Resilience and Growth in the Small States of the Pacific
Chapter

Chapter 2. Raising Potential Growth and Enhancing Resilience to Shocks

Author(s):
Hoe Khor, Roger Kronenberg, and Patrizia Tumbarello
Published Date:
August 2016
Share
  • ShareShare
Show Summary Details
Author(s)
Ezequiel Cabezon, Patrizia Tumbarello and Yiqun Wu 

The small states of the Asia and Pacific region face unique challenges in raising their growth potential and living standards. Small populations, geographical isolation and dispersion, narrow export and production bases, lack of economies of scale, limited access to international capital markets, exposure to shocks (including climate change), and heavy reliance on aid leave them particularly vulnerable. In providing public services, they face higher fixed government costs than other states because their governments must provide these services regardless of small population size. In small states, limited access to credit by the private sector is an impediment to inclusive growth, and capacity constraints are another key challenge. These challenges seem to be particularly acute in micro-states (countries with populations of less than 200,000). But as well as these challenges, Asia and Pacific small states face higher volatility than other small states in GDP growth per capita, changes in the terms of trade, aid, current account balances, and revenue.

This chapter’s econometric analysis confirms that the Pacific island countries (PICs), many of which are small states and microstates, have underperformed relative to their peers over the last 20 years. After controlling for standard variables that explain GDP growth per capita, PICs suffer a disadvantage in this measure of about 2 percentage points, compared with an average small state.

They also have more limited policy tools. Five out of 13 developing small states in Asia and the Pacific covered in this chapter do not have a central bank, and the scope for diversifying their economies is narrow.1 Given their large development needs, fiscal policies have been procyclical at times. Within the Asia and Pacific small states, the microstates are subject to more vulnerability and macro-economic volatility than the rest.

Despite the limited availability of policy tools, policies do matter and they can help build resilience and raise potential growth. Indeed, because of sound policies and strong links with resilient economies in the region, and despite all the challenges, PICs did slightly better than some comparators during the recent business cycle. Some Asia and Pacific small states have also made progress in building policy buffers. Nevertheless, growth rates have remained quite low. Given their high vulnerability to external shocks, these countries should continue to rebuild buffers and improve the composition of public spending for education, health, and infrastructure to better foster inclusive growth (see also Chapter 10).

The Asia and Pacific small states have enormous untapped marine resources, which require more effort to properly exploit and manage them. These states should continue to pursue regional solutions, mainly in fisheries, information technology, and aviation safety. Further integration with the broader Asia and Pacific region should help raise growth potential.

Characteristics of Small States in the Asia and Pacific Region

As noted, the region’s small states face unique challenges in raising growth potential and living standards, which distinguishes them from the broader group of small states in other regions. Yet even among them, heterogeneity is high, with the microstates subject to more vulnerability and macro-economic volatility than the other Asia and Pacific small states.2

Many small states in the Asia and Pacific region are remote, widely dispersed, and sparsely populated (Figure 2.1). Their remoteness from major markets and trading partners—unlike small islands in other regions—raises transport costs and keeps these economies relatively isolated. Their wide dispersion, shown in Table 2.1, precludes the exploitation of geographical agglomeration effects. Most PICs consist of hundreds of islands scattered across the Pacific Ocean in a space occupying 15 percent of the earth’s surface—and these are by far the most remote countries in the world, according to different indicators. These include the United Nations’ liner shipping connectivity index, which measures countries’ connectedness to global shipping networks based on the status of their maritime transport sectors and geographical distance (Figures 2.2 and 2.3). Two PICs are the IMF’s smallest members by population—Tuvalu and Palau—and the average population in PICs is half that of small states outside the Pacific.

Figure 2.1Asia and Pacific Small States: Population, 2014

(Millions)

Sources: IMF, World Economic Outlook database; and World Bank, World Development Indicators database.

Note: PICs = Pacific island countries.

Figure 2.2Small States: Distance to the Closest Continent

(Kilometers)

Sources: South Pacific Applied Geoscience Commission; United Nations Environment Programme; and IMF staff calculations.

Figure 2.3Asia and Pacific Small States: Liner Shipping Connectivity Index, 2004–131

Source: WorldBank, World Development Indicators database.

Note: PICs = Pacific island countries.

1 A smaller number indicates lower connectivity/high transportation costs. Countries with maximum connectivity = 100. Non-small states mean = 25.3.

Table 2.1Geographical Dispersion: Average Sea Distance between Two Inhabitants of the Same Country
CountryDistance (Kilometers)
Micronesia706
Kiribati691
Marshall Islands280
Solomon Islands267
Vanuatu210
Tuvalu177
Tonga105
Fiji71
Samoa19
Palau14
The Bahamas96
Trinidad and Tobago9
St. Kitts and Nevis9
Antigua and Barbuda2
Source: IMF staff calculations, based on country censuses.Note: This is equivalent to computing the average distance between islands of the same country weighted by population.
Source: IMF staff calculations, based on country censuses.Note: This is equivalent to computing the average distance between islands of the same country weighted by population.

