What Makes Small States Different

The report of the Commonwealth Secretariat/World Bank Joint Task Force on Small States, Small States: Meeting Challenges in the Global Economy, concludes that developing small states share a number of characteristics that shape their development challenges. For instance, many are especially vulnerable to external events, including natural disasters, that cause high volatility in national incomes; many suffer from limited capacity in the public and private sectors; and many currently face an uncertain and difficult economic transition to a changing world trade regime.

More specifically, the following characteristics define the development challenges and vulnerabilities that many small states face.

Remoteness and Isolation

Of the 45 developing small states with populations of 1.5 million or less, 34 (or three out of four) are islands and in some cases widely dispersed multi-island states, others are landlocked, and some are located far from major markets. For many small states, high transport costs make it hard to turn to world markets to compensate for the small size of domestic markets. And small domestic markets combine with large distances from other markets to reduce competition and its spur to efficiency and innovation.

Openness

A high degree of openness to the rest of the world brings benefits, opening up small states to competition and ideas. But it also means that small economies are heavily exposed to events in global markets and environmental threats. Developments in the global trade regime - over which small states have little influence - and in world markets can have a profound influence, especially where the domestic economy is relatively undiversified. Small states also tend to rely more heavily on taxing imports as a source of revenue, leading to difficulties as tariffs are reduced. The chart below indicates the significantly greater importance of imports and exports in GDP for the sample small states in Africa, the Caribbean, and the Pacific, as compared with their importance for the sample of all low and middle-income developing countries.

Susceptibility to Natural Disasters and Environmental Change

Most small states are in regions susceptible to natural disasters such as hurricanes, cyclones, droughts, and volcanic eruptions, which typically affect entire small states populations and economies. Some small states are threatened by global environmental developments and face ecological threats. Since most adverse events affect the entire population, risk pooling at the national level is not feasible.

For low-lying small states such as Kiribati, the Maldives, and the Marshall Islands, their very existence could be threatened by rising sea levels that could result from global warming, over which they have no control.

Limited Diversification

Because of their narrow resource base and small domestic markets, many small states are necessarily relatively undiversified in their production and exports. Where one dominant activity has declined, it has tended to be replaced with another. Capacity is limited in the private sector, posing difficulties when there is a need to respond to changing external circumstances. These factors add to small states' vulnerability to changes in the external environment. The table below indicates the extent of export concentration in selected small states.

Poverty

There is some evidence that poverty levels tend to be higher, and income distribution more uneven, in smaller than in larger states. Where this is so, income volatility can create additional hardship as the poor are less able to weather negative shocks to their incomes. The graph below suggests that within the sample of small states for which data were available, those lying above the trend line have a higher level of poverty than might be expected, given their relative income levels.

Limited Capacity

While weaknesses in both public and private sector capacity are a key problem for most developing countries, smallness of size adds a further dimension to the challenge. This is further compounded in states, like the Pacific Islands, where the internal distances are large and the population is scattered. Sovereignty entails the state having to bear the fixed costs of providing the necessary range of public services, including central government, regulation, taxation, education, health, social services, judiciary, foreign relations, and national security. Indivisibilities in the provision of these public goods mean that the public sector small states face diseconomies of small size in providing public services and in carrying out the business of government.

Small states tend to have relatively larger public sectors than other developing countries and the cost per person of providing these services is higher. As they face the challenges and opportunities of globalization small states are also finding they do not have sufficient institutional capacity to participate fully in international finance and trade negotiations-the outcomes of which can profoundly affect their economies. In the private sector, lack of diversification and domestic competition can hold back successful development.

Many of these factors combine to make small states's economies especially vulnerable, and in particular they affect:

Income Volatility

Overall, the range of per capita incomes and rates of growth are not significantly different in small and large developing countries. However, the residents of small states experience higher volatility in their incomes - the standard deviation of annual real per capita growth in small states is about 25 percent higher than in large states. This reflects several of the factors that make small states different - their high levels of exports and imports and low diversification in production and trade, which leaves them exposed to fluctuations in world markets, and their susceptibility to natural disasters. The following chart shows that income volatility increases with declining country size, the 31 small states in the sample having significantly higher volatility.

  Access to External Capital

Access to global capital markets is important for small states, and is one way to compensate for adverse shocks and income volatility. But the evidence is that private markets tend to see small states as significantly more risky than larger states, so that spreads are higher and market access more difficult.

During the late 1990s, foreign direct investment (FDI) to small states averaged about 15 percent more than official development assistance and aid to these countries. However, nearly 80 percent of this FDI went to just 7 countries—Bahamas, Botswana, Estonia, Equatorial Guinea, Guyana, Malta and Trinidad and Tobago.