Underlying characteristics and macroeconomic policies
The size of the economies of small states and territories—ministates for short—imposes particular constraints on the conduct of their monetary, exchange rate, and related policies. It is instructive to examine these constraints, both to illustrate the specific problems of ministates, on which virtually no research has been done, and to test and extend the policy implications of the large body of economic literature that deals with small open economies. In dealing with the smallest of all economies one expects to capture these implications in their clearest and strongest form.
The sample countries included in this study were the Bahamas, Bahrain, Barbados, Botswana, Cape Verde, the Comoros, Cyprus, Djibouti, Dominica, Equatorial Guinea, Fiji, Gabon, The Gambia, Grenada, Guinea-Bissau, Guyana, Iceland, Luxembourg, Maldives, Malta, Mauritius, Netherlands Antilles, Oman, Qatar, Sao Tome and Principe, Seychelles, Solomon Islands, St. Lucia, St. Vincent, Suriname, Swaziland, Vanuatu, and Western Samoa.
For the purposes of this article, which is based on a more detailed study by the author, ministates are defined as states and territories that have a population of less than one million people. Of course, other definitions would be possible for other purposes. This definition allows the investigation of the various macroeconomic implications of smallness, irrespective of a country’s stage of development, that cannot be captured by either the standard approach, which defines smallness in terms of price-taking behavior, or by a definition in terms of a macroeconomic variable, such as GNP.
Defining a country to be small if it cannot influence world prices for goods and assets involves the obvious problem that virtually all countries are price-takers, and hence small in this sense. This difficulty arises because price-taking is only one of the likely economic characteristics of smallness; the degree of openness to trade and to capital movements, and export dependence are others that bear directly on the conduct and effectiveness of economic policies in ministates. Nevertheless, the study utilizes some analytical insights of the literature on small open economies concerning the effects of substantial interest rate and price adjustment. The study uses a general macroeconomic model of a small open economy capable of capturing the underlying structural characteristics to illustrate the main propositions. A practical problem with defining smallness in terms of some direct macroeconomic variable, such as real GNP, capital, or the labor force, is the lack of data, particularly on the capital stock and the labor force. More important, such a definition would, ceteris paribus, tend to exclude the more developed countries and, therefore, frustrate the investigation of whether different development stages have an effect on the conduct of policies in mini-states.
The cut-off point of one million people in this definition of small size is somewhat arbitrary. The main justification is that while there are about 100 small states and territories of less than one million people—the majority of them islands or located in islands—there are only about a dozen with a population of between one and two million people and even fewer in the higher ranges. For empirical material this paper draws principally on a sample of 33 mini-states that are members of the Fund.
The two main conclusions of the study are, first, that ministates, in their pursuit of domestic stabilization goals, have generally been assisted by the adoption of stable effective exchange rates; and, second, that they are likely to benefit from an accommodating monetary policy (i.e., domestic credit and interest rate policies) designed to maintain the stability of the exchange rate. The limited scope of exchange rate and monetary policies in ministates is related to their basic structural characteristics: substantial openness to trade and financial capital, dependence on a few exports, price-taking behavior with its attendant vulnerability to large real economic shocks, and the likelihood that wages will rise with inflation but will be inflexible downward. A related conclusion is that ministates have to be especially careful to avoid large public sector deficits and excessive factor income demands in relation to GNP, which make the appropriate conduct of exchange rate and monetary policies difficult. These conclusions do not apply exclusively to ministates; they may also apply, although perhaps less certainly, to a number of relatively larger countries, particularly developing ones, that share some of the underlying characteristics of ministates.
Trade openness and dependence
The economies of ministates tend to be very open to trade. Available data show that the shares of imports and exports in GNP in ministates are normally well above 50 percent, a ratio that is much higher than that for larger countries. The few exceptions are the least developed of the group, such as Equatorial Guinea and Sao Tome and Principe. Further, the trade openness of ministates tends to increase with the level of development more than that of larger countries; advanced economies need to rely more on the rest of the world for a large variety of imports, particularly those with a high technological content.