In providing public services, the Asia and Pacific small states face higher fixed (per capita) government costs relative to other small states (Figures 2.4 and 2.5). This is because government must provide public services regardless of the population size. In the island states, remoteness and wide dispersion compound this effect, creating an inverse relationship between the size of the country and the size of government. Large dispersion and small populations increase input costs and worsen the diseconomies of scale in creating public institutions and providing public goods and services, such as education, justice, social services, and infrastructure. Current government spending as a share of GDP is generally higher in the microstates than in all other groups (Becker 2012).

Figure 2.4Asia and Pacific Small States: Government Expenditure, 2014

(Percent of GDP)

Sources: IMF, World Economic Outlook database; and IMF staff calculations.

Note: PICs = Pacific islands countries.

Figure 2.5Asia and Pacific Small States: Cost of Government, 1990–2010

(Percent of GDP)

Sources: World Bank, World Development Indicators; and IMF staff estimates.

Note: GNI = gross national income.

These countries are quite heterogeneous but they all have narrow export and production bases. Some rely primarily on tourism (Fiji, Maldives, Palau, Samoa, Vanuatu), and some on fishing and fishing license fees (Kiribati, Marshall Islands, Micronesia, Tuvalu—Table 2.2). Some are commodity or energy-resource based (Bhutan, the Solomon Islands, Timor-Leste). While scope for export diversification remains limited, with the exception of Fiji and Samoa, niche or ecotourism is gradually developing in Kiribati, Marshall Islands, and Micronesia. Recent experiences in setting up joint ventures for marine processing are also effective as ways to move up the value-added chain.

Table 2.2Asia and Pacific Small States: Main Exports of Goods and Services
CountryFirst Good or ServiceSecond Good or Service
BhutanHydroelectricityMinerals
MaldivesTourismFish
Timor-LesteOilCoffee
Pacific Island Countries
FijiTourismSugar
KiribatiFishCopra
Marshall IslandsFishCopra
MicronesiaFishCopra
PalauTourismFish
SamoaTourismCopra
Solomon IslandsLogsFish
TongaAgriculture (squash)Tourism
VanuatuTourismCopra
TuvaluFishCopra
Sources: Country authorities; and IMF staff reports.
Sources: Country authorities; and IMF staff reports.

PICs appear to be less open than comparators (Figure 2.6), which reflects their remoteness, underdeveloped infrastructure—which is hurting tourism—and low competitiveness. Poor connectivity and high transportation costs have prevented greater trade integration with the rest of the region. Trade openness, however, has increased in these countries over time and integration has benefited the Asia and Pacific small states. Yet this also poses challenges because shocks are transmitted more rapidly in a more interconnected world.

Figure 2.6Small States: Trade Openness

(Percent of GDP)

Sources: Penn World Tables; World Bank, World Development Indicators; and IMF staff calculations.

Note: Trade openness measured as exports plus imports of goods and services. PICs = Pacific island countries.

Financial depth is generally below that of small states in other regions and access to credit is more limited (Figure 2.7). Land tenure systems favoring communal land also constrain credit growth and private sector development, leading to less inclusive growth. Land in most PICs is owned by the government and large families rather than by individuals. Family tenure makes property rights unclear and limits the use of land as collateral; and if banks are unable to secure their lending effectively with land as collateral, lending becomes costly. This leaves the spread between lending and borrowing rates very high in PICs (see Chapter 17).

Figure 2.7Asia and Pacific Small States: Domestic Credit to the Private Sector, 2013

(Percent of GDP)

Sources: World Bank, World Development Indicators; and IMF staff calculations.

Note: PICs = Pacific island countries.

Yet commercial banks in PICs, which are mainly foreign banks, are well capitalized and highly profitable, despite relatively low lending growth in recent years. This reflects high levels of noninterest income (higher than some comparators), largely from foreign exchange activities and fees and charges (Table 2.3—see Chapter 18).

Table 2.3Small Pacific Island Countries: Interest and Noninterest Income of Commercial Banks, 2013
Net Interest Income

(Percent of total assets)
Noninterest Income

(Percent of total assets)
Fiji3.42.7
Marshall Islands5.91.4
Samoa5.53.6
Solomon Islands4.44.1
Tonga4.54.3
Vanuatu4.13.0
Memorandum:
Pacific island countries (average)4.63.2
Small Caribbean states (average)3.02.9
Small African states (average)2.41.2
Sources: Davies, Vaught, and Cabezon (2014); and central bank data.
Sources: Davies, Vaught, and Cabezon (2014); and central bank data.

The private sector’s limited access to credit impedes inclusive growth (Figure 2.8). Indeed, a simple regression suggests a negative relationship between inequality (proxied by the Gini coefficient) and the share of private credit as a percent of GDP.

Figure 2.8Asia and Pacific Small States: Financial Development and Income Inequality, 1990–2013

(Percent of GDP)

Sources: ADB (2012); World Bank, World Development Indicators; and IMF staff calculations.

1 One indicates maximum inequality.

Greater use of mobile phone networks for basic financial services is one recent method used in Fiji, Samoa, the Solomon Islands, and Tonga to support private sector growth that fosters financial inclusion. This also helps lower the cost of sending remittances to the Pacific from Australian banks, which, likewise, fosters financial sector intermediation.

International market access is also very limited. Because of capacity and structural impediments, including legal and administrative frameworks, these countries have still not been able to tap international capital markets and attract capital inflows. With the exception of Fiji and Maldives, their market access to private capital flows is almost nonexistent.

