Our guest today is John Rolle. John is the governor of the Central Bank of the Bahamas. He is a longtime veteran of the institution. He joins us today to discuss what it's like to manage a central bank in a small open economy with a fixed exchange rate. He also joins us to discuss the Sand Dollar, the CBDC of the Bahamas, and other topics. John, welcome to the program.
David, thank you for having me. It's a pleasure to be here.
Well, it's great to have you on. It's great to have a central bank governor. We just had another one from the Riksbank. Now, that's a small open economy central bank with a floating exchange rate. So, it's great to get your perspective because you're a small open economy central bank with a fixed exchange rate. So, a different set of issues, some similar, some different, and it's great to work through all of those implications.
Now, I also want to let the listeners know, John, that I'm connected to you through a colleague of mine, Virgil Storr. He is a colleague of mine here at the Mercatus Center. And he said, "Hey, David, I got this great person for the podcast. He's a relative of mine through marriage. I think you would love him." And I said, "Who's that?" He said, "John, he's the governor of the Central Bank of the Bahamas." Let's do this. So, he set us up, and I'm so grateful, John, you've taken time out today to talk about your central bank.
Well, David, thank you again. And let me say that I've taken a lot of opportunities since we were introduced to listen to the podcast, and they are very interesting. So you've found a new subscriber.
Oh, great. Fantastic. Good to know we got listeners in the Bahamas. So there you go, folks. All right. Well, let's talk about the Central Bank of the Bahamas. And for listeners who are not familiar with the institution, maybe walk us through what it is, its main responsibilities, and how it's different than a standard central bank, say the ECB or the Fed.
So just for context, in the Bahamas we have a fixed exchange rate. So we have the Bahamian dollar that is tied one to one with the US dollar, and it has been that way since the 1960s. Before that, we were also a fixed exchange rate country, but we switched to the US dollar during the 60s as the Bretton Woods system was coming to an end because we wanted to maintain the connection for tourism. So in the Bahamas, from that perspective, when you look at the central bank and what we do, our primary objective is maintaining that fixed exchange rate. So monetary policy is focused around the stability of the currency. We also have responsibility for regulating the banking sector with the financial stability and other implications that follow from that. And as is common in the central banking space, we also have a mandate for payments. So those are the three broad areas that we focus on in the Central Bank of the Bahamas.
I think I should also say that we also have two other important regulators in the Bahamas, given the way we divide responsibilities. One of those is responsible for insurance, and then we have a non-bank securities regulator that also focuses on digital assets and the investment sector. So those are the other two regulators alongside the central bank that have some shared responsibilities for part of the financial sector.
So what is the benefit of the peg? You've got a fixed exchange rate. You're effectively importing the Fed's monetary policy because of that. So what do you gain by pegging to the dollar one to one?
Well, if you go back historically, it provided a seamless convenience for a tourism-dependent economy, meaning that it was not only a fixed exchange rate, but it was tied one to one to the US dollar. And so, in an environment where physical cash circulated a lot more in the tourism space and tourism is priced in dollars, that was a tremendous advantage and benefit for the Bahamas being so close to the US and also having an economy that, if you look at it from the theoretical sense, we look a lot like an optimum currency area insofar as being near to the United States. So the challenges that you might typically have in having a fixed exchange rate and how you could have your misalignments, those pressures don't present themselves to that extent for us.
So being tied or pegged to the US, predominantly trading with the US, you also benefit from the US monetary policies and the outcomes that they achieve in terms of low inflation, low and stable inflation. So we typically import our inflation experience from the United States. And we're also in a situation where we have a very, very closely synced economy to the US in terms of how our economic cycles would look, give or take slight differences in terms of average growth rates, but we're very synchronized and correlated as economies.
So you have to defend the peg or maintain the peg, maybe it's a better term. And that requires you building up a big war chest of foreign exchange reserves. So tell us about that.
Yeah. So the way the system works is that you have by law, in the case of the Bahamas, by law we have to maintain foreign reserves to back the domestic currency liabilities of the central bank. The law says that we must hold at least 50% of any local currency liabilities that the central bank issues, we must hold at least 50% equivalent in foreign currency. Oh, I think the correct terminology is the demand liabilities of the central bank. So when you think about the demand liabilities, you're also considering the deposits and other reserves that commercial banks might hold with the central bank in addition to the currency that's in circulation.
In recent times and traditionally, we've always done much better than just the 50% coverage. As a matter of fact, the Bahamas has gone through quite a lot of episodes recently where the coverage has been over 100%. But it is really the ability to maintain that backing for the currency that helps you maintain the fixed exchange rate. And the backing and the balance is maintained by monitoring how you source foreign exchange versus how you use foreign exchange.
