ECONOMIC VULNERABILITY AND RESILIENCE OF SMALL STATES

1. ECONOMIC VULNERABILITY AND RESILIENCE OF SMALL STATES By Lino Briguglio and Gordon Cordina University of Malta Prepared for the conference “Small States and Resilience Building” Malta, 23-25 April 2007

2. Layout The presentation is organised as follows: • Introduction • Economic vulnerability • Economic resilience • Juxtaposing vulnerability and resilience • Strengths and weaknesses of this approach • Concluding considerations

3. Introduction ..1 The economic characteristics of small states are well documented, and include limited ability to exploit economies of scale; lack of natural resource endowments and high import content. Other characteristics relate to limitations of diversification possibilities; dependence on a narrow range of products; limitations on the extent to which domestic competition policy can be applied.

4. Introduction ..2 In the case of island states, a major problem relates to high international transport costs and uncertainties of industrial supplies due to insularity and remoteness. In spite of this, many small states would seem to be performing relatively well. This paper will explore this seeming contradiction.

5. Introduction ..3 It is pertinent here to refer to two strands of thought in the literature on small states: • that based on the premise that being small is an advantage and that is why small states succeed • that based on the premise (as is the case in the present study) that being small poses a number of disadvantages, and that those small states that succeed do so in spite of and not because of small size. The second strand of thought can be explained as follows: A young person who is born blind can succeed, even more than others with good eyesight, not because he is blind, but because he may try harder to succeed – ie success in this case is in spite of and not because of blindness

6. Economic Vulnerability ..1 There are inherent features associated with small states, which lead to economic vulnerability. Such vulnerability arises from the fact that the economies of small states are, to a large extent, shaped by forces outside their control.

7. Economic Vulnerability ..2 • Economic vulnerability refers to proneness of an economy to exogenous shocks, lying outside its control • many studies have shown, that small states tend to be more economically vulnerable than other group of countries • Manifestations of vulnerability include high degree of fluctuations in GDP and in export earnings

8. Economic Vulnerability ..3 • In spite of their economic vulnerability, many small states manage to generate a relatively high GDP per capita, when compared to other developing countries • This has been called the ‘Singapore Paradox’ • One can explain this paradox by juxtaposing economic vulnerability with economic resilience • Economic resilience refers to the extent to which an economy can withstand or bounce back from the negative effects of external shocks

9. Economic Vulnerability ..4 • Economic vulnerability indices have been constructed by Briguglio (1995, 1997), Briguglio and Galea (2003), Farrugia (2004), Commonwealth Secretariat (2002), United Nations Committee for Development Policy (2005). • Main determinants in Briguglio and Galea (2003): • Economic openness • Export concentration • Dependence on strategic imports • Vulnerability indices conclude that small states tend to be more vulnerable than other groups of countries

10. Economic Resilience ..1 Meaning of economic resilience (resilire) refers to: • the ability of an economy to recover quickly following adverse shocks: shock counteraction • The ability of an economy to withstand shocks: shock absorption

11. Economic Resilience ..2 • Nurtured resilience can be measured by an index which refers to what a country is doing to mitigate its inherent vulnerability, such as sound economic governance • The combination of the vulnerability and resilience indices would indicate the overall risk of being harmed by external shocks

12. Economic Resilience ..3 An economic resilience index has been constructed by Briguglio, Cordina, Farrugia and Vella (2006). It includes four variables capturing shock-absorbing and shock-counteracting elements: • Macroeconomic stability • Microeconomic market efficiency • Good political governance • Social and environmental conditions

13. Economic Resilience ..4 Macroeconomic stability is important for shock- Counteraction. Components used in the index : • Fiscal deficit to GDP • Misery Index: Inflation + unemployment • External debt to GDP

14. Economic Resilience ..5 Market flexibility is required for shock-absorption: Components used in the index: • Markets and their efficient operation through the price mechanism is the best way to allocate resources in the economy • Regulation of credit, labour and business (Economic Freedom of the World Index) • Measures the extent to which markets operate freely, competitively and efficiently • Identifies regulatory restraints and bureaucratic procedures on competition and the operation of markets

15. Economic Resilience ..6 Good political governance is an overarching requisite for good economic management conducive resilience building. Components used in the index (referring to the legal structure and security of property rights (Economic Freedom of the World Index) • Judicial independence • Impartiality of courts • Protection of intellectual property rights • Military interference in the rule of law and political system • Integrity of the legal system.

16. Economic Resilience ..7 Social development, leading to well developed social relations and effective social dialogue improve the chances of effectiveness of resilience building policies: Components used in the Index, taken from the HDI: • Heath (life expectancy at birth) • Education (adult literacy rate and school enrolment ratios)

17. Economic Resilience ..8 The resilience index was constructed as follows: All observations were standardised to give values from 0 to 1 • Index was computed by taking a simple average of the four components: • Macroeconomic stability • Microeconomic market efficiency • Good governance • Social development • The index was computed for 86 countries in different stages of development and of different sizes.

18. Juxtaposing Vulnerability and Resilience ..1 Vulnerability Index Resilience Index

19. Juxtaposing Vulnerability and Resilience ..2 Results produced by Briguglio et al (2006) Vulnerability Resilience

20. Juxtaposing Vulnerability and Resilience ..3 Overall tendencies: • countries which fall in the “best-case” quadrant are mostly the large developed countries; • countries which fall in the “self-made” quadrant include a number of small states with a high vulnerability score; • countries which fall in the “prodigal-son” quadrant include mostly large third world countries; and • countries which fall in the “worst-case” quadrant include a few vulnerable small countries with weak economic governance. Vulnerability Resilience

21. Juxtaposing Vulnerability and Resilience ..4 Regression results indicate that resilience is positively related to GDP per capita and vulnerability is negatively related to GDP per capita Vulnerability Resilience

22. Juxtaposing Vulnerability and Resilience ..5 • Creating a methodological framework: • By distinguishing between inherent economic vulnerability and nurtured economic resilience, it is possible to create a methodological framework for assessing the risk of being affected by external shocks, as shown in Figure 1. Figure 1 shows that risk has two elements: • the first is associated with the inherent vulnerability conditions of the country that is exposed to shocks, and • the second associated with good economic governance • the risk of being adversely affected by the shock is therefore the combination of the two elements.

23. Juxtaposing Vulnerability and Resilience ..6

24. Strengths and Weaknesses of the Approach ..1 Strengths: This approach could be used to: • Support decision-making, setting targets and establishing standards • Monitor and evaluate developments • Derive quantitative estimates • Disseminate of information and drawing attention to the issue • Quantitative estimation helps to focus the discussion on the essential elements • Promote the idea of integrated action

25. Strengths and Weaknesses of the Approach ..2 Weaknesses: The methodology requires indices to be applied. This is associated with a number of weaknesses: • Subjective choice of variables • Problems of measurement • Averaging and weighting procedure • Lack or shortage or other inadequacies of data • Non-homogenous data

26. Concluding Considerations • Results of juxtaposing economic vulnerability and resilience permit an assessment of the reasons behind the economic success or failure of small vulnerable countries. • Vulnerability is negatively related to economic development due to the effects of negative external shocks. On the other hand, resilience building influences positively economic development as it helps a country to withstand or absort these shocks. • Many small states succeed economically not because they are small, but in spite of the small size constraints, due to good economic governance.

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