange rates between trading partners. One more gain is that a currency union provides a
potential for reinforcing fiscal discipline and credibility of monetary policy.
There are also disadvantages to a common currency. They relate to the loss of two important
macroeconomic adjustment tools, namely independent monetary and exchange rate policies.
The member country has to abide by common monetary policy for the union as a whole; and
it has to relinquish its exchange rate, an instrument for protecting itself from economic
shocks. However, the costs are less severe if the shocks affect all member countries in the
union in a similar fashion, and a common monetary and exchange rate policy vis-à-vis with
the rest of the world would then be appropriate. In such a scenario the national gains would
be positive for all.
On the other hand if the shocks were asymmetric in nature, affecting the countries in a
dissimilar manner, due to reasons such as different industrial structures, a common policy
would be less desirable. However, disadvantages of such a nature can be reduced to a great
extent if prices and wages are flexible and if there is perfect labour mobility between member
countries. Thus, downward flexibility of wages and prices and labour mobility will enable the
member countries in a currency union to withstand shocks of asymmetrical nature.
The important issue here is what the operation of a common currency would imply for the
conduct of monetary policy in the CSME. A common currency necessitates a single set of
economic, monetary, financial and fiscal policies which would ensure balance of payments
viability for the region. Accordingly, all of the countries in the union would have to fall in line
with the currency's monetary and exchange rate dictates. No agreement has been reached
on whether the common currency would be fixed of floating. Also, there would need to be
harmonized fiscal policies to ensure the success of regional monetary policy.
Such a single set of policies has better likelihood of success when there is a high degree of
synchronization of business cycles for all prospective member countries of a currency union.
According to optimum conditions, countries experiencing common external shocks would be
better suited to form a currency union because it permits the use of region-wide policies to
correct any imbalances. The reality in the Caribbean is that some of these second order
conditions do not hold in all respects. For example, while Trinidad and Tobago is a major
producer of petroleum, most of its CSME partners are oil importers. Regional monetary
policy would have to be fashioned very cleverly and with the utmost sensitivity in order to be
generally applicable to all the countries in order that gains may be shared both at the national
and regional level.
However, a currency union it is argued, could help make the shocks affecting member
countries more symmetric in the future and might also expand intra-regional trade. These
arguments are not different from the observations made by theorists, when the European
Common Market was born. It was felt that common currency arrangements would by
themselves reduce dissimilarities among member countries. However, it should be noted that
the EU member countries did not plunge into a currency union arrangement, as they were
aware of the pitfalls and insisted on fulfilling the convergence criteria contained in the
Maastricht Treaty of 1991 and the requirements under the Growth and Stability Pact of 1996.
A common currency offers an easy way to economize on the use of foreign exchange since
all regional transactions would become domestic transactions and would not require foreign
exchange. This is the single most important area in which regional gains and national gains
coincide, and an area in which all can benefit.
Preliminary economic convergence
Convergence criteria which have been established as conditions for entry to the Caribbean
Monetary Union are currently often breached without sanction. It is interesting to note that in
an article by Alexandre Lamfulussy, it is claimed that in Europe, among the convergence
criteria for accession to EMU, the fiscal ones and the inflation criteria were of critical
importance in the ultimate success of the European integration efforts. The members of EU
were also required to open their capital and labour markets by implementing policies towards
harmonisation of a wide range of commercial and legal standards. Ancillary issues including
labour mobility and fiscal transfers have far reaching implications and often need their own
policy focus.
Monetary union apart, the full implementation of the CSME will bring to the fore a number of
issues which will require harmonization of macroeconomic policies in the region prior to the
establishment of a single currency.
In the present economic system, regional integration can at times be a naturally-occurring
phenomenon. Natural market integration is a process characterised by progressive
convergence of economic and social parameters among countries which exhibit increasing
degrees of interdependence. However, in the early years of CARICOM the Caribbean was
mostly policy induced, in later years, co-integration has been occurring more naturally with
greater movement of people and capital. This formal policy co-operation which began in
1973 with the Treaty of Chagauramas to be followed in 1989 with the Grand Anse
Declaration, set out the roadmap for the formal push towards the CSME.
There is a particularly extensive post-World War II experience of economic integration. We
have seen that the most typical starting point of economic integration has been the creation
of free trade areas, often with the objective of deepening into a common market or
community. In these respects, with the formation of the CSME, our regional direction is no
different from that of other groups. Financial and monetary cooperation tend to be the last
bastion as we have seen with the euro and the European Central Bank.
Structural reforms and global participation
While central banks in the region will need to be more closely involved in monetary policy
coordination, the broader need will be to strengthen structural reforms and to enhance the
capacity to participate in the globalisation process. This can be seen by examining some of
the key objectives of the new regional integration movement, namely export growth and
diversification, institutional modernisation, functional regional cooperation, economic
transformation, the promotion of foreign direct investment, and trade liberalisation.
Private sector participation
We have already seen that joint ventures and pan-Caribbean companies have been
expanding briskly in the region and have been using the region as a platform for launching
into the wider global environment. Such ventures build on the comparative endowment of
regional countries, promote cooperation in joint production by matching countries that have
natural resource endowments with those that have financial capital or other inputs. The
private sector should assume the lead role in developing these business arrangements.