Indicators on the business environment are weaker in the Asia and Pacific small states than in some comparators. According to the World Bank’s Doing Business 2015 report, procedures for starting and closing a business are more expensive in the small PICs than in the other Asia and Pacific small states as well as in the Caribbean island countries. Weak private sector development impedes sustainable growth (Figure 2.9).

Figure 2.9Asia and Pacific Small States: Ease of Doing Business Index

Sources: World Bank (2015), Doing Business Report; and IMF staff estimates.

Note: A lower number indicates a more business-friendly climate. PICs = Pacific island countries.

Policy tools are also limited. Five out of the 13 countries examined in this chapter have, as noted, no central bank (Kiribati, Marshall Islands, Micronesia, Palau, Tuvalu). The Australian dollar is legal tender in Kiribati and Tuvalu, and the U.S. dollar in Marshall Islands, Micronesia, and Palau. The use of dollarization or either fixed or managed exchange rate regimes for the Asia and Pacific region’s other small states reflects the fixed costs of operating an independent monetary policy as well as weak monetary transmission mechanisms. The latter are largely the result of structural characteristics of undeveloped financial markets, such as shallow money markets, the absence at times of institutions such as credit bureaus that facilitate bank lending, and small markets (see Chapter 12).

Capacity constraints are larger in PICs relative to comparators, another major challenge impeding economic potential. For example, school enrollment is lower than in other small states (Figure 2.10). A recent analysis suggests that in the small PICs capacity constraints in the public service are associated with small size and that this explains the underperformance on public financial management reforms (Haque, Knight, and Jayasuriya 2012). That said, Fiji, the Solomon Islands, and Vanuatu have recently taken meaningful steps to strengthen public financial management and promote budget transparency and accountability.

Figure 2.10Asia and Pacific Small States: Secondary School Enrollment

(Percent of population 12–17 years old, 1990–2012 average)

Sources: World Bank, World Development Indicators; and IMF staff calculations.

Note: PICs = Pacific island countries.

Managing Shocks, Vulnerability, and Volatility

Shocks

Small states in Asia and the Pacific are heavily exposed to shocks. Some shocks are related to external economic developments, some to weather and environmental events, and some are homegrown, such as political shocks. The main channels of spillover from the global economy are terms of trade, remittances, tourist flows, and financial channels. In particular:

  • All PICs remain especially vulnerable to global commodity price shocks—This is especially so for food and fuel, given their large share in total imports (about 50 percent). The change in commodity prices and their greater volatility in recent years has meant that terms-of-trade shocks have translated into large output shocks.3 Higher import prices in 2008 had also raised production costs and reduced real household income. The opposite effect has been in place since the fall in commodity prices that started in 2011.
  • External demand and financial shocks are also important—The main channels of contagion are changes in remittances (in Samoa, Tonga, Tuvalu and, to a lesser extent, Fiji) and tourism receipts (Fiji, Maldives, Palau, Samoa, Vanuatu—Figure 2.11). A fall in stock prices in advanced economies would also affect PICs with large trust funds whose assets are invested offshore (Kiribati, Marshall Islands, Micronesia, Palau, Tuvalu), as happened during the global financial crisis (Figure 2.12).

Figure 2.11Asia and Pacific Small States: Tourism and Remittances

(Percent of GDP, 2005–14 average)

Sources: Country authorities; and IMF staff calculations.

Figure 2.12Asia and Pacific Microstates: Sovereign Investment Fund Balances

Sources: Country authorities; and IMF staff calculations.

1 Fiscal year.

Aid flows proved resilient during the 2009 turmoil as Australia, the main donor in the Pacific region, weathered the global financial crisis relatively well. However, high dependence on foreign aid is a source of fiscal vulnerability. Much weaker than expected economic activity in Australia and to a lesser extent New Zealand would hit PICs particularly hard, as both countries are the main trading partners for most of the Pacific islands. Even in the case where donors do not decide to cut grants further, in the Solomon Islands grants are expected to gradually decline (in terms of GDP) over the medium term.4 Aid from the United States has a big impact on Marshall Islands, Micronesia, and Palau through the bilateral Compact of Free Association agreements (Figure 2.13). This aid represents over 65 percent of total aid in Palau and 90 percent of total aid in Marshall Islands and Micronesia. These PICs finance a large portion of their budget and balance of payment needs with compact grants, scheduled to expire in 2023/24.

Figure 2.13Asia and Pacific Small States: Official Development Assistance by Donors

(Percent of total aid, 1990–2012)

Source: World Bank, World Development Indicators.

Note: EU = European Union.

PICs are also severely affected by natural disasters and climate change (Figure 2.14). Of the 20 countries in the world with the highest average annual disaster losses measured by GDP, eight are PICs (Cook Islands, Fiji, Marshall Islands, Micronesia, Niue, the Solomon Islands, Tonga, Vanuatu). Several small island countries in the Asia and Pacific region are low-lying coral islands, with their populations and infrastructure concentrated along coastlines (Kiribati, Maldives, Marshall Islands, Tuvalu). This makes them highly vulnerable to the effects of sea-level rises and coastal erosion associated with climate change. While worldwide databases are available to account for the costs of natural disasters, the costs of climate change (including fiscal costs), which are likely substantial in the Asia and Pacific small states, have for the most part not been estimated.

