THE WVORLD BANK Discussion Paper 4 DEVELOPMENT POLICY ISSUES SERIES Report No. \ PFER52 The Costs and Benejfits of Being a Small, Remote, Island, Landlocked or Mini-State Economy T.N. Srinivasan March 1985 Office of the Vice President Economics and Research The views presented here are those of the author, and they should not be interpreted as reflecting those of the World Bank, K Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized
Transcript
THE WVORLD BANK
Discussion Paper
4 DEVELOPMENT POLICY ISSUES SERIES
Report No. \ PFER52
The Costs and Benejfitsof Being a Small, Remote, Island,
Landlocked or Mini-State Economy
T.N. SrinivasanMarch 1985
Office of the Vice President Economics and Research
The views presented here are those of the author, and they should not be interpreted as reflecting those of the World Bank,
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THE COSTS AND BENEFITS OF BEING A SMALL,
REMOTE, ISLAND, LANDLOCKED OR MINI-STATE ECONOMY
by
T.N. Srinivasan
March 1985
The author is Professor of Economics, Yale University and Consultant,World Bank. The author thanks Bela Balassa, John Duloy, Gregory Ingram,Deepak Lal and Sarath Rajapatirana for their valuable comments.
The World Bank does not accept responsibility for the views expressedherein which are those of the author(s) and should not be attributed tothe World Bank or to its affiliated organizations. The findings,interpretations, and conclusions are the results of research supportedby the Bank; they do not necessarily represent official policy of theBank. The designations employed and the presentation of material usedin this document are solely for the convenience of the reader and do notimply the expression of any opinion whatsoever on the part of the WorldBank or its affiliates concerning the legal status of any country,territory, city, area, or of its authorities, or concerning thedelimitations of its boundaries, or national affiliation.
Abstract
Any index of smallness is somewhat arbitrary, but common practice hasbeen to use population and income criteria. Experience suggests thatsmallness is neither a necessary nor sufficient condition for poor developmentperformance. Various fora have raised two important issues: 1) Do smalleconomies face special problems that call for special attention? and 2) Ifso, are these problems already being addressed? This paper analyzes thesebroad issues by considering the problems that small economies are most oftenalleged to face, including: absence of economies of scale; vulnerability;remoteness and other factors that raise transport costs; reduced access tocapital markets; problems of macro-economic policy dependence; andoverstatement of real income. After addressing these issues, the authorconcludes by asserting: "It would appear that many (though not all) of thealleged problems of small economies are either not peculiar to small economiesor can be addressed through suitable policy measures."
Table of Contents
Page No.
I. What Are Small Economies?.. .................................. 1
II. Problems of Small Economies ............................... 8
A. Economies of Scale ................................. 10B. Vulnerability .......................... 13C. Remoteness and Other Factors
Affecting Transport Costs ....................... 18D. Access to Capital Markets ......................... 19E. Macro-economic Policy Independence ................ 25F. Real Income Comparisons ........................... 27
III. Conclusions ............................................. f e 30
Tables
Number and Distribution of Countries Classifiedby Population Size (mid-1983) ............................ 4
Distribution of Countries by Population Size andPer Capita Income, 1982...... e................................. 5
Growth of Real GNP Per Capita, 1970-1980 .. .................. 6
Per Capita Net Resource Flows in 1982 (US$) e.. ........... 21
Per Capita Grpss Domestic Product in IJS Dollarsat Official Exchange Rates, and in InternationalDollars, 1975.. ................................................ 29
The Costs and Benefits of Being A Small,Remote, Island, Landlocked or Mini-State Economy
T.N. Srinivasan
I. What Are Small Economies?
In order to classify an economy into two citegories -- "small" and
"not small" -- one obviously needs two things: an index or measure of the
size of an economy according to some concept of size, and a cut-off point with
respect to this index so that all economies with an index value at or below
this cut-off value are classified as small. In the theory of international
trade the concept of size is market power, i.e. the ability of an economy to
affect its own terms of trade by changing its volume of trade, and the cut-off
point is zero. As an operational concept, this is not very useful --apart
from the problems in empirically determining whether a country has market
power, the fact that such power may be commodity-specific (that is, a country
may have positive market power in some commodity markets but none in others)
makes it difficult to generalize it into an economy-wide concept.
