F&D Sep'13
F&D Sep'13
F&D Sep'13
I N T E R N A T I O N A L M O N E T A R Y F U N D I N T E R N A T I O N A L M O N E T A R Y F U N D
FINANCE and DEVELOPMENT
September 2013 $8.00
Oil and water
Stanley Fischer profiled
Regional business cycles
In Our Hands
EARTHS PRECIOUS RESOURCES
FINANCE & DEVELOPMENT A QUARTERLY PUBLICATION OF
THE INTERNATIONAL MONETARY FUND
September 2013
Volume 50
Number 3
FEATURES
EARTHS PRECIOUS RESOURCES
8 Too Much of a Good Thing?
For natural resource riches to drive growth
and reduce poverty, countries must balance
spending now with investing in the future
Chris Geiregat and Susan Yang
12 A Drop in the Bucket
Successful management of water must
balance development needs and economic
considerations
Peter H. Gleick
16 On the Edge
How oil markets will adjust to high prices is unclear
Thomas Helbling
19 Extracting Resource Revenue
For countries with abundant oil, gas, and mineral deposits, formulating tax
and spending policies can be tricky
Philip Daniel, Sanjeev Gupta, Todd Mattina, and Alex Segura-Ubiergo
23 The Elusive Revival
The expected boost in growth from natural resource booms is not yet
happening
Andrew Warner
26 Capital Flight Risk
Natural-resource-rich countries
risk capital flight as multinational
corporations seek to avoid taxes
Rabah Arezki, Gregoire Rota-Graziosi,
and Lemma W. Senbet
29 Eurasias Next Frontier
For the Caucasus and Central Asia, natural resource
wealth holds the key to achieving emerging market status
Mark Horton and Jonathan Dunn
32 Picture This: Minerals of the Future
A secure, green, and innovation-filled future awaits us,
but only with the help of rocks buried deep in the ground
Glenn Gottselig
ALSO IN THIS ISSUE
34 A Bumpy Road Ahead
Latin America needs large and sustained productivity gains to maintain its
recent strong growth
Sebastin Sosa and Evridiki Tsounta
40 Closer to Home
Despite all the talk of globalization, business cycles seem
to be becoming more regional
Hideaki Hirata, M. Ayhan Kose, and Christopher Otrok
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8
Finance & Development September 2013 1
FROM THE EDITOR FROM THE EDITOR
Illustration: p. 26, Seemeen Hashem/IMF; p. 40, Randy Lyhus.
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I
N my dream, I tilt the pan flled with river silt from side
to side and see gold fakes, hundreds of them, glittering
as they emerge from the muck. Te fakes pile up. I have
it made. Ten the alarm clock jars me awake and, poof,
my riches vanish.
Sadly, in some places, my dreams abrupt end is an all too
familiar reality.
In many nations, the discovery of a precious natural
resourcesay, copper, oil, or a rare mineralgenerates high
hopes but then fails to deliver the sustained economic gains
its citizens expect.
Of course, some resource-rich countries fare well, but many
others struggle to capitalize on their riches. In nearly half of the
countries in sub-Saharan Africa, for example, natural resources
account for an important share of total exports. But many of
these countries have struggled to convert their resource wealth
into growth engines that work to benefit future generations.
Why isnt an abundance of precious natural resources an
economic slam dunka sure way to sustain growth over the
long haul? Partly, the answer lies in the exhaustible nature of
certain resourcesan oil well runs dry, a mine stops produc-
ing. Economists have explored many explanations over the
years: commodity boom-and-bust cycles, weak institutions,
and Dutch disease, whereby a booming resource sector
chokes off growth in other parts of the economy.
This issue of F&D explores the world of natural resource
management and puts forward new ideas for sustaining resource
revenues over the long haul, to support steady economic growth.
Our special feature kicks off with Too Much of a Good
Thing? by Chris Geiregat and Susan Yang, who examine the
challenges facing resource-rich countries and advocate the
use of a sustainable investing tool to help policymakers better
allocate resource revenue. In A Drop in the Bucket, Peter
Gleick of the Pacific Institute looks at the economics of the
one natural resource we cant live without: water.
Philip Daniel, Sanjeev Gupta, Todd Mattina, and Alex
Segura-Ubiergo tackle the challenges of formulating tax and
spending policies in revenue-rich countries in Extracting
Resource Revenue. Other articles cover natural resource
booms, the promise of resource wealth to boost the frontier
economies of central Asia, and capital flight associated with
the natural resource sector. And Thomas Helbling offers a
peek into the future of oil markets.
Elsewhere in the issue, Prakash Loungani profiles Stanley
Fischer, whose achievements in the public, private, and aca-
demic spheres place him at the forefront of modern econom-
ics. Other articles examine whether Latin American growth
can be sustained, why regional factors are trumping global fac-
tors in business cycles, and how remittances affect economies.
We hope you find this issue a veritable gold mine of ideas
and analysis.
