Macroeconomic Developments and Selected Issues in Small Developing States

This report builds on the work in the 2013 Board paper on Fund Engagement with Small States, the 2013 background papers on Asian and Pacific small states and Caribbean small states, and the 2014 staff guidance note. It provides a deeper analysis and policy recommendations in respect of three challenges identified in these papers. Looking ahead, the paper also analyses the impact and possible policy responses to two global economic trends—lower oil prices and diverse movements in major currencies.

Abstract

This report builds on the work in the 2013 Board paper on Fund Engagement with Small States, the 2013 background papers on Asian and Pacific small states and Caribbean small states, and the 2014 staff guidance note. It provides a deeper analysis and policy recommendations in respect of three challenges identified in these papers. Looking ahead, the paper also analyses the impact and possible policy responses to two global economic trends—lower oil prices and diverse movements in major currencies.

Introduction

1. This report focuses on macroeconomic developments and policy issues in small developing states. This grouping, comprising 33 countries with populations of less than 1.5 million, had a combined 2013 population of 14 million and a cumulative GDP of around $100 billion (see Text Table 1).1 The three largest members—the Bahamas, Mauritius, and Trinidad and Tobago—account for close to 50 percent of group output and 21 percent of population. Most members are middle-income countries, but the group also includes one low-income country (Comoros) and five high-income countries (all in the Caribbean).2 Caribbean small states represent about half of total group income, reflecting their higher income levels. In terms of population, the grouping is broadly evenly divided between the Caribbean, Asian Pacific, and Africa (with just one country, Montenegro, in Europe). Three-quarters of the group are island states.

Table 1.

Selected Macroeconomic Indicators, Small States and Rest of the World, 2013

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Source: World Economic Outlook, and IMF staff estimates

2. Small developing states face unique vulnerabilities. The challenges associated with diseconomies of scale were discussed in the 2013 Board paper on Fund Engagement with Small States, the 2013 background papers on Asian and Pacific small states and Caribbean small states, and the 2014 staff guidance note. The papers highlighted that “smallness” adds to production and distribution costs, undermines competitiveness, hampers the delivery of public goods, poses other administrative capacity constraints, and leaves small states with minimal diversification against external shocks, including natural disasters. In the absence of strong and sustained policy responses, these factors have contributed to weaker growth among small states, higher macroeconomic volatility, and high debt levels since the 2000s.

3. This report provides four perspectives on the economic outlook and policy challenges faced by small states:

  • Economic prospects through 2016. The report opens with a discussion of recent macroeconomic trends and the outlook through 2016. This analysis, which draws on February 2015 WEO projections, envisages generally sluggish growth for small states as a whole, somewhat higher fiscal deficits after a temporary narrowing in 2013, and a general upward drift in already relatively high public debt ratios. The recent sharp decline in global oil prices and more general easing of other commodity prices will contribute to maintaining low inflation. While creating pressures on commodity exporters, it will reinforce growth prospects and provide scope to improve domestic and external balances for other small states. However, prudent fiscal policies and a supportive structural environment will be needed to sustain these gains, and structural reforms to boost competitiveness will be even more critical for countries experiencing a real exchange rate appreciation on account of currency linkages to the US dollar.

  • Challenges of fiscal management. The first of three selected issues chapters focuses on challenges of fiscal management. Reflecting diseconomies of scale in providing public goods and services, recurrent spending by small states typically represents a large share of GDP. For some small states, this limits the fiscal space available for growth-promoting capital spending. At the same time, government revenues are often volatile for small states. With limited borrowing options, this can result in pro-cyclicality of expenditures, with capital spending bearing the brunt. Policies for smoothing spending and safeguarding fiscal space for capital investments are discussed.

  • Exchange rate devaluation. Given the greater openness and relatively undiversified economic base of most small states, it is commonly suggested that exchange rate devaluation will be less successful in achieving external adjustment than for larger states. This issue is addressed in a second analytical chapter, with insights drawn from macro modeling, event analysis, and econometrics. The chapter concludes by discussing policy elements that can maximize the likelihood of successful exchange rate adjustment in small states.

  • Financial inclusion. Provision of banking services to small and sometimes widely dispersed populations is costly, and many small states have a small and highly concentrated banking sector. For the smallest states, financial inclusion, measured by the number of bank branches or deposit accounts per capita, is low. This poses challenges for access to credit, with consequences for investment and growth. Options for fostering improved financial inclusion in small states are discussed.

4. Small states are considered in this report from several analytical perspectives. The conjunctural chapter distinguishes between tourism-based economies, commodity exporters, and small states in a fragile situation (Box 1, and Table 2). These categories are not exclusive, with several states belonging to more than one analytical group. Consideration was also given to the performance of micro states: however, trends for this group are very similar to that for tourism-based economies, given the considerable overlap in coverage. In some instances, distinction is also made between small states based on regional characteristics (distinguishing, for example, between Caribbean and Pacific Island small states). The chapter on financial inclusion also gives particular attention to the distinguishing features of small states that are offshore financial centers.

Definition of Analytical Groupings of Small States

The analytical breakdown of small states is as defined below:

  • Tourism based countries are those where exports of tourism services exceed 15 percent of GDP and 25 percent of total exports. Approximately half of the small developing states are tourism based, rising to three-quarters in the Caribbean region.

  • Commodity exporters are those countries where at least 20 percent of total exports in 2008–2012 were natural resources. The group includes two fuel exporters (Trinidad and Tobago, and Timor Leste) as well as other diverse commodity exporters: Guyana (gold); Belize (petroleum, citrus, sugar and bananas); Suriname (alumina, gold and oil); Solomon Islands (logs and minerals); Bhutan (hydroelectricity and steel). Trinidad and Tobago is the only commodity exporter that falls in the high-income group.

  • Small states in a fragile situation are defined as having weak institutional capacity (three year average of the Country Policy and Institutional Assessment (CPIA) score below 3.2) and/or being subject to significant political conflict and also face (a) severe domestic resource constraints; and (b) vulnerability to shocks. About a quarter of small developing states are in a fragile situation, and all except one (Comoros) are in the Asian-Pacific region.

  • Micro states are defined as having populations below 200,000. Almost half of all small states are micro states and combined they have about 10 percent of the total population of small states. All microstates are islands.

  • Three countries do not fall into the above analytical groupings—Djibouti, Montenegro, and Swaziland.

Table 2.

Profile of Developing Small States1/

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Sources: Staff guidance note on small states, WEO, LIC-DSA and MAC-DSA databases, and Fund staff calculations and estimates.

Following the guidance note on small states, “Small States” are defined as developing countries that are Fund members with populations below 1.5 million while “Micros States” are a sub-group with populations below 200,000 as of 2011.

High-income countries (HIC) have per capital annual incomes of $12,746 or more; Upper middle-income countries (UMC) of between $4,126 and $12,745; lower middle-income countries (LMC) of between $1,046 and $4,125; and lower-income countries (LIC)$1,045 or less based on the World Bank Atlas method, updated July 2014.

Based on the World Bank definition of (a) an average CPIA rating of 3.2 or less, or (b) a UN and/or regional peace-building mission within the country within the last three years.

Commodity-exporters are countries with the relevant characteristics used in the stylized facts have either natural resource revenue or exports at least 20% of total fiscal revenue and exports, respectively, over 2008–12 (average).

Exporters of tourism services (the ratio of exports of tourism services to output exceeds 15 percent and the ratio of exports of tourism services to total exports exceeds 25 percent; covers 10 percent of economies)

A country or jurisdiction that provides financial services to nonresidents on a scale that is incommensurate with the size and the financing of its domestic economy

Data is from the 2014 Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER)

This category combines the countries that are members of WAEMU, CEMAC and ECCU.

PRGT list effective as of 2014.

For PRGT-eligible members the risk rating is based on the latest available LIC-DSA. For the others, the risk assessment it is based on the latest available MAC-DSA or assigned according to criteria in the MAC-DSA guidance note.

Macroeconomic Trends1

Two important global developments will shape the near-term macroeconomic environment for small developing states—the recent fall in commodity prices, notably for oil, and movements in major currencies. The majority of small states are oil importers, and a balance is needed between using lower oil import costs to strengthen fiscal balances, which should be a priority where energy subsidies are high, and reducing costs to consumers, which can boost spending power and growth prospects. Where fuel is taxed on an ad valorem basis, fiscal policies also need to weigh a possible loss of tax revenues. Staff projections point to a moderate growth boost from lower oil prices in 2015, though the pace of expansion is expected to remain below that achieved prior to the global financial crisis. Overall, the windfall from lower oil prices is not expected to strengthen budgets significantly across the small states community—and oil exporters will see significant strains. With only modest growth and continuing high spending needs, public debt ratios are projected to rise further from an already generally high level. Many small developing states will experience more appreciated real exchange rates in 2015 on account of pegs to the US dollar or to currency baskets that include the dollar. Against a backdrop of slow recovery in advanced economy markets and less competitive exchange rates, small developing states should seek to exploit opportunities to strengthen links to faster-growing EMDCs. Given the narrow economic base in most small states, the required transformation will be challenging, and determined efforts to facilitate structural reform and foster competitiveness will be needed. In most cases, the private sector will need to play a key role.