Several important consequences follow from such a high degree of openness to trade. First, the overall domestic price level is dominated by movements in the foreign price level of imports (under exchange rate stability). The prices of nontraded goods also tend to adjust rapidly through the impact of foreign prices on wage and other cost movements. Second, effective exchange rate changes in terms of an import-weighted basket tend to produce immediate effects, similar to those of foreign price changes, on domestic prices. Third, trade barriers, tariffs, and exchange restrictions on current transactions tend to produce strong and detrimental effects on production and prices. Fourth, the combination of a large share of export goods in GNP and the small size of the economy tends to produce a severe concentration of production in a few export products—particularly some commodities and agricultural products—whose prices are subject to fluctuations in world markets.
This concentration of domestic production exposes the economies of ministates to real shocks of an intensity unparalleled in larger countries. These shocks resemble in some respects those of small regions within a large country, but can be more intractable. For instance, a change in world technology or in tastes can reduce the prices of the exports of ministates and force a restructuring of their lines of production. Often this occurs abruptly and unexpectedly, allowing only a brief period for adaptation and without either sufficient concessionary or commercial capital inflows to carry on a satisfactory adjustment process.
Available empirical evidence indicates that the economies of more advanced mini-states tend to be more diversified. Some of them, for instance, have avoided export concentration, partly by orienting their economies toward the provision of services—such as tourism, offshore banking, and multinational business—that are in greater demand as incomes rise in the industrial world. However, not all ministates have the opportunity to exploit these activities, being constrained by such factors as geographical location, climate, and cultural and political relations with metropolitan areas.
Financial capital mobility is even more directly relevant than trade openness for the effectiveness of monetary, exchange rate, and other macroeconomic policies. However, unlike trade openness, capital mobility is a difficult concept. It has been interpreted in three principal ways: as capital flow openness, capital stock openness, and capital market integration. Further, the relationship between these concepts seems to be somewhat complex.
Capital flow openness, measured by a ratio of gross external capital flows (average of inflows plus outflows) to GNP, is found by the study to be inversely associated with the size of ministates, a finding that corroborates an earlier one for a worldwide sample of larger countries. The study also finds that the majority of ministates have higher ratios than larger countries, although there is a surprisingly wide diversity within the group that may be attributed to both economic and other factors, such as geographical location and historical links with larger and more advanced countries. Among the economic factors, the pursuit of economic policies to increase the scope and size of government seems to have reduced the ratios in some ministates as these policies tended to insulate them from world capital markets. In others, domestic interest rate ceilings appear to have produced higher ratios as international financial intermediation tended to substitute for domestic intermediation.
For the sample of 33 ministates in the study, the level of economic development appears to have, if anything, a negative association with capital flow ratios. This may be because more advanced ministates are likely to have higher ratios of stocks of external financial assets and liabilities to GNP, so that relatively smaller external flows will be needed for interest rate equalization.
The hypothesis of capital market integration—that there should be a strong tendency to close the interest rate differentials between domestic and foreign rates as a result of intensified financial capital flows and larger international financial assets—does not hold true in all ministates. The scarce available data point to the persistence of such differentials, although they are smaller in ministates than in larger countries, particularly the developing ones. Capital market imperfections originating in the underdevelopment of financial markets and intervention by the authorities to fix domestic interest rates at artificially low levels, coupled with exchange controls designed to prevent interest-sensitive financial outflows, account for the observed differentials. However, the first factor seems to be the more relevant in ministates because, given their substantial trade and capital openness, it becomes more difficult and less worthwhile for the authorities to try to enforce a system of exchange controls.
Capital mobility, with a tendency toward complete equalization of interest rates, renders net domestic credit policy—the only viable form of monetary policy in this case—ineffective as a tool of adjustment of prices and output as it is offset by external capital flows. Capital mobility then takes up the role of a substitute, often a more efficient one, for monetary policy.