Jefrey Hayden
Editor-in-Chief
All That Glitters
44 A Big Question on Small States
Can they overcome their size-related
vulnerabilities and grow faster and more
consistently?
Sarwat Jahan and Ke Wang
48 Beyond the Household
Remittances that migrants send home to their
families also have a major impact on the overall
economy
Ralph Chami and Connel Fullenkamp
52 Strength in Lending
Strong balance sheets help banks sustain credit to
the economy during crises
Tmer Kapan and Camelia Minoiu
DEPARTMENTS
2 Letters to the Editor
3 In Brief
4 People in Economics
A Class Act
Prakash Loungani profiles Stanley Fischer,
academic, IMF deputy, and central bank governor
extraordinaire
38 Back to Basics
What Is the Output Gap?
Economists look for the difference between what
an economy is producing and what it can produce
Sarwat Jahan and Ahmed Saber Mahmud
56 Book Reviews
Treasurys War: The Unleashing of a New Era of
Financial Warfare, Juan C. Zarate
The Rise of the Peoples Bank of China, Stephen Bell
and Hui Feng
2 Finance & Development September 2013 2 Finance & Development September 2013
Arab Spring a misnomer
To the editor:
The articles in the March 2013 issue of F&D on the future
of the Middle East are thoughtful and exhaustive. But what-
ever is meant by the Arab Spring, a season for flowering and
growth or a time for leaping up or forward, reality belies the
titlea monumental misnomer confusing popular upheaval,
spontaneous and unorganized, with the need for drastic root-
and-branch societal change. The articles ideas for economic,
political, and other reforms are destined to lead nowhere not
for lack of trying but for landing on barren, toxic, and unre-
ceptive ground. Living for centuries under a perverted time
warp, the countries and people of the region need first and
foremost a rebirth not unlike the European Renaissance of
centuries ago, which, in the words of a recent commentary
in The Economist, broke through the carapace of medieval
thought to rediscover ancient
learning . . . . The movement
placed man, rather than God,
at the centre of the universe. To
change the human condition in
the region, politicians and opin-
ion leaders should sort out the
relationship of their people not
only to nature but to heaven as
well.
Mehdi AlBazzaz
formerly of the World Bank
Battling on Bretton Woods
To the editor:
Since Eric Rauchways review of my book The Battle of Bretton
Woods in your March issue I have been obliged to console
myself with accolades from the New York Times (should
become the gold standard on its topic), the Financial Times
(a triumph of economic and diplomatic history), and the
Wall Street Journal (a superb history). I confine myself here
to the two substantive charges in his article.
First, he writes of my account of Harry Dexter Whites
role in the crafting of the U.S. ultimatum to Japan in 1941
that The 2002 history [the Schecters book] Steil uses to
support the case relies, itself, on documentation that histo-
rians John Earl Haynes and Harvey Klehr have determined
to be fake. Only Rauchways charge is fake. Haynes and
Klehr themselves published the following response in the
Times Literary Supplement (TLS) on April 26: our account
does not, as Rauchway suggests, undermine Steils story of
Whites treachery or imply that he was bamboozled by fake
documents. In fact, Steil cites the Schecters only once in his
whole book.
Second, Rauchway, who is not an economist, thinks that
I dont understand the gold standard or the Bretton Woods
system. Interested readers can find my full response, with
graphical representations of historical economic relation-
ships that Rauchway denies, on the Web: http://on.cfr.org/
steilresponse. I note here only that Rauchways rhetorical
device of founding arguments on nonexistent quotes leaves
something to be desired. He quotes me, for example, not
once but twice, as saying that the Bretton Woods system
guaranteed an economic apocalypse. Compare this to
what I actually wrote on p. 334: Harry Whites creation, in
Triffins rendering, was an economic apocalypse in the mak-
ing. To paraphrase Oscar Wilde, once looks like careless-
ness, twice looks like an agenda.
Benn Steil
Council on Foreign Relations
LETTERS TO THE EDITOR
FD
I N T E R N A T I O N A L M O N E T A R Y F U N D I N T E R N A T I O N A L M O N E T A R Y F U N D
FINANCE and DEVELOPMENT
March 2013 $8.00
Christina Romer Profiled
U.S. Oil and Gas Output Surges
Mexicos Trade Comeback
The Middle East
Focus on the Future
Finance & Development September 2013 3
Female friendly
Chile, Peru, Colombia, Mexico, and Uruguay provide
the best environments for female entrepreneurs in Latin
America and the Caribbean, according to the Womens
Entrepreneurial Venture Scope, a new index released by
the Multilateral Investment Fund, a member of the Inter-
American Development Bank Group, and developed by the
Economist Intelligence Unit.
The index examines and scores 20 countries in the five areas
that most affect womens entrepreneurship: business operat-
ing risks; the entrepreneurial business environment; access to
finance; capacity and skills; and social services, including the
availability of family support programs, such as child care.