And typically, I mean, in a pure textbook sense, the only way you sort of create any divergences between how much demand liabilities the central bank has, like in the Bahamas, and its reserves is when the central bank prints money in a textbook sense, or to the extent that the central bank also may extend credit to the government and therefore the central bank is putting additional demand liabilities out there that it did not source by exchanging local currency liabilities for foreign currency. So it is really also the ability within that framework to somehow manage the total amount of exposure that a central bank maintains over time or comes into overtime relative to lending to a government.
Yeah, it's so fascinating to hear this, you know, in international economics, and you're at the IMF, so you probably thought about this a lot in your previous career and your work and all your time at the Central Bank of the Bahamas. But we talk about this macroeconomic trilemma or the unholy trinity where a country may want to do all three goals, but only two of these goals. They may want to have free capital flows, they want to have its own domestic sovereign monetary policy and a fixed exchange rate, but you only can do two of the three. And you have picked in the Bahamas effectively fixed exchange rate and then I guess free capital flows.
We have the capital controls. So...
Again, it looks a lot like the textbook case in the sense that you can't have perfect capital controls, fixed exchange rates, and independent policies. So to achieve what we've achieved, we have to have some means of moderating, if not fully to some extent controlling, the capital flows. And in this case, the emphasis is really on how we manage particularly short-term capital flows, because looking at the long-term capital flows which tend to feed into investments, we focus on ensuring that those types of flows are sustainable and that they are actually going to help boost our economy's ability to earn foreign exchange over the longer term.
Okay. So, as a central bank governor, how do you measure the stance of policy in your country? I know you're supposed to keep your rates pretty close to what the Fed's doing. You're pegging your dollar to what the US dollar is, but are there indicators that you look to besides those in terms of the heat of the economy? Oh, the economy is getting a little too hot, too warm. Do you look at inflation, money measures? What indicators do you look at like month-to-month to see where the economy is and maybe you need to step in and do something?
Well, because it reduces to ensuring that you have the adequate foreign reserve backing for your currency. The focus really is on the trends that are influencing either your foreign exchange inflows, and that's predominantly how the tourism sector is doing and how the other sectors that might be earning foreign exchange are doing. And you juxtapose that with where are the demand sources coming from for foreign exchange. They're two: either it's coming out of the natural income path or it's coming out of credit creation.
So for us, maintaining that balance is really making certain that there is a sustainable pattern of credit expansion. And to the extent that the credit expansion is fueling additional call on the use of foreign exchange, you're able to monitor whether you have any pressures that you have to address.
Now, the interesting thing about the economic setup that the Bahamas has, and it's similar in many of the very small open economies, fixed exchange rate, limited diversification, and even in some of those that might have flexible currencies, is that your policies have to be procyclical. And that's not necessarily the best because procyclicality means that when your foreign exchange earning sector weakens and your supply of foreign exchange changes to reduce relatively, unfortunately, the response is not to stimulate because then you would be stimulating the demand side of your economy if you're sort of like the Bahamas. So you have to go in and you have to try and moderate the demand.
So the procyclicality typically means that if you don't have the buffers, a central bank like the Bahamas would be forced to make economic downturns, you know, more aggravating than otherwise.
And so we get fully what it means to say you have buffers because if you have buffers then it means that you can tolerate demand being ahead of how your foreign exchange sector might be doing in a temporary downturn. So as a central bank governor, when you have to make these tough choices and you have to do monetary policy, again, some of it's automatic because of the peg, but some of it is choices you got to make explicitly as well with discretion. It's important to have independence as a central bank. So how does that operate in the Bahamas? Are you given the independence that you need to make tough decisions?
You know, I like this conversation about central bank independence, which is different from a conversation about monetary policy independence in a cross-border sense. But I think it's really the interdependency between a central bank, in the Bahamian case, and what's happening on the fiscal side, because again, in a textbook sense, the fiscal side matters much more in a setting like the Bahamas. So there's a very close collaboration and coordination between the central bank and the fiscal side.
And one of the ways that collaboration looks is not so much whether we have a say in terms of the fiscal deficit target, but we definitely have a say in terms of advising the government as to what are the sustainable ways they're financing a fiscal imbalance. And to the extent that you have a fiscal imbalance that might be putting pressure on demand for foreign exchange, then it also means that you sometimes have to get the fiscal authority to see how certain imbalances are only sustainable or financable if you have access to foreign currency financing.
And that really sums up the experiences that countries like the Bahamas had during the pandemic and in some of the other episodes where you had very strong external shocks in terms of avoiding the procyclicality but recognizing that even fiscal stimulus needed to have a financing source that was external.
Okay. So maybe independence is the wrong word here, but a close working relationship where both parties understand what needs to be done in terms of balance.
Yeah. And I think to be fair too, when you look at the monetary policy experience in the advanced economies too, there's an increasing appreciation that even if the monetary side has certain focuses, it still depends on what's happening on the fiscal side. And if there's tension, the monetary policy side loses some of the flexibility in terms of how it might focus as to perhaps compensate or correct for some of the fiscal pressures.