Indeed, the number and frequency of amalgamations, mergers and acquisitions across the
region continues to grow. However, a study on home -bias in Europe, by Kho, Stulz and
Warnock point to a preference for investing at home. This is likely also to be the case in the
Caribbean. They noted that investors are more optimistic about their home equity markets
than about foreign markets - even with free movement of capital. This means that interest
rate differentials need not fully reflect the competitive level needed to keep capital at home.
Growing and mutually beneficial economic interdependence among partners typically
induces demands for additional regional economic co-operation to exploit more fully the
advantages of a maturing regional market. Success is therefore likely to lead to further
success. There may even be some critical point that needs to be reached before take-off. In
the same manner regional gains will become national gains once this point is reached.
Non-economic cooperation
In effect the same forces of trade among partners can be the effective drive towards deeper
formal integration whether they were planned or not. In short, many countries that have
entered into a trade-based integration framework have found that it involves highly complex,
policy-induced financial integration which, as a result usually lags the integration of goods
markets. In this case the financial integration entails the liberalisation and harmonisation of
money and capital markets to facilitate payments and investments, and this provides a
primary source for medium to long-term securities and debt instruments, which are essential
for investments in the regional market. The process includes all capital markets' institutions,
such as commercial banks, private financial institutions, investment funds, insurance
companies and of course, central banks. That is, the process usually involves the business
development first and capital markets after. We have already been moving in this direction,
as is evidenced with the planned introduction of the Caribbean Exchange Network which is
the collaboration of the three stock exchanges of Barbados, Jamaica and Trinidad & Tobago.
That is with growing direct investment capital market development is likely to follow.
However, though the structures are being put in place to facilitate greater movement of
capital cross borders- where foreign exchange risks still exits, there may not be a massive
movement of funds until the single currency is in place. Such an event would then lead to a
faster elimination of interest rate differentials in the region and hence lower transactions cost.
Regional financial integration
With the drive towards a Caribbean Single Market and Economy, central banks can enhance
regional financial cooperation in other ways. One is through the development of real time
data sources on liquidity and interest rate movements shared with the region on a daily
basis. Notwithstanding the progress made, more can definitely be done to bring regional
financial cooperation to a level that is on par with the region's economic and financial
potential.
Financial cooperation and efficiency
Financial market efficiency is important in accelerating economic development, and market
efficiency also contributes to achieving and preserving macroeconomic stability. In addition
to pursuing sound economic and financial policies, the region may need to consider
implementing its own financial sector model. Such an arrangement will help ensure an
orderly and stable financial environment such that any emerging vulnerabilities may be
spotted early and may not pose serious risks to the region's financial markets and
economies. Unfortunately the more highly developed the capital market the more rapidly
money is able to move and the more volatility exists in the economy. For that reason at least
one central bank in Latin America - Chile - placed reserve requirements on inward
investments.
Stabilization Fund
Central Banks in the region have a history of financial cooperation going back to the 1970s,
when the Central Bank of Barbados made short term loans available to Jamaica and later
when Trinidad and Tobago made loans available to the Central Bank of Barbados. Also,
twenty-five years ago there was discussion of a regional Stabilization Fund to provide
balance of payments support. Three years ago, it surfaced again. On neither occasion did it
materialize. Yet a financing facility that draws on the region's own financial strength and
resources can be very important. With such a facility in place, there should be greater
confidence amongst policy makers and short term stabilization support could be accessed
without the major conditionalities associated with conventional international institutions - and
that such borrowing could be without strings provided such needs are not structural.
Regional financial cooperation should move progressively forward, with the process being
further strengthened and should work toward becoming more focused on this important area.
The Regional Stabilization Fund was conceptualized as a short-term financing facility to
assist member countries in managing their balance of payments shortfalls at a time of
financial distress. Such distress funds should continue to remain a key pillar of regional
financial cooperation. This is because it is important for the region to have its own liquidity
arrangement that can be called upon when the need arises. I mentioned earlier the Chang
Mai initiative in South East Asia.
It is important to note that the BIS had been doing this for European Central Banks since the
middle of the 20th century and that even now the European Central Bank does the same by
way of swap facilities for North American and European banks. Beth Simmons in an article in
a BIS working paper of February 2006 foresees that this kind of support will become more
available in Europe. If this is so in Europe how much more so should the Caribbean continue
to pursue this initiative.
A Caribbean community
In recent years - just 8 years after its introduction - the euro has strengthened considerably
and is increasingly being held as a reserve currency by many central banks.
It is my firm belief that in the same way that trade drove the closer integration of Caribbean
economies during the 1970s and 1980s, financial cooperation and cross border flows will be
the catalysts for the foreseeable future. Like Europe, financial and monetary cooperation will
be the last bastion. Central banking in the region has a role to play in the new dispensation
but it must adapt itself to these new paradigms during the adjustment period since continuing
stability will be important in the new more liberalized environment. In due course and with
careful staging, regional gains and national gains should coincide.
Ladies and gentlemen, I thank you.