Latest Central Bank of Barbados Study Illustrates Why Devaluation is not an Option for Small Open Countries

A recent Central Bank of Barbados study, entitled Size, Structure and Devaluation, shows why devaluation won’t 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. The paper’s authors are Dr. Winston Moore, of the Department of Economics, University of the West Indies, Cave Hill; Jamila Beckles, a recent UWI graduate; and Dr. DeLisle Worrell, Governor – Central Bank of Barbados.

Small economies are defined as those with a population below 1.2 million and GDP of US$8 billion or less. Drawing from a sample of 33 small countries and 32 large economies, the study demonstrates that the small economy has very limited scope to substitute domestically produced products for imports if there is an increase in the relative prices of imports. 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 percent 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 percent – limited import substitution potential, and a high import propensity, mean that for small economies, devaluation is inflationary, and is not growth-promoting.

Further, exports are constrained by supply because the country is a relatively small player in the global market for goods and services, and domestic production of nontradeables become less productive with devaluation, so there will be no expansion of output as a result of devaluation.

The study is available at www.centralbank.org.bb.

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