Resilience and Growth in the Small States of the Pacific
Chapter

Chapter 7. Major Economic Shocks and Pacific Island Countries during the Global Economic Crisis

Author(s):
Hoe Khor, Roger Kronenberg, and Patrizia Tumbarello
Published Date:
August 2016
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Author(s)
Patrick Colmer and Richard Wood 

Small island states are vulnerable to external shocks and generally experience greater instability in exports and agricultural production than other developing economies.1 Pacific island countries (PICs) face the additional challenge of being highly vulnerable to natural disasters as well as to other economic shocks.2 These economies are very small and have limited domestic and regional markets. They are remote from large international markets, they have high transportation costs, and they are not able to benefit from economies of large-scale production. PICs generally have narrow resource, production, and export bases, and many are dependent on primary commodities. Most PICs are heavily dependent on imports, particularly of food and fuel. Limited infrastructure, high import dependence, minimal export diversification, and an inability to rapidly increase exports make some PICs particularly vulnerable to shocks that have adverse effects on world trade. Even resource-rich PICs, as large commodity exporters, are vulnerable to global demand and international price shocks.

Economic shocks can arise from many sources, including major terms-of-trade adjustments, a sharp fall in external demand and other foreign economic developments, balance of payments difficulties, exchange rate misalignments, economic policy mistakes, debt explosions, political crises, business collapses, and corruption.

The global economic difficulties from 2007 to 2012 imposed a number of complex interrelated external shocks on PICs—the first food and fuel price shock, the global financial crisis, the global recession, the banking crisis, and, more recently, further food and fuel price shocks and public debt crises.

This chapter reviews available statistics and literature to shed light on the effects of these shocks on PICs, and discerns policy lessons from these experiences. As one can imagine, disentangling the various channels of causality and the different effects of these multiple, time-contiguous shocks is extremely difficult. Importantly, the effects of natural disasters are also reflected in the economic data and, consequently, care is needed to distinguish these from the impact of external economic shocks. We focus mainly on Fiji, Papua New Guinea, Samoa, the Solomon Islands, Tonga, and Vanuatu, referred to as “selected PICs,” which were chosen on the basis of data availability. However, other PICs are included where reliable data are available. We assess the policy scope for increasing resilience to external shocks and offer policy recommendations.

The Overall Effects of Global Economic Shocks During 2007–11

Effects on GDP

As is well documented,3 emerging market and developing economies generally fared better than industrialized countries during the global financial crisis, and this was also the case for the PICs. As Figure 7.1 shows, the economic slowdown in selected PICs owing to the global shocks arrived later and was shallower than the rate of slowdown experienced in the group of emerging market and developing economies. Compared to these economies, the recovery by selected PICs appears to have been slow in 2010, but it improved in the following year.

Figure 7.1Real GDP in Developing and Advanced Economies and PICs, 2006–11

(Percent change)

Source: IMF, World Economic Outlook database.

Note: PICs = Pacific island countries. Selected PICs are Fiji, Papua New Guinea, Samoa, the Solomon Islands, Tonga, and Vanuatu.

Figure 7.2 illustrates that the combined global economic shocks experienced during 2007–11 appear to have had no substantial negative impact on growth in Papua New Guinea, the Solomon Islands, and Vanuatu. During this period, output growth in Papua New Guinea was assisted by strong investment growth and fiscal spending. In the Solomon Islands, growth rebounded strongly in 2010 because of high demand for logging, strong logging prices, and increased copra production. Vanuatu was cushioned by strong tourism and investment growth and increased copra production. These countries reported relatively high average annual growth rates over the four years to 2011: 7.0 percent for Papua New Guinea, 4.2 percent for the Solomon Islands, and 3.9 percent for Vanuatu. In contrast, Fiji, Samoa, and Vanuatu experienced significant disruptions to their economic performance, going from annual average growth rates of 3.8 percent, 2.5 percent, and 8.5 percent, respectively, during 2000–07 to negligible growth or contraction in 2008–11.

Figure 7.2Real GDP in Selected PICs, 2006–11

(Index, 2006 = 100)

Source: IMF, World Economic Outlook database.

Note: PICs = Pacific island countries; PNG = Papua New Guinea.

The Pacific region is highly vulnerable to natural disasters and political disturbances.4 Samoa, the Solomon Islands, and Tonga suffered from a major tsunami in 2009; the physical damage costs were estimated at more than 10 percent of GDP for Samoa alone (IMF 2010). Kiribati and Tuvalu continue to suffer from climate challenges, including Tuvalu’s severe drought in September and October 2011, for which Australia and New Zealand provided freshwater and desalination units.

Fiji also suffered the effects of Cyclone Tomas in March 2010, with extensive damage to homes and infrastructure, and severe flooding in January 2012. Cane production losses from the same floods were 300,000 tons of raw sugar with a revenue worth F$27 million (ANZ 2012a).

The real output levels of a number of PICs were relatively resilient during the global crisis (Figure 7.2). In contrast, the smaller states, reviewed in Box 7.1, suffered greatly, experiencing substantial falls in real output.