A. Recent Macroeconomic Performance and Near Term Outlook

Economic growth continues to disappoint …

1. Growth remains well below pre-crisis levels. In 2013, real per capita GDP growth averaged 0.7 percent across small states, with one-in-three experiencing a decline. Preliminary estimates suggest a pick up to one percent growth, on the same basis, in 2014, down from an average of about 3 percent in 2000–2008. Small states have generally tracked the growth performance of advanced economies—which represent important markets for tourism, financial, and other service exports. As a result, their growth has fallen well short of that for larger emerging market and developing countries (EMDCs) (Appendix Figure 1a). For 2015-16, per capita GDP growth is projected to edge up to around 2 percent, reflecting differential performance between oil and non-oil economies.

2. Natural resource exporters face a more challenging environment. Small commodity exporters saw generally robust growth over the past decade, reflecting strong performance, in particular, by the fuel-exporting states of Timor-Leste and Trinidad and Tobago (Appendix Figure 2a). However, growth slowed in 2012–2014 as a result of weaker export market conditions as well as adverse supply shocks.2 With the latest decline in oil prices and softer commodity prices more generally, resource-exporting small states are projected to see only modest growth in 2015–16.3

Given that a significant element of the decline in oil prices is projected to be permanent, a priority is to adjust spending to sustainable levels, while using available financial buffers to smooth the adjustment. Structural reforms to promote growth in the non-fuel economy should also be a priority.

3. Lower oil prices offer a modest growth boost for oil importing small states. In 2015–16, the recent drop of oil prices and other factors have led to slight upward revisions of real GDP growth in most cases, compared with the Fall 2014 projections (see Figure 1). The strengthening economic recovery in North America will also benefit tourism in the Caribbean, and some Indian Ocean and Pacific tourism destinations (Mauritius, Fiji, Maldives, Seychelles, and Vanuatu) are seeing strong growth in tourist arrivals from Australia and China (though the latter from a low base). However, with only a sluggish recovery in the global tourism market, per capita GDP growth in tourism-based small states is projected to remain around 1¾ percent in 2015–16; for Caribbean states, this is about half that seen in the pre-crisis period. Many tourism-based economies also remain at particular risk from natural disasters.4 A few tourism-based economies have fared better: Mauritius has had sufficient policy space to support growth through expansionary domestic policies, and the Seychelles is benefitting from a program of strong structural reform initiatives.

Figure 1.
Figure 1.

Impact on 2015 Projections of Lower Oil Prices and Other Factors 1/

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

1/ WEO Fall 2014 is used as projections before shock, and the latest WEO is used as projections after shock.Source: World Economic Outlook, October 2014 and latest.

Inflation is projected to remain low, benefitting from strong nominal anchors…

4. Inflation in small states is projected to remain generally low, reflecting the anchoring role of pegged exchange rates and lower international commodity prices.5 After temporary spikes in inflation in 2008 and 2011 driven by international food and fuel prices, inflation averaged 2½ percent in 2013 and 2014. Across small states, differences in inflation tend to reflect demand strength, with slow-growing tourism-based economies experiencing the lowest inflation, on average (Appendix Figures 1a and 2a). Inflation is projected to decline further in 2015, mostly as a result of lower global oil prices, before increasing slightly in 2016 (Figure 1). Inflation remains higher than in advanced economies, however, contributing to real exchange rate appreciation.

After narrowing in 2013, fiscal deficits have subsequently widened …

5. The post-crisis rebuilding of fiscal buffers has not been sustained. Small states, like larger peers, saw fiscal deficits surge in 2009 with the onset of the global financial crisis. With steps to rebuild revenues and reduce spending ratios, deficits declined, on average, through 2010–2013. This process has been short-lived, however, with deficits widening again in 2014, and projected to stabilize at an average of around 3¾ percent of GDP in 2015–16 with a mixed impact of lower oil prices on fiscal outcomes (Appendix Figure 1a, and Figure 2).

Figure 2.
Figure 2.

Vulnerability Profile for Small States

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

6. The increases in fiscal deficits are driven by developments in commodity exporters and small states in fragile situations. Among commodity exporters, Timor-Leste and Trinidad and Tobago (both fuel exporters) saw sizeable fiscal surpluses in the 2000s, as did Solomon Islands (exports of logs and minerals). In each case, fiscal positions have deteriorated on account of weaker commodity prices, and the projected lower oil prices in 2015–16; for Timor Leste, the depletion of resources and spending pressures from projected large capital projects are also factors. For small states facing fragile situations, fiscal performance was buoyed in 2012–2014 by temporary positive developments, including debt relief under the enhanced Heavily-Indebted Poor Countries (HIPC) Initiative (Comoros), revenues under an Economic Citizenship Program (Comoros), and a surge in fishing license revenues (Kiribati and Tuvalu). With a return to more normal levels of fiscal receipts including lower grant revenues (Micronesia and Marshall Islands), the overall fiscal position of fragile states is projected to revert to deficits in 2016.

7. A mixed pattern of generally higher fiscal deficits is projected for tourism-based economies through 2015–16 (Appendix Figure 2a). The picture varies across the country grouping. Deficits in excess of 6 percent of GDP are projected for Barbados, St Lucia and Cabo Verde and in the 15 percent of GDP range for the Maldives, reflecting expansionary fiscal policies, weak revenues, and natural disaster-related reconstruction costs and social spending. At the same time, continuing fiscal surpluses are projected for Seychelles (benefitting from a successful adjustment program launched in 2008) and St Kitts and Nevis (with incomes from a Citizenship-by-Investment program). Recently adopted adjustment programs are projected to strengthen fiscal performance in Grenada, the Bahamas, and Samoa.

External current account balances of most non-commodity exporters will strengthen with lower oil prices …

8. After deteriorating in line with fiscal performance in 2014, external current account deficits of most non-commodity exporters are projected to improve somewhat in 20152016, mostly on account of lower oil import bills (Appendix Figure 1a). Given the dominant role of the public sector in small states, external imbalances largely mirror fiscal performance. Consistent with this, wider external deficits are largely associated with the declining earnings of commodity exporters and the unwinding of temporary positive earnings shocks for small states in fragile situations (Kiribati and Tuvalu) (Appendix Figure 2a). Excluding commodity exporters, Kiribati, and Tuvalu, the average current account deficit of small states is projected to decline by 2 percentage points to about 11 percent of GDP in 2015-16.

Exchange rate-based measures of competitiveness have diverged across small states …

9. Reflecting the role of currency pegs, real effective exchange rates have been dominated by major currency movements. The average real effective exchange rate across all small states has been relatively stable since 2000 (Appendix Figure 3). The pattern varies depending on the denomination of the currency peg. For countries pegged to the US dollar, real exchange rates depreciated through 2007-08, subsequently appreciating through 2013. By contrast, Pacific Island countries have seen a sustained real appreciation, following the trend in the Australian dollar. The immediate impact of real exchange rates on competitiveness and external imbalances is secondary, in many cases, to the dominant role of fiscal performance in determining trade and external balances; indeed, grant receipts and associated import-intensive capital spending dominate external accounts for many Pacific Island economies. That said, the weaker US dollar has been beneficial, on balance, for Caribbean tourism-based economies as they have sought to rebuild markets after the global financial crisis. To this extent, the recent strengthening of the dollar could pose new challenges for these economies, while the weakening of the Australian dollar could help tourism competitiveness for small states in the Pacific.6

External buffers have narrowed …

10. Total public debt has continued to rise in small states. The public debt-GDP ratio in small states has edged higher reflecting sizeable fiscal deficits and generally sluggish growth (Appendix Figure 1a). Tourism-based small states face the worst debt dynamics, with already high levels of public debt projected to rise further over 2015–2016. The majority of the highly indebted tourism-based small states are in the Caribbean, and debt ratios are projected to rise significantly for Grenada,7 The Bahamas, Barbados, St. Lucia, and St. Vincent and the Grenadines, mainly due to high fiscal deficits.8 Outside the Caribbean, Cabo Verde, the Maldives, and Bhutan are also projected to see public debt–to–GDP ratios exceed 100 percent in the near term, also generally reflecting projections for wider fiscal deficits.