Another index of size that has been proposed is the size of a
country's potential market for commodities and services measured in terms of
the country's real gross national product (GNP) or better still, gross
domestic expenditure (GDE). Of course, it is recognized that a poor
tountry -- in the sense of having a low per capita income -- may still be
large in terms of its GNP because of its large population but small as a
potential market. For example, if the income distribution is not unduly
concentrated, the bulk of the large population in such a low per capita income
economy will be too poor to be potential demanders of anything but basic
commodities. This has been taken to imply that an index of market size for
manufactured goods has to be related to the total consumption of such goods
which in turn has to be based on population, per capita income and some
measure of the concentration of the distribution of income. If one goes
beyond the market for manufactured goods to basic services covering
transportation, health and sanitation, edu2ation, etc., then the geographical
area of a country, the average density of its population settlements, a
measure of distribution of the density across settlements, and even the age-
sex distribution of population become relevant as possible determinants of the
size of the market for such services.
In an ever-changing world the definition of smallness may also have
to change, particularly in response to technological change. For instance,
the "optimum" size of a plant for producing ammonia (an input in the
manufacture of nitrogenous fertilizers) increased with the development of high
pressure compressors.
Given the vagueness of the concept and the arbitrariness inevitably
involved in choosing an index of size and a cut-off point with respect to this
index, the literature on "small" economies appears to have settled on a
country's population as the primary measure of size, with total GNP as a
secondary measure, rather than attempting to develop anything more
sophisticated. The population cut-off point in defining smallness has been
set anywhere between 1.5 million to 5 million. Ir cross-country regression
analysis of development processes Chenery and Syrquin 1/ use population as a
measure of size or scale of an economy, and countries with less than 5 million
population are classified by them as small.
1/ Chenery and Syrquin (1975).
-3-
Denoting a country with a population of less than 1.5 million persons
as very small and that with a population between 1.5 million and 5 million
persons as small, the data from the 1983 and 1985 World Bank Atlas for 189
countries and their dependent territories indicate (see Tables 1 - 3 for
details) that:
-- 42 independent countries and 25 dependent territories are very small
and 33 independent countries are small. One could characterize the
42 very small countries as mini-states.
-- 38 countries and 24 dependent territories are islands, of which 24
countries and 22 dependent territories are very small and 4 countries
and 2 dependent territories are small.
-- 26 countries are landlocked, of which 5 are very small and 6 are
small. The remaining 15 landlocked countries have populations
greater than 5 million.
Available GNP figures show that:
-- Of the 67 very small economies 4 can be classified as low-income with
per capita income below $410 but 21 can be classified as upper-
middle-income with per capita GNP exceeding $1,670.
-- For the 33 small economies 6 are considered low-income while 7 are
upper-middle-income.
-- For those 46 economies which are both very small and islands, 3 are
low-income, 18 are upper-middle-income.
-- Of the 6 small island economies none are classified as low-income and
2 are upper-middle-income.
Table 1: Number and Distribution of Countries a/Classified by Population Size (mid-1983)
Population Oceania North and All RegionsSize and Central South Independent Dependent
(millions) Africa Asia Europe Indonesia America b/ America Countries Territories Total
Source: World Bank Atlas, 1983, 1985, World Bank, Washington, D.C.
-6-
Table 3: Growth of Real GNP Per Capita, 1970-1910 a!
Oceania North Total
and & Central South All
Africa Asia Europe Indonesia America America Regions
ALL ECONOMIES
Negative growth rate 17 2 1 4 8 2 34
Zero to +2% growth rate 14 6 5 5 7 4 41
Greater than +2% growth rate 17 20 22 4 13 7 83
Data not available 5 10 7 7 2 - 31
TOTAL 53 38 35 20 30 13 189
VERY SMALL ECONOMIES
Negative growth rate 3 1 1 4 6 1 16
Zero to +2% growth rate 1 2 - 2 2 1 8
Greater than +2% growth rate 8 4 7 3 7 1 30
Data not available 3 1 1 7 1 - 13
TOTAL 15 8 9 16 16 3 67
SMALL ECONOMIES
Negative growth rate 6 - - - 2 - 8
Zero i'o +2% growth rate 5 1 - 2 3 - 11
Greater than +2% growth rate - 4 3 - 1 2 10Data not available - 3 1 - - - 4
TOTAL 11 8 4 2 6 2 33
OTHER ECONOMIES
Negative growth rate 8 1 - - - 1 10
Zero to +2% growth rate 8 3 5 1 1 3 21
Greater than +2% growth rate 9 12 12 1 5 4 43Data not available 2 6 5 - 1 - 14
TOTAL 27 22 22 2 7 8 88
a! Including dependent territories.