Box 7.1.External Shocks and the Pacific Microstates

We examine how the Pacific microstates fared relative to Pacific island countries (PICs) as a whole during the global economic crisis. The selected microstates are the Cook Islands (population 15,529), Kiribati (100,835), Marshall Islands (54,439), Nauru (9,976), Niue (1,479), Palau (20,518), and Tuvalu (11,149).

These countries are identified later in this chapter as the PICs that are most vulnerable to external food and fuel price shocks, based largely on their high import dependency. International food prices rose 57 percent from January 2007 to January 2008, and international fuel prices by 145 percent in the same period. During the second international price shock, food prices rose 68 percent from February 2009 to April 2011, and international oil prices rose 195 percent. Much of these international price gains were passed through to domestic inflation.

Apart from Palau, which has a relatively large tourism sector, the microstates have very low levels of foreign-sourced income. Nauru has negligible tourism or remittance receipts, and Tuvalu has negligible tourism or export receipts. As a consequence, it is not surprising that, among PICs, the microstates are among those farthest from “external balance.” And, in turn, they are the most heavily dependent on foreign aid.

Table 7.1.1 shows real output changes during the global economic crisis. It is clear that the microstates experienced substantial contractions in real GDP levels during 2007–09. By comparison, real GDP for “other PICs” increased by 4.8 percent in the same period. The microstates suffered large terms-of-trade shocks during the crisis, and, as Table 7.1.1 shows, their fall in exports was far greater than the fall in in “other PICs.” The case of Palau was made worse because of an “internal” shock—the failure of an airline company, which caused a contraction in the tourism sector. Palau’s GDP also fell due to the completion of construction projects and the curtailment of foreign investment. Tuvalu, meanwhile, suffered lower offshore earnings, including from Tuvalu Trust Fund distributions.

Table 7.1.1Percentage Change in Real GDP(From peak to trough)
Between 2007 and 2009
Cook Islands−7.0
Marshall Islands−3.2
Kiribati−1.8
Palau*−10.4
Tuvalu−2.2 (2008–10)
Nauru−18.1 (2008–09)
“Other PICs”+4.8
Sources: IMF data, except for Cook Islands and Nauru, which are based on data from the Asian Development Bank.

Financial years from 2006/7 to 2008/9.

Sources: IMF data, except for Cook Islands and Nauru, which are based on data from the Asian Development Bank.

Financial years from 2006/7 to 2008/9.

Inflation rates in the Pacific microstates were generally higher in 2008 than for “other PICs” (Figure 7.1.1), and averaged 12.4 percent in 2008. For “other PICs,” the average inflation rate in the same year was 9.5 percent, with five out of six “other PICs” recording inflation rates of below 12 percent. The implication here is that, as a consequence of the global financial crisis, the first food and fuel price hike, and the global economic recession, the export, output, and inflation performances of Pacific microstates were generally worse than for “other PICs.” This supports the supposition that these microstates are generally more vulnerable to external economic shocks than “other PICs.”

Figure 7.1.1Annual Inflation Rates in Pacific Microstates

(Percent)

Sources: Asian Development Bank (2011); and IMF, World Economic Outlook database.

Effects on Exports

The impact of weak global economic conditions on international trade was greater than the impact on global output. In 2009, real world output decreased by 0.7 percent, whereas real world trade flows fell by close to 11 percent (Bussiere, Ghironi, and Sestieri 2012). In light of this, it is not surprising that the major channel of disturbance to PICs has been through exports.5

Exports are very important to PICs, given their high dependence on imports, limited foreign capital inflows, and general balance of payments constraints. For the larger exporters (Papua New Guinea and the Solomon Islands), export receipts are a major source of budget revenues. In Papua New Guinea, revenues from mining and natural gas account for about 20 percent of government revenues. In the Solomon Islands, revenues from logging account for about 14 percent of government revenues.

Among the PICs, Fiji is a major exporter, with exports totalling 46 percent of GDP in 2009. The country has perhaps the region’s most diversified export base in terms of products and markets,6 and the country has benefited substantially from exporting over a long period. But exports are less than 15 percent of GDP in the smaller states of the Cook Islands, Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu.

Figure 7.3 shows that the value of exports for selected PICs fell by about 23 percent in 2009, recovering somewhat in 2010. For the microstates, export receipts fell about 25 percent between 2007 and 2010. In the advanced economies, export values contracted 20 percent between 2008 and 2009, but these declined only marginally in low-income countries as a group during the global financial crisis.

Figure 7.3Exports in High- and Low-Income Countries, PICs, and Microstates

(Index, 2006 = 100)

Sources: Asian Development Bank (2011); and World Bank, World Development Indicators database.

Note: OECD = Organisation for Economic Co-operation and Development; PICs = Pacific island countries. Selected PICs are Fiji, Papua New Guinea, Samoa, the Solomon Islands, Tonga, and Vanuatu.

The region’s largest commodity exporters (Papua New Guinea and the Solomon Islands) suffered substantial reductions in export values, driven by the decline in commodity prices in 2009. However, the strong rebound in prices in 2010 saw exports from Papua New Guinea returning to around 2008 levels, and exceeding previous highs in the Solomon Islands. The export performances of other PICs during the global financial crisis are shown in Table 7.1.

