Asia and Pacific Small States - Raising Potential Growth and Enhancing Resilience to Shocks

The small states of the Asia and Pacific region face unique challenges in raising their growth potential and living standards. These countries are particularly vulnerable because of their 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. In providing public services, they face higher fixed government costs relative to other states because public services must be provided regardless of their small population size. Low access to credit by the private sector is an impediment to inclusive growth. Capacity constraints are another key challenge. The small states also face more limited policy tools. Five out of 13 countries do not have a central bank and the scope for diversifying their economies is narrow. Given their large development needs, fiscal policies have been, at times, pro-cyclical. Within the Asia-Pacific small states group, the micro states are subject to more vulnerability and macroeconomic volatility than the rest of the Asia-Pacific small states.

Abstract

The small states of the Asia and Pacific region face unique challenges in raising their growth potential and living standards. These countries are particularly vulnerable because of their 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. In providing public services, they face higher fixed government costs relative to other states because public services must be provided regardless of their small population size. Low access to credit by the private sector is an impediment to inclusive growth. Capacity constraints are another key challenge. The small states also face more limited policy tools. Five out of 13 countries do not have a central bank and the scope for diversifying their economies is narrow. Given their large development needs, fiscal policies have been, at times, pro-cyclical. Within the Asia-Pacific small states group, the micro states are subject to more vulnerability and macroeconomic volatility than the rest of the Asia-Pacific small states.

Characteristics Of Small States In The Asia And Pacific Region

1. The small states of the Asia and Pacific region face unique challenges in raising their growth potential and living standards. These challenges distinguish them from the broader group of small states across other regions. Even among them, heterogeneity is high, with the micro1 states subject to more vulnerability and macroeconomic volatility than the rest of the Asia-Pacific small states.

2. The small states of the Asia and Pacific region are remote, widely dispersed, and scarcely populated (Figure 1). They are geographically distant from their major markets and trading partners—unlike small islands in other regions. Remoteness raises transport costs and keeps these economies relatively isolated. Their large dispersion poses another challenge (Table 1). Most Pacific Island Countries (PICs) consist of hundreds of islands scattered over an area in the Pacific Ocean that occupies 15 percent of the globe’s surface. Their small size and dispersion preclude the exploitation of geographical agglomeration effects. Two PICs are the smallest IMF members in terms of population—Tuvalu and Palau. PICs’ average population is half the average population of other small states outside the Pacific region. The Pacific Islands are by far the most remote countries in the world, according to different indicators: the United Nation’s liner shipping connectivity index—which measures countries’ connectedness to global shipping networks—based on the status of their maritime transport sector, and two different measures of distance (Figures 2-4).

Figure 1.
Figure 1.

Small States—Asia and Pacific Region: Population, 2011

(In millions)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: IMF, WEO; and World Bank, WDI.
Figure 2.
Figure 2.

Small States—Asia and Pacific Region: Distance to the Closest Continent

(In kilometers)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: South Pacific Applied Geoscience Commission, the United Nations Environment Program; and IMF staff calculations.
Figure 3.
Figure 3.

Small States—Asia and Pacific Region: Liner Shipping Connectivity Index1/

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Source: World Bank, WDI 2012.1/ A smaller number indicates lower connectivity/high transportation costs. Countries with maximum connectivity=100. Non-small states mean= 24.3.
Figure 4.
Figure 4.

Population versus GDP-Weighted Distance1/

(In kilometers)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Source:World Bank.1/ Distance to all countries weighted by GDP.
Table 1.

Geographical Dispersion: Average Sea Distance Between Two Inhabitants of the Same Country1/

article image
Sources: IMF staff calculations, based on country census.

This is equivalent to computing the average distance between islands of the same country weighted by population.

3. In providing public services, the Asia and Pacific small states face higher fixed (i.e., per capita) government costs relative to other small states (Figures 5 and 6). This is because public services must be provided regardless of the small population. In the island states, this effect is compounded by remoteness and large dispersion and it leads to an inverse relationship between the size of the country and the government. Large dispersion and smallness increase input costs and worsen the diseconomies of scale associated with small populations in providing such public goods and services as education, justice, social services, infrastructure, and in creating public institutions. Current government spending as a share of GDP is generally higher in the micro states than in all other groups.2

Figure 5.
Figure 5.

Small States—Asia and Pacific Region: Current Government Expenditure, 2011

(In percent of GDP)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: IMF, WEO; and IMF staff calculations.
Figure 6.
Figure 6.

Small States—Asia and Pacific Region: Cost of Government, 1990–2010

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: World Bank, WDI; IMF, WEO; and IMF staff calculations.

