Back Matter

Appendix. The Adverse Impact of Macroeconomic Volatility

1. A negative relationship between output volatility and growth found by Ramey and Ramey (1995) has been examined further in other studies. Hnatkovska and Loayza (2005), for example, find that a one standard deviation rise in output volatility leads to a 1.3 percentage point drop in the growth rate. Weaker growth has been associated with exchange rate volatility (under low financial development; Aghion and others, 2006), policy volatility (Fatás and Mihov, 2006) and aid volatility (Prati and Tressel, 2006). Others associate macroeconomic volatility and inequality through human capital investment (Gavin and Haussman, 1998). This literature suggests the main influences of volatility to be exogenous shocks, volatile policies, structural rigidities, and weak institutions.

2. Developing countries may face greater volatility because of larger exogenous shocks, more policy variability, and weaker policy buffers (Loayza and others, 2007). Aizenman and Pinto (2005) identify channels through which volatility has permanent effects:

  • Weak institutions and investment channel. Countries with weak institutions seem to be more affected by shocks of similar size. Property rights, creditor protection, contract enforcement, and financial supervision influence capital market development; incomplete or thin capital markets force firms to finance investment internally or from local banks, causing greater contraction of investment during downturns, when these sources are themselves strained.

  • Volatility and income inequality. Income inequality increases with the uncertainty that accompanies volatility, raising the share of households that face binding constraints on their ability to finance investment in human capital, undermining long-term growth.

  • Procyclical fiscal policy. Countries with weak fiscal capacity are less able to maintain broad-based tax systems, and may rely on inefficient or sensitive revenue instruments, including trade taxes. Together with expenditure rigidities, this encourages pro-cyclical fiscal policy.

3. To temper volatility and blunt its impact on growth requires strong institutions and adequate shock absorbers. The latter include deep, well-supervised financial markets, the ability to use countercyclical policies, and adequate reserve coverage. Crispolti and Tsibouris (2012) find that, even when reserve coverage is at levels normally considered adequate, island states may suffer persistent macroeconomic costs in the aftermath of an external shock.

Appendix Table 1.

Regression Results: Determinants of Growth, 1980–2010 and 1990–2010

article image
Standard errors in parentheses

p<0.01,

p<0.05,

p<0.1

All regressions include a full set of regional dummies.
Appendix Table 2.

Regression Results: Social Indicators and Income, 2005–10

article image
R-squaredStandard errors in parentheses

p<0.01,

p<0.05,

p<0.1

Appendix Table 3.

Regression Results: Determinants of Growth Volatility, 1980–2010

article image
Standard errors in parentheses

p<0.10

Source: Staff estimates.Regressions include regional dummies and are estimated with random effects. Column titles refer to the coverage of the small states dummy variable used in the regression: all small states (1); non-micro small states (2); micro states (3); island small states (4); Small Islands Club (5); Pacific Islands 6); Caribbean Islands (7); and commodity exporters (8). The fiscal policy procyclicality variable is defined as sample average of the 5 year rolling correlation between the growth rate of real GDP and the growth rate of government consumption as share of GDP.
Appendix Table 4.

Cost and Historical Probability of Natural Disasters, 1987–2011

article image
Source: WHO CRED (International Disaster Database) and staff estimates.

Ratio of estimated annual damage to annual GDP, averaged over the period.

Share of years (in percent) with a cost-to-GDP ratio in the top decile of the sample.

Appendix Table 5.

Doing Business Indicators, by Country Group

article image
Source: World Bank Doing Business 2013: Smarter Regulations for Small and Medium-Size Enterprises and staff calculations.
Appendix Table 6.

Aid Levels and Aid Volatility, by Country Group, 1980–2010

article image
Source: OECD DAC and staff calculations.
Appendix Figure 1.
Appendix Figure 1.

Volatility of per capita GDP Growth, Individual Small States, 1980–2010

Citation: Policy Papers 2013, 008; 10.5089/9781498342315.007.A999

Dots show the median and the 25th and 75th percentiles. Data are ordered by median.
Appendix Figure 2.
Appendix Figure 2.

Volatility of CA-to-GDP Ratio, Individual Small States, 1980–2010

Citation: Policy Papers 2013, 008; 10.5089/9781498342315.007.A999

Dots show the median and the 25th and 75th percentiles. Data are ordered by median.
Appendix Figure 3.
Appendix Figure 3.