Source: World Bank Atlas, 1983, World Bank, Washington, D.C.
-7-
-- Of the 6 small landlocked economies only 3 are low-income, none of
the 5 very small landlocked economies fall into this category; there
are no very small or small landlocked economies which are upper-
middle-income.
The data on the average rate of growth of real GNP per capita during
1970-80 (available for 158 economies) shows that:
The economies of 34 countries had negative growth rates. Of these
34, 16 (of which 14 are islands) were very small and 8 (1 island, 2
landlocked) were small. Among the remaining 10 countries, 6 were
landlocked and 1 was an island.
On the other hand, 83 economies had growth rates of real GNP per
capita of greater than +2 per cent. Of these, 30 (of which 19 are
islands and 4 are landlocked) are very small and 10 (of which 2 are
islands) are small.
The United Nations characterizes 36 countries as least developed, of
which 12 are very small, and 9 are small and the remaining 15 have population
greater than 5 million. A total of 15 least developed countries (3 very
small, 4 small and 8 others) are landlocked, and 5 are very small islands.
The rest, 16, are neither landlocked nor islands. Thus, it would appear that
if low population size is a criterion of smallness, a significant number of
least developed countries are very small or small economies, and/or islands or
landlocked countries. And in 8 least developed countries per capita real GNP
had declined in the decade 1970-1980.
Presumably, the expected interrelationship between smallness, low-
income, poor growth performance and geographical isolation reinforced by
specific country cases is what prompted international agencies to focus
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attention on the least developed, island and landlocked countries. On the
other hand, the fact that many small economies (a third of them including
islands like Singapore and Trinidad and Tobago) are neither poor nor even in
some respects less developed, and many have experienced significant positive
growth in per capita income and several have grown very rapidly, cannot be
altogether ignored, particularly from the point of view of analyzing policies
that may retard or promote the growth of a small economy. Smallness obviously
is not a necessary nor sufficient condition for poor development performance.
II. Problems of Small Economies
Among the international organizations, UNCTAD has probably devoted
the most time and effort to the special problems believed to be characteristic
of small island and landlocked economies. The Development Committee in
1982 1/ "noted the problems of small island and landlocked states, and
recognized the urgent need to review mechanisms and adjustment prescriptions
appropriate to the particular circumstances of such states." At the same
time, the Ministers of the Group of 24 2/ also "urged that the international
community pay particular attention to small island and landlocked developing
states, having regard to their limited size, their openness, their
vulnerability to the vagaries of the international economic environment."
They agreed with the Development Committee to an urgent need for "immediate
action to review the mechanism and format of conditionality and the nature and
1/ Press Communique of the World Bank Development Committee, September 5,1982.
2/ Communique of the Group of 24, September 3, 1982.
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content of adjustment prescriptions requested by multilateral financing
institutions in small island and landlocked economies." 1/ In the context of
graduation criteria (as contrasted with adjustment processes), the perceived
problems of small economies have been raised in recent discussions at the
World Bank. 2/
There are two related questions that need to be answered in
addressing the concerns expressed above. The first is, of course, the
question of whether such economies do face special problems not faced by large
or non-island or non-landlocked developing economies, and thus call for
special attention. If there are indeed a number of such problems, a further
question arises as to whether they are already being addressed to a
considerable extent in the operational policies of multilateral financing
institutions and international agencies, and through bilateral aid programs.
Besides these two broad questions, there is also the issue of whether the
criteria actually used in implementing policies that are in principle fair to
all, nevertheless are biased against small island economies. For instance, it
has been said that the use of real per capita national income in constant US
dollars as a trigger in initiating a graduation exercise is subject to such a
bias because it is suggested that converting conventionally measured real
national income in domestic currency into US dollars through official exchange
1/ Communique of the Group of 24, September 3, 1982.
2/ See World Bank document EDS84-4, "Executive Directors' seminar -
February 21, 1984, Special Problems of Very Small Economies" . Inaddition, the economic difficulties faced by small island economies werethe subject of a paper prepared for members of the Executive Board of theIMF entitled: "Small Tropical Island Countries - an Overview", Dec. 19,1983, EBD/83/325.
10 -
rates will overstate the "true" income of small economies relative to large
economies.