11. External debt is also projected to increase. Average external debt-to-GDP ratios are projected to rise from about 50 percent in 2013 to 53 percent in 2015–16. For small states, single large projects can have a major impact on debt ratios. For example, the construction of new hydropower projects in Bhutan is projected to add significantly to external debt, albeit with projected strong growth and export dividends. Similarly, external debt ratios have increased in Djibouti on account of infrastructure investments. In a few countries, external debt burdens have been significantly reduced through strong adjustment programs (Seychelles) and HIPC debt relief (Comoros).

Effects of Commodity Price Decline

About one-quarter of small states are commodity exporters. They have faced declining prices in recent years for gold (Suriname, Guyana) and oil prices (Belize, Trinidad and Tobago, Timor Leste). Export earnings in 2015 are projected to decline by more than 15 percent for Trinidad and Tobago, and by more than 10 percent for both Suriname and Guyana. In each case, fiscal balances will be adversely impacted.

At the same time, many small states will benefit from lower world oil prices. In comparison with the Fall 2014 WEO, growth has been revised upwards, on average, by 0.2 percentage points for 2015-16. The lower oil import costs and pass-through to transport and power generation costs will boost household and corporate spending power, stimulating private consumption and investment. Reflecting lower energy costs, the forecast for CPI inflation has been revised down in 2015 by about 0.7 percentage points, while projections for current account balances have strengthened by an average of 1.4 percentage points of GDP. With offsetting fiscal effects from lower fuel subsidies and lower fuel tax receipts, the updated projections for small states do not show a major change in fiscal balances.1

uA01fig02

IMF Commodity Price Indices

(2005=100)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: IMF Commodity Market Monthly, Feb 2015

Countries in the Caribbean with access to financing through Petrocaribe could be vulnerable. This financing covers a large share of the current account deficits in many of these countries (for example, 40 percent in Belize, 20–25 percent in Guyana, and up to 10 percent for ECCU countries). The sharp drop in world oil prices is straining Venezuela’s public finances. As a result, it may need to revisit its stated policy of preserving financing through Petrocaribe. This could pose financing challenges for Petrocaribe beneficiaries who do not have access to alternative concessional or market financing.

1See Robert Rennhack and Fabian Valencia (2015), Effect of lower oil prices on the Caribbean. Caribbean Corner, Issue 02, January 2015.

12. Debt sustainability is a challenge for most small states. About two-thirds of small states are categorized as in “high risk” of debt distress based on the latest debt sustainability analysis (LIC-DSF) conducted jointly by the IMF and WB9 (with one small state in debt distress and recently launched a debt restructuring), or “higher scrutiny” based on the latest available DSA for market-access countries (MAC-DSA). By contrast, only about one-in-seven small states are categorized as in “low risk” according to the LIC-DSF or “lower scrutiny” according to the MAC-DSA. Commitment to fiscal consolidation and growth-enhancing reforms would help address debt overhangs and lagging growth.

13. Reserve buffers have improved, but could benefit from further increases. Levels of international reserves among small states in 2013 were higher than the 2000–12 average (Appendix Figure 3). Reserve cover is approaching the average of 4 months of imports seen, on average, for advanced economies. However, it remains well below the average of 8 months cover for emerging markets. Given the need to defend currency pegs and smooth external shocks (including natural disasters and volatile aid flows) in the context of generally limited access to international capital markets, somewhat higher reserve cover appears warranted.10

B. Vulnerabilities and Structural Issues

14. Growth performance is vulnerable to external shocks. Based on the “growth decline vulnerability index” (GDVI) methodology, small states’ vulnerabilities in the event of a global shock are calculated to have diminished slightly in 2014, but remain higher than before the global financial crisis.11 Moving against the general trend, vulnerabilities have risen significantly for tourism-dependent economies, to the point that they are now seen as more vulnerable than fragile small states (Figure 2).

15. Several factors contribute to the vulnerabilities of small states. An underlying factor is the generally low quality of economic institutions. Empirically, countries with weak institutions do not typically conduct effective countercyclical macroeconomic management to smooth external shocks.12 In addition, debt levels are high for many countries and reserves could be higher, leaving little fiscal space to mitigate the impact of external shocks. More generally, government revenues and grants are volatile and often depend on economic developments in advanced country trading partners. Last, the geography of most small states put them at risk of natural disasters.13

16. A protracted global slowdown, would have a substantial impact on small states. Scenario analysis conducted using the Fund’s G20MOD and Euromod models suggest that small states are particularly vulnerable to risks of a slowdown in advanced economy growth. This reflects the importance of the latter for tourism, financial services and other exports, as well as for remittances, aid, and other investment inflows.14 Some small states have also diversified to BRIC markets and are vulnerable on this front.

17. Growth in small states has been held back by structural impediments. A comparison of the 2010 and 2013 World Bank Doing Business Indices suggests little progress. One exception is in regard to access to finance, where commodity exporters and fragile small states narrowed the gap with tourism-based counterparts.15 Progress in achieving economic diversification has also generally been limited (Box 4).16 A deepening of structural reforms to strengthen governance and improve the business environment is needed to boost the competitiveness and economic attractiveness of small states.

Diversification in Small States

Volatility in growth for small states partly reflects their limited diversification. Several small states are an exception, showing improved diversification in recent decades (Mauritius, Barbados, Belize, Fiji, and Antigua and Barbuda). These states also have relatively higher levels of income, though the direction of causation is difficult to establish.

uA01fig03

Evolution of Most Diversified Small States - Export Shares by Product

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

The process of diversification would benefit, in some cases, from better product quality.1 Surprisingly, data suggest that many small states produce manufacturing goods that are comparable in quality to larger emerging markets—though this may reflect participation in a supply chain, assembling goods produced elsewhere.2 There appears to be a clearer scope to strengthen product quality in the agricultural sector, which is important as agricultural products comprise about half of small states’ exports of goods.

uA01fig04

Quality index, 2010

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

1In the chart, the blue dots represent product quality in 2010 for individual countries. The red dot represents the median for small states while the black and green dots represent the medians for LIDCs and EMs, respectively.2The available data and methodology do not allow for a breakdown of commodities by position in the value chain.
Appendix Figure 1a.
Appendix Figure 1a.

Selected Macroeconomic Indicators for Small States 2000-2016

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: World Economic Outlook, and IMF staff estimates
Appendix Figure 1b.
Appendix Figure 1b.

Selected Macroeconomic Indicators for Small States 2000-2016

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: World Economic Outlook, and IMF staff estimates
Appendix Figure 2a.
Appendix Figure 2a.

Trends in Small States sub-groups 2000-2016

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: World Economic Outlook, and IMF staff estimates
Appendix Figure 2b.
Appendix Figure 2b.

Trends in Small States sub-groups 2000-2016

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: World Economic Outlook, and IMF staff estimates
Appendix Figure 3.
Appendix Figure 3.

Exchange Rate Development of Small States 2000-2016

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: World Economic Outlook, and IMF staff estimates

Strengthening Fiscal Frameworks and Improving the Spending Mix in Small States1

This chapter focuses on key challenges for fiscal management. Reflecting diseconomies of scale in providing public goods and services, recurrent spending by small states typically represents a large share of GDP. For some small states, this limits the fiscal space available for growth-promoting capital spending. At the same time, with limited buffers, revenue volatility often results in procyclical fiscal policy. To strengthen fiscal frameworks, small states should seek to streamline and prioritize recurrent spending to create fiscal space for capital spending. The quality of public spending could also be improved through public financial management reforms, fiscal anchors and multi-year budgeting.

A. Introduction

1. The unique characteristics of small states make fiscal management more challenging than elsewhere. Most importantly, the indivisibility in the provision of public goods and the public sector being the main employer introduce rigidities into the budget, tilting the composition of spending toward recurrent outlays. With limited fiscal resources, high recurrent spending can crowd out capital spending, leading to under-investment in infrastructure and other growth-enhancing areas. At the same time, small states generally face greater revenue volatility than other country groups (IMF 2013a, b), owing to their exposure to exogenous shocks and narrow production bases. This is particularly true for fragile states and commodity exporters. Small states often lack the capacity to weather revenue volatility for two reasons: they cannot finance temporary fiscal shocks because domestic banking systems are shallow, and they have limited access to international capital markets (Holden and Howell, 2009).

2. Despite the lumpiness (relative to their small GDP) of capital projects, fiscal frameworks are not typically designed with a multi-year perspective to allow smoothing of expenditures over the business cycle. Although foreign assistance has provided some countercyclical support during downturns to aid-dependent small states, the volatility of revenue has generally resulted in volatile spending patterns and procyclical fiscal policy. Reflecting the rigidities in recurrent spending cited above, budget pressures typically affect primarily capital spending. This means that already strained capital budgets face further cuts in the event of external shocks, which further undermines longer-term growth prospects.

