Free exchange | The economics of small states

Big problems for little countries

Why have small countries experienced such slow growth in recent years?

By C.W. | LONDON

IN THE past five years growth in the rich world has been measly. From 1990 to 2007 high-income countries managed an inflation-adjusted per-capita GDP growth of about 2.3% per year. From 2008 to 2013, though, the total growth was only 2%.

But spare a thought for people living in small states (see chart). These are countries with fewer than 1.5m people. About 29m people live in the 48 small states, according to the World Bank's classification. In the last five years GDP per capita in the small states has shrunk by 2.3%. Some little countries have done well: the Marshall Islands has seen per-capita growth of 8%. Others have done appallingly: St Kitts and Nevis saw a 12% fall. Antigua and Barbuda suffered a 21% drop.

Real GDP/capita growth 2008-13, selected countries/regions

A research paper from the IMF looks at why many small states have done badly in recent years. Small states have long faced problems that any economics undergraduate would understand. Two stand out. First, they struggle to find economies of scale. Imagine trying to provide public services in the Federated States of Micronesia—where over 600 islands are spread across 1m square miles of ocean. The lack of scale economies may result in expensive, sub-standard public services.

Second, trade is more difficult for small, isolated countries. Kiribati, an island nation of 100,000 people, is slap-bang in the middle of the Pacific Ocean (and a five-hour flight from Hawaii). The fixed costs of trading with Kiribati are high but the market is small. That raises the average cost of trading; people are inclined to look elsewhere.

These two problems have unfortunate consequences. First, big fixed costs in the public sector mean that small states have higher spending-to-GDP ratios than big countries. From 2007 to 2011, according to the IMF, government expenditure-to-GDP was nine percentage points higher in small states than in their larger cousins. That puts upward pressure on government debt, which may lead to lower growth. Second, in an attempt to break into global markets, small states often focus their energies on exporting a single good or service. Without export diversification, such states are vulnerable to economic shocks. The tiny island of Nauru is a notorious case of the dangers of focusing on a single commodity.

However, these geographical disadvantages have not always seemed so bad. According to the IMF, from 1980 to 2010 small states grew only slightly more slowly (0.7% a year) than their larger peers (and IMF economists argue about whether that tiny difference is statistically significant). But after 2000 things got worse. The World Bank reckons that there were two main problems. The first, it says, was finance. The bank claims that during the 2000s small states became increasingly exposed to global financial markets, and so suffered badly during the downturn. (Indeed, small states like Barbados and the Maldives have a reputation for shady tax deals.)

In fact data from UNCTAD suggest that small states became less dependent on finance during the 2000s. As a percentage of total world financial-services exports, small states contributed 0.1% in 2001, but 0.04% in 2008, when the crisis deepened. So increased exposure to financial markets may not be the explanation. Small states have probably benefited from global finance in recent years: from 2007 to 2013 remittances to small states rose by 18%.

The World Bank’s second explanation, though, seems more plausible. In the 2000s, tourism to many smaller states boomed. Tourism receipts rose by 50%, in real terms, from 1995 to 2008. But from 2008 and 2009 the world tourism market contracted by 10%. For small states, where tourism forms about 25% of export earnings, the contraction was tough.

The IMF offers other possible explanations for weak economic performance, including high emigration. Another reason is trade rules. For some small economies with high export dependence and export-product concentration in bananas or sugar, recent EU reforms were damaging. Take sugar. In 2005 the EU introduced a 36% price reduction for raw sugar, phased over four years. One paper, which looks at six sugar-exporting Caribbean countries, linked this to substantial declines in overall exports and a weaker fiscal balance. Banana markets have been hit by similar problems.

A recent IMF podcast discussed what small states should do to avoid such problems in the future. Mauritius, which in the 1970s was almost wholly dependent on sugar, was lauded for rapidly diversifying its economy. According to the OECD, manufacturing boomed as Mauritius invested heavily in export-processing zones. Research from the WTO found a strong relationship in Mauritius between export diversification and economic growth. That’s a worthy aim, but for countries where the economic crisis has damaged growth and the public purse, it may be an unrealistic one.

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