BRIDGETOWN, Barbados, Tuesday April 7, 2015, CMC – A study undertaken by the Central Bank of Barbados (CBB) is supporting arguments that devaluation of currencies will not improve price competitiveness in very small open economies like those in the Caribbean.
“In small economies, devaluation is more likely to cause high inflation and economic contraction, rather than economic growth,” said the study undertaken by Dr. Winston Moore of the Department of Economics at the Cave Hill campus of the University of the West Indies (UWI), CBB Governor Dr. DeLisle Worrell and UWI graduate Jamila Beckles.
They said the study using 33 small countries and 32 large countries demonstrated that the small economy has very limited prospects for import substitution, if there is an increase in the relative prices of imports relative to domestic production.
“Small countries tend to have smaller import substitution possibilities, averaging about 16 percent, while larger countries could on average substitute almost one-third of their imports with domestic production.
“The combination of high import content and exchange rate depreciation has a severe impact on inflation in the small open economy, far greater than the larger economies.
“The combination of high export concentration, limited import substitution potential, and a high import propensity, all of which appear from the data to be common characteristics of small economies, implies that devaluation in small economies is inflationary, and is not growth-promoting,” they wrote in the study titled “Size, Structure and Devaluation”.
The authors argued that there are insufficient domestic producers to substitute efficiently for imports, and therefore there is no possibility to mitigate the inflationary impact of devaluation or imports.
“Exports are constrained by supply because the country is an atomistic producer, domestic consumption of exportables offers no scope for expansion, and domestic production of nontradeables become less productive with devaluation, so there will be no expansion of output as a result of devaluation.”
The authors regarded small economies as those with a population below 1.2 million and gross domestic product (GDP) of eight billion US dollars or less.
They found that on average, small countries have domestic substitutes for about 16 percent of imports, while larger countries could on average substitute almost one-third of their imports with domestic production.
Barbados, for example, can only substitute a maximum of 15 per cent of the import bill for its top five goods, namely mineral fuels, vehicles, pharmaceutical products, organic chemicals and mechanical appliances.
The authors found that the combination of high import content and exchange rate depreciation has a significant impact on inflation in the small open economy, far greater than for larger economies. Together, the combination of high export concentration – on average 77 per cent – limited import substitution potential, and a high import propensity, mean that for small economies, devaluation is inflationary, and is not growth-promoting.
“This study provides an empirical explanation of the reason why, in small economies, devaluation invariably causes high inflation and often results in economic contraction, rather than economic growth,” they noted.