Exchange rate stability
In a world of flexible exchange rates among the currencies of major industrial countries, ministates in particular are subject to terms of trade disturbances (changes in the ratio of export to import prices) resulting from exchange rate changes and other factors against which they have no protection. More important, ministates are confronted with the inescapable task of having to choose their exchange rate regime and policy, as well as the standard used to peg their respective currencies.
Because ministates have relatively large external sectors compared with other economies and face given prices, changes in effective exchange rates tend to have seriously destabilizing effects on domestic prices, output, and employment. Appreciation tends to reduce output and employment in the face of downward wage rigidity; depreciation, on the other hand, may well result in inflation with little gain in output, particularly if wages are, for all practical purposes, indexed in terms of foreign currency, as they tend to be in mini-states. Conversely, a fixed effective exchange rate system that commits the authorities to moderate credit expansion tends to contribute to domestic monetary and price stability, subject, of course, to the condition that monetary and price stability prevails abroad. Another, more practical, reason many ministates have opted for fixed effective exchange rates is the narrowness, and often the backwardness, of their foreign exchange markets. Concentration in their export and financial markets often results in the domination of the foreign exchange market by one or few major export businesses and dealers, creating the risk that seriously destabilizing speculation might take place in the absence of intervention. In practice, therefore, the effective choice for ministates may be a fixed or a managed exchange rate system. The first is suitable for ministates with adequate control over domestic credit; the second becomes necessary under long-term wage, budgetary, and other macroeconomic disequilibria leading to excessive domestic credit creation.
If a ministate pegs its exchange rate to a single currency, it is subjected to exchange rate fluctuations against other flexible currencies, with potentially undesirable consequences. Therefore, for most ministates a basket of currencies is generally preferable as it is more likely to stabilize the effective exchange rate, prices, and output. In considering which basket of currencies, mini-states confront multiple choices that can affect income distribution, the internal terms of trade between traded and nontraded goods, inflation, the real effective exchange rate, and the balance of payments. In principle, an ideal basket weighted by trade, current invisibles, and capital flows can be constructed for a given choice of policy objectives. However, the construction of such a basket sometimes presents practical difficulties and can dictate limiting the choice to a simple trade-weighted basket of currencies of a few major trading partners or the SDR.
Empirical evidence suggests that mini-states have generally taken into account their limitations on the choice of exchange rate regime; virtually all have kept a fixed rate with respect to a major currency or basket of currencies, and none has followed the industrial countries in adhering to an independently floating system. The U.S. dollar has tended to replace less stable currencies as a single currency peg, and the SDR and composite baskets have tended to replace single currencies. By the end of 1982, 26 of the 33 ministates examined were pegging either to the U.S. dollar (10 countries), the French franc (2), other currencies (3), the SDR (5), or a composite basket (6). In addition, Luxembourg maintained a fixed exchange rate within the European Monetary System; Bahrain and Qatar, although formally pegging to the SDR within wide margins, de facto followed the U.S. dollar; Guyana and Maldives also largely followed the U.S. dollar; and Western Samoa determined the exchange rate administratively by reference to a basket of currencies and to other relevant factors. Only Iceland genuinely availed itself of a more flexible exchange rate system, having institutionalized exchange rate depreciation under managed floating in recent years as a means of maintaining the profitability of export and import-competing industries in the face of a very high rate of domestic inflation.
Monetary policy accommodation
The need to preserve a stable effective exchange rate sharply constrains the use of monetary policy in ministates, given their substantial capital mobility and trade openness. Capital mobility tends to offset domestic credit policy and equalize interest rates, so monetary policy is ineffective for controlling output and prices in the short run. Domestic credit then becomes solely an instrument to control the balance of payments and must be used, in conjunction with fiscal policy, to accommodate the need to maintain a sufficient level of reserves necessary to preserve a stable exchange rate. With less than perfect capital mobility, however, domestic credit or fiscal policy can also affect imports and, to a lesser extent, aggregate demand, and perhaps output. However, any initial gain from excessive credit or fiscal expansion might be more than offset by a subsequent loss as adjustment policies come into effect or as the consequent fall in international reserves forces exchange rate depreciation, monetary expansion, and inflation. Nevertheless, in the presence of intractable large public sector deficits or wage increases tending to produce excessive domestic credit expansion, a flexible exchange rate system becomes necessary to avoid relative price distortions, a fall in output, and an unsustainable fall in reserves; the attendant monetary expansion and inflation become unavoidable.
