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DOCUMENTOS DE TRABAJO FCEA
ISSN 1909-4469 / ISSNe 2422-4642
Año 2017
No.28
Departamento de Economía
CUBAN MACROECONOMIC TRENDS 1985 – 2013,
EXTERNAL SHOCKS AND POLICY
Pavel Vidal Alejandro
1
Facultad de Ciencias Económicas y Administrativas, FCEA
DOCUMENTOS DE TRABAJO FCEA
ISSN 1909-4469 / ISSNe 2422-4642
Año 2017
No.28
Documento de Trabajo FCEA
ISSN 1909-4469 / ISSNe 2422-4642
Año 2017 No. 28
Cuban macroeconomic trends 1985 – 2013, external shocks and policy
Autor:
Pavel Vidal Alejandro [[email protected]]
Departamento de Economía
WEBSITE: wp_fcea.javerianacali.edu.co
Comité editorial
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Julián Piñeres
Luis Fernando Aguado
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Ciencias Económicas y Administrativas, ni a la Pontificia Universidad Javeriana Cali.
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Contenido
1.
2.
3.
4.
4.1.
4.2.
5.
Introduction
Data
Empirical strategy
Results
Macroeconomic trends
Macroeconomic shocks
Conclusions
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10
14
14
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TENDENCIAS MACROECONÓMICAS CUBANAS 1985 – 2013,
CHOQUES Y POLÍTICA EXTERNA
Pavel Vidal Alejandro
[email protected]
Departamento de Economía
Pontificia Universidad Javeriana, Cali
RESUMEN
Este documento se enfoca en analizar las principales tendencias y políticas
macroeconómicas en Cuba en 1985-2013. Cinco índices macroeconómicos se estimaron
utilizando modelos de factores dinámicos. Las correlaciones entre los índices estimados y
la tasa de crecimiento del PIB muestran que, en promedio, la política fiscal era procíclica,
mientras que la política monetaria era contracíclica. Las simulaciones econométricas
confirmaron la alta vulnerabilidad de la economía ante un posible colapso en las
relaciones con Venezuela; causaría que el PIB se contrajera alrededor del 10% en más de
tres años. Igualmente, el análisis sugiere que las reformas monetarias pendientes podrían
crear presiones negativas en la producción de bienes y las condiciones de vida de los
hogares, lo cual podría no ser mitigado por una política fiscal expansionista. Por el
contrario, los efectos negativos de tales choques pueden ser mitigados solamente a través
de una mayor apertura internacional; este es un objetivo más viable, teniendo en cuenta la
actual situación de disminuir las tensiones con el gobierno de Estados Unidos.
Palabras Clave: Cuba, Reforma, Macroeconomía, Modelo de Factores Dinámicos,
Política Monetaria.
Clasificación JEL: E61; E63; E66; C22; P24.
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CUBAN MACROECONOMIC TRENDS 1985 – 2013, EXTERNAL
SHOCKS AND POLICY
ABSTRACT
The paper focuses on analyzing the leading macroeconomic trends and policies in
Cuba from 1985-2013. Five macroeconomic indexes were estimated using dynamic
factor models. The correlations between the estimated indexes and the GDP growth
rate show that, on average, fiscal policy was procyclical while monetary policy was
countercyclical. Econometric simulations confirmed the economy’s high vulnerability
to an eventual collapse of relations with Venezuela; it would cause GDP to contract by
about 10% over three years. The analysis also suggests that pending monetary
reforms could create negative pressure on goods production and on households’
living conditions, which could not be mitigated by an expansionary fiscal policy.
Instead, the negative effects of such shocks can be mitigated only through greater
international openness; this is a more feasible objective given the current situation of
diminishing tensions with the US government.
Key words: Cuba, Reform, Macroeconomics, Dynamic Factor Model, Monetary Policy.
JEL Classification: E61; E63; E66; C22; P24.
5
1. Introduction
The fall of the Soviet Union led to the biggest economic crisis of Cuba’s entire
revolutionary period. There was a huge depression, with GDP contracting by 35%
from 1990 to 1993. There were serious consequences for the balance of payments,
industry, agriculture, and investments. Significant macroeconomic disequilibrium
surfaced along with triple-digit inflation, which triggered the currency and exchange
rate duality that is still in force today. This period marked a dramatic worsening of
the quality of life for the Cuban people.
The government responded to the crisis by opening the economy to foreign
investment, tourism, remittances, and self-employment. The centrally planned system
was relaxed, and state-owned enterprises (SOEs) gained the autonomy to manage
and allocate resources. These liberalization measures were effective at stopping the
economic crisis and generated rapid improvements in macroeconomic indicators.
However, toward the end of the 1990s, the impetus for structural change weakened.
Then, between 2003 and 2004, when Cuba began to receive benefits from its alliance
with Venezuela, the liberalization process halted and many reforms were even
reversed.