Chile received the regions highest overall ranking for its
low macroeconomic risk, strong supplier diversity initia-
tives, and social service offerings. Peru, with robust busi-
ness networks and technical support programs for small and
medium-sized enterprises (SMEs), ranked a close second.
Colombia rounds out the top three for its well-developed
SME training programs and broad access to university-level
education for women.
Finance & Development September 2013 3
IN BRIEF
Kora workshop in Senegal.
Events in 2013
September 1719, Dili, Timor-Leste
Harnessing Natural Resource Wealth Conference
September 1730, New York
68th Session of the UN General Assembly
September 2527, Sopot, Poland
European Forum for New Ideas
October 12, Kiel, Germany
Global Economic Symposium
October 1113, Washington, D.C.
Annual Meetings of the World Bank and the IMF
October 1819, Panama City, Panama
Ibero-American Summit
November 78, Washington, D.C.
IMF Fourteenth Annual Jacques Polak Research
Conference
November 1314, Amsterdam, Netherlands
World Pension Summit
Business owner in San Miguel de Allende, Mexico.
Reducing trade barriers
While reducing trade barriers between the continents coun-
tries, African governments should take vigorous measures
to boost their private sectors, or gains from this streamlined
trading system will benefit foreign firms more than African
firms, says a new report from the United Nations Conference
on Trade and Development.
Economic Development in Africa Report 2013 notes that
intraregional trade in Africa holds great promise if African
firms can supply the goods.
In recent years, the share of intra-African trade in
total African trade fell from 22.4 percent in 1997 to 11.3
percent in 2011. This statistic may be an underestimate,
given the prevalence of informal cross-border trade on the
continent, but it is nevertheless low when compared with
other parts of the world. For example, during 200711, the
average share of intraregional exports in total exports was
11 percent in Africa, compared with 50 percent in Asia
and 70 percent in Europe.
The report argues that the
elimination of trade barri-
ers will not have the desired
impact unless it is comple-
mented by governments
efforts to increase the vari-
ety and sophistication of the
goods that their economies
producethe process that
economists call expanding
productive capacity.
The missing middle
Social protection systems in many fast-growing middle-
income countries in Asia and the Pacific are failing to sup-
port large numbers of poor and vulnerable people, leaving
them exposed to risks and unexpected difficulties like unem-
ployment, ill health, and natural disasters, says a new Asian
Development Bank (ADB) study, The Social Protection Index:
Assessing Results for Asia and the Pacific.
The study, which analyzes government programs that pro-
vide social insurance, social assistance, and labor market sup-
port in 35 countries across Asia and the Pacific, shows varied
spending patterns across income groups and subregions.
A few countriesJapan, the Republic of Korea, Mongolia,
and Uzbekistanhave social protection indexes that are
higher than 0.200, meaning that they are already investing 8
percent of their GDP in social protection programs. However,
spending in most middle-income countriesincluding
Armenia, Fiji, India, Indonesia, Pakistan, the Philippines,
and Samoaremains below 3 percent of GDP.
Government social protection programs need to be
expanded to cover this unprotected missing middle, said
Bart des, Director in the ADBs Regional and Sustainable
Development Department.
4 Finance & Development September 2013
I
N 2012, the magazine Global Finance gave Stanley Fisch-
er, then central bank governor of Israel, an A for his han-
dling of the economy during the fnancial crisis. It was
the fourth year in a row that Fischer had received an A.
Its a grade the former professorwho taught both Federal
Reserve Board Chairman Ben Bernanke and European Cen-
tral Bank (ECB) President Mario Draghicherishes: Tose
were some tough tests we faced in Israel.
Fischer stepped down as central bank governor in June this
year after eight years in the job, bringing the curtain down on
an extraordinary third act of his career. The second act was as
the IMFs second-in-command during the tumultuous period
of financial crises in emerging markets from 1994 to 2001.
This role as policymaker came after a rousing opening act in
the 1970s and 1980s, during which Fischer established himself
as a preeminent macroeconomist, one who defined the con-
tours of the field through his scholarly work and textbooks. It
speaks to Fischers success that stints as the World Banks chief
economist in the 1980s and as vice chairman at Citigroup in
the 2000swhich would be crowning achievements of many a
careercome across as interludes between the main acts.
Prelude
Fischer grew up in Mazabuka, a town in Northern Rhodesia,
now Zambia, where his family ran a general store. Te house
in which he was raised was behind the store; it had no run-
ning water and was lit with hurricane lamps. When he was
13, his family moved to Southern Rhodesia, now Zimbabwe.
Fischer became active in a Jewish nationalist youth move-
ment and first visited Israel in 1960 on a program for youth
leaders. For both Fischer and Rhoda Keetthen his girl-
friend and later his wife and mother of their three sonsthe
trip marked the beginning of a lifelong commitment to Israel.