Figure 2.14Average Impact of Natural Disasters

(Percent of GDP)

Source: World Bank and United Nations (2012), Natural Hazards, UnNatural Disasters: The Economics of Effective Prevention.

Note: Excludes the cost of climate change.

The frequency of shocks is also higher in the small PICs than in other comparators (Figure 2.15). Our event analysis shows that political, terms-of-trade, and natural disaster shocks are more frequent relative to other low-income small states.

Figure 2.15Small States: Frequencies of Shocks

(Low-income countries = 100)

Sources: United Nations, Natural Disaster database; Polity IV Project; and IMF staff calculations.

Note: Based on events during 1970–2007. PICs = Pacific island countries.

1 Low-income countries only.

2 Change in the terms of trade larger than 10 percent.

3 Defined as a deterioration by three points or more in the political stability index (Polity index) from Marshall and Jaggers (2009), complemented with country information.

Vulnerability

Reliance on aid and remittances to finance structural trade deficits remains a key vulnerability (Figures 2.16 and 2.17). Small domestic markets, coupled in most cases with poor resource endowments, result in large trade deficits. The Asia and Pacific small states rely heavily on imports given the shortage of arable land. Most PICs are net importers of energy and food, and they also import capital goods because of their dependence on imported technologies and other consumer goods.

Figure 2.16Asia and Pacific Small States: External Grants, 2014

(Percent of GDP)

Sources: IMF, World Economic Outlook database; and IMF staff calculations.

Note: PICs = Pacific island countries.

Figure 2.17Asia and Pacific Small States: Current Account Balance Excluding Grants

(Percent of GDP, 2005–14 average)

Sources: IMF, World Economic Outlook database; and IMF staff calculations.

Note: PICs = Pacific island countries.

Large official development assistance flows kept debt levels in check for most PICs until recent years (Figure 2.18). But since the global financial crisis, debt levels have increased, in part because of the need for countercyclical fiscal support and partly because of new borrowing from Asia’s emerging markets. Fiscal space is currently limited for the Asia and Pacific small states with high public debt, which narrows the scope for countercyclical policies should a cyclical slowdown materialize. As of November 2015, according to the debt sustainability analysis for low-income countries, which applies to 10 small states in the Pacific, based on the latest IMF Article IV staff reports, only one was at low risk of debt distress (Timor-Leste). Four were at high risk of debt distress (Kiribati, Marshall Islands, Micronesia, Tuvalu) and five at moderate risk (Bhutan, Samoa, the Solomon Islands, Tonga, Vanuatu).

Figure 2.18Asia and Pacific Small States: Public Debt, 2014

(Percent of GDP)

Sources: IMF, World Economic Outlook database; and IMF staff calculations.

Note: PICs = Pacific island countries.

The literature presents different indices of vulnerability to shocks. The Becker index (see Chapter 9) provides a vulnerability ranking based on different dimensions of vulnerability (such as small population, volume of arable land, and distance). The analysis also shows that using gross national income (GNI) per capita to determine the income status of small states can be misleading when the population is very small and dispersed. This is because a much higher proportion of income in microstates covers government fixed costs, such as establishing institutions and providing public services, especially in countries composed of scattered islands. Per capita indicators therefore tend to overstate the economic conditions of microstates. Because of high fixed costs and distance from the rest of the world, the effective purchasing power of these states is actually quite low, despite a not-so-low GNI per capita. Similar vulnerability indices have been developed by Briguglio (Chapter 3) and the Commonwealth Secretariat (Easter, Atkins, and Mazzi 2000).

Volatility

The small states of the Asia and Pacific region face greater volatility than other small states in GDP growth per capita, changes in the terms of trade, aid, current account balance, and revenue, as the following shows:

  • GDP per capita—During 1990–2010, the volatility of GDP per capita (Figure 2.19) was higher in Asia and Pacific small states—especially the microstates, which are all PICs—than in other small states. Tuvalu experienced the highest variability among the PICs, while Timor-Leste and Maldives faced higher GDP volatility than other small Asian states. Consistent with the literature on the negative impact of output volatility on growth, higher output volatility was associated with lower economic growth during 1990–2010 in Asia and Pacific small states and a lower quality of governance, after controlling for other variables (Figures 2.20 and 2.21).
  • Terms of trade, aid, and current account balance volatility—The terms of trade in the Asia and Pacific small states during 1990–2014 were more volatile than in other small states. Aid flows were also more volatile, especially to the microstates. Over the last 20 years, this volatility reflected a drop in assistance from traditional European donors and the emergence of Australia as the largest aid provider in the Pacific. In the microstates, the greater aid volatility may also reflect the fact that aid flows generally finance specific one-off projects. The volatility of terms of trade and aid has resulted in greater current account volatility (Figure 2.22).
  • Revenue volatility—Revenue volatility is higher in the Asia and Pacific small states, especially the microstates, than in other small states (Figures 2.23 and 2.24, and see Box 2.1). The main source of volatility in the region’s microstates is nontax revenues, particularly fishing license fees, which represent about 40 percent of their revenues. Managing revenue volatility is a major challenge for the Asia and Pacific small states as such volatility can foster fiscal policy procyclicality (that is, expansionary fiscal policy during upturns and contractionary policy during downturns). Indeed, fiscal policy appears to have been procyclical in many Asia and Pacific small states in recent years. Only five out of 13 countries have adopted a multiyear budget framework to help smooth the expenditure path over the medium term. And only one, Timor-Leste, has a fiscal rule and a stabilization fund to manage the volatility of fiscal revenue and ensure intergenerational equity in the distribution of earnings from its natural resources.