The rapprochement with Venezuela led to a double-digit rate of GDP expansion,
driven by Cuba’s exporting of medical services. However, this economic boom was
only transitory and unfortunately was not accompanied by responsible fiscal and
monetary policies, which ultimately led to a domestic financial crisis in 2009 (MesaLago and Vidal, 2010).
At that time, President Raúl Castro began taking action to restore macroeconomic
balance while returning to and expanding the incomplete reforms of the 1990s. The
new reforms tripled the number of private businesses and cooperatives, distributed
state lands to farmers, freed up sales of cars and homes, extended consumption
6
options (e.g., hotels and cell phones, among others) and made migration policy more
flexible.1
The new government has promoted a more rational public expenditure policy, meets
with more rigor financial commitments and is making notable progress in
renegotiating its outstanding international debts, including those to the Paris Club. To
reinvigorate GDP growth, policymakers have defined the core strategy to be opening
the country further to foreign investment. To attract international capital, the
government issued a new law and promoted a special economic zone around the
port of Mariel. As of this writing, however, significant positive results remain to be
seen.
Looking ahead, changes in the political landscape—most notably the recent
reestablishment of diplomatic relations with the U.S. and, in 2018, the end of Raul
Castro’s current presidential term—may provide opportunities for further reforms.
Whether these reforms will continue to unfold gradually, as they have so far, remains
to be seen; as the President himself declared, “We must resist the pressures of those
who insist that we should go faster.” However, taking a gradual approach to reforms
has not resulted in faster GDP growth rates. From 2008 to 2014, the average annual
GDP growth rate was 2.5%, far short of the government’s initial target of 5.1% and of
its revised target of 4.4%.
Low GDP growth rates may also be due to the failure to address currency and
exchange rate unification and further reform of SOEs. The monetary duality
(currency duality and multiple exchange rates), in place for more than twenty years,
has led to cumulative distortions for enterprises´ balance sheets, relative prices, and
the fiscal accounts, taking a toll on competitiveness and the efficient allocation of
resources (De la Torre and Ize, 2014; Vidal and Pérez, 2014).
For extensive analysis of the current reform in Cuba, see the texts by Alonso and Vidal
(2013), Brundenius and Torres (2013) and Mesa-Lago and Pérez-López (2013).
7
1
SOEs continue to hold monopoly power over most economic sectors. Most of them
have proven not to be capable of encouraging efficiency or technological progress
nor of boosting labor productivity (Font and Jancsics, 2015). The government has
already shrunk the size of the state sector in terms of employment, hoping thereby to
increase labor productivity and state salaries. Cuban authorities also promised to ease
command central planning further in order to generate new incentives for economic
efficiency. However, such actions so far have been implemented only on an
experimental basis (Torres, 2014).
Given this background, this paper focuses on analyzing the leading macroeconomic
trends and policies in Cuba from 1985-2013. I also evaluate the macroeconomic
effects of shocks that are likely to hit Cuba in the coming years due to the currency
reform, greater international integration as a result of the new U.S. policy, and the
impact of Venezuelan crisis on the Cuban economy.
Using dynamic factor models, I estimated macroeconomic indexes in five areas: 1) the
production of goods, 2) the external sector, 3) households’ economic conditions, 4)
fiscal policy, and 5) monetary policy. I collected 26 key macroeconomic series and
estimated common factor or co-movement for each group. This empirical strategy
overcomes, to some extent, the lack of macroeconomic data, the bias introduced by
the existence of two currencies and several exchange rates in the national accounting
system, and the derived complication for the international comparability of the
Cuban indicators. Thus the analysis does not focus on a specific macroeconomic
value or on a particular variable but on the common trend of several indicators over
time.
These five indexes are then included in a vector autoregression (VAR) model along
with Cuba’s GDP growth rate in order to simulate and analyze the macroeconomic
effects of monetary, fiscal and external shocks. Time series econometric techniques
were preferred to support the empirical strategy in the paper because conventional
structural models do not fit the special characteristics of Cuban macroeconomics and
policy.
8
The paper is organized as follows: Section 2 summaries the data. Section 3 lays out
the empirical strategy according to dynamic factor models and the VAR model.
Section 4 analyses the results of estimating the five indexes and the impulse-response
function of the VAR. Section 5 concludes.
2. Data
Data sources for the annual time series from 1985 to 2013 are Cuba´s Statistical
Yearbook prepared by the National Statistics and Information Office of Cuba (ONEI,
various years) and the series offered by the U.N. Economic Commission for Latin
America and the Caribbean (ECLAC, 2000). From 1996 to 2013, national accounts
were available with base year 1997, before that the base year was 1981; thus all
series were converted into base year 1997 applying the variation rates. Logarithmic
first difference is taken for all series, and they were also standardized.2
Production of goods. To examine economic conditions from the supply side, data on
value-added production at constant prices were analyzed for the following sectors:
agriculture and fisheries (AGR), manufacturing industry (IND), mining (MIN), and
construction (CONS). The services sector is not considered in this group. State
budgeted services, such as education and health, are considered below in the fiscal
policy group, while tourism is included in the external sector group. Investment (INV)
is considered even though it is a component of GDP from the expenditure side. I
include investment because the information it provides about variations in capital
factors strengthens the analysis of the economy from the supply side.
