Thinking Big

• Author: M. Ayhan Kose and Eswar S. Prasad
• Position: Economist in the IMF's Western Hemisphere Department/Assistant to the Director in the IMF's Asia and Pacific Department

How can small states hold their own in an increasingly globalized economy?

The term "small state" generally refers to sovereign countries with fewer than one and a half million people (see box). By this criterion, 45 developing countries (41 of the IMF's 184 member countries) are small states. They range from "micro" states, such as Palau and St. Kitts and Nevis, each with fewer than 40,000 people, to Botswana, Gabon, The Gambia, Guinea-Bissau, Mauritius, and Trinidad and Tobago, with more than one million people each (see Table 1).

Are small states different?

Per capita income varies. Small states range from low-income economies, such as Comoros, The Gambia, Guinea-Bissau, and São Tomé and Príncipe (with per capita GNPs of less than $700), to high-income economies, such as The Bahamas, Brunei, Malta, and Qatar (with per capita GNPs of about $10,000 or more) (Table 2). Their per capita incomes are, on average, higher than those of other developing economies. Other indicators of economic well-being, including poverty rates, life expectancy, and literacy, are similar for small states and other developing economies.

Trade is more open. Small states are generally more open to trade than other developing countries, and their average openness ratio (exports plus imports divided by GDP) has risen significantly over time. They also tend to have a less diversified production structure and export base, with one or two dominant products or industries. For example, garments represent more than 80 percent of Lesotho's total merchandise exports. In Antigua and Barbuda, Barbados, Samoa, St. Kitts and Nevis, and St. Lucia, tourism earnings constituted more than half of exports of goods and services in the late 1990s.

Larger public sectors. The size of government, as measured by the ratio of government expenditures to GDP, is greater in small states than in other developing countries. Economies that are more open to external trade and, consequently, more vulnerable to external shocks, tend to have larger public sectors, which help counteract the short-term effects of such shocks. But small states have higher ratios of government expenditures to GDP even after controlling for per capita income and degree of openness, perhaps reflecting the higher average costs of producing public goods on a small scale.

Strong trade links, but weaker financial links. Over the past four decades, average output growth has been higher in small states than in other economies, the apparent result of their strong trade links and their substantially higher investment ratios. Clearly, small states have benefited significantly from trade openness. Their financial links with the global economy are, however, weaker. Although the average ratio of the volume of capital flows to GDP is larger for small states than for other developing countries, it is still smaller than for industrial economies. In several small states where foreign aid remains a major source of income, aid dependency continues to be an important problem (Chart 1). The average ratio of foreign aid to GDP is about 20 percent in small countries, whereas it is less than 9 percent in other developing economies.

[ SEE THE GRAPHIC AT THE ATTACHED RTF ]

Exchange rates tend to be fixed. It would seem appropriate for small states, given their vulnerability to external shocks, to use freely floating exchange rates as a buffer. But this...