Table 7.1Decline in the Value of Exports during the Global Crisis
CountryChange in Exports (%) 2007–08Change in Exports (%) 2008–09Change in Exports (%) 2007–09
Cook Islands−16−25−38
Fiji22−162
Kiribati−23−22−39
Marshall Islands15621
Palau404
Papua New Guinea11−23−14
Samoa−259−19
Solomon Islands30−195
Tonga−25−4−29
Vanuatu12821
Source: Asian Development Bank.
Source: Asian Development Bank.

Table 7.2 indicates that, in 2010, Australia accounted for about 26 percent of exports from selected PICs. China and Japan together accounted for about 17 percent, while Europe accounted for about 4.5 percent of exports. The United States took only 2.5 percent of PIC exports. Figure 7.4 shows that PIC exports to Australia increased strongly over the past decade, while PIC exports to China and Japan increased far less rapidly.

Table 7.2Destination of Exports from Selected Pacific Island Countries (2010)
DestinationExports from Selected PICs as Percent of Their Total Exports
Australia25.8
China8.3
European nations4.4
Japan8.5
United States2.5
Source: Asian Development Bank.Note: The Pacific island countries selected are Fiji, Papua New Guinea, Samoa, the Solomon Islands, and Tuvalu.
Source: Asian Development Bank.Note: The Pacific island countries selected are Fiji, Papua New Guinea, Samoa, the Solomon Islands, and Tuvalu.

Figure 7.4Three Largest Export Markets for Selected Pacific Island Countries

(Millions of U.S. dollars)

Source: Asian Development Bank (2011).

Note: Selected Pacific island countries are Fiji, Papua New Guinea, Samoa, the Solomon Islands, Tonga, and Vanuatu.

The relatively strong economic expansion of Asia and Australia during the global recession provided direct demand for PIC exports, which partly cushioned the effects of the recession on the Pacific region. Australia’s demand for PIC exports has, in part, been buoyed by the strong Asia-Australia trade link. Assuming that any renewed global recession is largely confined to Europe, the “shock” effect of a new recession abroad on PICs will be smaller than would be the case if the PICs had larger export markets in Europe, rather than in Australia and China.

Effects on Remittances

For a long time, remittances have been an important source of income and foreign exchange for some PICs. Indeed, the contribution of remittance flows to output growth in the Pacific has been more than double that of the remittance flows to small island developing states in the Caribbean (Santos-Paulino 2011).

But as Figures 7.5 and 7.6 show, remittance flows to individual PICs vary considerably. Remittance flows are particularly important for Tonga (24 percent of GDP in 2010) and Samoa (25 percent of GDP in 2010). However, for a number of states, including the Melanesian states (Papua New Guinea, the Solomon Islands, Vanuatu), remittance flows are very small, reflecting limited migration or foreign work opportunities.

Figure 7.5Remittances in Selected Pacific Island Countries, 2006–11

(Index, 2006 = 100)

Source: World Bank, Prospects, Annual Remittances data.

Note: PNG = Papua New Guinea.

Figure 7.6Remittances in Selected Pacific Island Countries, 2006–10

(Percent of GDP)

Source: World Bank, World Development Indicators database.

Note: PNG = Papua New Guinea.

The value of remittances for Fiji fell 33 percent between 2006 and 2008, due primarily to international and domestic difficulties, before staging a recovery. For Tonga, remittances fell 29.4 percent between 2007 and 2009, largely reflecting Tonga’s heavy reliance on remittances from the United States, which went into recession in December 2007. For Samoa, remittances increased throughout the crisis. Papua New Guinea’s strong growth was from an extremely low base.

During the global economic crisis, remittances as a percentage of GDP remained relatively stable in most PICs, except for Tonga, where they fell. The principal sources of remittances to the Pacific are Australia, New Zealand, and the United States (Browne and Mineshima 2007). For Samoa, 73 percent of remittances derive from Oceania and 27 percent from North America. For Tonga, 50 percent of remittances derive from Australia and 48 percent from the United States (Migration Policy Institute 2011a, 2011b). The relative buoyancy of the Australian economy during 2006–10 worked to partly cushion the effects on PICs from declining remittances during the global economic crisis. In contrast, the prolonged recession in the United States, and the weakening in New Zealand, likely led to lower remittance flows to a number of PICs.

Effects on Tourism

While trade in physical goods declined sharply in many PICs during the global economic crisis, tourist and business visitor arrivals generally increased across the region (Figure 7.7). Tourism provides formal employment, and tourism receipts are an important source of income and foreign exchange in a number of PICs.7 Tourism receipts have historically accounted for about 60 percent of GDP in Palau and 50 percent in the Cook Islands. In Vanuatu, tourism accounts for almost 30 percent of GDP, and over 20 percent in Samoa and Fiji. Other small Pacific island states are more remote and have small tourism sectors.

Figure 7.7Tourism and Business in Selected Pacific Island Countries, 2006–10

(Visitor arrivals; index, 2006 = 100)

Source: World Bank, World Development Indicators database.