External sector. Unfortunately, this is an area where the Cuban government provides
less transparent statistics. It is impossible to get access to data on international
reserves, foreign debt, and current account’s primary and secondary incomes or the
financial account. For the external sector variables, I collected series on exports (X)
and imports (M) of goods and services at constant prices, terms of trade (TOT), and
external financing (EF) estimated by the trade balance at constant prices.
2
The logarithm is not applied to the unemployment rate.
9
Households’ economic conditions. To analyze economic conditions from the household
side, data on the following factors were compiled: the number of employed workers
(EMP), the unemployment rate (UNER), consumption at constant prices (CON),
average real wage in SOEs and institutions (WAGE), and real revenues received by
households (INCOM).3
Fiscal policy. The following series comprise the fiscal policy analysis: Total expenses
(FISEXP), expenditures on education (EDU) and health (HEA), subsidies to SOEs and
cooperatives (SUB), deficit (DEF), collected taxes (TAX), and government demand
(GOVD). All series are from the budget, except for government demand, which is
taken from the GDP components
Monetary policy. The following series comprise the monetary policy analysis: money
circulation (M0), the monetary aggregate (M2), individuals’ savings accounts (SAV),
the Consumer Price Index (CPI), and the exchange rate of the Cuban peso against the
US dollar for individuals (RATE)
3. Empirical strategy
Five macroeconomic indexes associated with the available variables were estimated:
1) goods production (ProdIndex), 2) external sector (ExtIndex), 3) households’
economic conditions (HousehIndex), 4) fiscal policy (FispIndex) and 5) monetary
policy (MonpIndex).
The methodological approach to index estimations is based on the dynamic factor
model (DFM) of Sargent and Sims (1977) and further developed by Stock and Watson
(1991). DFM attempts to identify repetitive and common sequences in series, in
INCOM registers the Cuban pesos income that families receive as follows: wages and other
payments related to employment in the state sector, the income received by cooperatives, the
self-employed, and other private sector workers from their sales to the state sector, and
revenues in pesos from selling foreign currency or convertible pesos at exchange houses
(Cadeca) and banks (these revenues come from remittances, tourism-related activities, and
other sources of hard currency earnings).
10
3
other words, co-movements. The interpretation of the co-movements depends on the
characteristics of the variables; the most common case is when data related to
economic activity are taken into account and, consequently, the co-movement
approximates the business cycle.
The most used methods for DFM are the principal components estimation and the
Kalman filter. Principal components estimation requires a large number of variables
which becomes a disadvantage when studying Cuba, given the lack of available data.
In this paper, the Kalman filter has been applied. It is the foremost algorithm for
estimating a dynamic system represented in state-space form.4
DFM assumes that a vector , with N observed variables, can be represented as the
sum of two unobserved, mutually independent components: one component is
common to all variables ( ), and one is idiosyncratic ( ) and represents the
dynamics of each series. Then, the equation for the observed
,
is:
(1)
where P is a loading matrix (N x 1) and represents the weight of each variable
in the common factor . The dynamic factor is given by:
,
where
matrix
(2)
is the normal multivariate white noise with variance and covariance
.
and
is the lag operator. The idiosyncratic
components may also present a dynamic structure in the form of:
,
where
Di ( B)  1  d i1 B  ...  d ipi B pi
(3)
, i=1, 2, …m, corresponds to the
autoregression structure of each idiosyncratic disturbance represented with the lag
operator.
4
is a zero mean white noise with diagonal covariance matrix. For the
Others using this method to build economic activity indexes are Angelini et al. (2010) and
Camacho and Doménech (2012) who applied a DFM using monthly and quarterly data to predict
economic activity in the euro zone and in Spain, respectively. Other models of the euro zone are
by Camacho and Perez-Quiros (2010) and Camacho et al. (2013).
11
specifications of the five indexes, factor and idiosyncratic components follow AR(1)
processes, which is feasible since we are dealing with annual data.
To estimate the model, it is written in state space form:
(4)
(5)
Equation (4) is called the measurement equation which describes the relationship
between the observed variables and a vector of the state variables, where H is a
matrix (N x m),
es (N x 1), with
iid N (0, R). Equation (5) is called the transition
equation. G is a transition matrix m x m,
es m x 1 and also
assumed that the errors in the measurement equation
errors in the transition equation
iid N (0, Q). It is
are independent of the
.
The basic Kalman filter relies on an algorithm of prediction and updating of the
vector
which is repeated for each observation from the beginning to the end of the
sample using the initial values on the system parameters (matrices: H, G, R and Q).