When he was appointed governor of the Bank of Israel sev-
eral decades later, many in Israel recalled the person they
had grown up with in southern Africa. We always knew he
was bright, but he must have been a hell of a lot brighter than
even we thought he was, said Judy Dobkins, who was in the
same youth program in 1960.
An economics course in high school and an introduction
to the work of John Maynard Keynes set Fischer on the road
to specializing in economics. He says he was hooked by
Keyness use of language and by the knowledge that, during
the Great Depression, the world as we knew it had nearly
collapsed and Keyness ideas had saved it. The London
School of Economics (LSE) was a natural choice for an
undergraduate degree: For us, England was the center of the
universe, Fischer has said. Of his professors at LSE, Fischer
remembers one who predicted in 1963, based on a study of
past patterns, that the United Kingdom would have a bal-
ance of payments crisis in 1964: The crisis took place on the
appointed date, and I was very impressed.
PEOPLE IN ECONOMICS
A
CLASS
ACT
Prakash Loungani
proles Stanley Fischer,
academic, IMF deputy, and
central bank governor
extraordinaire
Finance & Development September 2013 5
Fischer went on to graduate school at the Massachusetts
Institute of Technology (MIT), drawn by the presence there
of Paul Samuelson and Robert Solow, famous economists who
would both go on to receive the Nobel Prize. MIT was then
at the forefront of the development of a mathematically rig-
orous approach to macroeconomics. Fischer has said that his
MIT experience was truly formative, marked by great pro-
fessors and a remarkable group of fellow studentsamong
them Avinash Dixit (he could do the [New York] Times cross-
word puzzle in about 10 seconds), Robert Merton, and Joseph
Stiglitz, who later became a fierce critic of Fischer (see box).
Fischers first job was at the University of Chicago, which
was then at the cutting edge of applying economics to policy
problems. Fischer says he made the choice because Chicago
was the best place that made me an offer and because he
felt that he had learned a lot of economics but didnt know
much about the economy. Chicago enabled Fischer to com-
bine MITs analytics and the policy relevance that [Chicago
professor] Milton Friedman typified.
Uniting the wings
Bridging the worlds between MIT and Chicago was good
training for the role Fischer was to play in the 1970s, which
was to broker a peace between warring wings of classical and
Keynesian macroeconomists.
The Keynesian school advocated an active role for mon-
etary policythat is, actions by the central bankto smooth
out fluctuations in the economy. If unemployment was higher
than its long-run average, the central bank could try to nudge
it back down by increasing the growth rate of the money sup-
ply. In the Keynesian model, the ability of the central bank to
lower unemployment came about because prices and wages
were assumed to be difficult to change in the short runin
the jargon of macroeconomists, prices and wages were sticky.
The classical wing objected that if unemployment could be
lowered simply by printing more money, the economy would
be getting what Friedmana leading proponent of classi-
cal viewscalled a free lunch. He predicted that repeated
attempts by the central bank to lower unemployment would
lead to prices and wages starting to adjust instead of remain-
ing sticky. Once that happened, Friedman said, inflation
would rise and unemployment would go back to its long-run
average. The economy would thus eventually end up with
higher inflation and no long-run benefit in terms of reduced
unemployment.
As events in the United States and other economies in the
1970s started to mirror these predictionsthe drop in unem-
ployment proved short lived and inflation crept upthe balance
of power started to shift toward the classical school. Classical
economists now went a step further and started to assume that,
far from being sticky, prices and wages would adjust quickly
to any attempts by the central bank to affect unemployment.
Under that assumptionknown as rational expectationsthe
central bank would be ineffective in smoothing out fluctuations
in the economy, even in the short run.
Enter Fischer. In a 1977 paperhe had by then been lured
back to MIT from Chicagohe combined the assumption
that people had rational expectations with the key features
of Keynesian models. Fischer made the realistic assumption
that wages are set in advance through an implicit or explicit
contract between employers and their workers. This ren-
ders wagesand, through this channel, pricestemporarily
sticky. As long as the central bank can act more frequently
than contracts can be renegotiated, it can have an impact on
unemployment in the short run, as in Keynesian models. But
this is not an option in the long run because, over time, con-
Defending the Washington Consensus
It is not surprising that Fischer, as someone of Latvian-
Lithuanian descent who grew up in southern Africa, has
always been interested in issues of the economic develop-
ment of nations. His tenure as the World Banks chief econo-
mist gave him a chance to leave his imprint on these issues.
According to economist Brian Snowdon, Fischers work
emphasizes the importance of establishing a stable macro-
economic environment and sound financial institutions for
achieving the key long-run goals of growth and economic
development. Fischer also emphasized, Snowdon writes,
that poverty reduction occurs fastest where there has been
rapid growth, and also that openness to the international
economy is a necessary, though not a sufficient, condition for
sustained growth.