Figure 2.19Asia and Pacific Small States: Volatility of Real GDP Growth per Capita, 1990–2014

Sources: World Bank, World Development Indicators; and IMF staff calculations.

Figure 2.20Asia and Pacific Small States: Real GDP per Capita Volatility and Growth, 1990–2013

Sources: World Bank, World Development Indicators; IMF, World Economic Outlook database; and IMF staff calculations.

1 Volatility measured as the five-year backward-looking standard deviation of real GDP per capita growth.

Note: PICs = Pacific island countries.

Figure 2.21Asia and Pacific Small States: Volatility of Real GDP per Capita Growth and Governance, 1990–2013

Sources: World Bank, Worldwide Governance Indicators; and IMF staff calculations.

1 Controlling for inflation and terms-of-trade volatility.

2 Small values represent a low level of government effectiveness.

Figure 2.22Asia and Pacific Small States: Volatility of GDP Growth, Terms of Trade, Current Account Balance, and Aid, 1990–2014

Sources: IMF, World Economic Outlook database; World Bank, World Development Indicators; and IMF staff calculations.

Note: represents the median. The boxes represent 50 percent of the observations, between the 25th and 75th percentiles. PICs = Pacific island countries.

1 Weighted terms of trade indicates the changes in the prices of exports and imports weighted, respectively, by the share of exports and imports in GDP.

Figure 2.23Asia and Pacific Small States: Fiscal Volatility, 1990–2014

Sources: IMF, World Economic Outlook database; World Bank, World Development Indicators; and IMF staff calculations.

Note: = median. The boxes represent 50 percent of the observations between the 25th and 75th percentiles. PICs = Pacific island countries.

Figure 2.24Asia and Pacific Small States: Procyclical Bias in Fiscal Policy, 2005–10

Source: IMF staff calculations based on World Economic Outlook database.

Box 2.1.Special Challenges Facing Pacific Island Microstates

Pacific island microstates face several special challenges, including:

  • More volatility—Microstates face more volatility in their GDP growth, revenue, aid, terms of trade, and current accounts relative to the rest of the Asia and Pacific small states and other small states outside the region.
  • Climate change—Rising sea levels are a big threat for Kiribati, Marshall Islands, and Tuvalu, and individual countries cannot internalize the costs of climate change. And because development spending is sometimes redirected to building seawalls and other climate-change mitigation, it may crowd out other project-financing aid unless the aid envelope expands substantially.
  • High aid dependency—Pacific island microstates depend heavily on aid to finance their large external and internal imbalances and their development needs. The expiration of grants under the Compact of Free Association agreements with the United States in 2023/24 will create both fiscal and external difficulties for Marshall Islands, Micronesia, and Palau if they fail to implement reforms to achieve self-sufficiency.
  • Fragility—Kiribati, Marshall Islands, Micronesia, and Tuvalu are classified as fragile states.1
1IMF (2015). The other Asia and Pacific small states in fragile situations are the Solomon Islands and Timor-Leste.

Understanding Growth and Performance

As a result of these factors, real GDP per capita of PICs is among the lowest of the small states (Figure 2.25). Since 1990, real GDP per capita in purchasing-power-parity terms in PICs has increased less than 25 percent, compared with 45 percent in the Eastern Caribbean Currency Union and more than 30 percent in small states (IMF 2013a, 2013b). PICs have not been able to benefit from growth in Asia’s emerging market economies, where GDP has increased by about 120 percent since 1990.

Figure 2.25Asia and Pacific Small States: GDP per Capita, 2014

(U.S. dollars)

Sources: IMF, World Economic Outlook database; and World Bank, World Development Indicators.

Data on income per capita show a similar pattern (Figure 2.26). During 1990–2010 income per capita in purchasing-power-parity terms in PICs grew by 77 percent, compared with 130 percent in the Eastern Caribbean Currency Union and less than 85 percent in small states. Income per capita in Asia’s emerging market economies grew by over 250 percent during the same period.

Figure 2.26Asia and Pacific Small States: GNI per Capita, 2013

(U.S. dollars)

Source: World Bank, World Development Indicators.

Note: For The Bahamas and Barbados, data are as of 2012. For Djibouti, data are as of 2009.

As of 2013, the average GNI per capita for PICs was one-third the average income of Caribbean countries. While GNI per capita in Tuvalu and to a lesser extent Marshall Islands and Micronesia appears relatively high, it overstates public spending capacity in these countries. In Tuvalu, for example, GNI exceeds GDP by 60 percent because of sizable government investment income from its sovereign trust fund, which has its assets invested abroad.5

In Tuvalu, however, much of the government investment income cannot be spent because the multilateral agreement governing the country’s trust fund stipulates that its real value, indexed to Australian inflation, be maintained. This places limits on the use of earnings for budget support. The inflation component of earnings is some two-thirds of total earnings, or about 10 percent of GNI; this is the amount needed every year to maintain the value of the fund constant in real terms. Marshall Islands and Micronesia are bound by a similar bilateral agreement with the United States governing the management of their trust funds until 2023/24.