4. These countries are quite heterogeneous (Appendix, Table 1) but they all have narrow export and production bases. Some rely primarily on tourism (Maldives, Fiji, Samoa, Palau, and Vanuatu), and some on fishing (Kiribati, Marshall Islands, Micronesia, and Tuvalu) (Table 2). Some are commodity or energy-resource based (Bhutan, Solomon Islands, and Timor-Leste). While scope for export diversification remains limited, with the exception of Fiji and Samoa, niche or eco-tourism is gradually developing in Kiribati, Marshall Islands, and Micronesia. Recent experiences in setting up joint ventures for marine processing are also notable as ways to move up the value-added chain.

Table 2.

Small States—Asia and Pacific Region: Main Exports of Goods and Services

article image
Sources: IMF staff reports; and country authorities.

5. PICs appear to be less open than comparators but openness has increased recently (Figures 7 and 8). Less openness reflects their remoteness, their underdeveloped infrastructure (which hurts tourism), and low competitiveness. Poor connectivity and high transport costs have prevented greater trade integration with the rest of the region. Trade openness has increased over time and integration has benefitted the Asia and Pacific small states, but it has also posed challenges because shocks are transmitted more rapidly in a more interconnected world.

Figure 7.
Figure 7.

Small States: Trade Openness1/

(In percent of GDP)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: World Bank, WDI; Penn World Tables; and IMF staff calculations.1/ Exports plus imports of goods and services.
Figure 8.
Figure 8.

Small States—Asia and Pacific Region: Trade Openness1/

(In percent of GDP)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: World Bank, WDI; Penn World Tables; and IMF staff calculations.1/ Exports plus imports of goods and services.

6. Financial depth is generally below that of other small states (Figures 9 and 10). Access to credit is more limited than in other small states. And in the Pacific Islands, land tenure—communal land—is a constraint on credit growth and private sector development, leading to less inclusive growth. In most Pacific Islands, land is owned by the government and by large families, rather than by individuals. Family tenure makes property rights unclear and limits the ability to use land as collateral. If banks are unable to effectively secure their lending with land as collateral, lending becomes costly. The spread between lending and borrowing rates is very high in the Pacific Islands.

Figure 9.
Figure 9.

Small States—Asia and Pacific Region: Interest Rate Spread of Commercial Banks1/

(In percent)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: Country authorities; IMF, International Financial Statistics; and IMF staff estimates.1/ 2011 or lastest available.
Figure 10.
Figure 10.

Small States—Asia and Pacific Region: Domestic Credit to Private Sector1/

(In percent of GDP)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: World Bank, WDI; and IMF staff calculations.1/ 2011 or latest available.

7. Yet, commercial banks in the Pacific Islands—mainly foreign banks—are well capitalized and highly profitable, despite the relatively low lending growth of recent years. This reflects continued high levels of non-interest income, largely from foreign exchange activities and from fees and charges—which are higher than some comparators (Table 3).3

Table 3.

Small Pacific Island Countries: Interest and Non-interest Income of Commercial Banks, 2011

article image
Sources: Davies and Vaught, 2011; and Central Bank data.

8. Low access to credit by the private sector is an impediment to inclusive growth (Figure 11). 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. Fostering financial inclusion by increasing the use of mobile phone networks for basic financial services is a recent positive development in the small Pacific states (i.e., Fiji, Samoa, Solomon Islands, and Tonga) to support private sector growth. The decreasing cost of sending remittances to the Pacific by Australian banks is also helping foster financial sector intermediation.

Figure 11.
Figure 11.

Small States—Asia and Pacific Region: Financial Development and Inequality, 1990-2010

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: World Bank,WDI; ADB, Key Indicators for Asia and the Pacific, 2012; and IMF staff calculations.1/ One indicates maximum inequality.

9. International market access is also very limited. Because of capacity and structural impediments, including legal and administrative frameworks, the Pacific Islands have still not been able to tap international capital markets and attract capital inflows. Their market access to private capital flows is almost nonexistent, excluding Fiji and Maldives.

10. Indicators on business environment are weaker in the Asia and Pacific small states than in some comparators. According to the latest World Bank Doing Business Report, procedures for starting and closing a business are more expensive in the small Pacific islands than in the other Asia and Pacific small states as well as in the Caribbean island countries. Weak private sector development impedes sustainable growth (Figures 12 and 13).

Figure 12.
Figure 12.

Small States—Asia and Pacific Region: Real per Capita GDP Growth and Business Climate, 2000-10

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: World Bank, Doing Business, 2013; and IMF staff calculations.1/ A lower number indicates a more friendly business climate.
Figure 13.
Figure 13.

Small States—Asia and Pacific Region: Ease of Doing Business Index 1/

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: World Bank, Doing Business 2013; and IMF staff estimates.1/ A lower number indicates a more friendly business climate.