The special problems most often said to be faced by such economies
can be grouped into the following categories:
(A) Problems related to economies of scale and of agglomeration.
(B) Problems of vulnerability, including susceptibility of these
economies to external economic shocks because of their degree of
openness and dependence on a few commodities or services for foreign
exchange earnings, and to non-economic shocks such as natural
disasters (cyclones, hurricanes, earthquakes, volcanic eruptions) and
(C) Problems, of landlocked countries and islands remote from the nearest
natural market of any reasonable size, that arise from scale
economies and technological changes in transportation.
(D) Problems of access to markets for exports and in particular to
external capital markets. It can be argued, however, that these
problems are in fact a reflection of the above points (1) and (3).
(E) Problems of limited policy independence, particularly in respect of
macro-economic policies relating to exchange rates, monetary policy,
etc.
(F) Problems of real income comparisons.
A. Economies of Scale
The exploitation of economies of scale in the manufacture of goods
traded in international markets need not, of course, be constrained by the
limitations imposed by the small size of the domestic market. However, to the
extent remoteness i.tcreases the cost of transportation to the world markets,
the returns from manufacture for exports are reduced relative to more
favorably located competitors. On the other hand, the same factor provides
greater natural protection for import-substituting manufacture. Be that as it
may, even if there are no constraints on size of the market for a product
because of possibilities for export, to the extent the penetration into
foreign markets depends on the experience gained in producing and selling in
the domestic market, smallness of the latter may preclude export
development. Since market size for this purpose is not measured just by the
size of a country's population, and is not directly related to its status as
an island or its being landlocked, a similar problem arises in any country
(small or large) with a limited domestic market. The significance of this
problem is, in the final analysis, an empirical matter. The analysis of
Chenery and Syrquin (1975) suggests that there are substantial differences
even among small countries in their sources and patterns of
industrializations, with some successfully industrialized small countries
having a composition of exports similar to that of large countries even though
they depend on trade to a greater extent. In primary-product-oriented small
countries, on the other hand, they found that industrialization takes place
later and is due to import-substitution and perhaps to inapprop7iate policies
as well. l/
1/ In the study of the "Growth Experience of Small Economies", Metzler andHughes found that there was no "significant correlation (positive ornegative) of scale with growth for small and large countries", see Jalan(ed.) (1982), p,91.
- 12 -
It has been suggested that indivisibilities and consequent economies
of scale in the production of internationally non-traded goods and services
(particularly those relating to infrastructure) have the effect of raising
unit cost, both of capacity creation and of production in small economies.
For instance, it has been estimated that small countries experience an average
of 65 percent cost disadvantage in creating additional thermal capacity for
power generation. However, for small countries with high population density
(such as Barbados) this disadvantage is only 20 percent. 1/ To the extent
many of the non-traded goods or services are intermediate inputs in other
activities (including, in particular, foreign exchange earning activities)
international competitiveness of small economies may be affected. The
significance of this factor depends, in part, on the share of capital costs
(which are affected by economies of scale) in the unit cost of production of
infrastructure, and on the share of infrastructural costs in the cost of
production of other goods and services. Obviously, the smaller are these
shares, the more limited is the disadvantage of small economies on this
count. Besides, some of the infrastructural activities such as electric power
generation, education, communications and health facilities can be shared by
neighboring countries if they are not separated by cost-raising natural or
man-made barriers -- in other words, even some infrastructural services could
be internationally traded. Of course, island economies that are remote from
the nearest continental landmass do not have this option.
1/ Legarda (1983).
- 13 -
It is also suggested that indivisibilities in political and
administrative structures raise costs for small economies (e.g., a very small
and a very large country will each have one President or Prime Minister, the
number of ministers and government departments needed to take care of economic
development is not proportional to a country's size). On the other hand, it
has been argued that there are social and political advantages associated with
smallness, e.g., social and political cohesion, and fewer vested interests. 1/
In the extreme, one could envision a very small economy facing a
choice between the cost of running their own government infrastructure or
becoming part of a larger community. However, as F. Doumenge points out,
small islands may deliberately choose to retain their separate status rather
than form a larger political unit by joining with other islands for the reason
that "islanders are never happier with insularity than when asserting that
they are completely different from their neighbors, particularly in regard to
language, customs and laws, legal and administrative regulations, currency,
system of government and all other symbols which demonstrate the small self-
contained universe. Consequently, small islands tend to band together only
under the influence of external forces...." 2/
B. Vulnerability
Since many of the small island countries are located in the so-called
loring of fire", they are susceptible to volcanic eruptions and earthquakes.