No, absolutely. A basic macroeconomic accounting identity is the intertemporal government budget constraint which combines central bank and the fiscal side together. And so it really at some level is a bit of a mirage to think they're truly independent from each other. At the end of the day, in the long run, they constrain each other. There's no doubt about that. And you're right, and we see that more clearly in moments like we're in where fiscal pressures do not look very hopeful, at least in the US and some advanced economies over the next decade, where just a concrete example, as we run larger and larger primary deficits, it's going to be harder and harder for the Fed to want to independently set that interest rate because that interest rate then affects interest payments on the debt level. So it's hard to completely separate them. And even in like textbook New Keynesian models, it assumes in the background the fiscal house is in order so that you can have this independent central bank. So this is great to hear your perspective.
And one other point related to this is that when you look at an inflation targeting regime, the outcome is that if you don't achieve the sustainable path, you're dealing with an inflationary outcome that's not satisfactory. For us, it's not inflation, it's a loss of foreign reserves. And so we do see that play out if we don't achieve the sustainable level of coordination between the monetary and the fiscal.
And I must say that when I look at an economy like the Bahamas, and even to some extent I like to use the experience in Barbados, even though Barbados has gone through some severe austerity experiences in the recent decade, that there tends to be a very strong national consensus to that monetary policy objective around the currency stability and an appreciation often that when austerity or the equivalent is necessary, that you accept it just to deliver on the, in this case, the currency stability. So you do see that play out and it means that even at the political level, the more interesting conversation is who does a better job of supporting those objectives. And I think that's something that I've always found admirable about the Bahamian case.
That is so interesting. So maybe another way to frame this, at least the way I'm seeing this, is you see in real time more clearly the kind of the link between fiscal policy and monetary policy. You know, the consolidated government budget constraint is a real thing. And it just so happens in an economy like yours, it's very real, very binding all the time. Easier for you to see it than say someone in an advanced economy where it takes longer, maybe it's a little more hidden, but you are a great case study and why it matters.
So, John, this has been a fascinating conversation about the importance of both fiscal policy, monetary policy, how they work together hand in hand, and how you see this in real time in the Bahamas. Let's talk about the Bahamian economy a little bit more. We've touched on it, but it is a unique economy. A lot of tourism. How does that affect your job, the structure of the Bahamian economy?
Well, in some ways it simplifies the work, but it also highlights the sort of vulnerabilities that you have as an economy because it means that when we look at what the outlook is for tourism, we have a fairly good appreciation for what's going to drive the year-over-year fluctuations in our export earnings sector. And so we're able to anticipate how the stance of monetary policy might need to be modulated in that context.
And it means that you can focus on the US and the trends that manifest themselves in the US, but it does mean that as an economy where you have significant dependence on the US market for business, in this case, at least four-fifths of our business is US-sourced. It means that you are very much influenced by the consumer sentiment element of the US economy and how that filters into travel demand and spending. So that is sort of concentrating the kinds of vulnerabilities that we experience because of the US-centric nature of our tourism.
But the upside, David, is that we're close to the US. And so it's also easy for Americans to get to the Bahamas.
Yeah. Lots of cruise ships stop by at the Bahamas. And you guys get a lot of tourism there. So that's the primary driver. But you guys have also been diversifying into other sectors too, correct?
Yes. So financial services is important for the Bahamas. So in addition to what happens in the domestic space, the Bahamas has historically also provided international financial services. So there is an element of our banking sector that is focused on providing banking services to non-Bahamians or non-residents. And the bigger chunk of what happens in our non-bank securities sector is around digital assets, international portfolio investment services, and those as well tend to be directed more so at non-Bahamians.
And the financial services sector is significant because it employs a lot more concentration of high-skilled individuals, accountancy, law and the like. And those are professionals that typically earn much higher incomes on average than those that are in tourism. But still, tourism is the bread and butter insofar as the bulk of your foreign exchange inflows are concerned.
Okay. What happened in the Bahamas, say, during COVID when we had the global slowdown? How did that affect the economy then?
Well, COVID was quite an interesting experience because if you were a tourism-dependent country, it meant that that sector was at a complete standstill. And so what we experienced in the Bahamas was in real terms about a 20 to 25% contraction in economic activity over that period. And that is concentrated in 2020. I think as we progressed through 2021, you started to have a bit of a recovery, but because again it was tourism-driven, we were not fully recovered until around about the third, fourth quarter of 2022 and going into the first quarter of 2023. So it was quite a setback.
But all things considered, I think there was an upside to that because then it also increased the interest that people had in making investments in countries like the Bahamas in second homes. So I think when I look at what's happening right now in the Bahamas and the strength of our economy, we are still growing above medium-term potential because there's still a lot of investment going on in residential tourism. And some of that interest, sparked by the interest during the pandemic in wanting to live in places like the Bahamas and to have, I guess, more spacious surroundings given the COVID experience.
So you've benefited from the post-COVID boom that took place in the US afterwards. You're a recipient of it.