3. Assessing the fiscal stance in small states is complicated. Because of revenue volatility, especially in the Pacific, headline fiscal balances do not always accurately reflect the underlying fiscal position. However, data deficiencies, capacity constraints, and structural changes in the economy make it difficult to estimate meaningful cyclically-adjusted or structural balances based on output gaps (IMF, 2014c, Appendix Box 1). The existence of several extra budgetary funds that are not integrated in the budget presentation and the difficulties in measuring capital spending, when projects are implemented outside the central government or controlled by planning ministries using charts of accounts differing from that used by finance ministries, add additional challenges in evaluating the fiscal position.

4. Strengthening fiscal frameworks by isolating the budget from revenue volatility and shielding public spending (especially capital) could help increase small states’ resilience to shocks and boost their potential growth. This means using fiscal anchors to smooth the volatility of revenue and capital expenditure over the business cycle and creating policy space for spending on infrastructure, health, and education. It also means strengthening the medium-term orientation of fiscal policy as fiscal policy should not be formulated on a year-by-year basis only. And improving the quality of public spending through public financial management reforms is key to supporting growth.

5. However, policies need to be tailored to the special challenges of small states. The design of fiscal anchors should be country-specific and kept simple. Medium-term fiscal estimates could focus only on main aggregates to facilitate the adoption of a multi-year budget framework. Using such a framework could also help—from a political economy point of view—contain spending pressure, particularly acute in small states given their development needs by better sequencing the implementation of capital projects.

B. Improving the Mix of Public Spending

6. Current spending rigidity is a key issue in small states. It results from the large share of current spending in GDP relative to other countries. In providing public services, small states face higher per-capita government costs relative to other groups. This is because of the indivisibility of public goods and diseconomies of scale since broad public services must be provided despite small populations. Indeed, the relationship between the size of the country and current spending is U-shaped. Distance from key markets also raises import transport costs. These effects are worsened in microstates. Pacific Islands’ challenges are also compounded by their extreme remoteness and large dispersion. These characteristics lead to an inverse relationship between the size of the country and current government spending.

uA01fig05

Current Government Expenditure

(In percent of GDP)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Sources: IMF, WEO; and IMF staff estimates and projections.
uA01fig06

Current Expenditure and Population, 2003-13

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: IMF staff estimates.
uA01fig07

Small States: Current Government Expenditure and Size

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: IMF staff estimates.
uA01fig08

Small States1: Current Government Expenditure and Geographic Dispersion

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

1/ Includes Antigua and Barbuda, The Bahamas, Fiji, Kiribati, Marshall Islands, Micronesia, Palau, Samoa, Solomon Islands, St. Kitts and Nevis, Tonga, Trinidad and Tobago, Tuvalu, and Vanuatu.Source: IMF staff estimates.

7. The spending mix is tilted toward current spending, despite infrastructure bottlenecks (Figure 1) and this could impede higher real GDP per capita growth. This under-investment impedes sustainable growth. Despite large development and infrastructure gaps over the last ten years, capital spending in the small states accounted for less than 20 percent of government spending—well below the average of low-income countries which is 32 percent of government spending. An exception is Cabo Verde which in the past decade embarked on a large investment program, at the cost of recurrent spending.

Figure 1.
Figure 1.

Small States: Spending Mix and Infrastructure Gap

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

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

8. The composition of public spending matters in determining the impact of fiscal policy on growth in small states. Econometric results suggest that the higher the share of public investment for a given amount of public spending, the higher the per-capita growth (Appendix 1, Table 1). Moreover, the impact of capital spending on growth is stronger in small states than in other country groups. The effect is even stronger in Asia and Pacific small states, consistent with their large development needs, both in terms of capital and human infrastructure. Staff analysis also suggests that increasing the share of capital investment will boost per-capita growth but expanding the deficit and increasing public debt after a certain threshold do not support growth. The threshold derived within the model, after which debt negatively affects growth, is 30 percent of GDP for the Asia and Pacific small states—well below the 50 percent threshold that applies to the full sample. This calls for building buffers (keeping the debt at manageable levels and having low fiscal deficits) and tilting the composition of spending toward capital outlays.

9. Staff statistical analysis presented below suggests that building buffers (i.e., keeping deficits or debt low) is good for growth, even more so when spending is tilted toward capital investment. Higher capital spending is good for growth but less so when it expands deficits too much and raises debt unduly. This calls for preserving fiscal space for growth-enhancing investment, including infrastructure spending.

uA01fig09

Real GDP per Capita Growth

(In percent)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Notes: High (low) capital means the share of capital spending is above (below) the median. High (low) debt means public debt in percent of GDP is above (below) the median. 1990-2012.Source: IMF staff estimates.
uA01fig10

Real GDP per Capita Growth

(In percent)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Notes: High (low) capital means the share of capital spending is above (below) the median. High (low) deficit means the fiscal deficit in percent of GDP is above (below) the median. 1990-2012.Source: IMF staff estimates.

10. Additional staff findings based on an event analysis show that in small states, government spending expansion led by capital spending results in higher real GDP per capita and lower public-debt-to-GDP ratios than do expansions led by current spending. In the small states, government spending expansions driven by capital lead to a minimum increment in public-debt-to-GDP ratios (about 2 percent), while during government expansions led by current spending, the public-debt-to-GDP soars by about 10 percentage points of GDP. The impact on growth of government expansion led by capital is also much higher during and after the episode than the impact on growth led by increased current spending.2 However, one important caveat is that event analysis does not determine causality. This is because it does not control for the endogeneity of the variables and should therefore not be interpreted as indicating a causality relationship among them. The endogeneity issues are solved within the econometric analysis presented in Appendix I, Table 1 by using the generalized method of moments (GMM).3 These results are in line with a recent IMF World Economic Outlook (WEO) analysis (IMF, 2014g) which found that public investment raises output in a wide range of countries. However, relative to the WEO, this chapter finds that for small states the impact of public investment on real GDP growth is somewhat lower than for larger states. This could be due to lower fiscal multipliers in small open economies whose capital inputs are mainly imported as well as weaker PFM frameworks that could prevent efficient public investment.

uA01fig11

Small States: Real GDP per Capita during Episodes of Government Expenditure Expansion1

(Year-on-year percent change)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

1/ Includes only public expenditure episodes that resulted in higher fiscal deficits. 1990-2012.2/ Three-year average after the episode.Source: IMF staff estimates.
uA01fig12

Small States: Public Debt during Episodes of Government Expenditure Expansion1

(In percent of GDP)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

1/ Includes only public expenditure episodes that resulted in higher fiscal deficits. 1990-2012.Source: IMF staff estimates.

11. Public spending efficiency in small Pacific states is lower than in other small developing states (Figure 2). In the Pacific Islands, a large share of government spending (combining both current and capital) is allocated to health and education, relative to other small states, consistent with these states’ large development needs (Figure 3). However, relatively poor outcomes in terms of human development indicators can be explained by the high cost of providing these services in small remote islands. By looking at the relation between population dispersion and efficiency in public expenditure (proxied by the ratio between education and health outcomes and the share of health and education spending as a percent of GDP), we find a positive relationship between population density and efficiency indicators in public expenditure (Figure 2). High population dispersion is associated with lower efficiency education and health expenditure (i.e., positive slopes) with a correlation of 0.3–0.4. While remoteness and dispersion matter, recent analysis (Haque and others, 2014) points to the need to improve the quality of public spending by accelerating public financial management reforms.

Figure 2.
Figure 2.

Measures of Efficiency of Public Spending and Population Dispersion

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

1Density computed as inhabitants per square kilometers. The variable was rescaled by taking log of the density multiplied by 1,000. Efficiency measured as secondary enrollment rate divided by public education expenditure-to-GDP ratio. Efficiency measured as life expectancy divided by public health expenditure-to-GDP ratio, 1990-2012.Source: IMF staff estimates.
Figure 3.
Figure 3.

Health, Education Expenditure, and Selected Human Development Indicators

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

1Excludes advanced economies.Sources: World Bank, WDI; and IMF staff estimates.

C. Coping with Revenue Volatility

12. Revenue volatility in small states is larger than in developing non- small states. The revenue base is narrow and is subject to several exogenous shocks. The volatility in revenue is expected to continue due to the recent large drop in oil prices.