Note: PNG = Papua New Guinea. No 2010 data available for Samoa, the Solomon Islands, and Tonga; no 2009–10 data available for Papua New Guinea.

Tourist and business arrivals in most PICs increased during the global economic crisis, though they were subdued in Fiji and Samoa. In Palau, tourism receipts fell 17 percentage points during 2008 and 2009, largely because of the bankruptcy of an airline from Taiwan Province of China. Civil unrest and extreme weather events can also have a substantial influence on tourism in the Pacific islands.

At face value, an increase in visitor arrivals during a global crisis may appear somewhat counterintuitive. However, about 36 percent of all tourist and business visitor arrivals in PICs come from Australia (Pacific Islands Trade and Investment Commission 2008), which experienced relatively strong growth during this period. Consequently, as Australia was quite buoyant during the global recession, and the Australian dollar was particularly strong,8 tourist and business visitor arrivals to PICs were stronger than might otherwise have been the case.

Effects on Financial Systems

Many of the Pacific island microstates covered in this chapter were largely immune from the worst direct monetary transmission impacts of the global financial and debt crises. This reflected the fact that Pacific island financial markets and banks are small, largely domestically funded, and not strongly or directly integrated into or exposed to international financial markets.

However, Kiribati was affected by large falls in the value of its wealth and pension funds—the Revenue Equalization Reserve Fund and the Kiribati Provident Fund. The value of assets of the former fund fell 20 percent in 2008 due to the global financial crisis and drawdowns to finance the budget deficit. In Tuvalu, the value of its trust fund fell about 13 percent for the same reasons. Marshall Islands, Micronesia, and Palau also have trust funds with assets invested offshore, and were also negatively impacted, including through lower earnings flows.

Effects on Aid Flows to the Pacific

Aid flows into many PICs have historically been a more important source of finance than remittances and foreign direct investment. The small PICs are more dependent on aid flows than the small island developing states in Africa and the Caribbean (Santos-Paulino 2011). Aid in the form of grants represents 74 percent of GDP in Tuvalu, 69 percent in Kiribati, 45 percent in Marshall Islands, 34 percent in Micronesia, and 24 percent in Palau (Hezel 2012).

The global financial crisis, the global economic recession, and ongoing public debt problems in Europe, Japan, and the United States may have implications for the flow of foreign aid to developing economies and small island states.

Dabla-Norris, Minoiu, and Zanna (2010) conclude that severe economic downturns in donor countries have historically triggered persistent declines in aid disbursement, and that bilateral aid flows decline more sharply in the aftermath of large output contractions in donor countries when they have higher public debt burdens. In particular, the United States, Japan, and euro area countries have been experiencing output weakness and relatively high levels of public debt. Together, these countries account for about 32 percent of aid flows to the Pacific.

Australia is the major bilateral aid donor to the PICs, and the Pacific will continue to be a priority for the Australian aid program. As Figure 7.8 shows, Australia provided about 45 percent of all aid resources in the Pacific in 2010 and provides more than 60 percent of all donor assistance to Melanesia. Some 95 percent of official development assistance to the Pacific is in the form of grants, rather than loans.

Figure 7.8Gross Official Development Assistance to Pacific Island Countries, 2000–10

(Millions of U.S. dollars, left scale; percent, right scale)

Source: Organisation for Economic Co-operation and Development, aid statistics.

Note: ODA = official development assistance; PICs = Pacific island countries.

Summary of Transmission Effects

Global economic difficulties hurt PICs mainly through a widespread decline in exports. Remittance flows fell substantially during 2006–09, and by about 30 percent in Fiji and Tonga. In some PICs, the difficulties reduced the values of trust funds. The global economic crisis hit output and the inflation performances of the smaller, fragile, and most vulnerable PICs in particular.

A Buffer Role for Reserve and Exchange Rates

Foreign Currency Reserves

Table 7.3 shows actual and target levels of foreign exchange reserves measured as months of import cover over recent years. Reserves declined in a number of PICs during 2008 and into 2009, suggesting that they played a cushioning role in the face of external shocks, particularly when nominal exchange rates generally remained fixed.

Table 7.3Official Foreign Currency Reserves(Months of import cover)
Reserve Target at 2011End-2007End-2008200920102011
Fiji54.42.91.3 (Apr)3.4 (Apr)5.1 (Oct)
Papua New GuineaNo target13.010.99.7 (Mar)10.5 (Jun)10.5 (Jun)
Samoa44.74.45.1 (May)7.0 (May)6.1 (Aug)
Solomon Islands33.72.53.2 (May)6.2 (May)8.5 (Sep)
Tonga3–44.44.84.6 (May)7.1 (Jun)8.2 (Oct)
Vanuatu47.05.85.2 (Mar)5.9 (Feb)6.5 (Oct)
Sources: ADB (2009b, 2009c, 2010, 2011); Central Bank of Samoa (2009); National Reserve Bank of Tonga, Monetary Policy Statement, 2009 and later; Reddy (2009); and Ministry of Finance and National Planning, Tonga (2009).
Sources: ADB (2009b, 2009c, 2010, 2011); Central Bank of Samoa (2009); National Reserve Bank of Tonga, Monetary Policy Statement, 2009 and later; Reddy (2009); and Ministry of Finance and National Planning, Tonga (2009).

