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How the US rate increase affects the Caribbean

BARBADOS BUSINESS AUTHORITY,

Added 06 February 2016

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THE OUTLOOK for the world economy is mixed. While some major economies are experiencing solid growth, several economies, including major emerging markets, are facing challenges.

The United States (US), the United Kingdom, India, and some European countries are projected to continue to perform well, while the outlook for countries such as China, Brazil, and Japan remains uncertain. Similarly, the Latin American and Caribbean region has experienced a marked slowdown in 2015, and challenges have increased.

The fall in commodity prices has been a major driver, but weak policies and a failure to build sufficient buffers have also contributed to uncertainty and economic challenges. Additionally, political tensions are creating uncertainties in regions, including the Middle East and Europe. Finally, the expected increase in world interest rates is creating additional challenges. The normalisation of interest rates by the US Federal Reserve (Fed) will be a central theme of the world economy in 2016. As is often the case, one solution to a problem can produce a new problem.

Such is the case with the monetary stimulus that the Fed used during the world economic recession.

Reduction in policy rates and quantitative easing brought a situation of ultra-low interest rates in the US that also had far-reaching effects on global interest rates, capital flows, and asset valuations.

However, at some stage monetary policy has to be adjusted and normalised to avoid an overheating of the economy and inflation.

In the US, this moment has arrived, and it could have far-reaching effects as monetary policy in the US influences the rest of the world.

Channels for the influence include exchange rate adjustments as well as potential upward pressure in interest rates and capital outflows from emerging economies.

The increase in interest rates has different effects. Depending on the level of countries’ debt portfolios and their characteristics, deficits could increase with higher interest rates.

In addition, in some emerging markets, the private sector has accumulated significant liabilities in US dollars. A re-pricing of these securities or a need to roll them over at higher interest rates could have adverse effects for some businesses and, through them, the financial sectors.

Finally, as countries would have to align their monetary policy to that of the US, they might be forced to tighten monetary policy too early, suppressing investment and thus economic growth. The lift-off signals a strong recovery.

While the higher interest rates can cause disruptions, they also reflect the strength of the recovery in the US, which has important linkages to the Caribbean through trade, tourism, and remittances. This is an important point because monetary policy changes can be made for different reasons.

Expected adjustments in the policy rate signify normalisation from ultra-low interest rates in order to avoid inflationary pressure as the economy strengthens versus runaway inflation.

The effects from the interest rate increase could be small as the Fed moves from near zero interest rates to normal interest rates. Inflation currently remains low, which should permit the Fed to gradually raise interest rates.

Increases in US interest rates are likely to be a major factor for the world economy in 2016.

Following the December 2015 increase – the first in nine years – further rate increases in the US seem likely even though other advanced economies continue to provide monetary stimulus.

The divergence of their monetary policies could create new challenges in an already weak economic environment. Caribbean countries do not seem to be especially vulnerable to increases in US interest rates.

Countries with high levels of US-denominated debt, private or public, with weak fiscal and/or external positions, and countries that are highly integrated into the international financial system face the biggest challenges.

In addition, their vulnerabilities strongly increase when several of these characteristics are present at the same time.

However, private capital flows are relevant for Caribbean countries, especially in the form of foreign direct investment, but less in terms of foreign investors holding domestic securities or direct lending of foreign banks to companies in the Caribbean.

External debt is relevant in the Caribbean, but there is no strong reliance on short term debt. Several countries rely on variable rate debt.

Interest payments will increase in countries that depend on variable rate debt or debt that matures in the short term. For Caribbean countries, variable rate debt mostly plays a role as interest rates from multilaterals, including the Inter-American Development Bank, which are based on labour. Buffers across the region need boosting.

Buffers such as international reserves and fiscal savings are weak in the Caribbean. The Fed normalisation should not distract from other risks.

The Caribbean is highly dependent on the performance of the US economy. Current projections for US economic growth are positive, but downside risks arising from a marked slow down of the global economy remain.

Commodity producers in the Caribbean also face low prices and weak global demand. Moreover, the region is vulnerable to extreme weather, including hurricanes.

This analysis was produced by the Inter-American Development Bank’s (IDB) Caribbean Country Department. It was published in the IDB’s January 2016 Caribbean Region Quarterly Bulletin.

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