13. The sources of volatility vary across small states and depend on cyclical and non-cyclical factors (Figures 4 and 5, and Appendix I, Table 2). On average, revenue shows strong pro-cyclicality, especially in net commodity importers. Revenue volatility in small states also owes to terms-of-trade shocks attributable to a lack of diversification and narrow production bases. The elasticity of revenue to terms of trade, after controlling for GDP, is much higher in resource-rich small states than in other comparators. Revenue in small states also depends on their vulnerability to natural disasters. Staff analysis suggests that a natural disaster that affects 1 percent of the population causes a drop in real revenue of 0.2 percentage point. Further analysis of the small states of the Pacific points to a contraction in tax revenue of 0.2 percentage point of GDP in the year of the disaster, followed by a revenue rebound in the following year (Appendix I, Figure 1). After controlling for GDP, the volatility of trade flows (including tourism) and of remittances also affects revenue volatility. In Asia and Pacific small states, most of the volatility is also caused by fishing license fees, which are independent of the economic cycle.

Figure 4.
Figure 4.

Small States: Sources of Revenue Volatility1

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

1 Revenue excludes grants. Developing non- small states are defined as developing countries excl small states.Sources: IMF, WEO; and IMF staff estimates.
Figure 5.
Figure 5.

Small States: Revenue Volatility Across Different Groups

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

1Volatility after excluding time trend in the underlying ratios to remove structural factors. 2/ Excluding grants. 3/ Excluding advanced economies.Sources: IMF, WEO; and IMF staff estimates.

14. The degree of revenue volatility differs across small states, with fragile states, commodity exporters, and microstates affected the most. The volatility of tax revenue is highest among most resource-rich countries (Solomon Islands, Trinidad and Tobago, Guyana, and Suriname) as a result of commodity price shocks as well as uncertainty regarding the size and exhaustibility of resources. The volatility of non-tax revenues is extremely high, especially in APD micro states that rely on fishing license fees (e.g., Kiribati and Tuvalu—where these fees represent about 50 percent of revenues) and in such resource-rich countries as Timor-Leste, Sao Tome and Principe, and Bhutan, owing to the volatility of royalties associated with natural resources.

15. The volatility of revenue is a potential source of vulnerability. High revenue volatility may lead to significant output volatility and undermine overall fiscal performance in the absence of a stabilization fund (IMF, 2012).

Addressing Procyclical Fiscal Policy

16. The combination of revenue volatility and current spending rigidities, compounded by small states’ low access to finance, has prevented expenditure smoothing over the business cycle and has thus fostered fiscal pro-cyclicality (i.e., namely spending went up together with revenues during upturns and vice versa during recessions)—Figure 6. The volatility of revenue has generally been translated into spending volatility, especially capital spending. Staff analysis suggests that revenue shortages have resulted in cuts to capital spending. Econometric results also confirm the pro-cyclicality of capital spending (Appendix 1, Table 3).

Figure 6.
Figure 6.

Small States: Procyclical Bias in Fiscal Policy

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Sources: IMF, WEO; and IMF staff estimates.

Building Fiscal Buffers to Enhance Resilience: The Role of Fiscal Anchors

17. Policies that manage revenue volatility and avoid procyclical fiscal bias could foster resilience in small states. Given small states’ vulnerability to shocks, enhancing resilience requires building adequate fiscal buffers for countercyclical support during rainy days and creating policy space for spending on infrastructure to boost potential output. Indeed, some small states have made progress in rebuilding fiscal buffers after the 2008–09 crises, but more than half still have less comfortable buffers (higher debt and lower fiscal balances) than before the crisis.

uA01fig13

Small States: Gross Public Debt

(In percent of GDP)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Sources: IMF, WEO; and IMF staff estimates.
uA01fig14

Small States: Overall Fiscal Balance

(In percent of GDP)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: IMF staff estimates.

18. Because of revenue volatility, small states’ headline fiscal balances do not always reflect accurately the underlyling fiscal position. The improvement in the fiscal position of small states, defined by the change in the underlying fiscal balance (see definition used below), appears to be smaller than the change in the overall balance suggests in a quarter of the small states.

uA01fig15

Fiscal Balance and Underlying Fiscal Balance, 2013

(Deviation from 2010-11; percentage points of GDP)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: IMF staff estimates.

19. Strengthening fiscal frameworks by using fiscal anchors to insulate the budget from revenue volatility is key. A country-specific fiscal anchor could help illustrate that fiscal policy reflects both short-term cyclical and medium-term sustainability goals. It will also help properly assess a country’s underlying fiscal position, which is sometimes masked by headline fiscal balances. Stronger fiscal frameworks will avoid fiscal pro-cyclicality by saving windfall revenue during an “up” cycle and vice versa. The use of a fiscal anchor to smooth spending over the cycle would also go hand in hand with strengthening the medium-term orientation of fiscal policy, replacing the year-by-year formulation based on volatile and uncertain revenue.

20. The design of fiscal frameworks by using anchors that help manage revenue volatility and ensure debt sustainability in small states should be kept simple. Moreover a fiscal rule framework should set a target on both fiscal anchor and an operational target. While the former is the final objective to preserve fiscal sustainability, the latter is an intermediate target under the direct control of the governments with a close link to the debt dynamics. As the final objective of the framework is to preserve fiscal sustainability, a natural anchor for expectations is the debt ratio, which creates an upper limit to repeated (cumulative) fiscal slippages. In addition to the anchor, the framework should also include an operational target, which would be under the direct control of governments, while also having a close link to debt dynamics.

21. As reported in IMF 2014f, the choice of the operational target is more difficult and controversial. Public debt cannot play this role, as factors other than policy decisions affect public debt changes, including below-the-line operations and valuation effects. Available options include a revenue rule, an expenditure rule, a nominal balance, a structural balance target—in level or in first difference—or a combination of them”. De facto, capacity constraints and, importantly, structural changes in the economy imply that meaningful cyclically-adjusted balances are difficult to calculate. In this context not only the output gap is difficult to estimate, but it is erratic in nature. This is because it depends less on the dynamics of the domestic economies and more on external and unpredictable developments (e.g., trends in activity in trade partners, terms of trade and commodity prices, including the recent drop in oil prices) given the undiversified export bases. The underlying fiscal balance could be designed using a normal level of revenue (i.e., backward-looking averages) or for commodity exporters by removing the direct and indirect effect of commodity revenue.4

22. Fiscal anchors are not a panacea if not accompanied by a more broadly-based fiscal reform strategy. Political economy considerations suggest that moving away from a budget balance rule without strengthening fiscal institutions could create a fiscal deficit bias. While a country will find it easy to run a deficit during downturns, building fiscal buffers during upturns by saving revenue windfalls could be difficult owing to political pressures to spend in the face of large development and infrastructure needs. Reforms of fiscal frameworks need to be supported by appropriate fiscal institutions, including those that facilitate the formulation of long-term revenue forecasts, the implementation of quality public investment projects, and the sound management of rainy-day funds.

D. Policy Reform Options

23. Small states need to strengthen their fiscal frameworks to sustain economic growth. This requires achieving the appropriate balance between building fiscal buffers for rainy days and providing space for investment in infrastructure and human capital. Strengthening the fiscal framework is important for growth because it will:

  • allow enhanced resilience by minimizing fiscal risks, which are particularly high in microstates, and arise from volatile revenue and budget-spending rigidities;

  • create fiscal space for growth-enhancing and poverty-reducing investment, including infrastructure spending;

  • build fiscal buffers to enhance macroeconomic management and use counter-cyclical spending during more difficult times; and

  • allow nonrenewable resource revenue in resource-rich small states to be used wisely and ensure long-term fiscal sustainability.

24. But strengthening fiscal frameworks is particularly challenging in small states. This is because of their budget rigidities, extreme revenue volatility, spending procyclicality, and limited capacity.

25. Tackling these challenges thus requires a comprehensive macro and fiscal reform strategy, including spending and revenue reforms. This strategy should include several pillars:

  • Preserving strong fiscal fundamentals. Over the cycle, deficits should be kept low, on average, to avoid accumulating rising debt burdens. As discussed in ¶9, low deficits and moderate debt burdens are correlated with stronger GDP growth.

  • Minimizing fiscal rigidity and lowering recurrent spending to create fiscal space for capital spending. Typical sources of rigidities are high spending on public wages, large entitlement programs for civil servants, and revenues earmarked for large capital projects. Reforms of the wage bill, public servants’ benefits, and revenue administration should thus be included in the fiscal package. Countries should also seek to deliver public goods and services at the lowest possible recurrent cost, avoiding the use of public resources to support loss-making, inefficient public sector enterprises. To this end, exploring opportunities to outsource service delivery to the private sector, where possible, is warranted. This will create scope to finance growth-enhancing capital spending (see charts in ¶9).