Many of the policies that Fischer championed became
known as the Washington Consensus. Despite criticism
of the policies, and the term itself, over the years, Fischer
says he still has faith in the set of policies but that the label
attached to them was an unfortunate one. It was a mistake
to call it Washington Consensus because it was at that time
a global consensus. He says the importance of openness to
trade, sound macroeconomic policies, and a market orienta-
tion has been proven over and over again. He defends the
move to open capital markets to foreign capital, arguing that
the experience has shown, not its undesirability as a long-
term goal, but rather the need to manage this capital account
liberalization carefully.
Fischer was also associated with the advice given to transi-
tion economiesthe economies of the former Soviet bloc
on the pace and nature of the reforms they should undertake.
This advice too has come in for criticism, not least from
Joseph Stiglitz, for pushing for too much, too soon. Stiglitz
has said that the transition economies should have followed
a more gradualist path, learning from the enormous suc-
cess of China, which created its own path of transition rather
than use a blueprint or recipe from Western advisors. The
advice given by Fischer and others has its defenders. Harvard
Universitys Ken Rogoff (previously IMF chief economist)
endorses the need for speed: It is unlikely that market
institutions could have been developed in a laboratory set-
ting and without actually starting the messy transition to
the market. Rogoff notes that the transition economies had
already tried a Chinese-style approach of limited reform
for instance, under Gorbachev in the Soviet Union, Kadar in
Hungary, and Jaruzelski in Polandand it was the failure of
these attempts that led to more aggressive efforts towards a
market economy.
6 Finance & Development September 2013
tracts would take into account the inflation that the central
bank has generated. Thus, the economy would behave in the
long run according to the classical models.
Fischers paper marked the beginning of New Keynesian
Economics, which now draws support from both the clas-
sical and the Keynesian camps and provides a synthesis in
which the economy has Keynesian features in the short run
and classical features in the long run. Chris Erceg, a senior
official at the Federal Reserveand a Chicago graduate who
made important contributions to New Keynesian Economics
in the 1990ssays that Fischers paper is now seen as a criti-
cal turning point in scaling back the internecine warfare of
the two wings.
From theory to policy
Over the course of the 1980s, Fischer continued to contrib-
ute to scholarly work while also becoming active in the policy
arena. As a scholar, his most famous work was in the form of
two textbookscoauthored with his MIT colleagueswhich
played a key role in charting the changing landscape of mac-
roeconomics. One was a textbook for undergraduates written
with Rudi Dornbusch, and the other for graduate students,
coauthored with Olivier Blanchard, currently the IMFs chief
economist. Blanchard says that writing the book with Fischer
was one of the most exciting intellectual adventures of my
life. We both felt there was a new macroeconomics, more
micro founded and full of promises. . . . While we had not
thought of it as a textbook, it quickly became one, and it is
nice to know that it still sells surprisingly well today.
Fischer first tried his hand at policymaking when George
Shultz, then U.S. secretary of state, called on him and Herbert
Stein, a former chairman of the U.S. Council of Economic
Advisers, to help Israels government deal with triple-digit infla-
tion, dwindling foreign exchange reserves, and slow growth.
Fischer and Stein concluded that Israel needed to come up with
a firm plan to reduce the excessive government spending that
was the source of the other problems. Without such a plan,
Fischer told the U.S. Congress in April 1985, the likelihood is
strong that two years from now, she [Israel] will still be grow-
ing slowly, still fighting high inflation, and more than ever reli-
ant on outside aid. Fischer and Stein also recommended that
milestones be set to measure Israels progress toward reducing
its budget deficit and that the flow of U.S. aid to the country be
conditional on the attainment of those milestones.
Shimon Peres, Israeli prime minister at the time, later
recalled that he didnt know enough about economics to
argue with Fischer. But he followed Fischers advice and was
amazed to discover that it worked. Inflation fell from a
peak of 450 percent to 20 percent in the course of a year. No
one could have advised us better, says Peres.
Fischer soon got a chance to tackle a much broader range
of policy issues as the World Banks chief economist from
1988 to 1990. He then returned to MIT but found that
it was hard readjusting to academic life: I remember
going to theory seminars and saying to myself, what dif-
ference does it make whether this guy is right or wrong?
Harvards Greg Mankiwformer chair of the U.S. Council
of Economic Advisers and another famous Fischer stu-
dentrecalls that he got the sense [Fischer] was a little
impatient with academics. Even becoming chairman of the
economics department at MIT was only partly inspiring,
says Fischer, likening the role to Alfred Kahns description
of a deans role: the dean is to the faculty as the fire hydrant
is to the dog.
Bring on the crises
Fischers turn on the policymaking stage came in 1994 when
he was appointed the IMFs frst deputy managing director,
the institutions number two spot. Over the next seven years,
Fischer dealt with crises in Mexico, Russia, several Asian
countries, Brazil, Argentina, and Turkeyand that list still
leaves out quite a few.