Some of them are also in the tropical latitudes in which cyclonic storms and
1/ Metzler and Hughes in Jalan (ed.) (1982), pp. 85-86.
2/ Doumenge (1983).
- 14 -
hurricanes develop. Since any country (large or small) located in these areas
is subject to such natural disasters, the particular vulnerability of small
(island) economies is attributed to the disproportionate effect which natural
disasters could have on them. For instance, a strong earthquake could destroy
a large proportion of the housing stock and public buildings on a small
island. Similarly, an epidemic could affect a large proportion of its
population, although their possible remoteness from the nearest continental
population centers provide significant protection from the occurrence of such
an epidemic. Some islands representing the tip of volcanoes may not be
suitable for agriculture but the sea itself is a resource for them, though its
exploitation may require resources that a small economy may be unable to
provide itself.
The presumption that such vulnerability imposes relatively higher
costs on small economies also arises from the fact that the "self-insurance"
available to large economies is not feasible for them. That is to say, a
large economy can absorb a local disaster by spreading its cost over the rest
of the economy unaffected by the disaster, while in a small economy there is
likely to be no sector unaffected by the disaster. On the other hand, even a
small economy may have opportunities for some self-insurance which can help
spread the effects of a disaster over other periods. For example, a buffer
stock of food built during good crop years can help cushion the impact of a
severe drought which reduces crop yields drastically. More generally, in an
open economy buffer stocks of generalized purchasing power in terms of foreign
exchange reserves accumulated over normal years can help augment, more
economically, domestic production shortfalls due to a natural disaster through
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imports. In the absence of o¢:her cheaper ways of insurance, the return to
such stocking activity can be high. Of course, disruptions in the provision
of non-traded and non-storable (e.g., electric power) goods due to a disaster
cannot be made good by imports and stock depletion. However, such disruptions
are likely to be of relatively short duration. At the same time, the
international community has repeatedly demonstrated its willingness to provide
disaster assistance.
While the potential exists for a small country to insure itself
against major losses, and in fact all countries need to undertake some level
of insurance against unforeseen negative events, it is also argued that a
small and poor economy cannot afford to tie up a volume of resources in buffer
stocks of commodities and foreign exchange or purchase insurance sufficient to
adequately cover these risks. These forms of insurance do represent a cost to
the economy. If the probability of a disaster occurring is high, the
corresponding insurance costs will also be high. The net result is that these
countries, if they are in fact more vulnerable, are more likely to have to
devote more of their available resources to insurance than other countries.
Small economies allegedly suffer increased economic vulnerability
because, being necessarily more open than large economies, they are more
affected by shocks originating elsewhere in the world. Further, being small
and hence specialized in a few exports while widely dispersed in the
composition of imports, any external shock that affects the market only for
their exports has a disproportionate effect on their economies. Also, a small
economy in the sense of not having or not perceiving to have any influence on
its own terms of trade does not have the option of adjusting to external
demand shocks by varying its optimal export tax. It is of course, true that
- 16 -
external shocks are transmitted to the domestic economy to a greater extent,
the more open an economy happens to be. Also, small economies with relatively
few and less serious distortions in their foreign trade can and do exploit
their comparative advantage to a much greater extent than large economies. In
any case, if one takes into account gains from trade and the relative severity
of shocks originating at home compared to those originating abroad, it is by
no means always the case that, on balance, small economies have been pushed
(because of their smallness) to a degree of openness that is not optimal
compared to their larger cousins. Further, not all small countries are
affected to the same extent by external shocks, partly because of the
variations in the composition and size of their export basket. Sonme had more
stable export earnings in the period 1967-81 than other not so small but
comparable countries.
It is but natural that given a narrow resource base, an economy may
specialize in the production of a few commodities and services, although some
otherwise small economies (Singapore or Hong Kong, for example) apparently
have resources, mainly entrepreneurship and skilled labor, that appear to have
enabled them to have a diversified production structure. There are some
otherwise large economies which have at least as high a commodity
concentration, in their exports if not in their total production. Thus, being
small and having a high commodity concentration are not synonymous. In any
case, the really important point is that a high commodity concentration,
either in export earnings or in domestic production (and in domestic value
added), need not imply that the changing fortunes of exports or of domestic
production are mirrored in foreign exchange expenditure on imports or in
aggregate domestic expenditure. To the extent that an economy invests in an
17
appropriately diversified portfolic of domestic assets (inclusive of
inventories) and foreign assets (particularly reserves) expenditures can be
more stable than earnings and incomes.
