ECONOMIC VULNERABILITY AND RESILIENCE WITH SPECIAL REFERENCE TO SMALL ISLAND DEVELOPING STATES

1. ECONOMIC VULNERABILITY AND RESILIENCE WITH SPECIAL REFERENCE TO SMALL ISLAND DEVELOPING STATES Prepared by LINO BRIGUGLIO, Small States Network for Economic Development Regional Policy Briefing No. 7 BUILDING RESILIENCE IN SMALL ISLAND ECONOMIES: FROM VULNERABILITIES TO OPPORTUNITIES Hotel Victoria, Pointe aux Piments, Mauritius, 23-24 April 2012

2. The presentation is organised as follows: Economic Vulnerability Economic Resilience Juxtaposing economic vulnerability and resilience Results of the resilience index and country categorisation Policy Implications and concluding considerations Layout

3. ECONOMIC VULNERABILITY

4. Economic vulnerability refers to inherent proneness of an economy to harmful exogenous shocks. In the case of small states, such vulnerability arises from the fact that the economies of these states are, to a large extent, shaped by forces outside their control. Meaning of Economic Vulnerability

5. Studies on economic vulnerability so far have focused on measuring the phenomenon by proxying exposure to shocks. The so-called UNCDP index, used for the graduation from LDC status also attempts to factor-in structural factors. What follows is based on the Economic Vulnerability Index developed by the University of Malta. Studies on Economic Vulnerability

6. The research carried out by the University of Malta focuses on inherent (as against policy induced) factors that lead to exposure to external shocks, and is measured by: Openness to international trade Export concentration Dependence on strategic imports. The studies carried out by the University of Malta (Briguglio, 1995; Briguglio and Galea, 2003) conclude, like many other studies, that small states tend to be more economically vulnerable than other group of countries Studies on Economic Vulnerability

7.  Trade openness, measured by Exports + Imports/2 as a ratio of GDP, arises because (a) small states import a high proportion of their final expenditure due to limited natural resource endowments and (b) export a high proportion of their output mainly due to the limited size of the domestic market and to meet import expenditure. Export concentration (i.e. reliance on a few items of exports of goods and services) is relatively high in small states because of their limited diversification possibilities. This leads to the risk of having too many eggs in one basket. High dependence on strategic imports (food, fuel and industrial supplies) leads to high exposure to shocks. These imports are characterised by low price and income elasticity of demand and therefore have a high impact on small states when the prices of these imports change. What causes Economic Vulnerability?

8. 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. Success In Spite of and Not because of Economic Vulnerability

9. ECONOMIC RESILIENCE

10. Economic resilience refers to the extent to which an economy can withstand or bounce back from the negative effects of external shocks. 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 Meaning of Economic Resilience 10

11. The University of Malta has also undertaken research to explain why, in spite of their vulnerability, some small states like Malta, manage to attain economic success. The policy framework that was investigated towards this end was labelled “resilience building”. The measurement of such policies was labelled “resilience index”. Economic Resilience Index 11

12. A framework for the measurement of economic resilience was developed by Briguglio, Cordina, Vella and Farrugia (2006; 2009) who constructed a resilience index,consisting of the following components: macroeconomic stability; market efficiency; good governance; and social development. What helps to Build Economic Resilience?

13. Macroeconomic stability relates to the interaction between an economy’s aggregate demand and aggregate supply. If aggregate expenditure in an economy moves in equilibrium with aggregate supply, the economy would be characterised by internal balance, as manifested in a sustainable fiscal position, low price inflation and an unemployment rate close to the natural rate, as well as by external balance, as reflected in the international current account position or by the level of external debt. These can be all considered to be variables which are highly influenced by economic policy and which could act as good indicators of an economy’s resilience in facing adverse shocks. Macroeconomic stability 13

14. The macroeconomic stability component of the resilience index proposed in this study consists of three variables, namely the fiscal deficit to GDP ratio; the sum of the unemployment and inflation rates; and the external debt to GDP ratio. Good performance in these variables indicate that the country will have room for manoeuvre when being affected by shocks. The variables are available for a reasonably wide set of countries spread over a spectrum of stages of development, size and geographical characteristics. Macroeconomic stability 14