Sources of Debt Accumulation, Western Hemisphere Countries, 2007–11

Citation: Policy Papers 2013, 008; 10.5089/9781498342315.007.A999

Appendix Figure 4.
Appendix Figure 4.

Sources of Debt Accumulation, Asia-Pacific Countries, 2007–11

Citation: Policy Papers 2013, 008; 10.5089/9781498342315.007.A999

Appendix Figure 5.
Appendix Figure 5.

Macroeconomic Adjustment in Fund-Supported Programs: Small States and other Fund Members, 2002–11

Citation: Policy Papers 2013, 008; 10.5089/9781498342315.007.A999

Sources: Staff calculations based on IMF 2011 Review of Conditionality, Background Paper 2, Figure 3.1.
Appendix Figure 6.
Appendix Figure 6.

Debt Dynamics in Fund-Supported Programs: Small States and other Fund Members, 2002–11

Citation: Policy Papers 2013, 008; 10.5089/9781498342315.007.A999

Source: IMF, 2011 Review of Conditionality Background Paper 3, Figures 5 and 12.Red denotes small states. See source for methodology.
Appendix Figure 7.
Appendix Figure 7.

Program Goals and Instruments: GRA-Supported Programs, 2006–11

Citation: Policy Papers 2013, 008; 10.5089/9781498342315.007.A999

Source: Staff calculations using MONA, based on the methodology followed in the 2011 Review of Conditionality.
Appendix Figure 8.
Appendix Figure 8.

Program Goals and Instruments: PRGT-Supported Programs, 2006–11

Citation: Policy Papers 2013, 008; 10.5089/9781498342315.007.A999

Source: Staff calculations using MONA, based on the methodology followed in the 2011 Review of Conditionality.
Appendix Figure 9.
Appendix Figure 9.

Technical Assistance, by Department, 2000–07 and 2008–12

Citation: Policy Papers 2013, 008; 10.5089/9781498342315.007.A999

Source: ICD data and staff estimates1/ TA is measured in person-years.
1

This paper was prepared under the overall guidance of Hugh Bredenkamp and Peter Allum (SPR) by a staff team led by Brad McDonald (SPR) and comprising Valerio Crispolti (AFR), Patrizia Tumbarello (APD), Luisa Zanforlin (ICD), and Sarwat Jahan, Francisco Roch, and Ke Wang (SPR), and with substantial contributions from Yiqun Wu (APD), Michael Filippello (OBP), Katrin Elborgh-Woytek, Kerstin Gerling, and Nkunde Mwase (SPR), and JoonKyu Park (WHD). Lisa Kolovich (SPR) coordinated the database and provided research assistance, along with Ezequiel Cabezon (APD), Martin Wachs (ICD), and Sibabrata Das and Lamin Njie (SPR). The regional background papers were led by Patrizia Tumbarello (APD) and Therese Turner-Jones (WHD).

2

The Task Force was established in 1998 and submitted its final report, Small States: Meeting Challenges in the Global Economy, to the Development Committee in April 2000 (DC/2000-04). The report was discussed informally by the IMF Executive Board in 2000.

3

Other members are the CS, EU, IMF, UNCTAD, and WTO.

4

With regard to the PRGT eligibility framework, see Decision No. 15105-(12/17). The Small States Forum covers a few countries with populations above 1.5 million.

5

This arbitrary cutoff has the advantage of sub-dividing the small state group into similar sized sub-groups.

6

Winters and Martins (2004) document higher trade costs in small remote economies. Gibson and Nero (2008) and Becker (2012) examine the impact of remoteness, small size, and other factors on growth in the Pacific Islands. Malik and Temple (2008) find that remote countries and those with weaker capacity experience more volatility.

7

During 2007-11, the ratio of total government expenditure-to-GDP was 9 percentage points of GDP higher in small states than in their larger comparators. Among small states, micro states have considerably higher expenditure ratios than non-micro small states. Differences are greatest among LMLs, and less pronounced among UMCs.

8

Yusuf and Nabeshima (2012) attribute much of their success to investment in human capital.

9

The literature is summarized in Alesina and others (2005). Hodler and Knight (2011) find that rent-seeking contests for aid inflows become more damaging as ethnic fractionalization grows, and that this effect is primarily responsible for the detrimental impact of ethnic fractionalization on economic development.