Again the issue is whether the probability of major fluctuations
constitute a substantial cost for many of the small and low-income countries
which exceeds that imposed on other countries. Furthermore, portfolio choice
and management are generally not inexpensive in terms of skills, information
needs, access to swift communication channels, etc. And fixed costs involved
in setting up the needed institutions may make it prohibitively expensive for
"small" economies. One could envision that several "small" countries could
share in the costs of setting up and operating such an institution, However,
there are numerous political and operational problems to such arrangement
which make this an unlikely and unrealistic option for most countries.
Apart from diversification of its financial asset portfolio, an
economy may have the option of diversifying its portfolio of human capi:al,
i.e., have some of its workers emigrate and remit part of their earnings
abroad to their families at home. A number of island economies appear to have
a significant proportion of their labor force working abroad.
Appropriate choice and management of the asset portfolio, coupled
with the use of international facilities (e.g., the IMF compensatory
financing, food facility, STABEX) available to finance temporary (and
reversible) shocks and to ease the cost of adjustment to permanent shifts, can
reduce the unfavorable effects of external shocks. Given these facilities and
small countries' access to them, it is unclear as to ;hether any additional
facilities aimed specifically at helping these countries are needed.
- 18 -
C. Remoteness and Other Factors Affecting Transport Costs
It has been argued that the location of many island countries far
away from the nearest major port places them at a considerable disadvantage in
spite of the relative cost advantage of sea transport over land transport. It
is also claimed that technological change in air and sea transportation in the
form of the long-haul wide-bodied passenger jets and containerized cargo
traffic has resulted in economies of cargo size and, as such, some island
ports handling limited amounts of cargo are left out of trunk routes
altogether or have become less frequent scheduled ports of call. And
alternative arrangements for connecting these islands to the nearest major
port on a trunk route could increase transportation costs. In the case of
landlocked economies, besides their having to bear relatively higher costs of
land transportation, dependence on their neighbors' transportation network for
their access to the sea places them in a disadvantageous position because: the
design of the network and its operation need not necessarily be based on their
requirements; and it has been argued, the transit countries have at times
utilized their monopolistic control over land transportation to charge
additional "rents" on transshipments.
The small size in combination with remoteness is also likely to lead
to stronger tendencies for market imperfections and monopolistic situations in
the country itself. This results from the fact that, ceteris paribus, the
smaller the market and the higher the transportation costs, the greater the
danger that competition will not be effectively felt by individual producers
(domestic and foreign) in the small country, thus permitting the producer to
capture and exploit a monopolistic position in specific markets. Given this
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danger, small and remote economies need to be vigilant of this potential and
take steps to reduce or prevent its occurrence.
It is undoubtedly true that the high costs of transport can reduce
their foreicga trade just as tariff barriers can. One can even show how, in a
simple Ricardian model, the introduction of sufficiently high transport costs
will eliminate trade altogether. As a consequence, compared to an otherwise
identical economy, an unfavorably located island economy will have lower real
income. Of course, the cost of its remoteness can be taken into account by
appropriately computing real income comparisons (section 6 below discusses
these comparisons in some detail) when per capita incomes are being used as a
decision criteria, e.g., aid allocation, graduation. Focussing on high
transport costs per se, however, ignores the extent to which economies have
adapted to these costs by the choice of its export products; a classic example
is Switzerland, which produced and exported high value but low weight per unit
value products such as watches and instruments.
There is yet another sense in which remoteness is sometimes used. It
is argued that many small economies (in particular, dependent territories) are
at the remote periphery of the centers of power at which decisions affecting
them are made. To the extent such remoteness means less interference from the
center, it could have positive effects. In any case, remoteness in this sense
is not unique to small island territories -- areas within a large economy
could be remote from the center of decision-making.
