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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 Alina Gómez Mejía Julián Piñeres Luis Fernando Aguado Correspondencia, suscripciones y solicitudes Calle 18 No. 118-250 Vía Pance Santiago de Cali, Valle del Cauca, Colombia Pontificia Universidad Javeriana Cali Facultad de Ciencias Económicas y Administrativas Teléfonos: (57+2) 3218200 Ext.: 8694 Correo electrónico: [email protected] Sello Editorial Javeriano - 2017 Coordinador: Iris Cabra [email protected] Concepto Gráfico: William Fernando Yela Melo Formato 28 x 21 cms. ©Derechos Reservados ©Sello Editorial Javeriano Enero de 2017 La serie de Documentos de Trabajo FCEA pone a disposición para el análisis, discusión y retroalimentación de la comunidad académica los avances y resultados preliminares del trabajo académico de los profesores de la Facultad de Ciencias Económicas y Administrativas. Estos documentos no han sido sometidos a procesos de evaluación formal por pares internos ni externos a la Facultad. Se espera que muchos de estos documentos posteriormente sean sometidos a evaluación en publicaciones especializadas. Las opiniones expresadas en este documento son de exclusiva responsabilidad de los autores y no comprometen institucionalmente a la Facultad de Ciencias Económicas y Administrativas, ni a la Pontificia Universidad Javeriana Cali. 2 Contenido 1. 2. 3. 4. 4.1. 4.2. 5. Introduction Data Empirical strategy Results Macroeconomic trends Macroeconomic shocks Conclusions 6 9 10 14 14 20 28 3 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. 4 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. 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