During the Mexican crisis of 199495, Fischer was content
to leave the driving to Michel Camdessus, who was IMF
managing director from 1987 to 2000. Fischer thought he
had not yet fully earned Camdessuss trust and that he didnt
know enough yet about how to steer through a financial cri-
sis. By early 1995, it became clear that the resolution of the
crisis required a large and swift injection of money, $20 bil-
lion from the U.S. Treasury and $20 billion from the IMF.
The IMF Executive Board balked at making such a huge loan.
It took, says Fischer, the most dramatic board meeting I
have seen [and for] Camdessus to challenge the board to fire
him to win approval for the loan.
In mid-1997, a financial crisis hit Thailand and spread
quickly to many other Asian countries, including Indonesia,
Korea, Malaysia, and the Philippines. By now, Fischer had
gained Camdessuss confidence and was ready to cocaptain
with him in navigating through the crises. But their initial
advice turned out to be a misstep. The IMF advised Thailand
and the other Asian countries to tighten fiscal policy even
thoughunlike the situation in Israel in 1985government
profligacy was not the root cause of the crisis. Fischer now
says that the tightening of fiscal policy was mistaken. That
is why the IMF quickly reversed that policy [in Thailand] by
the end of 1997 and in Korea by the beginning of 1998. So I
do not think that the initial fiscal mistake had a big impact
on what happened later.
The IMFs advice to the Asian economies regarding mon-
etary policy also came under fire, particularly from Stiglitz,
then the chief economist at the World Bank, who advocated
lowering interest rates to help the domestic economy. But
Fischer has stuck to his guns and steadfastly argued that this
criticism of monetary policy was not correct. Fischer says
Finance & Development September 2013 7
the IMF argued that a short period of interest rate tighten-
ing was necessary to stabilize the currency, after which inter-
est rates would be reduced to normal levels. And that is what
happened. Fischer also notes that many Asian countries had
foreign-denominated debt; a further depreciation of their cur-
rency, the likely consequence of lowering interest rates, would
have increased the burden of that debt.
Thailand and Korea quickly recovered from the crisis, but
Indonesia entered a long period of economic turmoil. Fischer
blames this on politics rather than on
inappropriate economic advice: I dont
think people understood, us [the IMF] or
anybody else, that a regime that looked so
stable was not. It soon became clear that
[former Indonesian president] Suharto
had no intention of delivering [on agreed
reforms]. And that was sort of how the
thing got out of control.
Many have remarked on how in control Fischer stayed
despite the crises raging around him. Blanchard says that
from the peeks I got of [Fischer] during those times, what
strikes me most is how he remained the same he had been
at MIT: calm, careful about the facts, analytical, using mac-
roeconomic theory even in the middle of the most intense
fires. Horst Khler, former IMF managing director, adds that
in the midst of crisis it was reassuring to hear Stan Fischers
sonorous, calm, balanced, unexcited voice. That voice
restrains you from panicking and encourages you by itself to
a considered and systematic way of thinking.
The responsible adult
Fischer lef the IMF in 2001 when his term as deputy ex-
piredhis bid to win the IMFs top job had failedand
started at Citigroup the following year, drawn by the fact that
he had never been in the private sector. He says he enjoyed
the work at Citi; the intellectual challenges, and the organi-
zational challenges of working in an institution with 280,000
people, were as tough as what he had faced in other jobs. But
the chance to be the governor of the Bank of Israel drew him
back into the public sector.
The situation Fischer faced in 2005 was significantly bet-
ter than in 1985 when he had last actively advised the Israeli
government. The low-inflation environment had persisted
and the economy was on its way to recovering from a reces-
sion. But there were challenges nonetheless. Fischer had to
resolve a long-standing labor dispute involving the staffs of
both the central bank and the treasury. He also had to shore
up the political will to make changes to the central bank law
to give it an explicit mandate for flexible inflation targeting,
a system under which the central bank targets price stability
while keeping other objectives in mind; in the case of the Bank
of Israel, these other objectives were employment and growth
as the second objective and financial stability as the third. The
law also set up a monetary policy committee so that the central
bank governor was no longer the sole decision maker. This
was the advice we gave central banks when I was at the IMF,
says Fischer, and so it was only fitting that I take it myself.
Then the global crisis struck. On October 6, 2008, Fischer
cut policy interest rates, a day before similar policy moves
by the U.S. Federal Reserve, the Bank of England, and the
ECB. Throughout the crisis, Fischer stayed ahead of the
curve, making the needed policy changessuch as launch-
ing a program of quantitative easing by buying long-term
bondsbefore markets had anticipated them. Bloomberg
News found that among central bank governors of the
Organisation for Economic Co-operation and Development,
Fischers policy actions during the crisis
surprised markets more than those of
any other governor.