11. Policy tools are also limited. Five out of 13 countries do not have a central bank (Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu). The Australian dollar circulates as legal tender in Kiribati and Tuvalu, and the U.S. dollar in Marshall Islands, Micronesia, and Palau. The use of dollarization or of fixed/managed exchange rate regimes for the other Asia-Pacific small states reflects the fixed costs of operating an independent monetary policy as well as weak monetary transmission mechanisms. The latter is largely the result of structural characteristics of financial markets (e.g., shallow money markets, the absence of such institutions as credit bureaus that facilitate bank lending, and small market size).4

12. Capacity constraints are another key challenge. These constraints are larger in the PICs relative to their comparators. For example, school enrollment is lower than in other small states (Figure 14). A recent analysis5 suggests that in the small PICs capacity constraints within the public service are associated with small size and explain the underperformance on public financial management reforms. These constraints represent another impediment to raising growth potential. That said, Solomon Islands has recently taken commendable steps to strengthen public finance management and promote budget transparency and accountability, as have Fiji and Vanuatu.

Figure 14.
Figure 14.

Small States—Asia and Pacific Region: Secondary School Enrollment

(In percent of population between 12-17 years old, 1990-2010 average)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: World Bank, WDI; and IMF staff calculations.

13. Human development indicators are among the lowest in the region (Figure 15). In the Asia and Pacific region, of the 12 countries with the lowest rank on the human development index, 6 are small states, and 3 are micro states.

Figure 15.
Figure 15.

Selected Asia and Pacific Countries: Lowest Human Development Index (HDI) Rank1/, 2011

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Source: UNDP, Human Development Report.1/ A lower rank indicates a poor HDI.

Managing Shocks, Vulnerability, and Volatility

A. Shocks

14. Small states in the Asia and Pacific region are heavily exposed to shocks. Some shocks are related to external developments, some to weather and environmental events, and some are home grown, such as political shocks.

15. The main channels of spillover from a global downturn are the terms of trade, remittances, tourist flows, and the financial channels.

  • All PICs remain especially vulnerable to global commodity price shocks—particularly for food and fuel, given their large share in total imports (about 50 percent). In light of the rise in commodity prices and their greater volatility in recent years, terms-of-trade shocks have translated into large output shocks.6 Higher import prices have also raised production costs and reduced real household income.

  • 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 (in Maldives, Palau, Vanuatu, Samoa, and Fiji) (Figure 16). A fall in stock prices in the advanced economies would also affect PICs with large trust funds whose assets are invested offshore (Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu), as occurred during 2008–09 (Figure 17).

Figure 16.
Figure 16.

Small States—Asia and Pacific Region: Tourism and Remittances

(In percent of GDP, 2005-11 average)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: Country authorities; and IMF staff calculations.
Figure 17.
Figure 17.

Micro States—Asia and Pacific Region: Sovereign Investment Fund Balances

(In percent of GDP) (2007=100)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: Country authorities; and IMF staff calculations

16. Aid flows have proven resilient, as the main donor in the region, Australia (Figure 18) weathered the global financial crisis relatively well. While aid flows from Australia and New Zealand are expected to hold up, weaker-than-expected economic activity in these countries could hit the PICs particularly hard, as both of these countries are also their main trade partners. Aid from the United States has a large impact on three Pacific Island countries (Marshall Islands, Micronesia, and Palau) that have signed the bilateral Compact of Free Association agreement with the United States (Figure 19). 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 budgetary and balance of payments needs with “Compact grants,” which are, however, scheduled to expire in the 2023/24 fiscal year.

Figure 18.
Figure 18.

Small States—Asia and Pacific Region: Official Development Aid by OECD Donors

(In percent of total aid, 2005-11)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Source: OECD.
Figure 19.
Figure 19.

Small States—Asia and Pacific Region: Official Development Assistance by Donors

(In percent of total aid, 2005-11 average)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Source: World Bank, WDI.

17. PICs are also severely affected by natural disasters and climate change (Figure 20). According to a 2012 World Bank Report, Acting Today for Tomorrow, of the 20 countries in the world with the highest average annual disaster losses measured by GDP, 8 are PICs: Vanuatu, Niue, Tonga, Micronesia, Solomon Islands, Fiji, Marshall Islands, and the Cook Islands. Several small island countries in the Asia and Pacific region are low-lying coral islands, with their population and infrastructure concentrated along the coast (Kiribati, Maldives, Marshall Islands, and Tuvalu). This makes them highly vulnerable to the effects of such climate change as sea-level rise and coastal erosion. While worldwide databases are available to account for the costs of natural disasters, the costs of climate change (including the fiscal costs), which are substantial in the Asia and Pacific small states, remain largely unestimated.

Figure 20.
Figure 20.

