Building Resilience in SIDS for Trade & Climate Change Policies

1. Building Resilience in SIDS for Trade & Climate Change Policies 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 success and higher incomes: • Tourism • Financial Services • Natural Resources The contribution of Manufacturing is consistently insignificant while a greater dependence upon Agriculture is associated with significantly 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. Structural Sources of Growth Volatility Openness to trade gives rise to several structural sources of growth volatility in small economies: • Export concentration: the high reliance on limited range of exported goods and services. • Exposure to export price and earnings volatility: greater exposure to trade shocks in export prices and earnings. • Geographic export concentration: reliance on a few key trading partners with exposure to specific trade shocks. • Strategic import dependence: high dependency upon strategic imports and exposure to specific trade shocks. • Remoteness: greater risk of supply disruption exacerbating co-ordination and effects of trade shocks.

6. The Impact of Growth Volatility Large-scale studies of the impact of growth volatility, irrespective of its causes, find that volatility tends to reduce the long-run average rate of economic growth, notably because of the ‘negative ratchet’ effect. The adverse growth effects of volatility tend to be greatest for: • Low income countries (limited resilience capacity). • Countries with weak institutional structures and poor governance. There is also some degree of correlation between low incomes and weak institutions/poor governance.

7. 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.

8. Policy Remedies for Structural Growth Volatility • Export diversification: standard solution to export concentration and export price and earnings volatility but highly constrained in small economies. Niche income elastic exports often have lower price and earnings volatility. • Export market diversification: improving market knowledge, marketing and distribution logistics, possibly aided by inflows of FDI. • Strategic production and inter-temporal management: output almost regardless of cost together with effective supply management (smoothing using stocks). • Improved infrastructural co-ordination: national or regional co-operation in transportation logistics.

9. Environmental Vulnerability in Small Island & Littoral Developing Economies (SILDEs) 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. Further, developing ones (SILDEs) probably have the least resource capacity (resilience) to deal with their consequences. In addition, they tend to specialise in sectors particularly affected by long-term climate change: agriculture, fisheries and tourism. Although it is conceptually difficult to quantify environmental vulnerability, it is very clear that additional resilience capacity and policy strategies are required for SILDEs, over and above those for dealing with economic volatility.

10. The Environmental Vulnerability Index (EVI), SIDS & SILDEs The EVI has environmental vulnerability data for 235 states (www.vulnerability.index.net), classifying them as Extremely Vulnerable (EV), Highly Vulnerable (HV),Vulnerable (V), At Risk (AR) and Resilient (R). • SIDS comprise 20% of states but almost 50% (17/35) classed as Extremely Vulnerable and 27% (17/62) as Highly Vulnerable. • SILDEs comprise 19% of states but 29% are Extremely Vulnerable and 21% Highly Vulnerable. (SIDS comprise several non-sovereign states included in the EVI and which tend to be smaller and even more vulnerable.)

11. Regional Patterns of Environmental Vulnerability in SILDEs The EVI has three components – Hazards, Risks and Resilience –only the latter is state-specific. Therefore expect some semblance of a regional pattern of geology and climatic conditions. • East Asia & Pacific: 13 states; 5-EV, 4-HV, 3-V, 1-AR. • Indian Ocean: 4 states; 1-EV; 3-HV. • Caribbean: 16 states; 4-EV, 6-HV, 1-V, 3-AR, 2-R. • Sub-Saharan Africa: 11 states; 5-V, 3-AR, 3-R. This exercise using EVI data suggests that SILDEs in the Indian and Pacific Oceans are more vulnerable/less resilient than those in the Caribbean or Sub-Saharan Africa.

12. 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.

13. Enhancing Resilience: Improving Technological Capacity Resilience can be enhanced by developing local capabilities to close the ‘knowledge gap’ to aid diversification, improve productivity and increase value added. In the context of climate change, this includes the incorporation of adaptation and mitigation technologies into domestic productive activities. • Specialisation in SILDEs implies a need for only a narrow range of climate-change related technologies. • A strong services bias means that SILDEs are generally more amenable to carbon reduction requirements and climate change adaptation.

14. Improving Local Technological Capacity The challenge of enhancing resilience by improving local technological capacity in small economies is daunting: • They generally lack critical mass to generate domestic R&D and their human capital has limited absorptive capacity. • They primarily rely upon external sources of technology. • Issue of whether the private sector can perform this role alone – FDI is a critical potential source of advanced technology. • Public/private support: co-operation and transfer of ‘best-practice’ technology; active government policy to upgrade technology.

15. Improving Technological Capacity in Services Services provides a relatively scale neutral means for diversification in small economies. A critical distinction needs to be made between the environmental implication of activities within the service sector: • Financial services, data processing and other ICT-based activities are relatively ‘clean’. They offer high growth potential and have a high local ‘carrying capacity’, dependent upon local human capital and support infrastructure (e.g., optical fibre links and capacity). • Tourism – mass tourism in particular – is a prime cause of environmental degradation and threatens social development owing to limited ‘carrying capacity’.

16. Enhancing Resilience:Improving Domestic Linkages Growth, international competitiveness and resilience can be enhanced by improving the depth and quality of domestic linkages – up- and down-stream – to develop local supply chains: • Raise domestic productivity. • Increase domestic value added. • Reduce import dependence. • Improve the balance of payments position. • Generate new high value product/export niches. • Reduce food mileages.

17. Improving Domestic Linkages inSmall Economies Narrow/shallow economic structures and a lack of absorptive capacity can severely constrain linkage development in small economies. Many have also failed to maximise potential linkages, reflecting institutional and/or policy weaknesses. Linkage creation is likely to be confined to specific sectors, notably: • Agriculture: the development of downstream processing to improve employment and value added. Also diversification into certified organic production. • Tourism: often highly import dependent with low levels of local (retained) value added. The greatest potential linkages are in local sourcing of food, support services and niche (handicraft) manufacturing.

18. Enhancing Resilience:Openness, FDI & Local Linkages Foreign direct investment (FDI) offers an important additional means to enhance supply-side capabilities and resilience 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.

19. Enhancing Resilience:Promoting Human Capital Formation People are small economies’ most important asset. They are the principal determinant of their international competitiveness and a key component in building resilience. Human capital formation through education and training is essential to improve absorptive capacity and facilitate the assimilation of new technologies. Many small economies have invested heavily in their human capital but several critical issues arise: • High levels of migratory outflows, particularly of key skills. • High dependence upon worker remittances. • Need to create appropriate local employment opportunities to match skill creation to reverse ‘brain drain’ . • Climate change pressure for further out-migration.

20. Enhancing Resilience:Improving 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.

21. Social Capital & Governance inSmall Economies Arguably, small economies are well-placed with respect to their social capital and good governance: • They have a strong sense of identity. • Many have achieved very high HDI scores. • Their policy-makers and constituents are in close proximity. • They must be highly flexible in responding to external growth opportunities and threats. • They have limited scope to implement/sustain mis-specified growth policies. Small economies however, are not homogenous and some suffer from internal strife.

22. 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.

23. 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.