The East Caribbean’s Test Tube Tsunami

With continued economic and banking strains the past decade in the six island East Caribbean Currency Union, with a joint central bank and currency peg, an IMF working paper applied stress tests to model major shocks on the interconnected financial system, which revealed that a regional crisis could trigger the collapse of half its lenders. Bad credit is down from the peak but still one-tenth the total and provisioning lags while good deposit growth has created excess liquidity. The sector averages 150% of GDP, with St. Kitts and Nevis and Montserrat at double the proportion, and Grenada, Dominica and Antigua and Barbuda at or below the norm. The 35 institutions are evenly split between local and foreign-owned, mainly from Canada. Interbank exposure has dropped in recent years, but sovereign debt holdings are 15% of assets in some members and close ties are common with non-bank credit unions, insurers and pension funds. In St. Vincent and the Grenadines they control 10% of deposits, and wholesale withdrawal carries risk. These relationships are not simulated in the disaster scenarios with the paucity of information and data, and the exercise also excludes global groups that would depend on their parent for support in the absence of separately-capitalized area subsidiaries. The East Caribbean Central Bank has limited lender of last resort capacity and deposit insurance is lacking. After calculating isolated bank failure and severe individual country and regional output contraction that could result from tourism scares or natural disasters, the research finds that 10 institutions would be insolvent in the direst case, as undercapitalization and heavy public debt portfolios play out. The results are an additional warning to foreign frontier bond investors after serial restructurings in Grenada, and planned haircuts and swaps now in neighboring Barbados. If an IMF program accompanies the workout as in Jamaica, the process can be further complicated and lengthened with authorities there conducting two exchanges over the course of consecutive arrangements. In the broader region, calls have circulated for sovereign wealth fund formation to act as contingency buyers, as the latest Invesco survey of the field identifies 2% emerging market debt allocation. It points out that equity and alternative investments in turn are fast expanding categories, as managers look to increase returns after mixed records the last decade.

According to fund trackers retail and strategic investor bond outflows accelerated at the end of the first half, and are larger than during the Taper Tantrum five year ago. ETFs are 15% of the former, and dedicated manager cash positions remain steady at under 5%. Even though sovereign wealth vehicles as a group may level off in the near term, Norway and others maintain big exposures at 15% of the fixed income bucket. Foreign ownership of local bonds stands at a 25% average, and frontier name participation in Central and Latin America, like Costa Rica and Ecuador, may be stretched in the view of major market-making firms. In mainstream instruments technical indicators suggest excess weightings in Mexico, Russia, South Africa and Indonesia as the respective regions endure practical stress tests the IMF may help cushion in financial and research terms.