The algorithm minimizes the mean square error in a recursive way: each observation
is updated with the new information contained in the prediction error (Kalman
gain).5
Then, in the
state vector and on the H matrix is the most relevant information for
the analysis: the common factor or co-movement ( ) of the variables (the index) and
the weight matrix (P) with which each one contributes to the index calculation.
These five indexes are then included in a vector autoregression (VAR) model along
with Cuba’s GDP growth rate. The VAR model is estimated in order to simulate the
macroeconomic effects of different kinds of shocks, considering the dynamic relations
in multiple directions among the variables:
AX t  C( L) X t 1  ut
(6)
A complete description of the Kalman filter is in Hamilton (1994) and Koopman et al.
(1999).
12
5
where X is a vector with five indexes and GDP growth rate (also standardized), all the
variables being I(0). C(L) is a polynomial in the lag operator having the coefficients
that relate each variable with the lags of the rest of the variables and with its own
lags. Only one lag is specified following the Likelihood Ratio (LR) test.
ut represents
the shock associated with each variable (structural shocks) and there is assumed to
be no correlated residual white noise ( E ut ut ' is assumed to be a diagonal matrix).
Matrix A is formed by the coefficients a ij containing contemporary relationships
among variables. Matrix A is a restraint following Cholesky’s decomposition in order
to identify the system and estimate impulse-response functions. A is a triangular
matrix:
0
 1

 a21 1
a
a32
A   31
 a41 a42
 a51 a52

 a61 a62
0
0
1
0
0
0
0
0
0
a43
a53
a63
1
a54
a64
0
1
a65
0

0
0

0
0

1 
where every line defines the contemporaneous effect over the ExtIndex, ProdIndex,
FispIndex, MonpIndex, HousehIndex and GDP, in that order. GDP is the most
“endogenous” variable since it can be affected contemporaneously by all indexes. The
rest of the restrictions are established by trying to approximate characteristics of
macroeconomic relations and policy in the Cuban economy.
Given the particular characteristics of the markets in Cuba (price controls, currency
and exchange rate duality, market segmentations, and command central planning)
conventional structural modeling of transmission mechanisms is ineffective;
specifically, it makes little sense to use equations like the Phillips curve, the IS curve,
Uncovered Interest Parity, or the Taylor rule. In the Cuban case, time series
econometrics result in a more viable alternative. But, it should be noted that the
13
forecasts would only extrapolate from relationships and channels that have prevailed
in the past.
4 Results
4.1
Macroeconomic trends
Table 1 shows the weights (P) estimated using the Kalman filter, that is, the weight
that variables contribute to each index. All variables have a positive correlation with
the index to which they belong. The exception is the unemployment rate, and this
finding is in line with expectations, since an increase in the unemployment rate
means a worsening of the households’ living conditions. The only series with a
questionable sign is that of collected taxes, since tax increases are associated with a
contractionary fiscal policy. Note that this study is not measuring tax rates but tax
revenues.
Table 1. Weights (P) with which each variable contributes to macroeconomic
indexes
(P)
ProdIndex
Agriculture (AGR)
Manufacturing
industry
(IND)
Mining (MIN)
Construction (CONS)
Investments(INV)
HousehIndex
Employment (EMP)
Aggregate
consumption
(CON)
Real average wage (WAGE)
Real income (INCOM)
Unemployment rate (UNER)
FispIndex
Government
(P)
ExtIndex
Import (M)
Export (X)
19.1
22.9
External financing (EF)
Terms of trade (TOT)
22.5
16.2
19.2
25.8
MonpIndex
Cash in circulation (M0)
Monetary aggregate (M2)
21.5
24.6
29.7
27.5
-2.2
Savings accounts (SAV)
Consumer price index (CPI)
Exchange rate (RATE)
21.3
14.5
18.1
20.8
26.3
5.7
18.8
28.4
demand 19.2
14
(GOVD)
Tax revenue (TAX)
Total fiscal expenditures
(FISEXP)
Education
expenditures
(EDU)
Health expenditures (HEA)
Subsidies to enterprises
(SUB)
Fiscal deficit (DEF)
10.5
19.8
20.3
14.2
8.5
7.6
Figure 1: Macroeconomic indexes, 1985-2013
Co-movement ( ) estimated with the Kalman filter
(standardized variation rate)
Figure 1 shows the five estimated indexes. Indexes provide synthetic information on
trends and turning points of macroeconomic performance and fiscal and monetary
policies. According to the variables included in each of the indexes, an increase above
zero means: improvement in the growth rate of production of goods (ProdIndex),
favorable balance-of- payments position (ExtIndex), improvement in economic
15
conditions of households (HousehIndex), expansionary fiscal policy (FispIndex) and
expansionary monetary policy (MonpIndex); all in relation to their average value for
the period 1985-2013.
There are four visibly different moments distinguishing Cuban macroeconomic
trends and policy over the period. The main shocks and policy decisions that are
behind these periods are as follows:
1990-1993:
Indexes show a sharp deterioration of the external sector situation, collapse of goods
production, and significant negative effects on households’ economic conditions.