10

They found small size per se a substantial disadvantage: holding trade openness constant (at its median level), they associate a 10-fold increase in population with a 0.33 percentage point increase in the growth rate.

11

Similar to other studies, the regressions attribute a substantial growth advantage to trade openness, while showing a negative relationship between high levels of debt and growth, and between output volatility and growth.

12

Remote countries are defined as those in the bottom third in trade connectivity, measured by the Liner Shipping Index. Several alternative and equally plausible definitions for remoteness have been used in the literature, each measuring somewhat different characteristics. As discussed in the Pacific Islands background paper, these different perspectives help to shed light on the severe challenges faced by small, extremely remote countries.

13

The choice of social indicators used here was driven in part by data availability, since some indicators that would be desirable for this purpose (such as poverty rates) are not consistently available for some small states. Recent changes to the construction of the HDI have been criticized by Ravallion (2012) as devaluing longevity.

14

Other studies have also pointed to a recent deterioration in small states’ performance. Favaro and Peretz (2008) review growth studies in Africa, the Caribbean, Europe, and the Pacific over two periods: 1986-95 and 1995-2003. In contrast to a 1 to 2 percentage point increase in growth by other developing countries in the latter period, annual growth among small states slipped by about ½ percentage point. The growth decline was particularly marked among the Pacific island states, but was also observed in Africa and the Caribbean.

15

Considering the spread of free trade agreements and unilateral preference schemes, an exporting country’s third-country competitors typically also receive trade preferences in major markets. In most product categories and for most developing countries, this sharply reduces the potential impact of preference erosion from multilateral liberalization (Low and others, 2005 and 2006).

16

Linked to these policies, the EU has provided partial financial compensation to ACP countries under its Special Framework of Assistance (1999-2008), its STABEX facility, and a Sugar Action Plan (2007-13).

17

Volatility has a number of different meanings. It is used in this paper to refer to realized variability, measured as a five-year backward-looking standard deviation of a variable.

18

The experience varies considerably. Small states such as the Marshall Islands, St. Lucia, and Tuvalu have experienced high and persistent volatility, as have Montenegro and Timor Leste (Appendix Figure 1).

19

Meilak (2008) finds that export concentration is higher in small states; this seems to hold in the present sample states as well. Similarly, ongoing IMF staff work on diversification shows that small states (defined as those under 1 million population) have more concentrated output and exports, controlling for per capita income.

20

Gounder and Saha (2007) examine the empirical relationship between output volatility and growth in the South Pacific Island Nations. They conclude that in this region output volatility has translated into lower growth, principally through an investment channel.

21

When looking at a weighted terms of trade index for both goods and services, however, there is no such difference among small states and the larger countries in their income group. The goods and services measure is preferred in principle, but because data on services prices are less reliable it may not be preferable in practice.

22

In cross-country regressions, staff examined various measures of fiscal volatility against a small state dummy variable and regional and additional controls (such as trade openness and terms of trade volatility). In these regressions, fiscal policy pro-cyclicality (defined as a rolling correlation of GDP growth and the growth rate of the ratio of public consumption to GDP) was not a significant influence on small states’ fiscal volatility.

23

The EM-DAT database used in the Table is the most comprehensive source available. It may understate losses, however, as Strobl (2012) argues with regard to hurricanes in Central America and the Caribbean.

24

Details for Western Hemisphere and Asia-Pacific small states are provided in Appendix Figures 3 and 4.

25

The “risk of debt distress” rating is available only for LICs (that is, those countries eligible for the PRGT). The country in debt distress, Comoros, reached the completion point under the HIPC Initiative in December 2012 and its debt distress risk is now assessed to be high.

26

Amo-Yartey and others (2012) looked at the composition of debt reduction efforts over a larger sample and found similar results. They examined 206 episodes of large debt reductions (15 percent of GDP or more over 5 years) in a data set of 155 advanced and emerging economies between 1970 and 2009. The average decline in the debt-to-GDP ratio in these episodes was 35 percentage points. In about half the cases, debt reduction was achieved through higher GDP growth, higher inflation, or fiscal consolidation, with a quarter of these episodes being preceded by the introduction of a fiscal rule. The remaining cases included debt restructuring or default.