PICs seem to be stuck on a low-growth path. Growth in these countries has been weak over the last two decades, and even more so relative to other small states (Figure 2.27). Because of their demographics, the underperformance of PICs, in per capita terms, is also more striking.

Figure 2.27Asia and Pacific Small States: Real GDP per Capita Growth

(Percent, 1990–2014 average)

Sources: IMF, World Economic Outlook database; and World Bank, World Development Indicators.

Note: PICs = Pacific island countries.

While PICs have done slightly better than comparators during the recent business cycle, growth rates remain quite low, especially among the net commodity importers. Strong linkages with resilient economies in the region (Australia and, to a lesser extent, Asia’s emerging markets) helped cushion the downturn in all PICs during the global financial crisis.

Since then, some Asia and Pacific small states have made progress in rebuilding policy buffers, but they need to do more (see Chapter 6). Their reserve position, on balance, has improved relative to 2004–07, but more than half of the PICs emerged from the crisis with somewhat less comfortable fiscal buffers from higher debt and larger fiscal deficits than before the crisis.

Econometric Analysis: Growth Determinants in Asia and Pacific Small States

Our econometric analysis confirms that PICs have underperformed relative to their peers (Table 2.4). After controlling for some standard variables that explain GDP growth per capita, PICs suffer a disadvantage in GDP growth per capita of about 2 percentage points, compared with an average small state.

Table 2.4Determinants of Real GDP per Capita Growth
Model 1Model 2Model 3Model 4Model 5Model 6
Small states−0.0126***−0.0098**−0.0105**−0.0084*−0.0070−0.0066
PICs−0.0197**−0.0161
Asia and Pacific small states−0.0111−0.010
Oil exporters−0.0150**−0.0149***−0.0150***−0.0167***−0.0163***−0.016***
OECD−0.0094**−0.0094**−0.0095**−0.0085*−0.0087*−0.0087**
Openness0.0084***0.0079***0.0081***0.0085***0.0081***0.0082***
Initial GDP per capita−0.0017***−0.0018***−0.0018***−0.0017***−0.0018***−0.0017***
GDP volatility−0.4184***−0.4160***−0.4178***−0.4206***−0.4183***−0.4200***
Education0.00640.00420.00540.00860.00640.0077
Debt-to-GDP ratio−0.0089***−0.0092***−0.0091***−0.0088***−0.0092***−0.0090***
Government-consumption-−0.0913***−0.0811***−0.0876***−0.0939***−0.0852***−0.0905***
to-GDP ratio
Distance−0.0011*−0.0009−0.0011*
Constant0.0565***0.0583***0.0574***0.0575***0.0587***0.0581***
Observations1,7411,7411,7411,7411,7411,741
Source: Authors’ calculations.Note: Panel regressions, 1990–2010. All regressions include a full set of regional dummies. The dependent variable is the real GDP growth per capita. The estimation period starts in 1990 because of a lack of data for many PICs soon after independence. OECD = Organisation for Economic Co-operation and Development; PICs = Pacific island countries.*p < 0.1, ** p < 0.05, *** p < 0.01.
Source: Authors’ calculations.Note: Panel regressions, 1990–2010. All regressions include a full set of regional dummies. The dependent variable is the real GDP growth per capita. The estimation period starts in 1990 because of a lack of data for many PICs soon after independence. OECD = Organisation for Economic Co-operation and Development; PICs = Pacific island countries.*p < 0.1, ** p < 0.05, *** p < 0.01.

All variables have the expected sign. Trade openness and a well-educated population have a positive impact on real GDP growth per capita, while public debt, GDP volatility, and government consumption do not. High government consumption crowds out productive investment. Our analysis shows that, while small states have grown 1¼ percentage points less than big states (model 1 in Table 2.4) after controlling for other variables, PICs have grown by 3 percentage points less than non-small states (model 2)—reflected in the sum of the coefficients of the PIC and small states dummies.

Our econometric results show that the geographic disadvantage of PICs undermines their growth performance. Once distance is included in the regression, the dummies for the PICs and other small states become insignificant (model 5). This suggests that distance is a key variable in explaining the difference in growth performance in small states—especially the PICs—even after controlling for other factors. Remoteness is proxied by distance to the closest continent and the coefficient has the expected negative sign. This result is in line with other studies (see Chapter 4). The Asia and Pacific small states as a whole have also underperformed relative to the average small states, but this difference is not statistically significant (models 3 and 6). Finally, higher fixed government costs, capacity constraints, less openness, and higher GDP volatility relative to other small states help explain the difference in growth performance.

Further econometric analysis shows that Asia and Pacific small states are indeed different from other small states. To quantify the importance of different growth determinants of PICs relative to comparators, we regressed each explanatory variable used in Table 2.4 on the same set of regional dummy variables as well as on the dummies for small states and PICs. Compared with an average small state, PICs have lower initial income, less openness, lower education, and lower debt (as expressed by the negative sign of the coefficients of the PIC dummy in Table 2.5), but they have greater GDP volatility and higher government consumption, as expressed by the positive sign of the coefficients of the PIC dummy in the same table.