Average Impact of Natural Disasters1/

(In percent of GDP)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Source:World Bank and United Nations, Natural Hazards, UnNatural Disasters: The Economics of Effective Prevention, 2012.1/ Excludes the cost of climate change.

18. The frequency of shocks is also higher in the small Pacific Islands than in other comparators (Figure 21). Our event analysis shows that political, terms-of-trade, and natural disaster shocks are more frequent relative to other low-income small states.

Figure 21.
Figure 21.

Small States: Frequencies of Shocks1/

(Low-income countries=100)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: UN, Natural Disaster Database; Polity IV Project; and IMF staff calculations.1/ Based on events during 1970-2007.2/ Low-income countries only.3/ Change of the terms of trade larger than 10 percent.4/ Defined as a deterioration by 3 points or more in the political stability index (Polity index) from Marshall and Jaggers (2009), complemented with country information.

B. Vulnerability

19. Reliance on aid and remittances to finance structural trade deficits remains a key vulnerability (Figures 22 to 24). Small domestic markets coupled in most cases with poor resource endowments result in large trade deficits. The Asia-Pacific small states rely heavily on imports; most are net importers of energy and food, given the shortage of arable land. They also import capital goods because of their dependence on imported technologies and other consumer goods.

Figure 22.
Figure 22.

Small States—Asia and Pacific Region: External Grants, 2011

(In percent of GDP)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: IMF, WEO; and IMF staff calculations.
Figure 23.
Figure 23.

Small States—Asia and Pacific Region: Trade Balance of Goods and Services

(In percent of GDP, 2005-11 average)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: IMF, WEO; and IMF staff calculations.
Figure 24.
Figure 24.

Small States—Asia and Pacific Region: Current Account Excluding Grants

(In percent of GDP, 2005-11 average)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: IMF, WEO; and IMF staff calculations.

20. Owing to large official development assistance (ODA) flows, debt levels have remained in check for most countries until recent years (Figure 25). But since the 2008–09 crisis, debt has increased, in part because of the need for countercyclical fiscal support and partly because of new borrowing from Asian emerging markets. Fiscal space is currently limited for Asia and Pacific small states with high public debt, which narrows the scope for countercyclical policies should the economies weaken. As of February 2013, based on the latest published Article IV staff reports, four Asia-Pacific small states were at high risk of debt distress (Kiribati, Maldives, Tonga, and Tuvalu), according to the low-income countries debt sustainability analysis; three were at moderate risk of debt distress (Bhutan, Samoa, and Solomon Islands); and two at low risk of debt distress (Fiji and Vanuatu).

Figure 25.
Figure 25.

Small States—Asia and Pacific Region: Public Debt, 2011

(In percent of GDP, 2005-11 average)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: IMF, WEO; and IMF staff calculations.

21. Different indices of vulnerability to shocks have been developed in the literature. The Becker index (2012) provides a vulnerability ranking based on different dimensions of vulnerability (e.g., small population, volume of arable land, and distance). The analysis also shows that using GNI per capita to determining 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 micro states covers fixed costs of government, such as the costs of establishing institutions and providing public services, especially in countries composed of scattered islands. Therefore, per capita indicators tend to overstate the economic conditions of micro states. Because of the high fixed costs and distance from the rest of the world, these states’ effective purchasing power is actually quite low despite a not-so-low GNI per capita. Similar vulnerability indices have been developed by Briguglio (1995) and the Commonwealth Secretariat (2000).

C. Volatility

22. The small states of the Asia and Pacific region face higher volatility than other small states in several respects, specifically, per capita GDP growth, changes in the terms of trade, aid, current account balance, and revenue.

  • GDP per capita (Figures 26, 27, and 28). During 1990–2010, the volatility of GDP per capita was higher in Asia and Pacific small states than in other small states—especially the micro states, which are all PICs. 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 the Asia-Pacific small states and a lower quality of governance, after controlling for other variables.

    Figure 26.
    Figure 26.

    Small States—Asia and Pacific Region: Volatility of Real per Capita GDP Growth, 1990-2010

    Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

    Sources: World Bank, WDI; IMF, WEO; and IMF staff calculations.
    Figure 27.
    Figure 27.

    Small States—Asia and Pacific Region: Real per Capita GDP Volatility and Growth, 1990-2010

    Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

    Sources: World Bank, WDI; IMF, WEO; and IMF staff calculations.1/ Volatility measured as the five-year backward looking standard deviation of real per capita GDP growth.
    Figure 28.
    Figure 28.

    Small States—Asia and Pacific Region: Volatility of Real per Capita GDP Growth and Governance, 1990-2010

    Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

    Sources: World Bank, Governance Indicators; and IMF staff calculations.1/ Small values represent a low level of government effectiveness.