Fischer also had to take strong and
prompt actions to keep Israels exports
competitive. As the crisis engulfed first
the United States and then many coun-
tries in Europe, foreign capital started
to flow into the relatively safe haven of
Israel. As a result, the shekel appreciated 20 percent against the
dollar, a problem in a country where exports constitute 40 per-
cent of GDP. After Fischer started buying $100 million a day in
foreign currency in 2008, the shekel started to fall, and Israeli
exports remained robust. Noted author and economist David
Warsh credits Fischer with having steered Israels economy
with barely a scrape through the worst [global] crisis since the
Great Depression.
No wonder then that Fischers announcement in
January 2013 that he would step down on June 30 led to
much breast-beating in Israeli press and policy circles.
The newspaper Haaretz said it marked the departure of
a superhero, named the responsible adult, who had
served admirably not just as central bank governor but
also, at times, as the unofficial foreign minister of the
Israeli economy: it was Fischer who calmed foreign inves-
tors and assured them that the economy was in good
hands. Fischer says he has been touched by the response:
I cannot tell you how gratifyingand movingit is for
Rhoda and me to be walking along the beach and have
someone stop us and thank us for our service to Israel.
Encore, encore
Fischers announcement that he was stepping down pro-
voked much speculation about his next act. Haaretz said
Fischer was holding out for a job as Israeli foreign minister
or even president. In the United States, there was talk that
he would succeed his student Ben Bernanke as chairman
of the Fed. In academia, there was hope that Fischer would
turn to a reconstruction of textbook macroeconomics to
incorporate what had been learned from the experience of
the Great Recession.
Fischer remained tight lipped, saying only that he was not
ready to leave the stage. We always feel younger than we are:
when I jog, I realize that I run more slowly than I used to, but
I dont feel Ive lost speed in other regards.
2
0
0
2
2
0
0
3
1
2
1
9
9
0
2
0
0
2
2
0
0
3
1
2
1
9
9
0
2
0
0
2
2
0
0
3
1
2
1
9
9
0
2
0
0
2
2
0
0
3
1
2
Sosa, corrected 8/5/13
Chart 3
On the rebound
After declining in most of Latin America from 1981 to 2002, total
factor productivity has recently been on the rise.
(total factor productivity growth, annual average, percent, 200312)
Sources: Barro-Lee (2010); IMF, World Economic Outlook, 2013; Penn World Tables 7.1; and
IMF staff calculations.
Note: Commodity exportersBOL=Bolivia, BRA=Brazil, CHL=Chile, COL=Colombia,
ECU=Ecuador, PRY=Paraguay, PER=Peru, URY=Uruguay, and VEN=Venezuela. Noncommodity
exportersBRB=Barbados, CRI=Costa Rica, SLV=El Salvador, HND=Honduras, JAM=Jamaica,
MEX=Mexico, and NIC=Nicaragua. Total factor productivity essentially measures how effciently
economic resources are being used in the production process, and includes both technological
progress and the effciency of markets.
Total factor productivity growth, annual average, percent, 19812002
4 3 2 1 0 1 2 3 4
4
3
2
1
0
1
2
3
4
BOL
BRA
CHL
COL
ECU
PRY
PER
URY
VEN
CRI
SLV
HND
BRB
JAM
MEX
NIC
Commodity exporters
Noncommodity exporters
36 Finance & Development September 2013
But improvements in TFP also reflect some structural (that
is, permanent) factors, such as the movement of economic
activity away from the less efficient informal sector. For
example, half of the salaried workers in Peru are currently
employed in the informal sector, according to the Socio-
Economic Database for Latin America and the Caribbeana
large decline from the early part of the century when three-
fourths of total employment was informal.
Underperformers
While growth in noncommodity exporters was similar
to that in commodity exporters in previous decades, non
commodity exporters underperformed in the last decade.
There are several reasons for the disparity.
First, capital accumulation has been higher among com-
modity exporters. This reflects, in part, high local and foreign
direct investment in the primary sector (mainly agriculture
and mining), associated with the commodity price boom.
But it also reflects the easy global financing conditions. With
the exception of Mexico, noncommodity exporters could
not fully benefit from these favorable foreign factors because
of their limited links to international financial markets.
Second, and more important, the worse performance
reflects lagging TFP in Mexico, Central America, and the
Caribbean. In fact, with the exception of Costa Ricaa coun-
try with relatively strong institutions and one of the first in
the region to introduce economic reformsTFP perfor-
mance in these economies has been disappointing over the
past 30 years. The large informal sector, the large number
of small firms, and barriers to competitionfor example,
in the telecommunications sectorare often cited as rea-
sons for Mexicos weak TFP performance (Busso, Fazio, and
Levy, 2012). In most Central American countries and in the
Caribbean, the absence of well-developed domestic financial
markets and barriers to competition in the agriculture and
electricity sectors also are at play (Swiston and Barrot, 2011).
To understand productivity growth differentials, one has to
look beyond productivity in the manufacturing sector, which
tends to be the focus of most studies in the literature. In fact,
what differentiates labor productivity in South America from
that in the rest of Latin America in the last decade is the perfor-
mance of the services sector (Sosa and Tsounta, forthcoming).