Given their high trade openness and monetary policy accommodation, a measurable translation of international into domestic price increases should have been expected in ministates. They did, in fact, experience a surge in inflation rates in the mid-1970s, following the large export price increases in industrial countries partly associated with the first oil price shock, and again toward the end of the 1970s, following the second shock. Also, as might have been expected, inflation abated in the majority of ministates as external factors ceased to operate, and countries with a depreciating exchange rate tended to have higher rates of inflation than others, and vice versa. Iceland’s experience illustrates this position. Propelled by large wage increases, budgetary deficits, and other domestic factors, Iceland’s rapid domestic credit expansion required equally rapid depreciation of the exchange rate. As a result, Iceland became, by far, the most inflationary country in our sample of ministates.
As an aid to maintain an adequate level of external reserves to support the stability of the effective exchange rate, the majority of the ministates in the sample impose a minimum legal external reserve asset cover against currency in circulation and other domestic demand liabilities of the central monetary authority. This legal cover varies from 100 percent to 50 percent, except for Cyprus (which has one of 30 percent) and Gabon (20 percent). However, the legal cover has not been a binding constraint on the behavior of the monetary authorities, as the effective cover has normally been much higher than the legal minimum. Furthermore, the commitment by the authorities to maintain a fixed exchange rate must logically be viewed as distinct from the legal cover; indeed the lack of usable foreign exchange resulting from the legal cover may require greater exchange rate depreciation. Once more, Iceland illustrates this proposition, since it suffered the most severe depreciation and inflation in the sample of ministates under a 50 percent legal cover (and an effective average cover over a prolonged period of about 150 percent). Conversely, several of the ministates operating without a legal cover were able to maintain large external reserves, stable exchange rates, and the lowest inflation rates, as the authorities successfully used the principle of monetary policy accommodation to steer the economy toward domestic and external balance.
In ministates, exchange rate and monetary/fiscal policies are closely intertwined and this makes their use difficult as instruments to improve economic performance. (One should, of course, not overlook the indirect contribution that effective exchange rate stability and monetary policy accommodation can make to minimizing the adverse effects of real disturbances, such as terms of trade shocks.) Should, therefore, the authorities manipulate the underlying structural characteristics and, if so, in what way?
If experience is any guide to policy, attempts to reduce trade openness should be resisted. Autarkism is essentially opposed to development in ministates. However, the authorities might be able to contribute to the appropriate choice and diversification of economic activities, as well as reinforce the capacity for structural adaptation, through government investments, particularly on infrastructure, and through incentives to the private sector. Of particular importance are policies designed to promote labor market flexibility, the growth of human capital, and the appropriate conditions to retain it within the country.
Similarly, governments should not introduce policies to reduce capital mobility in order to regain monetary policy independence. As noted earlier, capital mobility can act as a substitute for monetary and/or exchange rate policy and, under some conditions, as a more automatic and efficient stabilizer, as it tends to subject the government’s policy to external creditworthiness tests that counteract fiscal disequilibrium, and facilitate the intertemporal transfer of resources necessary to adjust to real disturbances.
The limited scope for exchange rate and monetary policies need not have any deterministic implications for the appropriate system of institutional monetary arrangements in ministates. It is not clear, for instance, that monetary and exchange rate stability has to rest necessarily in the imposition of rigid rules of behavior such as a minimum legal external reserve asset cover. It would appear at this stage that the variety of structural and cyclical factors, as well as historical, geographical, and other considerations, advises caution in relating too closely the policy principles to practical monetary arrangements.