D. Access to Capital Markets
One of the disadvantages from which small economies are said to
suffer is their alleged limited access to private external capital. The
- 20 -
limited evidence sometimes offered on the basis of observed flows of private
capital is hard to interpret. Such flows are influenced by the general
policies towards external capital, and a country's policies perceived to be
unfavorable by the market can result in limiting capital flows to that country
regardless of its size. And the policy stance of a country may affect the
perception of foreigners of the political risk associated with lending or
investing in that country. It would appear that some small economies have
succeeded not only in borrowing abroad in private capital markets but also in
attracting private foreign investment, particularly by multinationals. A few
island countries have attracted off-shore banking and tax sheltering
investments. However, this is perhaps more a consequence of the banking
regulation and tax codes of rich and large countries than of comparative
advantage of small islandsl In any case, whether or not small economies are
disadvantageously placed with respect to access to private capital markets,
they seem to receive much higher levels of official development assistance on
a per capita basis than do many large economies, as is evident from the data
presented in Table 4. 1/ In almost every region, very small and small
countries received much higher net official transfers per capita and a larger
share in terms of IDA loans than large countries.
1/ An analysis of this small country bias 4n aid allocations is contained inIsenman (1976).
Table 4: Per Capita Net Resource Flows in 1982 (US$) '-;2/--
Average: Other Countries 14.1 0.3 22.7 19.7Average: All Countries 27.7 0.2 40.0 38.9
Sources: World Debt Tables, 1983-84 Edition, World Bank, Washington, D.C.,and World Tables, Third Edition, Volume 1: Economic Data,World Bank, Washington, D.C., 1983.
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E. Macro-economic Policy Independence
It is argued that small economies have very little choice except to
be open; they have very little room for independent exchange rate and monetary
policies; and the range of activities that can be taxed and on which public
expenditures can be made are apt to be limited as well, thus restricting the
scope of fiscal policies. It is clear that autarkic policies are likely to be
costlier for a small economy than for a large economy, and hence small
economies are likely to be more open purely from self-interest. As a
consequence, such an economy has to retain its competitive edge in
international markets, which in turn means that it cannot distort its foreign
trade sector unduly nor for long through disequilibrium exchange rates,
tariffs and/or quotas. Even though, in principle, it can operate a market for
foreign exchange and adopt a floating exchange rate regime, in practice it is
more likely that a regime maintaining fixed parity with a single currency or a
basket of currencies is likely to be adopted. Since the exchange rate of
currencies within the baskets are likely to fluctuate relative to each other
and to others outside the basket, such fluctuations will be transmitted to the
exchange rates of a currency that maintain a fixed par value to the basket.
Ever since the early seventies' shift away from the Bretton Woods
fixed parity system for the major international currencies and particularly
since the progressive integration of international private capital markets,
even large developed countries have found that the scope of independent (i.e.,
internationally uncoordinated) macroeconomic policies is limited. In any
case, the argument about lack of macro-economic policy independence boils dowm
to the assertion that small open economies have greater difficulties in
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successfully employing macro-economic policies to stabilize domestic incomes
or prices in the face of external shocks. It is easy to see that if domestic
income generation is largely through a few export activities and the domestic
consumption basket consists mostly of imported commodities and consumer prices
influence wage rates, etc., external shocks in terms of changes in export and
import prices affect domestic incomes and prices to a greater extent in a
small open economy than in a more diversified and less open large economy.
But the real issue is whether and to what extent a small country should seek
to stabilize income generated and/or prices given the costs which the pursuit
of such an objective could impose on a small economy and the practical limits
the countries face in the development and maintenance of a diversified
portfolio of domestic production and foreign exchange reserves.
In chis context, it has been suggested that policy prescriptions
relating to adjustment to external shocks have to be different in the case of
small island developing economies. Often this suggestion is based on the
belief that in a large, mo-a diversified and less open economy, the effect of
shocks will be relatively less severe and the cost of adjustment could be
spread to a greater extent within the economy, yet little evidence that this
is the case has been presented. Furthermore, the dictum to "finance shocks of
a temporary duration and reversible in direction" and "adjust to permanent
shifts" applies equally to large and small economies. And the problem of
determining whether an observed shock falls into the 'temporary"f or
"permanent" category is no easier in the case of large economies!
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F. Real Income Comparisons
It was argued in section 3 that the transport cost disadvantages of a
remote' economy will be reflected in its real income, properly computed.