  • Terms of trade, aid, and current account balance volatility (Figure 29). During 1990–2010, the terms of trade were more volatile than in other small states. Aid flows were also more volatile, especially among the micro states. 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 micro states, the greater aid volatility may also reflect the fact that aid flows generally finance specific one-off projects. Volatility of terms of trade and aid has resulted in greater current account volatility.

    Figure 29.
    Figure 29.

    Small States—Asia and Pacific Region: Volatility of GDP Growth, Terms of Trade, Aid, and Current Account Balance, 1990-2010

    Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

    Sources: World Bank, WDI; IMF, WEO; and IMF staff calculations.—represents the median. The boxes represent the 50 percent of the observations, between the 25th and 75th percentile.1/ Weighted terms of trade indicate the changes in the prices of exports and imports weighted, respectively, by the share of exports and imports in GDP.

  • Revenue volatility (Figures 30, 31, and 32). Revenue volatility is higher in the Asia and Pacific small states—especially the micro states—relative to other small states (Box 1). The main source of volatility in micro states is non-tax revenues—particularly fishing license fees—which represent about 40 percent of revenues in micro states. Managing revenue volatility is a major challenge for Asia and Pacific small states as such volatility can foster fiscal policy pro-cyclicality—that is, expansionary fiscal policy during upturns and contractionary policy during downturns. Indeed, fiscal policy appears to have been pro-cyclical in many Asia and Pacific small states in recent years. Only 5 out of 13 countries have adopted a multi-year budget framework to help smooth the expenditure path over the medium term. And only one country, 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 30.
    Figure 30.

    Small States—Asia and Pacific Region: Revenue Volatility

    Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

    Sources: IMF, WEO; and IMF staff calculations.
    Figure 31.
    Figure 31.

    Small States—Asia and Pacific Region: Fiscal Volatility, 1990-2010

    Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

    Sources: World Bank, WDI; IMF, WEO; and IMF staff calculations.—represents the median. The boxes represent the 50 percent of the observations between the 25th and 75th percentile.
    Figure 32.
    Figure 32.

    Small States—Asia and Pacific Region: Pro-cyclical Bias in Fiscal Policy, 2005-10

    Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

    Source: IMF staff calculations, based on IMF, WEO.1/ Indicates quadrants.

    Special Challenges Facing Pacific Islands Micro States

    More volatility. Micro states face more volatility with respect to their GDP growth, revenue, aid, terms of trade, and current accounts relative to the rest of the Asia-Pacific small states1 and other small states outside the region.

    Climate change. Rising sea level is a large threat for Kiribati, Marshall Islands, and Tuvalu. The costs of climate change cannot be internalized by individual countries. And development spending is sometimes redirected to building sea walls. Aid for climate-change mitigation is expected to come at the expense of other project-financing aid, unless the aid envelope expands substantially—which does not appear likely.

    High aid dependency. The micro states depend heavily on aid to finance their large external and internal imbalances, and their development needs. The expiration of the “Compact grants” in fiscal year 2023/24 would 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, and Micronesia are also classified as fragile states by the World Bank.2

    http://web.worldbank.org/WBSITE/EXTERNAL/PROJECTS/STRATEGIES/EXTLICUS/0,,contentMDK:22230573~pagePK:64171531~menuPK:4448982~piPK:64171507~theSitePK:511778,00.html

    1/ This is consistent with Colmer and Wood, 2012.2/ The other fragile Asia and Pacific small states are Solomon Islands and Timor-Leste.

Understanding Growth Performance

23. As a result of these factors, PICs’ real GDP per capita is among the lowest among the small states (Figure 33). Since 1990, real GDP per capita (in PPP terms) in the PICs has increased less than 25 percent, compared with 45 percent in the Eastern Caribbean Currency Union (ECCU) and more than 30 percent in small states. PICs have not been able to benefit from growth in emerging Asia—where GDP has increased by about 120 percent over the same period.

Figure 33.
Figure 33.

Small States: GDP per Capita, 2011

(In U.S. dollars)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: World Bank, WDI; and IMF, WEO.

24. Data on income per capita show a similar pattern (Figure 34). During 1990–2010, per capita income (in PPP terms) in the Pacific grew by 77 percent, compared with 130 percent in the ECCU and less than 85 percent in the small states. Per capita income in emerging Asia had grown by over 250 percent over the same period.

Figure 34.
Figure 34.

34. Small States: GNI per Capita1/, 2011

(In U.S. dollars)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Source: World Bank, WDI.1/ For Bahamas, Guyana, Suriname and Timor-Leste data are as of 2010. For Barbados and Djibouti, data are as of 2009.

