WASHINGTON, WILLEMSTAD - One of the main topics these days in Curaçao is the currency. Curaçao and St. Maarten, which form a monetary union, are still using the Netherlands Antilles currency. There are talks about dollarization. The International Monetary Fund (IMF) explained what needs to be in place for Curaçao to consider this possibility.
The IMF indicated that a hypothetical dollarization would be a major structural change that should not be taken lightly. It would entail significant transitional costs even during non-crisis periods and these costs would be much higher during the current pandemic. Moreover, in order to take advantage of the benefits while minimizing the costs, a hypothetical dollarization would require careful planning and putting in place key supporting reforms. Dollarizing without supporting reforms would be a very risky strategy. In addition, the cost-benefit considerations would be more nuanced in the case of a long-standing peg such as the CSMU: both Curaçao and Sint Maarten already benefit from low and stable inflation, public sector financing is done through a special arrangement as opposed to the market, and room for independent monetary policy is already limited.
The IMF indicated that the monetary union aspect and small-island constraints add additional layers of complexity. “A dollarization by one or both members of the monetary union would effectively imply its dissolution and require an agreement on the new objectives/mandate for the CBCS (Central Bank of Curaçao and St. Maarten)—which should be underpinned by a new CBCS’s Statute—or alternative arrangements for a number of essential functions. It would also require agreements on the division of the CBCS’s assets between the two governments—this could be especially complex if only one country decided to dollarize. The small-island constraints—especially in Sint Maarten—could pose challenges for the continuity of essential institutional functions currently fulfilled by the CBCS,” reports the IMF.
According to the IMF the authorities would need to choose a target currency and a conversion rate that would need to be credible and in line with external sustainability. The two plausible options would be the US dollar and the Euro. A choice could be made based on minimizing the volatility of the real effective exchange rate by giving preference to the currency of the largest trading partner. In Sint Maarten, the dominant trade and overall economic ties with the United States suggest that the U.S. dollar would be more natural choice than the Euro, although it should be noted that Saint Martin—located on the other side of the island—uses the Euro as its official currency. In Curaçao, the choice would be more nuanced as the Euro Area has a large weight among Curaçao’s tourism markets, even though most international transactions are conducted in US dollars. The conversion rate would also need to be credible, so that the existing international reserves of the CBCS would cover its liabilities denominated in local currency (i.e. the monetary base). It would be also important to set the conversion rate at the equilibrium level to avoid the need for painful and protracted adjustment through nominal prices and wages. If dollarization were to lock in an uncompetitive exchange rate—or were to lead to a gradual loss of competitiveness due to choosing the wrong currency area—it would eventually trigger the need for a protracted painful adjustment.
In the case of a hypothetical dollarization, the authorities would need to maintain continuity of several critical functions currently carried out by the CBCS. These include (i) supervision of the financial sector entities (banks and non-bank institutions), including in the financial integrity (AML/CFT) area, (ii) macroprudential supervision and policies, (iii) an adequate resolution regime for financial institutions, (iv) maintaining the payment system, (v) fiscal agent function for the government, and (vi) providing analytical support for the governments. Whereas the CBCS could presumably continue to provide these functions in Curaçao, it is not clear how this would be done in Sint Maarten if the dissolution of the monetary union were to trigger a dissolution of the banking union. Setting up these functions locally in Sint Maarten would be very challenging due to capacity constraints. It would be critical to ensure continuity of supervision of Sint Maarten financial institutions.
Furthermore the IMF states that a dollarized regime would place a special premium on the quality of micro- and macro supervision and the crisis resolution framework due to the limitations of the lender of last resort in the dollarized setting. Weaknesses in supervision and macroprudential risk monitoring could lead to accumulation of risks and eventually financial sector instability due to the loss of the lender of last resort function. Thus, it would be important to improve these functions before a hypothetical dollarization to minimize the risks.
IMF says that it is important to note that even a strong financial sector supervision would not be able to completely eliminate the need for a lender of last resort. Securing contingency credit lines could be an option, but in times of crisis, the first best solution would be to have large reserves. If the central bank were replaced by alternative arrangements, the reserves could be held in the form of government deposits. However, building an adequate stock of deposits does not appear feasible in the near to medium term given the difficult fiscal position in both countries. Moreover, it is unlikely that either central bank reserves or government deposits would be sufficient for addressing system-wide pressures. Given the limited lender of last resort function, the emergency liquidity arrangement (ELA) framework would need to be very strict, and banks would need to hold significantly more ex-ante liquidity buffers than in other regimes, which could have implications for their profitability.
The authorities would also need to resolve several operational issues such as arrangements to assure an adequate supply of currency. For example, the supply of U.S. dollar currency on the island of Bonaire is the responsibility of the DNB (Dutch National Bank) and banks on Saba and St. Eustatius are supplied by their head offices. It should be noted that whereas dollarization entails the administrative costs of supplying a foreign currency, it saves on the costs of production and management of a separate national currency.
Dollarization would also need to be considered in conjunction with the future of the current fiscal arrangement. In Curaçao and Sint Maarten, the fiscal arrangement provides access to loans at below-market interest rates subject to the fiscal supervision. If this arrangement were to remain unchanged, dollarization by itself would not strengthen incentives for improving the institutions and policies and would not necessarily improve fiscal discipline. At the same time, the exceptionally high vulnerability of both countries to external shocks, as demonstrated by the 2017 hurricanes in Sint Maarten and the 2020 pandemic, suggests that both countries would still require access to external financing during abnormal negative shocks. Whereas the reform of the fiscal arrangement is beyond the scope of this paper, its future setup needs to be considered as one of the key factors in the authorities’ decision.
Given that dollarization by itself would not address the long-standing structural economic problems, the authorities would need to implement a number of supporting policies to get the full benefit of dollarization.
· Strong financial sector reform would be needed to minimize the risk of banking/financial sector crises due to the absence of the lender of last resort function. The pockets of vulnerability would need to be addressed and the prudential/supervisory functions strengthened. The authorities would have to introduce higher capital/liquidity requirements. Other elements of the financial safety net would have to be put in place such as a special resolution regime for banks and a deposit guarantee scheme.
· Labor market reform—and broader structural reforms—would also be needed to enable adjustments via the wage channel. External adverse shocks might require downward adjustments in nominal wages and prices, which are politically very difficult.
· Public financial management and strengthening the overall fiscal policy is needed regardless of the chosen exchange rate regime. These reforms would be especially important if the fiscal arrangement were to be modified.
IMF says that it should be noted that the needed structural supporting reforms constitute a priority regardless of the exchange rate regime. In the near term, available current capacity should be allocated to priority reforms improving the Union’s public finances, reducing financial sector vulnerabilities, and making it more resilient. These reforms, in conjunction with deeper economic integration between Curaçao and Sint Maarten, could improve the functioning of the monetary union. It is critical that any country considering dollarization carries out a serious, open, and broad public discussion of the subject, making clear the costs and benefits, and would only go forward based on a strong political consensus.