Consider, for simplicity, two otherwise identical economies which face the
same prices in world markets, one of which is located sufficiently close to
these markets that the transport costs of taking its exports to and bringing
its imports from these markets can be neglected, while the second is located
so far that transport costs preclude its participation in world trade. Assume
further that there are no distortions in either economy. Clearly, if the
income (i.e., value added) in each of these economies is computed by valuing
its net output at the common set of world prices, then the second, which is
forced into autarky because of high transportation costs, will have a lower
income than the first. The reason being that the first (the second) will have
an output composition that approximates the maximum income that can be
achieved at world prices (domestic prices) and the two sets of prices differ
because of transport costs. Even though in the above argument it is implicit
that both countries produce only internationally traded commodities, it can be
shown to be valid even when non-traded goods are admitted into the analysis as
long as they are valued at prices that equal the value of the inputs used in
their production, the input prices being those prevailing in the first
economy.
In practice, real incomes in units of a common currency such as the
US dollar are often computed by dividing the real income in national currency
unit by the official exchange rate (the national currency price) of the US
dollar. A number of arguments have been made suggesting that such a procedure
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may be biased in some sense or the other against small economies, apart from
the general (i.e., not specific to small economies) problem that per capita
real national income is not necessarily a good index of the welfare of a
country's population or that of its level of economic, social and
institutional development. Since this problem is well understood and other
indices of social and institutional developments are often-used in conjunction
with per capita real income, no further discussion of it is offered here.
It is argued that in many small and poor countries there is a rich
expatriate community which may be sufficiently large to pull the per capita
income of the residents much above that of resident citizens. However, if
valid, this is easily addressed: given an adequate data base, per capita
incomes of resident citizens, or for that matter the per capita income of any
other sub-group of residents, can be computed.
An apparently more serious argument is that conversion at the
official exchange rate understates the transport or other cost disadvantages
of small island economies. One could interpret this as asserting that an
exchange rate that better reflects these costs will be higher than the
official one. The results from the International Comparisons Project funded
in part by the World Bank seem to contradict this assertion (see Table 5):
the exchange rate derivation index, i.e. the ratio of official exchange rate
to the purchasing-power corrected exchange rate is greater than one for all
the developing countries included in the project. In other words, allowing
for the differing relative purchasing power of currencies, applying a common
set of prices representative of the world price structure to the quantities of
the commodities and services entering into each country's final expenditure or
GDP raises the per capita income of each developing country above the level
- 29 °
Table 5: Per Capita Gross Domestic Product in US Dollars at Official
Exchange Rates, and in International Dollars, 1975
Converted at the official exchange rate.b/ The 1975 international dollar has the same purchasing power as a 1975 US dollar.
cJ Reference year beginning April 1.
d/ Reference year beginning March 21.
Source: Kravis, l.B., A. Heston and R. Summers, World Product and Income: International Comparisons of
Real Gross Product, The Johns Hopkins University Press, Baltimore, 1982, Table 1.2.
- 30 -
obtained by using official exchange rates. On the other hand, an alternative
interpretation could be that even though the use of official exchange rates
instead of the purchasing-power corrected one for conversion understates the
"true" income of all developing countries, it understates it less in the case
of small island economies so that they appear richer relative to other
developing countries than they truly are. If this is valid, the use of
purchasing-power corrected exchange rates may make more small economies
eligible for various concessions than the use of official exchange rates would
suggest. However, there is no evidence that this argument is indeed valid.
In any case, even if data were available (which they are not) for the
computation of purchasing-power corrected exchange rates for small island
economies, a selective use of such rates for small island economies is
obviously out of the question before making that move more locally.
III. Conclusions
It would appear that many (though not all) of the alleged problems of
small economies are either not peculiar to small economies or can be addressed
through suitable policy measures. It is also the case that the transport cost
disadvantage that a small economy suffers because of its location will already
be reflected in its real income. As long as operational decisions about a
country such as its graduation and its eligibility for various forms of
concessions, etc., continue to be-based on flexible applications of a number
of indices and criteria and not rigidly on a single index such as that
country's per capita real income in US dollars at that official exchange rate,
there is little danger that small island or landlocked economies would be
unfairly treated. However, this is not to suggest that all is well with small
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island or landlocked economies (which clearly they are not, as evidenced by
the decline in per capita real GNP in several of them during the 1970s), nor
to argue that the external environment for developing countries is currently
buoyant. What is being suggested is that causes of economic and social
stagnation in some of these economies cannot be attributed to their smallness
or similar exogenous characteristics nor to the failure or non-existence of
international institutional mechanisms to address their development problems.
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