25. As of 2011, the average GNI per capita for the PICs was one third the average income of the Caribbean countries. While per capita GNI in Tuvalu and, to a lesser extent, in 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 whose assets are invested abroad. 7 In Tuvalu, however, much of the investment income cannot be spent as the multilateral agreement governing the fund stipulates that the real value of the Trust Fund, indexed to Australian inflation, be maintained. This places limits on the use of earnings for budget support. The inflation component of earnings is about two-third of total earnings, or about 10 percent of GNI, which 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 trust fund management until 2023/24.

26. PICs seem to be stuck on a low-growth path. Growth in these countries has been weak over the last two decades, even more so relative to other small states (Figures 35 and 36). Over the last 20 years, PICs’ annual GDP growth has averaged just 2 percent—much lower than the Asian low-income countries (6 percent), the ECCU countries (4 percent), and the small states (4½ percent). Because of their demographics, the underperformance of the PICs, in per capita terms, is also more striking.

Figure 35.
Figure 35.

Small States—Asia and Pacific Region: Real GDP per Capita Growth

(In percent, 1990-2010 average)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: World Bank, WDI; and IMF, WEO.
Figure 36.
Figure 36.

Small States—Asia and Pacific Region: Real GDP Growth, 1990-2012

(In percent)

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Sources: World Bank, WDI; and IMF, WEO.

27. While the 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, emerging Asia) have helped cushion the downturn in all PICs.

28. Since the 2008–09 crises, some Asia and Pacific small states have made progress in rebuilding policy buffers but they need to do more (Figure 37). Their reserve position has improved on balance relative to 2004–07. But more than half of the PICs emerged from the crisis with somewhat less comfortable fiscal buffers (higher debt and larger fiscal deficits) than before the crisis.

Figure 37.
Figure 37.

Small States—Asia and Pacific Region: Rebuilding Policy Buffers

Citation: Policy Papers 2013, 009; 10.5089/9781498342285.007.A001

Note: Diamonds indicate Asia-Pacific small states; circles indicate non-Asia-Pacific small states; triangles are non-Asia-Pacific low-income countries. Based on the same methodology as in IMF, 2010.Sources: Country authorities; and IMF staff calculations.

A. Econometric Analysis: Growth Determinants in the Asia and Pacific Small States

29. Our econometric analysis confirms that PICs have underperformed relative to their peers (Table 4). After controlling for some standard variables that explain per capita GDP growth, PICs suffer a disadvantage in per capita GDP growth of about 2 percentage points, compared with an average small state.

Table 4.

Determinants of Real per Capita GDP Growth1/

article image

Panel regressions, 1990-2010. All regressions include a full set of regional dummies. The dependent variable is the real per capita growth. The estimation period starts from 1990 because of lack of data for many PICs soon after independence.

The asterisks indicate the p-values: p-value<0.1

p-value<0.05

p-value<0.01.

30. All variables have the expected sign. Trade openness and a well educated population have a positive impact on real GDP per capita growth, 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), after controlling for other variables, PICs have grown by 3 percentage points less than non-small states (Model 2).

31. Our econometric results show that PICs’ geographical disadvantage 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 (Yang and others 2013). The APD 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 also contribute to explain the difference in growth performance.

Policy Implications: How to Raise Growth Potential and Enhance Resilience?

Decisive policy measures by Asia-Pacific small state governments 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 rebuilding policy buffers in a way that reinforces efforts to implement growth-enhancing reforms:

  • Strengthening domestic revenue mobilization would support the rebuilding of policy buffers. Revenue compliance is extremely challenging to enforce, especially in islands that are widely scattered. Further progress in strengthening revenue collection, including by streamlining and simplifying existing tax and customs regimes with technical assistance provided by development partners, would also help create fiscal space to meet critical development spending needs.

  • Improving the composition of public spending with regard to education, health, and infrastructure would be key to fostering inclusive growth. Public investment in infrastructure could help crowd-in private investment, thereby promoting more broad-based growth, including by attracting FDI and stimulating more tourism. Increasing investment in education would also raise potential growth.

  • Sound structural policies can 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 effort is needed to properly exploit and manage them.

  • Strengthening institutions and improving governance should be a key part of governments’ reform agenda and of development partners’ capacity-building programs. Bolstering public institutions, particularly through public finance management reforms, would also improve expenditure efficiency. Strengthening public finance by introducing a multi-year budget framework will help bring about realistic fiscal plans and guard against pro-cyclical policies. A multi-year 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 point of view, this would also help build consensus on the appropriate sequencing of development projects and contain spending pressure in the near term. This would also help better calibrate the pace of spending by taking into account capacity constraints.

33. Some scope exists for increasing competition in the banking sector, but financial deepening also requires the development of non-bank institutions. These include finance companies, foreign exchange dealers, and micro-credit institutions, which 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.