Procyclical reaction of fiscal policy and countercyclical reaction of monetary policy.
Exports, at constant prices, plummeted by 34% between 1990 and 1993. Imports fell
even further (-69%) due to a sharp decline in foreign exchange revenues because of
the dramatic decrease in the terms of trade (-44%) and the collapse of external
financing (-100%). All economic sectors suffered during the 1990 crisis. From 1990
to 1993, agriculture fell 51.9%, industry 36.5%, and construction 25.8%. These
sectoral contractions went hand by hand with the 86.8% decline in investments
accumulated during these four years. The mining sector had the smallest decrease (21.6%) thanks to more open foreign investment, which contributed to the expansion
of oil production beginning in 1992. Despite government efforts to lessen the social
costs of the 1990 depression, the household sector suffered significant declines. The
biggest adjustment—a cumulative fall of 89.9% between 1990 and 1993—was in real
wages and incomes due to climbing inflation.
At the beginning of the 1990s, all of the fiscal variables suffered a contraction, except
for enterprise subsidies, which increased as the government sought to avoid a
massive closure of SOEs. At the time, only 30% of SOEs were profitable. Because the
reduction in expenses was not enough to offset the drop in revenues, the deficit
exceeded 30% of GDP in 1992 and 1993. Monetary policy was clearly expansionary
in the early 1990s. The Central Bank’s monetary policy depends on fiscal policy, since
16
deficits are financed by printing new money (monetization). Increasing the money
supply between 1990 and 1993 (M0 by 116% and M2 by 165%) when goods
production and importation were contracting led to an excess of monetary liquidity,
which in turn resulted in a triple-digit inflation rate and a significant devaluation of
the exchange rate. In 1993, prices were 10 times higher and the exchange rate for
individuals was 20 times higher than in 1989.
This episode of monetary instability resulted in the partial dollarization of the
economy and led to the currency duality. The developments during these years were
also the roots of the multiple exchange rate regime, as enterprises and state
institutions continue to use the official fixed exchange rate of the Cuban peso,
namely, a one to one parity with the US dollar
1994-2003:
Compared to previous years, indexes show that constraints on the balance of
payments were relaxed, production of goods began to grow with ups and downs, and
household’s economic conditions slowly improved. Fiscal and monetary policy moved
progressively from contractionary to moderate.
Opening the economy to tourism, remittances and foreign investment was a vital step
to emerging from the crisis. In 1994, external sector indicators bounced back. The
opening rate increased from 25.2% in 1993 to 34.8% in 1996. The production
sectors hit their lowest levels in 1994. From 1995 to 1997, the economy expanded,
demonstrating the effectiveness of the greater openness to international trade and
liberalization policies of those years. Indeed, all of the production sectors slowed once
those measures lost momentum.
In 1994 the government began to implement the so-called “measures of financial
restructuring” [medidas de saneamiento financiero] which included a significant
reduction in subsidies to SOEs and an increase in taxes (mainly on sales); as a result,
tax revenue that year increased by 42%. The government regained control of
expenditures and managed to reduce the deficit to less than 3% of GDP beginning in
17
1996. That allowed to restore control over the money supply and inflation. The
exchange rate for individuals appreciated. In the period 1994-2003, monetary policy
had a rather contractionary bias, even causing deflation in some years.
2004-2008:
Indexes show a relaxing of the balance of payments constraints, which, however, had
no substantial and sustainable effect on either production of goods or households’
economic conditions. Fiscal policy was extremely expansionary. Monetary policy was
excessively expansionary in 2005 during the de-dollarization of the economy.
In 2004, when Cuba had a rapprochement with Venezuela, a remarkable increase in
exports and imports occurred; from 2004-2006 they rose by 78% and 71% at
constant prices, respectively. In 2008 the export of medical services exceeded four
billion US dollars annually, and it represented, by far, the main source of foreign
currency income; specifically, it was double the size of export revenues from tourism.
In 2008, trade with Venezuela accounted for about 12% of Cuban GDP, making that
country Cuba’s largest trading partner.
In 2004, encouraged by the revenue coming from Venezuela, the Fidel Castro´s
government launched plans for huge investments in education, health services, and
energy, both to expand capacity and to increase efficiency in energy consumption. In
just three years (2004-2006) investment grew by 90% and construction by 80%; by
contrast, manufacturing industry grew by only 9%, while agriculture and mining both
contracted, by 17% and 6%, respectively. Revenue from Venezuela was mostly
allocated to the services sector and to the expansion of imports and expenditures.
Fiscal policy clearly became more expansive. Between 2005 and 2008, expenditures
on education and health increased by 139% and 181%, respectively. Total
expenditures increased by 135% and government demand rose by 35%. In 2008 the
deficit scaled up to 6.9% of GDP.