15. The science of economics views markets and their efficient operation through the price mechanism as the best way to allocate resources in the economy. If markets adjust rapidly to achieve equilibrium, following an external shock, the risk of being negatively affected by such a shock will be lower than if market disequilbria tend to persist. Indeed, if with very slow or non-existent market adjustment, resources will not be efficiently allocated in the economy, resulting in welfare costs, manifested, for instance, in unemployed resources and waste or shortages in the goods markets. These considerations have important implications for resilience of the shock absorbing type. Market efficiency 15

16. The market efficiency indicators used related to: the financial market. These indicators assess the extent to which (a) the banking industry is dominated by private firms; (b) foreign banks are permitted to compete in the market; (c) credit is supplied to the private sector; and (d) interest rates are in line with the workings of the market. the labour market. Here the indicators relate to unduly high unemployment benefits (which could undermine the incentive to accept employment), dismissal regulations, minimum wage impositions, centralised wage setting, extensions of union contracts to non-participating parties and conscription. Bureaucratic control of business activities. This indicator measures the extent of government interference which is also thought to inhibit market efficiency. Market efficiency 16

17. Good governance is essential for an economic system to function properly and hence to be resilient. Governance relates to issues such as rule of law and property rights. Without mechanisms of this kind in place, it would be relatively easy for adverse shocks to result in economic and social chaos and unrest. Hence the effects of vulnerability would be exacerbated. On the other hand, good governance can strengthen an economy’s resilience. Good Governance 17

18. The Economic Freedom of the World Index (Gw has a component which focuses on legal structure and security of property rights. This is considered to be useful in the context of the present exercise in deriving an index of good governance. The component covers five sub-components, namely: judicial independence; impartiality of courts; (c) the protection of intellectual property rights; military interference in the rule of law; and political system and the integrity of the legal system. Good Governance 18

19. An alternative governance index is presented by the World Bank (Kaufmann et al., 2006). A Pearson correlation test of the World Bank governance indicators and the Economic Freedom of the World's "legal structure and security of property rights" component yielded a value of 0.92. Thus, both indices are likely to be measuring a similar phenomenon. In fact when the Kaufmann Index was used in the compilation of the resilience index the ranking of countries only changed marginally. Good Governance 19

20. Social development is another essential component of economic resilience. This factor indicates the extent to which relations within a society are properly developed, enabling an effective functioning of the economic apparatus without the hindrance of civil unrest. Social development can also indicate the extent to which effective social dialogue takes place in an economy, which would in turn enable collaborative approaches towards the undertaking of corrective measures in the face of adverse shocks. Social Development 20

21. Social development can be measured in a number of ways. The variables chosen for the resilience index werethe education and health indicators utilised to construct the UNDP Human Development Index. Educational advancement, measured by the adult literacy rate and school enrolment ratios, is considered to be a good indicator of social development. In addition, an improved standard of education could be indicative of an improved ability to cohere in the face of external shocks—a condition conducive to economic resilience. Life expectancy at birth is considered to be suitable for measuring the health aspects in society. This in turn is likely to be related to medical facilities, housing and degree of proneness to accident or risk of injury.   Social Development 21

22. JUXTAPOSING VULNERABILITY AND RESILIENCE

23. Juxtaposing Vulnerability and Resilience • 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 the following figure. • The figure shows that risk has two elements: • the first is associated with the inherent vulnerability - conditions of the country that expose it shocks, and • the second is associated with good economic governance • the risk of being adversely affected by the shock is therefore the combination of the two elements. 23

24. Juxtaposing Vulnerability and Resilience (cont) Risk of being harmed by external shocks

25. On the basis of this methodology, one can propose 4 scenarios into which countries may be placed according to their vulnerability and resilience characteristics. These scenarios are termed “best-case”, “worst-case”, “self-made”, and “prodigal-son”. Countries classified as “self-made” are those that take steps to mitigate their inherent vulnerability by building their economic resilience, thereby reducing the risks associated with exposure to shocks. Countries falling within the “prodigal-son” scenario are those with a relatively low degree of inherent economic vulnerability but which adopt policies that expose them to the adverse effects of exogenous shocks. FOUR COUNTRY SCENARIOS