Reserves fell substantially below target levels in Fiji and less sharply in the Solomon Islands to cushion these economies in 2008. But the result was that both were threatened by balance of payments crises—and Fiji subsequently raised its reserve target from three months of import cover to five (the new target was reached in September 2011). Reserves in the Solomon Islands recovered comparatively quickly.

During August and September 2009, the IMF allocated new special drawing rights9 to member countries, including the PICs, equivalent to some US$370 million,10 effectively raising their holdings of foreign currency reserves. Import compression, higher remittances, and increased tourism receipts contributed to the buildup in reserves during 2009 in some PICs. Most of these countries continued to build foreign reserves after the global recession. The rebound in commodity prices assisted this in Papua New Guinea and the Solomon Islands, and substantial development assistance flows helped Samoa and Tonga in particular strengthen their reserves.

Fiji, Samoa, the Solomon Islands, and Tonga had a higher level of reserves in 2011 than at the end of 2007, and with these larger buffers they were better placed to withstand future economic shocks.

Exchange Rate Overvaluation

PICs use different exchange rate systems (Table 7.4), and the nature of these differences would have had some implications for the manner and extent to which the effects of the global crisis were transmitted to these countries.

Table 7.4Exchange Rate Regimes1
Fixed (peg)Fiji, Samoa, Solomon Islands, Tonga, Vanuatu
Dollarization
Australian dollarKiribati, Nauru, Tuvalu
New Zealand dollarCook Islands, Niue, Tokelau
U.S. dollarMarshall Islands, Micronesia, Palau
Managed floatingPapua New Guinea
Sources: National authorities; and authors’ compilation as of March 2012.

For Samoa and Tonga there is a margin, a horizontal band, in the pegged arrangements that provides the opportunity for the authorities to move the exchange rate within the band. For Samoa, the margin is ±2 percent, while for Tonga the margin is ±5 percent per month around the central value.

Sources: National authorities; and authors’ compilation as of March 2012.

For Samoa and Tonga there is a margin, a horizontal band, in the pegged arrangements that provides the opportunity for the authorities to move the exchange rate within the band. For Samoa, the margin is ±2 percent, while for Tonga the margin is ±5 percent per month around the central value.

Figure 7.9 shows that, as a result of the global financial crisis, the real effective exchange rates of a number of PICs became overvalued in 2009.11 While this did not persist into 2010 in some countries, the overvaluation may nonetheless have damaged trade performance, particularly in 2009, when trade volumes collapsed. More recently, real exchange rates have appreciated in a number of countries, largely as a result of the higher inflation rates recorded in the Pacific than in major trading partner nations.12 As a consequence, some exchange rates became overvalued once again.

Figure 7.9Real Effective Exchange Rates in Selected Pacific Island Countries

(Index)

Sources: IMF, International Financial Statistics database; and Article IV Consultation Staff Reports.

Note: The descriptors for overvaluation are from the Article IV Consultation Staff Reports.

One question that arises from the currency overvaluation in some PICs in 2009 and more recently, is whether those countries with fixed exchange rate regimes would have been better able to cope with the series of external economic shocks if they had a system that allowed for greater exchange rate flexibility—or had made greater use of the existing scope for flexibility within their adjustment bands. This issue—the use of the exchange rate as a shock absorber—may become relevant depending on the magnitude and nature of future economic shocks.

The international evidence appears to suggest that, generally, developing economies with flexible exchange rate regimes are better able to absorb economic shocks—for example, external demand shocks, negative terms-of-trade shocks (Berg, Borensztein, and Mauro 2003), and natural disasters—and deal more effectively with high current account deficits and exchange rate risk13 than those with fixed exchange rates. However, empirical paradigms established by the experience of developing economies as a whole may not necessarily be applicable to Pacific micro-states (Imam 2010).

Vulnerability to International Food and Fuel Price Surges and Exchange Rates

Small island states are generally characterized by low levels of diversification in production and exports, and are thought to be highly vulnerable to adverse external price shocks. Consequently, adverse terms-of-trade shocks, particularly long ones, can lead to a substantial deterioration in their current account balances, which, in turn, increases national indebtedness.

The PICs most vulnerable to international food price hikes are mainly smaller, remote, high-import-dependent states with low export bases—in contrast to Papua New Guinea and the Solomon Islands, which produce most of their own food. The smaller PICs also have a relatively high dependence on imported food (Figure 7.10). However, when consideration is also given to the ability of PICs to pay for food imports and to the vulnerability of children and women (UNICEF 2011), many other small PICs are also highly vulnerable to international food price hikes.

Figure 7.10Proportion of Food Expenditure Accounted for by Imported Food

(Percent)

Source: Pacific Island Ministers of Agriculture and Fisheries (2008).

Note: Data for Nauru are not available, but the country’s dependence on imported food is high.