In 2005, the Central Bank purchased circulating dollars in exchange for the two
national currencies in order to de-dollarize the economy. This meant an expansion of
18
money supply. At first, this was complemented by an increase in international
reserves, but over time, international reserves gradually dwindled. Until 2005, a
currency board ensured the parity between the convertible peso and the US dollar,
but after the de-dollarization this system was no longer used.
2009-2013:
Indexes show a negative external shocks and procyclical adjustment of fiscal and
monetary policies, while goods production slowed down, and the households’
economic conditions tended to stagnate.
Irresponsible fiscal and monetary policies—namely, an out of control fiscal
expansion since 2005 and a de-dollarization process that compromised monetary
equilibria—left the economy exposed to the 2009 negative shock to terms of trade
and the global financial crisis and plunged Cuba into its own financial crisis. In 2009,
foreign debt payments were stopped and banks froze investors’ and international
suppliers’ deposits. The Central Bank was unable to sustain the full convertibility of
the convertible peso and consequently established an exchange control mechanism
for the enterprises; this scheme is still in force.
With Raúl Castro’s ascension to the presidency in 2008, the investment and
construction boom deflated. The investment rate as a share of GDP share fell from
15.9% in 2008 to 12.3% in 2010. Seven years of economic reforms failed to provide
the promised vitality to investments, agriculture, and industry. The latter two have
been growing at an annual pace of only 0.6% and 2.6%.
The fiscal policy of Raúl Castro’s government has exerted tight control over
expenditure growth. From 2009 to 2013, the cumulative increase in total government
spending was only 5%, spending on education grew by just 0.9%, and public health
spending contracted 1.8%. Government demand grew by 5%, while income from
taxes expanded 13.7%. As a result, the deficit shrank, and in 2013 it represented
1.3% of GDP.
19
The reforms have not resulted in a significant improvement in households’ economic
conditions. Since 2008, the annual rate of consumption has grown 2.6%, real wages
in the state sector have risen 1.3%, and households’ incomes have increased 1.5%.
Even today, the average real salary in SOEs is only 32% of its level in the late 1980s.
The correlations between the indexes and GDP growth show that, on average during
the period 1985-2013, fiscal policy has been procyclical (the correlation coefficient is
0.69), while monetary policy has been countercyclical (the correlation coefficient is 0.43). In turn, the external sector index correlation is 0.72.
These correlations indicate a monetary transmission channel every time the
economy faces a balance of payments shock. A negative external shock leads to a
contraction in GDP. Monetary policy is then affected in two ways, namely, via
monetization of the fiscal deficit and devaluation of the exchange rate, resulting in an
upsurge of inflation, as occurred in the early 1990s. If the exchange rate remains
fixed, then the consequence is a fall of international reserves and a financial crisis, as
happened in 2009. In short, the decline in external revenue increases inflation
and/or the likelihood of falling into a financial crisis, while an increase in external
revenue would lower inflation and/or the risk of falling into a financial crisis.
4.2
Macroeconomic shocks
The following analysis focuses on simulating with the VAR model three kinds of
shocks that are most likely to arise in the near future: monetary policy shock, fiscal
policy shock, and external shock. The monetary and fiscal policies shocks would be
connected with the currency and exchange rate unification. The external shock could
be linked to opening the economy and international integration along with the new
US policy; it could also be linked to an unfavorable outcome of the current situation in
Venezuela for the Cuban economy.
20
Shock 1: Currency and exchange rate unification
Cuban monetary reforms imply the following aims: 1) devaluation of the official
exchange rate of the Cuban peso for organizations (since the 1980s it has been
anchored to an artificial parity to the US dollar), 2) reestablishing the Cuban peso as
the only monetary denomination (in other words, eliminating the convertible peso),
and 3) building a scheme of monetary and exchange rate policies that can provide
convertibility and stability to the national currency (Vidal and Pérez, 2014).
Whatever monetary reforms the Cuban authorities finally undertake (today their
detailed plans are secret), devaluation of the official exchange rate of the Cuban peso
would be the cornerstone, allowing the achievement of the other two goals to
advance. Devaluation of the exchange rate would have to be significant due to the
huge gap between the current exchange rates (2300%).
Devaluation of the exchange rate would present costs and benefits to the Cuban
economy. Most of the benefits would depend on the Cuban SOEs’ reaction to the
opportunities that the new exchange rate would generate for increasing exports and
imports substitution. It would also attract foreign investors (and Cuban private sector
investment, if the private sector is allowed to participate in foreign trade). None of
these benefits would be realized quickly, nor can it be taken for granted that they will,
in fact, emerge.
Costs, on the other hand, are more certain and imminent. Devaluation would generate
upward pressure on inflation and create financial stress on the SOEs’ and banks´
balance sheets. The impact would be extraordinary for the fiscal accounts, since the
devaluation will have a multiplicity of impacts on SOEs and relative prices (De la Torre
and Ize, 2014).