  • Improving the spending mix toward investment in human and physical capital. This will require spending reforms in the form of spending reviews and medium-term expenditure frameworks. Their goal should be to reallocate resources toward priority spending, especially infrastructure investment, including to climate-proof infrastructure, and strengthen health and education sectors. It will also improve the business environment and attract private investors from abroad.

  • Adopting budget and investment practices that can foster high returns on capital investments. Since resources for capital spending will remain tight, countries need to adopt investment practices that maximize value-for-money. This will involve efforts to effectively identify, prioritize, and implement public investment projects. At the same time, strengthening the medium-term orientation of fiscal policy by adopting a multi-year budget framework can help clarify which projects should be financed, and over what timeframe. Developing a multiyear budget framework should also help, from a political economy point of view, deal with spending pressures arising from large development needs. The multiyear budget framework could help build consensus on the appropriate sequencing of development projects and better calibrate the pace of development spending--taking into account capacity constraints, which is a pressing issue in small states.

  • Identifying resources to help weather revenue volatility. These could take the form of contingency funds within the budget, sovereign wealth funds for resource-rich economies, and/or insurance policies. Contingency funds can also be used to manage shocks. Natural disaster funds or general budget contingency reserves can be used to save resources to deal with natural disasters. From a public financial management perspective, access to these funds and reporting on their use should be clearly defined and budget allocations, transparent. Solomon Islands’ National Transport Fund is a case in point.

  • Using fiscal anchors to help smooth spending and isolate the budget from revenue volatility. Where resources can be identified (see above), the budget should allow for spending to be smoothed in the face of revenue shocks. In commodity-resource-rich countries, targeting the non-commodity fiscal balance and using sovereign wealth funds to enhance the management of natural resources will also ensure the long-term sustainable use of exhaustible resources. Rather than focusing on the current fiscal deficit, the budget should provide for spending in line with underlying revenues. The caveat is that countries will need to distinguish between temporary and more sustained revenue shocks. In the latter case, there may be no alternative to adjusting spending, and the focus should be on the pace of adjustment and on achieving a balanced adjustment between recurrent and capital spending.

  • Strengthening domestic revenue mobilization to support the rebuilding of policy buffers. Mobilizing revenues by bolstering administration capacity and reforming the domestic tax system is also needed y to increase fiscal space to meet critical development spending needs while improving the business environment. In practice these reforms need to be tailored according to country circumstances. For example, realistically, enforcing customs compliance in very large and scattered territories such as many Pacific islands is extremely challenging and costly. There is a need to focus on large taxpayers who account for 70-80 percent of revenue by creating a special unit to deal with them in the tax administration office while using a simplified tax system and simplified compliance rules for medium-sized and small taxpayers. Developing a proper mix of income and consumption taxation (VAT and sales tax) would raise additional revenues.5 Lower oil prices also offer an opportunity to reform energy subsidies and taxes in both oil exporters and importers. In small states oil importers, the saving from the removal of energy subsidies should be used to strengthen fiscal buffers or to increase public infrastructure if conditions allow.

  • Enhancing regional cooperation on nontax revenue to increase revenue mobilization. In the small states of the Pacific in order to compensate for geographical isolation and dispersion and create a more attractive business environment for foreign investors, regional economic, institutional, and technological networks need to be strengthened. Key sectors are fisheries and information and communication technology. Improvement of fishing sector productivity could stem from the adoption of regional agreements and cooperative sub-regional measures to strengthen the bargaining power of license-issuing countries. The Nauru agreement, a regional agreement on fisheries among eight Pacific island countries (Kiribati, the Marshall Islands, Micronesia, Nauru, Palau, Papua New Guinea, Solomon Islands, and Tuvalu), represents a success story of how regional cooperation could mobilize more revenues (see IMF, 2014e).

26. These fiscal reforms need to be accompanied by measures to strengthen fiscal institutions and fiscal governance. The reform measures should aim at improving transparency (by enhancing budget planning, internal auditing on the use of public funds, monitoring, reporting, and evaluation systems to improve accountability), cash management, and project management capacity. Developing institutional frameworks will help better identify, quantify, monitor, and mitigate fiscal risks. Finally, fiscal frameworks should be integrated with a debt management strategy to manage cash flows effectively and reduce sovereign financing risks. In this regard, a successful case is Solomon Islands that introduced in May 2012 a strategy to strengthen debt management and debt sustainability, superseding the Honiara Club Agreement that prevented the country from contracting external borrowing.

27. The IMF has been assisting small states through capacity development in strenghtening fiscal frameworks. This involved both the work of regional technical assistance centers (RTACs) by providing technical assistance and training as well as headquarters. In this respect, the work by the Fiscal Affairs Department (FAD) could be further leveraged to reduce the pro-cyclicality of fiscal policy (e.g., appropriate design of fiscal rules), create fiscal space (e.g., energy subsidies reforms, and revenue enhancing measures), and strengthen revenue and public financial management systems.

Pacific Islands: Quantifying the Opportunity Cost of Building Fiscal Buffers

Policymakers in small developing states face a key fiscal policy choice: building fiscal buffers to enhance resilience to shocks—including natural disasters—or funding development spending. When a government expands fiscal space by accumulating public savings instead of financing spending for development needs, it forgoes the rate of return on the associated public investment. The opportunity cost of building fiscal buffers can be used to assess the optimal mix between building fiscal space and capital spending.

Pacific Small States: Opportunity Cost of Building Fiscal Buffers

article image

The share of capital in income was assumed at 0.3 and the depreciation was assumed at 0.07.

Source: IMF staff estimates.

Staff estimated the social return of public investment assuming that it equals the marginal productivity of capital. Following Caselli (2007), IMF staff calibrated a Cobb-Douglas production function for a group of Pacific Island economies using data on output and investment from the Penn World Table and WEO data for the period 1970–2010.

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Pacific Islands: Opportunity Cost of Building Fiscal Buffers and Human Development Index

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: IMF staff estimates.

The results suggest that several Pacific Islands enjoy a high rate of return to capital. Thus, they would benefit from capital spending, which is consistent with these countries’ large infrastructure needs (proxied by the Human Development Index). The social return to capital in the Pacific Islands is also in line with the return in low-income countries.

Staff also estimated two measures of fiscal space: one based on the IMF/WBG debt sustainability analysis (i.e., a fiscal liquidity indicator is derived by measuring the average gap over the medium term between the debt-service-to-revenue ratio of public and publicly guaranteed debt and an indicative threshold after which the debt becomes unsustainable), and a second one calculated as the difference between the actual debt, relative to GDP, and an estimated sustainable debt (á la Ostry) implied by the each country’s historical record of fiscal adjustment.

uA01fig17

Pacific Islands: Fiscal Space and Human Development Index

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

1/Fiscal space measured by the gap in the IMF/WBG DSAs between the threshold of the public and publicly guaranteed debt external debt service-revenue ratio and the forecasted baseline path of the same ratio.Source: IMF staff estimates.

The charts shed light on the Pacific Islands’ room for fiscal maneuver. A plot of the estimated cost of building buffers against the Human Development Index (HDI)—a proxy for infrastructure needs—suggests that some Pacific Islands stand to gain the most from increasing the share of their budget devoted to capital spending. When plotting the three different measures of fiscal space against the HDI, despite their being different, the measures provide similar ordering in terms of countries across methologies regarding the size of the fiscal space or the opprtunity costs of building buffers.

uA01fig18

Pacific Islands: Fiscal Distress and Human Development Index

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Source: IMF staff estimates.

From Best Practice to Best Fit: Lessons from Small States

Small states face extra challenges relative to other comparators in strenghtening fiscal framworks and achieving the right mix of public spending due to political economy consideration, capacity constraints, vulnerability to shocks, and data issues. However, many of them have achieved progress in handling the challenges described in this chapter. Some examples are reported below:

  • Mauritius: The new PFM Act, which is yet to be adopted, look to alleviate some of the budget execution difficulties that have led to create the special funds. In addition, the new government has announced the intention to eliminate the special funds and incorporate the related operations fully in the budget. Regarding the fiscal rule, the authorities have adopted a rather liberal approach on its application whereby the (in principle legally binding) debt target could be pushed out if it becomes difficult to achieve.