Most PICs are heavily dependent on oil for their energy needs, especially power generation and transportation. Intensity of oil use is more than 80 percent in the Pacific, with the Cook Islands, Kiribati, Nauru, the Solomon Islands, and Tonga relying almost exclusively on oil for their commercial energy requirements (ADB 2009a). The smaller PICs use more oil per citizen and are therefore generally more vulnerable to international fuel price hikes. The Asian Development Bank has noted that PICs are among the most vulnerable countries to fluctuations in crude oil prices (ADB 2009a). Figure 7.11 shows the vulnerability of various PICs to oil price movements.

Figure 7.11Oil Price Vulnerability, 2008

(Index)

Source: Asian Development Bank calculations.

Note: PNG = Papua New Guinea.

It seems likely that Kiribati, the Marshall Islands, and Nauru are highly vulnerable both to food and fuel price shocks. In 2008 surging international food and fuel prices contributed to increased domestic inflation across the Pacific region, lifting inflation rates for PICs from 2.5 percent to about 12 percent per year.

Exchange rate arrangements, local exchange rate developments, and the currency used to pay for purchases of imported food and fuel can be important determinants of the severity of international price increases for PIC economies.14 Generally those PICs with appreciating currencies during periods of global food and fuel price hikes have suffered less from rising domestic inflation than those with depreciating currencies. This pattern can be observed in Figures 7.12 and 7.13. Those countries with exchange rates tied to the depreciating U.S. dollar reported substantially higher imported fuel costs than those using the appreciating Australian and New Zealand dollars. However, the choice of exchange rate policies, anchors, and tying arrangements is, desirably, based on various longer-term considerations, including the pattern of trade and investment linkages, remittance and tourism sources, sources of aid, migration arrangements, and relative competitive advantages, rather than on shorter-term trends in exchange rates that may not be sustained and are unpredictable. It seems possible that the food and fuel price surge combined with exchange rate policies may have resulted in significant adverse effects on competitiveness and exports for some countries.

Figure 7.12Oil Prices in Selected Pacific Island Countries, 2002–12

(Index)

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

Note: Oil prices in U.S. dollars for Marshall Islands, Micronesia, and Palau; local currency for Vanuatu; Australian dollars for Kiribati, Nauru, and Tuvalu; and New Zealand dollars for the Cook Islands and Niue.

Figure 7.13Wheat Prices in Selected Pacific Island Countries, 2002–11

(Index)

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

Note: PNG = Papua New Guinea. Wheat prices are in the local currencies of Fiji and PNG; Australian dollars for Kiribati, Nauru, and Tuvalu; and U.S. dollars for Marshall Islands, Micronesia, and Palau.

Exchange Rates and Shocks Resulting from the Global Economic Recession

The global recession directly contributed to falling global demand, which affected some exports of the PICs. In some small Pacific island states, capacity is likely to be limited for rapid import substitution or for substantially increased exports in the short term. This is because of their narrow production bases, high export concentration and inflexible economic structures, high import dependence, low short-term trade elasticities, constrained external demand, and slow supply-side responsiveness. To the extent this is the case, the ability of a more flexible exchange rate regime to act as a shock absorber, and to cause export and import substitution production to increase in the short term, is likely to be limited.

However, looking beyond the short term to a time when foreign demand will no longer be so volume constrained, and resource allocation can be adjusted to take advantage of relative price changes, the devaluation that would be permitted by a more flexible exchange rate arrangement is likely to be more effective15 in raising foreign demand for exports from Pacific island states.16 This assumes, however, that the real devaluation is maintained.

There were two major external economic shocks in quick succession: the food and fuel price shock and the global recession. To have addressed both of these shocks using the exchange rate could have created tensions between the objective of offsetting higher inflation due to rising food and fuel prices (by currency appreciation) and the objective of stimulating exports to address falling global demand (by currency depreciation).

Monetary, Fiscal, and Resource Allocation Policy Response

Monetary Policy: Shocks and Responses

The monetary authorities in most PICs adopted a generally cautious approach to policy management during the global economic crisis. In line with the charters of PIC central banks, the principal objectives of monetary policy during much of this period were to maintain an adequate level of foreign currency reserves and to contain and lower inflation. The scope to attempt a countercyclical monetary stimulus to lift economic activity—an objective not usually listed in the central bank charters of these small island states—was largely precluded in 2008 and into 2009 by the need to address the higher-priority problems of declining reserves and high inflation.

During the global economic crisis, foreign currency receipts contracted and reserves fell in a number of PICs. As a result, the balances of exchange settlement accounts also fell and, in turn, fewer funds were injected into the banking system and demand deposits, resulting in lower liquidity. Injecting liquidity when reserves fell, and draining off excess liquidity when it accumulated, proved to be a substantial function of monetary policy in PICs during the global economic crisis.

The management of interest rates also contributed to economic adjustment during the global economic crisis.17 However, the relatively large gap between lending and borrowing interest rates in some PICs complicates the task of using a policy interest rate to impact inflation and smooth economic cycles, encourage saving, influence private investment, and address large current account deficits.