34. Regional solutions to common problems should also continue to be pursued. A regional approach can help individual countries mitigate the challenges associated with their small size and high dispersion, including 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 could be pursued.8 The key sectors include fisheries, information and communication technology, and aviation safety. Progress has been made in the fishery sector, through the Nauru Agreement, to strengthen regional capacity to increase bargaining power of license-issuing countries, and regional control to stop illegal fishing, but major barriers to labor and investment persist and require further collective efforts. The seasonal employment scheme, opened to PICs and Timor-Leste, first introduced by New Zealand in 2006 and followed more recently by Australia is a successful case of enhanced integration with neighboring countries that has generated income opportunities and enhanced skills of Pacific island workers in countries with a shortage of labor.

35. 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, the closest markets are the most dynamic in the world. The resilience of Australia and emerging Asia in recent years has played an important role in helping the Pacific Islands’ recovery.

IMF Engagement in the Asia and Pacific Small States

36. The IMF engagement with small developing states in the Asia and Pacific region covers several areas. The Fund supports these countries through surveillance, both bilateral and cross-country, including analytical work, programs—as in the case of Solomon Islands, and in the recent past of Maldives and Samoa—technical assistance, cooperation with other institutions, and outreach.

37. On surveillance and analytical work, progress has been made in understanding the unique challenges facing the Asia and Pacific small states. Recent analysis and working papers focused on understanding the impact of global and regional spillovers to PICs, growth underperformance, the link between international commodity prices and exchange rate pass-through, and how to enhance the monetary transmission mechanism. To strengthen its engagement with the Pacific Islands, the IMF established in September 2010 a regional resident representative office for Pacific Island countries based in Suva (Fiji) and a Pacific Islands Unit at headquarters (HQ) to increase synergies across country teams and awareness within the IMF of the main policy issues facing the Pacific Islands. The Asia and Pacific Department Regional Economic Outlook includes extensive coverage of the small states of the Asia-Pacific region.

38. Enhanced interdepartmental work has also been undertaken. The Asia and Pacific Department launched in October 2011, together with the African and Western Hemisphere Departments, an interdepartmental working group—the Small Island Club. This group provides an internal forum for sharing analytical and policy work on small island states and finding more innovative and better-tailored policy solutions to small island member countries.

39. The IMF has currently an Extended Credit Facility (ECF) program with Solomon Islands and has recently provided financial assistance to other small states in the Asia-Pacific region. The three-year ECF started in early December 2012, soon after the Stand-By Credit Facility (SCF) arrangement expired—building on the success of the SCF-supported program. Firm program implementation under the SCF, together with progress in structural reforms and more selective use of conditionality, has helped restore macroeconomic and financial stability. But the economy remains vulnerable because of a lack of diversification, a strong dependence on aid, and frequent natural disasters. Bolstering resilience to shocks, strengthening institutional capacity, and pursuing more inclusive growth remain top priorities under the current ECF-supported program. After the 2009 tsunami, the IMF approved a Rapid Access Component of the Exogenous Shocks Facility for Samoa; it also approved a Stand-By Arrangement and an Exogenous Shocks Facility for Maldives in late 2009.

40. Technical assistance and capacity building are key components of the Fund’s assistance in the region, most notably through the Pacific Financial Technical Assistance Centre (PFTAC). PFTAC has been providing technical assistance and training to Pacific Island countries for almost twenty years, helping the PICs greatly improve their economic management. PFTAC was the first IMF Regional Technical Assistance Centre and its success in the Pacific led to the model being replicated by the IMF in other regions. PFTAC consists of seven advisors and a coordinator. Its effectiveness in delivering technical assistance has enabled it to generate substantial increases in funding which have allowed it to almost double in size since mid-2011 to seven advisors and a coordinator. PFTAC supports countries’ reform implementation and its work is closely integrated with HQ-based technical assistance delivery and surveillance work under Article IV consultations. In addition to the technical assistance provided by PFTAC, since December 2012, the IMF Statistics Department has also been providing technical assistance to selected small states in the Asia and Pacific region on projects funded by Japan relating to external sector statistics.

41. The Fund has also increased synergies with development partners. World Bank and Asian Development Bank colleagues regularly join IMF Article IV missions in the Asia and Pacific small states. The Fund has co-organized outreach events, such as the Pacific seminar co-hosted with the World Bank, in Tokyo, during the 2012 Annual meetings. Fund staff has also liaised regularly with World Bank colleagues working on small states and on Pacific Island issues. Closer engagement with other development partners—such as AusAID, the New Zealand aid programme, and the EU—has also occurred through regular dialogue and participation in development partner meetings in the region.