  • Jamaica:1 Its rule-based fiscal framework has two distinct, but complementary, components: Macro-fiscal or quantitative: The overall fiscal balance path is calibrated over a trailing three-year window to achieve a debt ceiling of 60 percent of GDP at the end of March 2026. The path is based on projections of, for example, real GDP growth, inflation, and the interest rate. This component will kick in only after the IMF Extended Fund Facility Arrangement, but the fiscal targets under the program are aimed at achieving the same policy goal and can be seen as a de facto fiscal rule. An exceptionally large adverse shock could require a temporary deviation from the debt reduction path, and for this purpose an escape clause was built into the fiscal rule. The escape clause is limited to natural disasters, a severe economic contraction, banking or financial crises, and a state of emergency; it may only be activated if the estimated fiscal impact of such shocks exceeds 1½ percent of GDP. Institutional: 1) Strengthened budgetary procedures-Budgetary procedures have been strengthened, and in 2015 the budget will be presented to parliament before the start of the fiscal year for the first time in many years; 2) Exclusion criteria-The fiscal rule covers the public sector at large, except for the Bank of Jamaica and public entities deemed commercial; 3) Bolstering capacity at the Office of the Auditor General (OAG)-The Auditor General is responsible for monitoring compliance with the fiscal rule; thus, the office must be appropriately staffed to fulfill its expanded mandate; and 4) Sanctions regimes for infringement of the rule-The authorities have initiated dialogue with the IMF’s Legal Department on the design of an enforcement mechanism.

  • Seychelles: The country is the top performer in Africa for health, nutrition and population outcomes, and health indicators compare favorably with some OECD countries, reflecting longstanding government commitment to providing universal free basic healthcare and access to education, while health spending accounts for only around 3½ percent of GDP.

  • Solomon Islands: The new PFM Act passed in December 2013 and the accompanying PFM roadmap (2014-17) provide a coherent platform to anchor fiscal reforms, in particular by improving the quality of spending and enhancing budget planning.

  • Swaziland: During the 2014 Article IV consultation, the authorities agreed with anchoring the fiscal policy with a medium-term international reserve target of 5–7 months of imports, while exploring the options of a fiscal rule or a stabilization fund to help address the high volatility of fiscal revenues.

  • Timor-Leste: The estimated sustainable income (ESI) rule (Annex 1) has worked well to minimize the effects of revenue volatility. It has also allowed Timor-Leste’s Petroleum Fund to grow to be equivalent to three times GDP.

1 Prepared by WHD.

Appendix I. Econometric Analysis

1. Determinants of real per capita GDP growth (Table 1). To assess the effects of fiscal policy on per capita output, we use dynamic panel regressions where real per capita GDP growth (i.e., the dependent variable) is regressed on a fiscal balance indicator, on the share of government capital spending over total public spending, and on the ratio of public debt as in Baldacci and others (2004). The model controls for external conditions by including an indicator of trade openness. The signs and the significance of the coefficients of the model suggest that for a given amount of public spending, expanding the share of capital investment helps boost per capita growth while expanding the deficit does not. The impact of capital spending on growth is stronger in Asia and Pacific small states than in other small states, consistent with their larger development needs. The model also suggests that there is a non-linear relationship between debt and growth in line with previous results (IMF, 2012a): while low levels of debt are good for growth, high levels are not.

Table 1.

Determinants of Real Per Capita GDP Growth1

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Panel regressions, 1990-2013 using the generalized method of moments (GMM) to correct for endogenity by instrumenting with lagged explanatory variables. Asterisks indicate p-values: *** p<0.01, ** p<0.05, * p<0.1

Excludes small states.

2. Determinants of real revenue (Table 2). Separate dynamic panel regressions were run for different groups (small states, Pacific Island small states, LICs, emerging markets, resource-rich small states, and non-resource-rich small states) to identify the variables that explain real revenue. The dependent variable (real revenue) is regressed on GDP (and its lag), weighted terms of trade (and its lag), a variable on natural disasters, lagged real revenues and fishing license fees. Revenue shows strong procyclicality, especially in small states that are net commodity importers. And revenue procylicality is a source of revenue volatility. Coefficients on real GDP growth variables higher than 1 suggest revenue pro-cyclicality (i.e., revenue is growing faster than GDP during upturns and slower than GDP during downturns). For small states, the sum of the coefficients on real GDP growth (current period and one-period-lagged)—a proxy for cyclical components of revenues—is equal to 1.7. After controlling for GDP, revenue depends on terms-of-trade shocks, especially in resource-rich small states. Natural disasters also heighten revenue volatility. Staff analysis suggests that a natural disaster that affects 1 percent of the population causes a drop in real revenue of 0.2 percentage point.

Table 2.

Determinants of Real Revenue1

(Year-on-year percent change)

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Panel regressions, 1990-2013 using the generalized method of moments (GMM) to correct for endogenity by instrumenting with lagged explanatory variables. Combined coefficients higher than 1 on real GDP growth and lagged GDP growth imply revenue procyclicality. Asterisks indicate p-values: *** p<0.01, ** p<0.05, * p<0.1.

Includes countries dependent on fishing license fees.

3. Impact of natural disasters on tax revenue (Appendix I, Figure 1). Staff analysis using a panel VAR suggests that a natural disaster that affects 1 percent of the population in the small states of the Pacific leads to a contraction in tax revenue of 0.2 percentage point of GDP in the year of the disaster, followed by a revenue rebound the next year (Cabezon and others, 2015). The model focuses on the impact of natural disasters on real GDP and fiscal variables. The specification includes the following variables: natural disaster intensity, real GDP growth, change in total government expenditure as a percent of GDP, change in tax revenue as a percent of GDP, and change in the overall fiscal balance as a percent of GDP. The variable on natural disaster intensity is measured by the number of fatalities and others hurt by the disaster as a share of total population, in line with Fomby and others (2013).

Appendix I. Figure 1.
Appendix I. Figure 1.

Pacific Island Small States: Response of Tax Revenue to Natural Disasters

(In percentage points of GDP)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

4. Degree of spending procyclicality (Table 3). This model assesses the degree of spending procyclicality (i.e., capital spending increasing during good times and declining during recessions). The change in real government spending is regressed on changes in real growth. The elasticity of real current government spending is lower than 1, suggesting that current spending is not procyclical. The elasticity of capital is much larger than 1, suggesting fiscal procyclicality.

Table 3.

Degree of Spending Procyclicality1

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Panel regressions, 1990-2013.

Asterisks indicate p-values: *** p<0.01, ** p<0.05, * p<0.1Spending is procyclical if the coefficient on real GDP growth is higher than 1.
Annex I.

Fiscal Anchors in Small Developing States

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An ECCU target requires reducing the public debt-to-GDP ratio to 60 percent by 2020.

Sources: Country authorities and IMF teams.

External Devaluations: Are Small States Different?1

This chapter discusses the effectiveness of exchange rate devaluations in small states, which are typically more open and less diversified than larger peers. Several analytical approaches used in the paper find that the effects of devaluation on growth and external balances are not significantly different between small and large states, although the transmission channels are different. Devaluation in small states is more likely to affect demand through expenditure compression, rather than expenditure-switching channels. In particular, in small states consumption tends to fall more sharply than in larger states due to adverse income effects, thereby reducing import demand; however, investment improves strongly. Policy conclusions point to the importance of social safety nets in small states, the need for complementary wage and anti-inflation policies, investment-boosting reforms, and attention to potential adverse balance sheet effects.

A. Introduction

1. The role of exchange rates in small states has come under increased debate with the weakening of their economic performance, especially after the 2008–09 global downturn. Many small states have lagged behind their peers during the past decade (IMF 2013a), in part reflecting long-standing competitiveness challenges. The recent downturn has imposed an additional cost on output given the prevalence of inflexible exchange rate arrangements and recent appreciation of the U.S. dollar (Box 1). Attempts to shore up the economies with the only tool available in many countries – fiscal policies – has quickly exhausted the policy space in small states at a time when the economies remain weak and not well placed for a strong growth recovery. This has turned the focus of many policy debates back to the exchange rate as a tool to address long-standing internal imbalances (high unemployment) and external imbalances (large current account deficits and external indebtedness).

Exchange Rate Regimes in Small States

Three-quarters of small developing countries maintain fixed exchange rate regimes. About 20 percent of the small states use the most rigid arrangement, dollarization, in which another country’s currency serves as legal tender, and exchange rate changes are impossible. In the currency board regime, adopted by another 20 percent of these countries, a domestic currency exists, but is covered by foreign reserves sufficient to always allow the monetary authority to exchange the local currency for the anchor currency at a fixed parity. In this case, devaluation is possible, but only as the result of a policy decision. Finally, almost 35 percent of small states have pegs, where a domestic currency exists and policies are directed towards the preservation of a fixed exchange rate. Under pegged regimes, devaluations are uncommon, but possible, due either to policy decisions or insufficient reserves to defend the peg through foreign exchange market intervention. For many of the 26 small states adopting currency board arrangements and pegged exchange rates, exchange rate changes have been uncommon: 14 of them have experienced flat exchange rates for more than a decade.

uA01fig19

Small States’ Exchange Rate Regimes in 2012

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Sources: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions.1/ The use of another country’s currency as legal tender, not necessarily the U.S. dollar.2/ Conventional peg and peg with horizontal bands.
uA01fig20

Exchange Rates in Small States

(indexes, 1980=1; log scale)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Sources: International Financial Statistics and Fund staff estimates.