The VAR simulates only one of the many options available to the Cuban government
for dealing with the transmission mechanisms of the devaluation, but it is consistent
with the pieces of information the government has provided on its strategy to
implement the monetary reform. This option considers an economic policy response
21
that tends to cushion most of the real effects of the devaluation on SOEs’ balance
sheets through subsidies and accounting adjustments. The government would try to
keep inflation under control, so price subsidies in retail markets increase. The
exchange rate is devalued but continues to be fixed. In this scenario the transition to a
single currency is accompanied by higher government expenditures and deficits and
by expansionary monetary policy. This option would lead to a rise in both the fiscal
policy index and the monetary policy index. The impulse-response functions
associated with each of these shocks are shown in Figures 2 and 3.
Figure 2. Response to a shock in monetary policy index
22
Figure 3. Response to a shock in fiscal policy index
According to the impulse-response functions, an expansionary monetary policy (a
positive shock in the index) would have a negative impact on goods production, on
households’ living conditions, and even on GDP. The major negative effects manifest
themselves with a two-year lag. Therefore, the Cuban authorities’ preoccupation with
the possible negative effects of monetary reform is well founded.
It is expected that the government will attempt to mitigate the negative impacts of an
exchange rate devaluation by pursuing an expansionary fiscal policy; however,
according to the simulations, neither goods production nor households’ conditions
show a significant response to fiscal policy shocks (see Figure 3). Rather, such a
fiscal shock could mitigate only the negative impact on GDP, and the reason might be
23
that this variable has a large service sector component (76.3%) including education
and medical services.
To understand the results for fiscal policy shocks, consider the following. During the
study period (1985-2013), two expansionary monetary shocks occurred: one at the
beginning of the 1990s and the other in 2005. The first one led to triple-digit
inflation, and the second led to a financial crisis. Both had a negative consequence for
production and households, and neither event could be mitigated by fiscal policy.
Even when fiscal policy can help provide subsidies to a certain group of enterprises
and households, it does not have the capacity to exert a significant influence on these
sectors as a whole.
The lack of significance of fiscal policy for the goods-producing sector can be
explained by its dependency on balance-of-payments constraints. The major budget
constraint on the SOEs is not defined by subsidies or fiscal expenditures in Cuban
pesos or convertible pesos, but by foreign currency availability to pay for imported
inputs and capital goods. Below we will see that the goods production index shows a
very significant response to external shocks. The lack of significance of fiscal policy
for households’ economic conditions can also be explained by the fact that only
economic indicators have been considered (income, consumption, employment) and
not the related social indicators.
Based on this discussion, clearly fiscal policy alone is not sufficient to cushion the
Cuban economy from the shocks of the expected exchange rate devaluation.
Shock 2: The choice between taking advantage of U.S. policy to increase
international integration and maintaining dependency on Venezuela
On December 17, 2014, the Obama administration began launching several measures
to ease travel and the sending of remittances to Cuba, to make trade in foodstuff,
medication, and telecommunications more dynamic, and to promote exports to
24
support farmers, cooperatives, and micro entrepreneurs. In addition, Cuba was
removed from the list of countries sponsoring terrorism, and embassies were
opened in both countries’ capitals.
As a result, in 2015 tourist arrivals to the island rose 15%. In addition, since these
actions lowered the financial risks of having links with the Cuban economy and
increased the opportunities for the future once the embargo (currently in force) is
totally lifted, international interest in investing or having some kind of presence in
Cuba has risen.6
The Cuban market is very attractive because of its high levels of education, health, and
security, and because of its location, including its proximity to the US. However, more
structural reforms are needed to make the most of the new international landscape
and to attract capital in adequate quantities to address the depletion of the Cuban
infrastructure and the island’s obsolete productive apparatus.
Such reforms could include: eliminating current mechanisms for labor contracts of
foreign investors, reducing the time and the requirements to open an enterprise with
international capital, more transparency on statistics and legal procedures,
eliminating monetary duality, granting significant autonomy to SOEs, and allowing
the private sector and cooperatives to establish their own relations with
international markets (Brundenius and Torres, 2013).
In addition, joining
international financial institutions like the World Bank, the International Monetary
Fund, and the Inter-American Bank for Development (IDB) and Corporación Andina
de Fomento (CAF), are seen as essential steps to speed up international integration
(Feinberg, 2011; Vidal and Brown, 2015; Klein and Vidal, 2016).
Opening the economy in the 1990s was a positive experience that produced rapid
and visible improvement in Cuba’s macroeconomic indicators and its households’
Business optimism about the Cuban economy was evident in the First Cuba Standard
Business Confidence Survey: 61% of those surveyed said that economic conditions on the
island will improve during the next 12 months. Half of those surveyed (50.5%) indicated that
their company had augmented its intentions to invest in Cuba (Cuba Standard, 2015).
25
6
economic conditions. The VAR model estimation confirms this impression: A
favorable shock in the external sector results in very significant and same-sign
responses in goods production, GDP growth, and households’ economic conditions.