26. The “best-case” scenario applies to countries that are not inherently highly vulnerable and which at the same time adopt resilience-building policies. Conversely, the “worst-case” scenario refers to countries that are inherently highly vulnerable but make matters worse by adopting policies that exacerbate the negative effects of their vulnerability. FOUR COUNTRY SCENARIOS (cont)

27. These four scenarios or cases are depicted in the following figure, where the axes measure inherent economic vulnerability and nurtured resilience, respectively.In this scheme the best situation in economic terms falls in quadrant IV. The vulnerable small island states that have adopted resilience-building policies are likely to fall in quadrant II. FOUR COUNTRY SCENARIOS (cont)

28. FOUR COUNTRY SCENARIOS (cont) Vulnerability Index Resilience Index

29. RESULTS OF THE RESILIENCE INDEX AND COUNTRY CATEGORISATION

30. Results of the V&R Juxtaposition Results produced by Briguglio et al (2006) Malta Singapore Jamaica Trinidad & Tobago Resilience

31. Results of the V&R Juxtaposition (cont) The overall tendencies that emerged from the study: • 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, including Malta; • 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 31 Resilience

32. CONCLUDING CONSIDERATIONS

33. Main Implications The main implication of this presentation is that vulnerability has negative connotations on economic development due to the effects of negative external shocks. On the other hand, resilience building has a positive influence on economic development as it helps a country to withstand or absorb these shocks. Also, economic resilience building is associated with good economic governance. Many small states succeed economically in spite of the small size constraints, due to good economic governance. Concluding Considerations

34. Usefulness for policy The juxtaposition of economic vulnerability and resilience permits an assessment of the reasons behind the economic success or failure of small vulnerable countries. This approach was utilised in a recent ESCAP study (ESCAP, ABD, UNDP, 2010). A number of policy implications emerge from this presentation, but the most important one is the small states should give major importance to resilience building by: - reducing instability, - improving the workings of the market, - enhancing political governance, and - promoting social development. Concluding Considerations (cont)

35. Usefulness for country profiling For the purposes of policy formulation and implementation, it is useful to undertake in-depth investigation of issues within the specific context of the country and its circumstances This was done by the Commonwealth Secretariat in collaboration with the University of Malta through profiling exercises. These exercises have enabled a number of small island states to carry out a self-examination in order to identify gaps in their policy framework. Visit: http://publications.thecommonwealth.org/Uploaded/Products/ProductInfoPDF/Profiling%20Vulnerability%20and%20Resilience841.pdf Concluding Considerations (cont)

36. REFERENCES • Briguglio, L. (1995). “Small Island States and their Economic Vulnerabilities,” World Development, Vol.23 (9): 1615-1632. • Briguglio, L. Cordina, C. Farrugia, N. and Vella, S. (2006). “Conceptualizing and Measuring Economic Resilience.” In Building the Economic Resilience of Small States, Edited by L. Briguglio, C. Cordina and E.J. Kisanga, Malta: Islands and Small States Institute and London: Commonwealth Secretariat. • Briguglio, L. Cordina, C. Farrugia, N. and Vella, S. (2009). “Economic Vulnerability and Resilience: Concepts and Measurements.” Oxford Development Studies,Vol. 37 (3): 229- 247 • Briguglio, L. and Galea, W. “Updating the Economic Vulnerability Index.” Occasional Papers on Islands and Small States, No. 2003-4. Malta: Islands and Small States Institute. (2003). • Briguglio, L., Cordina, C. Vella, S. and Vigilance, C. (2010). Profiling Economic Vulnerability and Resilience: A Small States Manual. London: Commonwealth Secretariat. • ESCAP, UNDP, ADB (2010). Achieving the Millennium Development Goals in an Era of Global Uncertainty. Asia-Pacific Regional Report 2009/10 (Annex 3)

37. THANK YOU FOR YOUR ATTENTION