2. Small countries, however, have repeatedly voiced reservations about the efficacy of the exchange rate as a policy tool, as they see the contractionary effects of devaluations much more likely to dominate in their case. The argument is that―because small states import a large share of their consumption basket―nominal devaluations of domestic currency would lead to larger price increases which would erode the real gains in the exchange rate, failing to sufficiently improve the competitive position of a country. At the same time, the social and balance sheet costs of higher prices and the perceived loss of a strong price and macro-stability anchor is seen as too high relative to the expected gains in competitiveness. As a result, many small states have opted for internal devaluations as an adjustment tool, albeit not less painful (notably Barbados in 1991, Latvia in 2009).

3. This paper aims to take a systematic look at the potential impact of large exchange rate devaluations in small states. The objective is to explore whether devaluations have systematically different effects in small states compared to large ones, in other words whether small states are less likely to have expansionary devaluations. The theoretical and empirical literature on the overall effects of currency depreciation is extensive, and suggests that the effect of depreciation can be indeterminate (Annex I). The early literature generally highlighted the positive effects of a real exchange rate depreciation for growth and current account balances through the expenditure-switching channel.2 The subsequent literature highlighted a myriad of less favorable effects of depreciations on both demand and supply. These include contractionary effects on income and wealth through (i) valuation effects on a trade deficit; (ii) lower price elasticities of imports and exports, which could reduce net exports in the short run (J-curve response) or even long-run (if the Marshall-Lerner condition is not met); (iii) redistribution of profits from labor to capital, with the latter’s higher propensity to save depressing demand; (iv) a fall in real wages following the post-devaluation spike in inflation, which reduces income and consumption; (v) a higher cost of imported inputs for firms, which puts pressure on their earnings and ability to invest; (vi) an increase in the burden of servicing net foreign currency debt following devaluations, which could dampen investment, consumption and growth.

4. While a number of papers discuss exchange rate issues in small states, we are not aware of papers that assess the effects of external devaluations in small states and whether these are indeed different relative to large states. This paper aims to fill this gap. We study the macroeconomic effects of external devaluations in small and larger states using three methodologies: simulations with a DSGE model; event studies of country experiences with large (over 20 percent) devaluations; and econometric analysis. These methodologies are briefly described in Annex II, while in the remainder of the paper we focus on the results and policy implications.

5. We find that the effects of a devaluation on growth are similar for both small and larger economies: on average, an initial slowdown in growth is followed by a pickup over the medium-term. The distribution of outcomes is also similar, with about half of the devaluations followed by a contraction and about half by an expansion in output. However, the channels through which devaluation affects macroeconomic outcomes differ between small and large states. Devaluation in small states is more likely to affect demand by compressing expenditure, rather than through expenditure-switching channels. In particular, consumption may be relatively harder hit in small states due to adverse income and distribution effects, combined with limited scope for import substitution or a rapid scaling up of exports due to size-related constraints. Likewise, the investment response, while ultimately strongly positive in all countries, takes longer to manifest itself in small states. The improvement in the external current account may be initially stronger in small states, but in large part it is also due to import compression. Ultimately, whether the devaluation is contractionary or expansionary overall does not appear to be related to country size but to other factors at play. Thus, devaluations can result in stronger growth in small states and improve the external position, especially if supportive policies are in place.

B. Results

In this section, we summarize the results of our studies and discuss what they predict about the likely effect of a nominal devaluation on macroeconomic outcomes. The main finding is that large devaluations do not appear to lead to different growth outcomes in small and larger states, and can boost investment and exports, but the negative effects of expenditure compression could be particularly apparent in small states.

Inflation

6. Following large depreciations, the short term pass-through of an exchange rate depreciation to inflation appears to be faster and stronger in small states, reflecting the higher import content of production and consumption. During past events of large devaluations, for example, inflation surged from a median of about 7½ percent in the year before devaluation in both small and larger countries to 16½ percent in small economies and 13½ percent in the larger economies. However, we found that inflation also fell faster in small states. The differences in outcomes, however, are not statistically significant after the first year, as can also be seen in the distribution of inflation changes post-devaluation.

uA01fig21

Distribution of Changes in Average Inflation

(differences in 3-yr avg inflation in pct. pts., t+2 to t+4 from t-4 to t-2)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Sources: World Economic Outlook and Fund staff estimates.

Real Depreciation

7. As a result of the response in inflation, the real depreciation might be smaller in small states for a given size nominal depreciation. Despite the marginally higher nominal depreciation, the REER was about 14 percent below pre-devaluation levels in small states and 18 percent lower in larger countries after four years post-devaluation.

8. Given the importance of containing inflation to generate real depreciation gains, we used a probit regression to look at the factors that increase the probability of inflation being brought fast under control.3 The results suggest the importance of tight incomes policies and preventing further rounds of depreciation, which could have a more persistent effect on inflation. The coefficient estimates on both wage growth and depreciation in the post-devaluation period are significant and negative in sign, implying that public sector wage increases or loose monetary policies tend to limit the probability that a country will bring inflation under control following a devaluation. The estimate on the small countries dummy was not significant, implying that they do not face an inherent disadvantage in achieving price stability in the years following a devaluation, even if the initial effects tend to be larger.

uA01fig25

DSGE Simulations: Real Effective Exchange Rate

(pct difference, rise indicates depreciation)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

uA01fig26

Events Study: Real Effective Exchange Rate

(indexes, t-1 = 100)

Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

Sources: World Economic Outlook and Fund staff calculations.

Growth

9. The empirical evidence suggests that average growth outcomes following devaluations are similar in small and larger states, with an immediate slowdown followed by a pickup over the medium-term. The distribution of outcomes is also similar, and reveals a large range of outcomes, with about half of the devaluations followed by a contraction and half by an expansion in output. The results for the model simulations are somewhat different than the empirical averages but consistent with a significant range of outcomes, and highlight the possibly more contractionary effects of devaluations in small states.

Empirical studies

10. The evidence from our empirical studies suggests that on average: (i) large depreciations may dampen growth in the short term, but boost it over the medium term, with no long-run effects; and that (ii) the results for small and large economies are similar in the two empirical studies. As we will see below, however, the transmission channels and the composition of growth between small and large states would, in fact, differ significantly.

  • In the event study, growth declines immediately following devaluations both in small and large states, exacerbating the weakening trend prior to the devaluation. Growth picks up notably over the medium-term, with the pickup somewhat stronger in small states (1.3 percentage points, compared to 1.1 in larger economies, between years 2–4 prior and post devaluation), although not in a statistically significant way.

    uA01fig27

    Events Study: Real GDP Growth

    (percent)

    Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

    Sources: WEO and staff estimates.

  • The distribution of outcomes is also broadly similar among the small and large states (histogram). Within the entire sample, about half the events—51 percent—experienced some degree of growth pickup, even if small. In the case of small states, a slight majority (13 cases, or 62 percent) experienced a pickup, while for the larger countries just under a majority (27 cases, or 47 percent). In some cases, small states experienced growth in one devaluation episode (e.g. Jamaica 1983, Fiji 1987, Trinidad and Tobago 1993) but not in others (Jamaica 1991, Trinidad and Tobago in 1985, Fiji 1998), suggesting that underlying country economic institutions and structures are less important than the policy or overall economic context. A non-negligible amount of devaluation events ― 14 percent of the small state events and 11 percent of large state events―are followed by significant slowdown in growth.

    uA01fig28

    Events Study: Distribution of Changes in Average Growth

    (diff. in 3-yr avg real GDP growth, t+2 to t+4 from t-4 to t-2)

    Citation: Policy Papers 2015, 046; 10.5089/9781498344852.007.A001

    Sources: World Economic Outlook and Fund staff estimates.

  • The similar behavior of small and large states following devaluations is robust to further econometric analysis that controls for other factors. Here, large nominal devaluations have immediate negative effect on real growth. The effects turn positive starting in the second year, and die out overtime and as such we find no significant long-run growth effects. The interaction term between devaluation and small countries dummy is not significant at any lag, suggesting the growth effects of large devaluations are not significantly different for small countries relative to the average effect for all countries in the sample. While the cumulative effect of the devaluation alone may be on average negative (chart), this does not mean there is a permanent loss in output. The empirical evidence suggests that other factors (supportive policies, external environment or credit conditions) offset this effect and allow a strong pick-up in growth post-devaluations.

    uA01fig29

    Econometrics: Effect of Large Devaluation on Real GDP Growth1/

    (pct. points)

    Citation: Policy Papers 2015, 046;