The response is immediate (in the same year) and increases in the following year
(see Figure 4).
Figure 4. Response to a shock in external sector index
The monetary policy index shows a significant response to an external sector shock,
with the opposite sign and a one-year lag. Therefore, such a positive external shock
could compensate the inflationary effects associated with the monetary reform.
In short, econometric estimation informs economic policy recommendations by
showing that the best way to cushion the cost of monetary reforms is not by
26
following an expansionary fiscal policy but by opening the economy and promoting
international integration, so that monetary unification can proceed under better
balance-of-payments conditions, which in turn reduces inflation pressures.
Table 2 presents the results of analyzing two international scenarios for Cuban GDP
growth: increasing international integration and a collapse of the relationship with
Venezuela. In the first scenario, the external sector index in the VAR was treated like
a totally exogenous variable, and it was assumed that it would improve from 2016 to
2020 at the same rate as it did from 1994 to 1996, when the government
implemented the first measures to open the economy. The resulting forecast suggests
that the GDP growth rate could speed up over 6% beginning in 2018.
Table 2. Two international scenarios for Cuban GDP growth
Scenario 1: Increasing
international integration
Scenario 2: Collapse of
the relationship with
Venezuela
Effects on GDP growth rate:
2016
4.3%
-1.8%
2017
5.6%
-5.5%
2018
6.2%
-3.2%
2019
6.5%
0.6%
2020
6.7%
2.1%
Note: Scenario 1 assumes that the external sector index grows at the same
rate as during 1994-1996. Scenario 2 assumes that the external sector index falls
with the same temporal dynamic, but by half as much, as in 1991-1995 following the
collapse of the relationship with the Soviet Union.
In the second scenario, the external sector index was equally treated like a totally
exogenous variable, but it is assumed that it falls by about half as much as it did from
1991-1995 when relations with the Soviet Union collapsed. This choice is based on
the fact that trade with the Soviet Union accounted for 30% of the GDP, while today
trade with Venezuela accounts for 15% of GDP.
27
The most complicated part of the relationship with Venezuela is that, as with the
Soviet Union, it is very hard to find substitutes or other markets for the commercial
and financial linkages between the countries, since they are based on very specific
agreements built up as a consequence of a political alliance. For example, Venezuelan
oil is essential to maintaining the country's power generation and production at the
refinery in Cienfuegos (a joint venture between Cuba and Venezuela); and Cuba’s
provision of medical services to Venezuela is by far the main source of foreign
income in the country. All of these transactions are carried out with prices and
payment terms that Cuba could not get in other markets.
The forecast indicates that GDP would register a negative rate from 2016 to 2018,
with a cumulative decrease of 10.5%. It would take four years to get the economy
back into positive territory. As the VAR impulse-response functions show, this
negative external shock would have enormous costs for goods production and
households’ economic conditions. Additionally, it would pressure the government to
follow an expansionary monetary policy (increasing money supply and higher
inflation), which would complicate further the process of eliminating the monetary
duality.
5 Conclusions
The correlations between the estimated indexes and GDP growth show that, on
average, during the period 1985-2013, Cuba´s fiscal policy has been procyclical while
monetary policy has been countercyclical. The analysis of this period also shows that
a decline in external revenue increases inflation and/or the likelihood of falling into a
financial crisis, while an increase in external revenue reduces them.
The estimated indexes exposed that during the period 2004-2007, when relations
with Venezuela took off, the Cuban economy did not get a significant or sustainable
upsurge in goods production and households’ economic conditions. Furthermore, the
prevalent tendency since 1995 toward moderate fiscal and monetary policies was
28
broken. All this derived into a financial crisis once the economy was hit by a negative
external shock in 2008.
From 2008 up to the present, economic policy under Raúl Castro’s presidency has
been obliged to apply procyclical fiscal adjustments. Structural reforms failed to
provide the promised vitality to investments, agriculture, and industry, and have not
resulted yet in a significant improvement in households’ economic conditions.
Econometric simulations confirm the high economic vulnerability to an eventual
collapse of relations with Venezuela, which would cause GDP to contract by about
10% over three years. The analysis also suggests that pending monetary reforms
could create negative pressure on goods production and on households’ living
conditions that cannot be mitigated with an expansionary fiscal policy. Instead,
mitigation of the negative effects of a Venezuelan shock and successful currency
reform can only be achieved through greater international openness. To revive the
economy, the best option for Raúl Castro’s government seems to be to speed up the
international integration process; this is a more feasible objective given the current
situation of diminishing tensions with the US government. Empirical evidence
(taking into account the favorable experience in the 1990s) indicates that such
external shock would have a significant and immediate positive effect on the
economy as a whole, and GDP growth could be accelerated by over 6%.
Acknowledgements
I thank the helpful input and comments from Augusto de la Torre, Daniel Lederma
and Judith Goff that greatly improved the earlier version of the manuscript.
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