27

The adjustment is given by the debt stabilizing primary balance minus the actual primary balance.

28

As a caveat, it should be noted that these findings were based on a sample that included only 12 small states.

29

This study focused on episodes where the average primary balance increased by at least 10 percentage points of GDP for a three-year period, relative to the preceding three-year period. In two-thirds of the episodes, growth increased (by an average 1.7 percent).

30

Guyana received enhanced HIPC relief in the early 2000s and subsequently received relief under the MDRI; Comoros reached the HIPC Completion Point in 2012, and Sao Tome reached the Completion Point in 2007.

31

Worrell (2012) notes that “the responsiveness of wages tends to be the critical factor” in determining whether a depreciation has medium-term effects.

32

Endegnanew and others (2012) conclude that fiscal policy in small states has little effect on the current account, beyond its direct impact on import demand. On a more positive note, Blake (2012) finds very low fiscal multipliers in the case of Jamaica and notes that other studies have reached similar conclusions in the case of high openness.

33

Financial institutions in OFCs typically serve nonresidents.

34

Steps to strengthen monetary transmission mechanisms could help in macroeconomic management. Deeper financial markets could strengthen monetary policy transmission through interest rate and credit channels and, in deeper and more sophisticated markets, through asset prices and balance sheet effects.

35

See the Asia-Pacific background paper and the 2011 Article IV reports for the Bahamas, Belize, and Tonga.

36

Examples are the ECCU FSAP (IMF Country Report No. 04/293), Belize FSAP (IMF Country Report No. 04/373), and Barbados FSAP (IMF Country Report No. 09/64).

37

For example, the ECCU FSAP found that while banks report risk-weighted ratios well above the minimum requirement, asset values do not accurately reflect actual recovery rates.

38

See, for example, Melecky and Raddatz (2011).

39

Recent staff work in this area includes IMF-World Bank (2011) and Laframboise and Loko (2012).

40

Recent reforms seem to have increased small states’ use of emergency financing facilities (Section V).

41

Aid can promote sustained growth if used to support the right policies and provided effectively (Favaro and Peretz, 2008, and World Bank, 2006). Studies also point out, however, that in small states with limited government capacity the challenge of dealing with multiple aid agencies is even greater than in larger countries.

42

The Analytical Costing and Estimation System (ACES): Costing the Fund’s Outputs, November, 2012.

43

This database is currently being enhanced and made easier to use.

44

Beginning with the 1997 Biennial Review of Surveillance, the use of extended consultation cycles with some members has been motivated by a desire to free up the limited resources of both the Board and staff—including, more recently, to address the demand for cross-country work in support of bilateral surveillance (Modernizing the Surveillance Mandate and Modalities, March 2010, p. 19).

45

Average grade levels for Table 6 were calculated on the basis of the cost shares of the different grades.

46

See Review of Facilities for Low-Income Countries (July 2012). These gaps contributed to PRGT-eligible members turning to non concessional facilities.

47

This paragraph pertains to lending facilities only and excludes the PSI. The discussion of program objectives and conditionality excludes non-UCT facilities, such as emergency assistance, and follows the methodology in the 2011 Review of Conditionality. Figures refer to 2000-11.

48

Specifically, the median small state using GRA facilities had annual access equivalent to 130 percent of Fund quota during 2000-11; this compares to 133 percent among larger countries. The median small state using PRGT (concessional) facilities had average access equivalent to 30 percent of quota, compared to 21 percent among larger countries. During this period, program duration for small states was nearly identical to that for larger countries.

49

The patterns of TA provision measured in person-years are not directly comparable to the budgetary cost estimates from ACES, but the two perspectives provide a similar picture. The ACES data do help to illustrate the importance of donor-financed TA for the poorest countries (whether or not small) and the micro states.

50

The data exclude regional FSAPs with BCEAO/WAEMU in 2009, CEMAC in 2007, and the ECCU in 2004.

51

See the World Bank’s recent book (joint with the UN) on Natural Hazards, Unnatural Disasters: the Economics of Effective Prevention (UN-World Bank, 2010).

52

Eastern Caribbean Currency Union—Staff Report for the 2011 Discussion on Common Policies of Member Countries.

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Macroeconomic Issues in Small States and Implications for Fund Engagement
Author: International Monetary Fund