With constrained transmission mechanisms,18 macroeconomic variables may not be strongly responsive to changes in monetary policy. It follows that the ability to quickly offset the effects of the global economic recession on economic activity with countercyclical monetary policy is likely to be limited, particularly as monetary policy was already busy addressing elevated inflation rates.

During 2011 headline inflation picked up as a result of the higher food and energy prices. Banking sector liquidity remained high across the region, reflecting healthy balance of payments outcomes and a more conservative approach to lending by commercial banks following the global financial crisis. Despite an increasingly strong case for the withdrawal of the stimulus of the past several years, several factors explain the cautious approach of PIC central banks toward tightening monetary policy. Headline inflation is not expected to rise much beyond current levels, with core inflation remaining within reasonable bounds, and private sector credit growth remains generally subdued. The healthy level of foreign exchange reserves in the region is also likely to have delayed the need to aggressively tighten monetary policy.

From a structural perspective, the PICs face enormous challenges in enhancing the effectiveness of monetary policy and the ability of monetary policy to deal with external economic shocks. Financial intermediation is low compared to other small island economies at a similar stage of economic development. Interbank lending is limited and secondary markets for government and central bank securities are mostly nonexistent. There is substantial banking sector liquidity, reflecting limited lending opportunities, though official interest rates remain quite low. Large subsistence sectors, shallow financial markets, limited private investment opportunities, sticky interest rates, limited financial arbitrage and oligopolistic commercial banking sectors also inhibit the effectiveness of monetary policy to respond to economic shocks.

Fiscal Policy: Shocks and Available Fiscal Space

At the beginning of the global economic crisis, public debt was already very high in Marshall Islands, Nauru, and the Solomon Islands, and for these countries there was judged to be no space for additional fiscal stimulus. By 2009 the Cook Islands, Kiribati, and Papua New Guinea had relaxed fiscal policy excessively in response to the global economic crisis (ADB 2009b).

From the beginning of the global economic crisis to 2011, fiscal balances have deteriorated in Samoa, Tonga, and Vanuatu. Figure 7.14 suggests that budget deficits in 2011 were clearly excessive in Kiribati and Samoa, and that public debt levels have deteriorated since the beginning of the global crisis. As of 2010 several countries had levels of public external debt that exceeded the IMF and World Bank threshold parameter of 30 percent of GDP (Table 7.5; IMF/World Bank 2004). And total public debt is excessive in some other PICs. The main implication from this is that the room for additional fiscal stimulus is currently limited in a number of countries.

Figure 7.14Net Government Lending and Borrowing, 2007–11

(Percent of GDP)

Source: IMF, World Economic Outlook database.

Note: PNG = Papua New Guinea.

Table 7.5Debt in Pacific Island Countries, 2010
CountryExternal Public Debt (Percent of GDP)1Total Gross Public Debt (Percent of GDP)2
Fiji955.6
Kiribati11.331.9
Papua New Guinea10.726.5
Samoa52.454.3
Solomon Islands19.928.1
Tonga36.642.8
Tuvalu3143.6
Vanuatu1620.2
Source: IMF Article IV Reports (2010–12).

Fiji represents actuals; Tonga represents preliminaries; Papua New Guinea, the Solomon Islands, and Tuvalu represent estimates; and Kiribati and Samoa represent projections.

Fiji and Tonga represent actuals; all others are estimates and projections.

Source: IMF Article IV Reports (2010–12).

Fiji represents actuals; Tonga represents preliminaries; Papua New Guinea, the Solomon Islands, and Tuvalu represent estimates; and Kiribati and Samoa represent projections.

Fiji and Tonga represent actuals; all others are estimates and projections.

Resource Allocation Policies

The food and fuel price hikes and the global economic recession have exposed resource allocation vulnerabilities in PICs. Clearly, broadening economic bases—where this is possible—would result in more diversified production and export structures, thereby creating potential for PICs to better withstand external economic and other shocks. Enhancing export capacity, and the diversification of exports and export markets, may therefore assist some countries to achieve greater internal stability during periods of economic shocks.

Some PICs are heavily dependent on imported food and fuel. Greater diversification in energy supplies and greater self-sufficiency in agriculture production could assist in reducing the adverse effects on domestic inflation and living standards created by surges in international food and fuel prices. Greater diversification of output and exports into service industries, including tourism, where feasible, may also assist PICs to become more resilient to external economic shocks.

Structural policies generally aimed at raising productivity are also likely to assist in generating scope for flexibility, lower production costs, improved competitiveness, and higher incomes. They also establish the basis for greater overall economic resilience in difficult times. Such policies would include addressing inefficiencies in state-owned enterprises, improving transport and communication links, progressively removing trade-distorting barriers, improving government service delivery, facilitating land reform and adopting improved agricultural techniques, greater deregulation, and encouraging greater domestic and overseas competition.

Conclusion

A number of PICs are experiencing relatively large macroeconomic imbalances, including excessive budget deficits, high public or external debt, and high current account deficits. Such macroeco-nomic imbalances may constrain the ability of these countries to respond to future economic shocks. Large budget deficits and high public debt constrain fiscal responses to shocks, and high current account deficits and high external debt imply greater vulnerability to adverse external shocks.

