Building Resilience for Sustainable Development in Small Island Economies

1. Building Resilience for Sustainable Development in Small Island Economies Robert Read Lancaster University Management School UK

2. Key Elements of the Size-Growth Relationship Key economic characteristics of small size: • Small populations – diseconomies of scale/higher costs; limits on developing large-scale industries, agglomeration and firm clusters; limited competition. • Limited Resources – limited natural resources and labour supply – reliance on human capital-intensive activities instead of large-scale labour-intensive industrialisation. • Constrained diversification – a high degree of specialisation in production and exports. • Openness to trade – ‘structural’ trade openness, exposure to exogenous shocks, constrained domestic policy-making.

3. Key Growth Sectors in Small Economies Empirical analyses of the growth of small economies, notably by Armstrong & Read, consistently find that three sectors are key to economic growth and high incomes: • Tourism • Financial Services • Natural Resources The contribution of Manufacturing appears to be consistently insignificant while Agriculture is associated with lower growth and incomes.

4. ‘Structural’ Openness to Trade in Small Economies Small economies are highly open to international trade because of their limited ability to produce a broad range of goods and services domestically. This ‘structural’ openness has important implications: • Economic growth: trade openness has strong positive growth effects based upon underlying comparative advantage. • Growth volatility: more open economies are exposed to greater volatility in their growth – need for greater resilience. • Domestic policy-making: openness limits policy autonomy, particularly with respect to the exchange rate. for domestic policy-making as well as comparative advantage and exposure to exogenous (external) terms of trade shocks.

5. The Impact of Growth Volatility Large-scale studies of the impact of growth volatility all find that it tends to reduce the long-run average rate of growth. These adverse growth effects of volatility tend to be greatest for: • Low income countries (limited resilience capacity). • Countries with weak institutional structures and poor governance.

6. Trade Openness & Growth Volatility in Small Economies Analyses of the impact of growth volatility on small economies is more limited but the available evidence (notably, Easterly & Kraay, 2000; Cavallo, 2007) suggests that: • Greater trade openness gives rise to greater exposure to destabilising terms of trade shocks. • Greater trade openness enhances their growth. • The stabilising effects of integration with the global economy more than compensates for the destabilising effects of terms of trade shocks. • Reducing openness to limit growth volatility can therefore be expected to reduce growth and incomes.

7. Growth & Resilience in Small Economies Resilience refers to the resource capacity of economies to deal with and ameliorate the impact of their vulnerability to economic and natural shocks: • Exposure to growth volatility is expected to be greatest for economies that have achieved the greatest growth success. • Specialisation in high growth sectors appears to reduce the impact of growth volatility. • Growth success increases resilience capacity. Growth volatility and resilience capacity is therefore primarily a critical challenge for poorer less well-managed small economies.

8. The Environmental Vulnerability ofSmall Economies Small island and littoral economies are among the most vulnerable environments to the effects of natural disasters and the long-term effects of climate change because of their size, location and topography. It is conceptually difficult to quantify environmental vulnerability, particularly with respect to evaluating the risk, magnitude and effects of infrequent climatic and geological events. It is clear however, that environmental vulnerability requires additional resilience capacity and policy strategies over and above those for dealing with economic volatility.

9. Building Resilience Capacity inSmall Economies To build their resilience capacity, small economies therefore need to adopt a range of policies to stabilise the impact of growth volatility and deal with the effects of environmental vulnerability. • Export diversification. • Improving domestic linkages. • Enhancing domestic social capital and governance. • Insurance.

10. Export Diversification in Small Economies Small economies have a high degree of specialisation in output and exports but only very limited scope for diversification (the standard solution). More successful small economies tend to be less prone to trade shocks because of their individual or aggregate sectoral specialisation. A second element is to reduce geographic export concentration – the dependence upon a limited number of markets, often in former metropolitan countries.

11. Improving Domestic Linkages Growth and international competitiveness can be enhanced by improving the depth and quality of linkages, both up- and down-stream, to develop local supply chains and increase domestic value added. For small economies, this potential is likely to be confined to key areas of activity, notably natural resources and tourism. A particular challenge is the need to develop critical local capabilities to improve innovatory and adaptive capacity – indigenous R&D is constrained by the lack of critical mass of financial and human capital as well as diseconomies of scale.

12. Openness, FDI & Local Linkages Foreign direct investment (FDI) offers an important additional means to enhance supply-side capabilities in small economies because inflows embody technology, know-how and market access. Inflows of FDI to small economies are unexpectedly high given their size, primarily because of their high openness to trade – openness to trade and FDI inflows are strongly related. Evidence suggests that the fundamental policy issue for small economies is not attracting FDI inflows but rather maximising their local growth effects.

13. Enhancing Social Capital & Governance Good governance and social capital are key to optimal policy-making and building resilience capacity generally. Khan (2007) identifies three key institutional-building and objectives: • Facilitating rapid and effective market and non-market transfers of assets and resources to more productive sectors. • Managing incentives and needs for achieving rapid and effective productivity improvements through technological acquisition (innovation or up-grading), enhanced learning and knowledge absorption. • Maintaining political stability in a context of rapid social and economic transformation.

14. Social Capital & Governance inSmall Economies It is argued that small economies are particularly well-placed with respect to social capital and good governance: • Small societies have a stronger sense of identity. • The short distance between policy-makers and constituents. • Their need to be highly flexible in responding to external growth threats and opportunities. • Limited scope to implement mis-specified growth policies. A note of caution; many small economies are not homogenous and some suffer from internal political strife.

15. Insurance & Growth Volatility inSmall Economies A key policy conclusion with respect to the incidence of volatility in small economies is that they should make greater use of available insurance markets and products as a growth stabilisation strategy (Easterly & Kraay, 2000). The use of insurance is particularly pertinent to environmental vulnerability and the need to hold sufficient precautionary reserves (i.e., resilience capacity) to deal with its effects.

16. Achieving Sustainable Growth inSmall Economies Achieving sustainable growth in small economies is likely to be the outcome of a combination of effective growth policies, resilience capacity and ensuring the environmental sustainability of domestic activities. Small economies are, to an extent, better prepared to cope with these challenges than many other developing countries although they face critical challenges relating to their size and capacity for resilience.

17. Achieving Sustainable Growth inSmall Economies On the plus side is their sectoral structure, generally reliant –with the exception of some natural resource processing activities – on ‘cleaner’ technologies. This includes crop rather than large-scale livestock production in agriculture, small manufacturing sectors and large service sectors although attention needs to be paid to the ‘carrying capacity’ for tourism. To this can be added bio-diversity which is a natural resource asset in its own right. On the negative side are the pressures of social and economic development on fragile environments susceptible to the long-term effects of climate change.

18. Concluding Comments • Small economies face a range of challenges but many have achieved growth and high incomes. • Their high ‘structural’ openness to trade and vulnerability to natural disasters exposes them to greater growth volatility. • Trade is critical to growth and building resilience capacity. • Reducing trade openness will reduce growth, incomes and resilience capacity but increase growth volatility. • A range of policies may enhance growth, reduce growth volatility and build resilience capacity, particularly with respect to environmental vulnerability • Sustainable development is dependent upon effective policy-making founded upon social capital and good governance.