42. Outreach. The Fund participates regularly in several regional meetings (i.e., Forum Economic Ministers’ Meeting and the South Pacific Central Bank Governors Meeting) and in several outreach events. The Asia and Pacific Department organized the first high-level regional conference on the Pacific Islands in Samoa, in March 2012, on fostering inclusive growth and building resilience to shocks, bringing for the first time together all major stakeholders, the private sector, and the academia.

43. The agenda going forward will continue to be guided by the authorities’ priorities. On the analytical front, possible topics could include: (i) leveraging regional integration with neighboring countries to achieve sustainable growth. While these countries are remote and scattered, their closest markets are among the most dynamic in the world; (ii) moving up the value chain to remain competitive in the global economy. While diversification may be a challenge, the potential for tapping fishing resources by establishing joint ventures for marine processing and attracting FDI remains huge; and (iii) strengthening fiscal frameworks in resource-rich countries to achieve inclusive growth. A more inclusive growth model remains a top priority, especially in countries whose commodity wealth does not spill over to the rest of the economy. More inclusive growth will also speed up progress toward achieving the Millennium Development Goals and strengthening the fiscal framework would reduce revenue volatility. On surveillance, despite progress on engagement with the Fund, two-thirds of the Asia and Pacific small states are currently on a 24-month Article IV consultation cycle. Their vulnerability to shocks suggests that more effective surveillance could be achieved by moving them to a 12-month cycle, as for most of the small states in other regions. Finally, further coordination with development partners could be pursued to avoid duplication of effort among stakeholders and prevent an excessive burden on the authorities. The next IMF regional conference on the Pacific Islands is scheduled for late 2013 and will focus on policies aimed at boosting potential growth.

Asia and Pacific Small States - Raising Potential Growth and Enhancing Resilience to Shocks
Author: International Monetary Fund
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    Small States—Asia and Pacific Region: Population, 2011

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    Small States—Asia and Pacific Region: Distance to the Closest Continent

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    Small States—Asia and Pacific Region: Liner Shipping Connectivity Index1/

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    Population versus GDP-Weighted Distance1/

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    Small States—Asia and Pacific Region: Current Government Expenditure, 2011

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    Small States—Asia and Pacific Region: Cost of Government, 1990–2010

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    Small States: Trade Openness1/

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    Small States—Asia and Pacific Region: Trade Openness1/

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    Small States—Asia and Pacific Region: Interest Rate Spread of Commercial Banks1/

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    Small States—Asia and Pacific Region: Domestic Credit to Private Sector1/

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    Small States—Asia and Pacific Region: Financial Development and Inequality, 1990-2010

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    Small States—Asia and Pacific Region: Real per Capita GDP Growth and Business Climate, 2000-10

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    Small States—Asia and Pacific Region: Ease of Doing Business Index 1/

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    Small States—Asia and Pacific Region: Secondary School Enrollment

    (In percent of population between 12-17 years old, 1990-2010 average)

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    Selected Asia and Pacific Countries: Lowest Human Development Index (HDI) Rank1/, 2011

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    Small States—Asia and Pacific Region: Tourism and Remittances

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    Micro States—Asia and Pacific Region: Sovereign Investment Fund Balances

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    Small States—Asia and Pacific Region: Official Development Aid by OECD Donors

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    Small States—Asia and Pacific Region: Official Development Assistance by Donors

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    Average Impact of Natural Disasters1/

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    Small States: Frequencies of Shocks1/

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    Small States—Asia and Pacific Region: External Grants, 2011

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    Small States—Asia and Pacific Region: Trade Balance of Goods and Services

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    Small States—Asia and Pacific Region: Current Account Excluding Grants

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    Small States—Asia and Pacific Region: Public Debt, 2011

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    Small States—Asia and Pacific Region: Volatility of Real per Capita GDP Growth, 1990-2010

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    Small States—Asia and Pacific Region: Real per Capita GDP Volatility and Growth, 1990-2010

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    Small States—Asia and Pacific Region: Volatility of Real per Capita GDP Growth and Governance, 1990-2010

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    Small States—Asia and Pacific Region: Volatility of GDP Growth, Terms of Trade, Aid, and Current Account Balance, 1990-2010

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    Small States—Asia and Pacific Region: Revenue Volatility

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    Small States—Asia and Pacific Region: Fiscal Volatility, 1990-2010

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    Small States—Asia and Pacific Region: Pro-cyclical Bias in Fiscal Policy, 2005-10

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    Small States: GDP per Capita, 2011

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    34. Small States: GNI per Capita1/, 2011

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    Small States—Asia and Pacific Region: Real GDP per Capita Growth

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    Small States—Asia and Pacific Region: Real GDP Growth, 1990-2012

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    Small States—Asia and Pacific Region: Rebuilding Policy Buffers