References

This chapter benefited from the contributions and comments of Michael Anderson, Nicole Elsmore, Siddharth Shirodkar, Sarjit Singh, Millie Soei, Curtis Stewart, and Sharon Traucki. The views are those of the authors and do not necessarily reflect those of the Australian Treasury.

See the United Nations Conference on Trade and Development (UNCTAD) webpage on Indicators Entering the Formulation of the Economic Vulnerability Index, http://unctad.org/sections/ldc_dir/docs/ldc_highlight001evi_en.pdf.

For example, see Santos-Paulino (2011). UNCTAD estimates that small island developing states are 34 percent more economically vulnerable than other developing economies.

For example, see the IMF’s September 2011 World Economic Outlook and Naudé (2011).

Since the 1950s, PICs have experienced more than 200 disaster events, affecting 3.5 million people and costing in excess of US$6.5 billion. Natural disasters are believed to hit small island states, which are least able to cope, relatively hard. Natural disasters can substantially lower exports for up to three years (Andrade da Silva and Cernat 2012). The World Bank (2006) reports that in Samoa the average disaster costs 46 percent of GDP. During 1972–2004, Fiji suffered annual losses of F$20 million per year from cyclones and storms. The Asian Development Bank (2007) reports that the earthquake and accompanying tsunami that hit the Solomon Islands in 2007 cost about 90 percent of the recurrent budget estimate. In Niue, damage costs from Cyclone Heta in 2004 exceeded the value of the country’s GDP by over five times. And in 1989 a series of cyclones in Vanuatu resulted in damage and economic losses amounting to twice the national income (Commonwealth Secretariat/World Bank 2000).

Care is required when assessing the impacts of falling recorded export volumes on individual PICs, as significant elements of export values (for instance, some significant part of mineral export earnings) may not always be received in these economies.

Among PICs, Fiji and Papua New Guinea have increased export diversification over the past two decades. Prospective liquefied natural gas exports in Papua New Guinea and mining exports in the Solomon Islands will further contribute to their export diversification. There has been little export diversification in other PICs in recent decades, and in some, increased export concentration has occurred (ANZ 2012b).

As with exports, care is required in interpreting the effects on PICs implied by tourism data. Significant elements of tourism receipts are held offshore, or are earned by foreign-owned hotels and airlines, and do not reach the island states.

The Australian dollar fell 17.3 percent against the U.S. dollar from September 2008 to January 2009, at the outset of the global economic crisis.

The special drawing right is an international reserve asset allocated by the IMF to its member countries. These are recorded as part of a country’s official foreign currency reserves and are readily convertible into foreign currency held by another IMF member.

Special drawing right allocations to PICs included Fiji (US$94 million), Kiribati (US$8.4 million), Marshall Islands (US$5.2 million), Micronesia (US$7.6 million), Palau (US$4.7 million), Papua New Guinea (US$183 million), Samoa (US$15.7 million), the Solomon Islands (US$14.6 million), Tonga (US$10.4 million), and Vanuatu (US$25.6 million).

Such assessments are based on information in IMF Article IV Staff Reports. Where no label is provided, the IMF does not appear to have expressed a concluded view on currency alignments.

The rise in the nominal exchange rates of Papua New Guinea contributed to a real appreciation of the currency during 2011. Nonetheless, a tendency may develop toward currency undervaluation in Papua New Guinea, based on the current level of the real effective exchange rate and prospective exports of liquefied natural gas (IMF 2011).

Floating exchange rate regimes force borrowers to confront the existence of exchange rate risk, thereby reducing unhedged foreign currency borrowing. See Cespedes, Chang, and Velasco (2004).

If a country is a net exporter of food and fuel (Papua New Guinea, for instance), some part of the observed rise in the real effective exchange rate during this period may not have reflected a loss of price competitiveness but, rather, an improvement in the terms of trade.

The November 2009 IMF Article IV Staff Report for the Solomon Islands suggests that, while the authorities are concerned about the low elasticity of imports, the historical experience suggests that exports are more responsive than imports to a devaluation of the currency, and that devaluation could, therefore, be a useful adjustment instrument. Round logs, which account for 70 percent by value, are sold predominantly on the basis of contracts transacted in U.S. dollars, and are not affected by changes in the Solomon Islands exchange rate (which is de facto pegged to the U.S. dollar).

There are few published studies on trade elasticities in PICs. In the case of Fiji, the long-term, own-price elasticity for export demand is estimated to lie between –1.25 and –1.49, suggesting devaluation improves export performance in the long term. See Narayan and Narayan (2004). In another article, the same authors (2007) find that a 10 percent devaluation in Fiji increases output by around 3.3 percent.

There is little evidence to suggest that interest rate policy was used proactively to directly reduce cross-border capital outflows and protect foreign currency reserves.

A number of academic studies suggest that the existence of stable monetary demand functions and inadequately developed capital markets in some PICs provides a basis to use monetary aggregates rather than interest rates as an instrument of policy. See Jayaraman and Choong (2009), Jayaraman and Dahalan (2008), and Singh and Kumar (2009).

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