Fiscal Policy in Small States

• Author: Stephanie Medina Cas and Rui Ota
• Position: IMF African Department
• Pages: 69

Page 69

Fiscal policy carries greater importance in small states than in large countries, and certain fiscal characteristics of small states can affect the implementation of sound policies, according to IMF research.

A new IMF study cites two reasons for fiscal policy's greater weight and leverage in small states: first, there is greater need forPage 74 countercyclical fiscal policy because small states are more prone to shocks; and second, because most small states have fixed exchange rate regimes, fiscal policy is the main tool for adjustment.

Since the early 1990s, a growing public debt problem in many small states has been worsened by a slowdown in growth rates, owing partly to the erosion of trade preferences and to shocks. During this period, sluggish growth and fiscal pressures have emerged in some Pacific islands, for instance, while rising debt has been especially pronounced in the Caribbean countries. Small low-income and African states also tend to have very high external debt, which curtails these economies' fiscal flexibility.

Small states are broadly defined as developing and emerging market countries that have a population of about two million or less. Using a new fiscal data set for 42 small states, the analysis showed that small states tend to have higher government expenditures, including spending on goods and services, wages and salaries, and capital investment.

Weak governance

Small states also tend to have weaker primary balances, higher public debt, and higher external debt than the large countries examined. Furthermore, the study unveiled evidence that weak governance is significantly correlated with higher total public and external debt in small states.

Why, in recent years, do many small states tend to spend more, have weaker primary balances, and have more public debt than large states? The literature shows that these fiscal challenges principally reflect the following characteristics of many small states:

* Remoteness and limited economies of scale help explain small states' higher cost structure, which raises government expenditures and can increase public debt. Remoteness tends to raise transport and input costs, and keeps the economy isolated.

* A lack of economic and export diversification stemming from fewer human and capital resources and small domestic markets can raise government expenditures because it makes small states particularly vulnerable to...