Table 2.5Pacific Island Countries: Growth Advantages and Disadvantages
Dependent Variable/ Independent Variables1Initial Real GDP per CapitaGDP VolatilityOpennessEducationDebt-to-GDP RatioGovernment-Consumption-to-GDP RatioDistance
Pacific island countries−2.3030.001−0.279−0.130−0.1130.1673.102
Small states−0.086−0.0020.3560.1800.0090.0483.182
Source: Authors’ calculations.Note: OECD = Organisation for Economic Co-operation and Development.

All regressions include, in addition to Pacific island countries and small states, a full set of regional dummies, dummies for the OECD, and dummies for oil exporters.

Source: Authors’ calculations.Note: OECD = Organisation for Economic Co-operation and Development.

All regressions include, in addition to Pacific island countries and small states, a full set of regional dummies, dummies for the OECD, and dummies for oil exporters.

Combining the results of Tables 2.4 and 2.5, we can disentangle the relative impact of each determinant in explaining growth in the PICs relative to other small states. For example looking at model 4 in Table 2.4, PICs’ lower initial income has a positive effect on growth. Based on the convergence hypothesis we found in the regression, the lower initial income has allowed PICs to grow about ½ percentage point (= –2.3* – 0.0017) faster than an average small state. However, this positive factor, together with the lower debt level of the PICs relative to other small states, which has increased their growth by about 0.1 percentage point (= –0.113* – 0.0088), has been negatively offset by other factors that have been detrimental to their growth performance. These include lower education, greater distance, higher government consumption relative to GDP, less openness, and high GDP volatility. For example, higher government consumption relative to GDP has a large negative growth effect for the PICs (0.167* – 0.0939 = –1.6 percentage points). Table 2.6 shows the same exercise for all Asia and Pacific small states.

Table 2.6Asia and Pacific Small States: Growth Advantages and Disadvantages
Dependent Variable/ Independent Variables1Initial Real GDP per CapitaGDP VolatilityOpennessEducationDebt-to-GDP RatioGovernment-Consumption-to-GDP RatioDistance
Asia and Pacific small states−1.820.002−0.403−0.14−0.2230.1562.098
Small states−0.094−0.0020.4220.1930.0520.0373.144
Source: Authors’ calculations.Note: OECD = Organisation for Economic Co-operation and Development.

All regressions include, in addition to Asia and Pacific small states and small states, a full set of regional dummies, dummies for the OECD, and dummies for oil exporters.

Source: Authors’ calculations.Note: OECD = Organisation for Economic Co-operation and Development.

All regressions include, in addition to Asia and Pacific small states and small states, a full set of regional dummies, dummies for the OECD, and dummies for oil exporters.

Policy Implications: How to Raise Growth Potential and Enhance Resilience

Decisive policy measures by the governments of small states in the Asia and Pacific region can go a long way toward addressing the challenges they face. Given their high vulnerability to external shocks and still low potential growth, these countries should continue to rebuild policy buffers in a way that reinforces efforts to implement growth-enhancing reforms. This could be done by:

  • Strengthening domestic revenue mobilization to support the rebuilding of policy buffers. Revenue compliance is extremely challenging to enforce, especially in widely scattered islands. Further progress in strengthening revenue collection, including by streamlining and simplifying existing tax and customs regimes with technical assistance provided by development partners, would help create fiscal space to meet critical development spending needs.
  • Improving the composition of public spending in education, health, and infrastructure. This will be essential for fostering inclusive growth. Public investment in infrastructure could help “crowd in” private investment, thereby promoting more broad-based growth, including by attracting foreign direct investment and stimulating more tourism. Increasing investment in education would also raise potential growth.
  • Sound structural policies to enhance long-term resilience to shocks and boost growth potential. Implementing growth-oriented structural reforms that enhance the business environment can boost investor confidence and private sector growth. The Asia and Pacific small states have enormous untapped marine resources and further efforts are needed to properly leverage and manage them.
  • Strengthening institutions and improving governance. This should be a key part of the reform agenda of governments and the capacity-building programs of development partners. Bolstering public institutions, particularly through public finance management reforms, would also improve expenditure efficiency. Strengthening public finance by introducing a multiyear budget framework would help bring about realistic fiscal plans and guard against procyclical policies. A multiyear fiscal framework built around simple fiscal anchors could also contribute to a better balance between rebuilding buffers and allocating sufficient budget resources for priority needs. From a political economy standpoint, this would also help build consensus on the appropriate sequencing of development projects and contain spending pressures in the near term. It would also help to better calibrate the pace of spending by taking capacity constraints into account (see Chapter 10).

Scope exists for increasing competition in the banking sector, but financial deepening also requires the development of nonbank institutions. These include finance companies, foreign exchange dealers, and microcredit institutions that have the potential to be competitive, apart from the main commercial banks. Financial-inclusion initiatives, such as lowering the cost of remittances and mobile phone banking, can also help foster private sector development.

Regional solutions to common problems should continue to be pursued. This approach can help individual countries mitigate the challenges associated with small size and high dispersion, for example, by increasing economies of scale through cooperation. Regional approaches can encourage the alignment of regulations and laws across the Pacific, lower transaction costs, and reduce the need for country-specific knowledge on regulatory approaches. They can also promote regional integration and the exchange of knowledge, best practices, and experience. Regional solutions to natural disaster risk insurance should be pursued, and a start has already been made in five PICs.6

Key sectors of common interest include fisheries, information and communication technology, and aviation safety. Progress has been made in the fishery sector through the Nauru Agreement Concerning Cooperation in the Management of Fisheries of Common Interest to increase the bargaining power of license-issuing countries and enhance regional actions to stop illegal fishing. Further collective efforts are required to remove barriers to labor and investment. The seasonal employment scheme opened to PICs and Timor-Leste, first introduced by New Zealand in 2006 and followed by Australia, is a successful case of enhanced integration with neighboring countries that has generated income opportunities and increased the skills of Pacific island workers in countries with labor shortages.

Further integration with the Asia and Pacific region through trade and investment should help raise growth potential. While the Pacific islands are geographically scattered and remote, their closest markets are among the most dynamic in the world. And the resilience of Australia and Asia’s emerging market economies in recent years has played an important role in helping the recovery of PICs.

References

    Asian Development Bank (ADB). 2012. Key Indicators for Asia and the Pacific.Manila: ADB.

    EasterChristopher D.Jonathan P.Atkins and SoniaMazzi. 2000. “A Commonwealth Vulnerability Index for Developing Countries: The Position of Small States.Economic Paper 40Commonwealth SecretariatLondon.

    • Search Google Scholar
    • Export Citation

    HaqueTobiasDavidKnight and DinukJayasuriya. 2012. “Capacity Constraints and Public Financial Management in Small Pacific Island Countries.Policy Research Working Paper 6297World BankWashington.

    • Search Google Scholar
    • Export Citation

    International Monetary Fund (IMF). 2013a. “Macroeconomic Issues in Small States and Implications for Fund Engagement.Board PaperInternational Monetary FundWashington. www.imf.org/external/np/pp/eng/2013/022013.pdf.

    • Search Google Scholar
    • Export Citation

    International Monetary Fund (IMF). 2013b. “Caribbean Small States: Challenges of High Debt and Low Growth.Board PaperInternational Monetary FundWashington. www.imf.org/external/np/pp/eng/2013/022013b.pdf.

    • Search Google Scholar
    • Export Citation

    International Monetary Fund (IMF). 2015. “IMF Engagement with Countries in Post-Conflict and Fragile Situations—Stocktaking.Board PaperInternational Monetary FundWashington. http://www.imf.org/external/np/pp/eng/2015/050715.pdf.

    • Search Google Scholar
    • Export Citation

    TumbarelloPatriziaEzequielCabezon and YiqunWu. 2013. “Are the Asia and Pacific Small States Different from Other Small States?IMF Working Paper 13/123International Monetary FundWashington.

    • Search Google Scholar
    • Export Citation

    World Bank Group2014. Doing Business 2015.Washington: World Bank.

This chapter is based on IMF Working Paper 13/123 (Tumbarello, Cabezon, and Wu 2013). The authors thank Peter Allum, Luis Breuer, Ian Davidoff, Sergei Dodzin, Romain Duval, Tubagus Feridhanusetyawan, Craig Fookes, Leni Hunter, Sonali Jain-Chandra, Fazurin Jamaludin, Nghi Luu, Vance Martin, Koshy Mathai, Brad McDonald, Shanaka Peiris, Alexander Pitt, Jack Ree, Neil Saker, Werner Schule, Niamh Sheridan, Shiu Singh, Olaf Unteroberdoerster, Yongzheng Yang, Akihiko Yoshida, and the participants of the Small Islands Club at the IMF for their comments; and Hoe Ee Khor for his guidance throughout the project. Shari Boyce provided excellent editorial assistance.

1

The 13 comprise Bhutan, Fiji, Kiribati, Maldives, the Marshall Islands, Micronesia, Palau, Samoa, the Solomon Islands, Timor-Leste, Tonga, Tuvalu, and Vanuatu. With the exception of Bhutan, Maldives, and Timor-Leste, they are all PICs. The microstates are Kiribati, the Marshall Islands, Micronesia, Palau, Samoa, Tonga, and Tuvalu.

2

See Chapter 9 for a discussion of the importance of geographic isolation as a source of vulnerability and on the higher fixed costs of government in PICs.

3

See Chapter 6 for an assessment of the impact on PICs of external shocks from global and regional economies.

4

The Regional Assistance Mission to Solomon Islands, which commenced in 2003 following the period of civil conflict known as the “ethnic tensions” (1998–2003), started to scale down its operations in 2013.

5

Tuvalu’s trust fund was established in 1987 by several development partners. The trust funds of the Marshall Islands and Micronesia were established by the amended Compact of Free Association agreement between the United States and these countries, which came into force in 2004.

6

In January 2013 Japan, the World Bank, and the Secretariat of the Pacific Community teamed up with Marshall Islands, Samoa, the Solomon Islands, Tonga, and Vanuatu to launch the Pacific Catastrophe Risk Insurance Pilot (see Chapter 5).

    Other Resources Citing This Publication