In the past, declining labor productivity in services dragged
down all of Latin America. But in the past decade, service sec-
tor productivity has been on the rise in South America, grow-
ing three times faster than in the rest of the region. Important
factors behind the better performance in South America are
the decline in informalitymost notably in services, which
partly reflects the ease of finding jobs in the formal sector dur-
ing the boomand improvements in policies and institutions.
The challenge of sustaining growth
Our analysis suggests, however, that the more recent slow-
down in the growth performance of commodity exporters
could be more than a blip: sustaining high growth rates in
these countries will be difficult. Estimates of potential growth
rates for 201317 are generally lower than those for recent
years (see Chart 4). While these economies grew, on average,
at 4!/2 percent a year during 200312, Sosa, Tsounta, and Kim
(2013) estimate that the average potential GDP growth rate
in 201317 will be closer to 3#/4 percent. The growth outlook
appears to be particularly disappointing for the regions larg-
est economy, Brazil, where GDP growth is expected to hover
around 3 percent over the next few years. That projected slow-
down reinforces rising concerns about a regional economic
decelerationespecially because of potential spillovers to
smaller neighboring economies (Adler and Sosa, 2012).
Several factors are at work in the anticipated slowdown.
First, growth of physical capital is expected to moderate,
as the low global interest rates that facilitated large capital
flows to the region start to rise and commodity prices sta-
bilize. In addition, the contribution of labor will likely be
limited in the coming years by such natural
constraints as an aging population. Record-
low unemployment rates, typically well below
the rates considered sustainable over the long
run (known as the natural rate), also make it
unlikely that employment will grow strongly
in the future.
In other words, as the impact of favorable
external conditions on growth dissipates and
some supply constraints kick in, the strong
growth South American commodity exporters
experienced over the past 10 years is unlikely to
be sustained unless TFP performance improves
significantly. Indeed, despite its recent improve-
ment, when compared with emerging Asia, TFP
performance remains weak in these economies.
In fact, most of the superior growth in emerg-
ing Asia is explained by the TFP differential.
Among noncommodity exporters, the dis-
appointing growth performance appears to be
in line with their production capacity. For these
Sosa, corrected 7/26/13
Chart 4
Future shock
Estimates of potential growth rates for 201317 are generally below those of
recent years.
(annual average, percent )
Sources: Penn World Table 7.1; IMF, World Economic Outlook, 2013; United Nations Population Projections database;
and authors calculations.
Note: Commodity exportersBOL=Bolivia, BRA=Brazil, CHL=Chile, COL=Colombia, ECU=Ecuador, PRY=Paraguay,
PER=Peru, URY=Uruguay, and VEN=Venezuela. Non-commodity exportersBRB=Barbados, CRI=Costa Rica, SLV=El
Salvador, HND=Honduras, JAM=Jamaica, MEX=Mexico, and NIC=Nicaragua.
PER ECU COL PRY URY BOL CHL VEN BRA CRI HND MEX NIC SLV BRB JAM
0
1
2
3
4
5
6
7
0
1
2
3
4
5
6
7
Ranges
Actual real GDP growth (200312)
Ranges
Actual real GDP
growth (200312)
Commodity exporters Noncommodity exporters
Finance & Development September 2013 37
countries, potential GDP growth is estimated at an annual
average of about 2!/4 percent for 201317.
Significant efforts will be needed to unlock this regions
growth potential, especially policies that foster investment
and productivity growth. The good news for the non
commodity exporters is that they are unlikely to be badly hurt
by the fading effects of external liquidity and strong com-
modity prices, given their limited financial integration (with
the notable exception of Mexico) and the fact that they are
mostly net importers of primary goods. It is also good news
that these economies are, for now at least, less constrained
by population aging and have a lot of room to improve pro-
ductivity levels, including by shifting resources to the more
productive formal sector. However, the lukewarm growth
outlook projected in the United States and the euro area
economies to which noncommodity exporters are strongly
linkedwill continue to affect their growth potential.
TFP to the rescue?
The Latin American and Caribbean countries could improve
their growth potential by increasing domestic savingsand,
in turn, investment levels, which remain low by international
standards. Domestic saving rates in Latin America are less
than 20 percent of GDP, compared with more than 40 percent
in emerging Asia. Mobilizing higher domestic savings could,
for instance, help increase investment in infrastructuresuch
as roads, ports, and airports. Inadequate infrastructure has
constrained growth in the region. Improvements in infrastruc-
ture will not only help increase the contribution of capital to
growth but will also enhance TFP. Improvements in the quality
of the workforce (so-called human capital) can also increase
potential growth in the region. In fact, there is ample room for
improvement in the quality of education, as the region gener-
ally underperforms on standardized international tests.
But improving TFP performance will be pivotal to sustain-
ing growth in the region. Although improvements in infra-
structure and human capital would help increase productivity,
by themselves they would be insufficient. Despite the recent
improvements in South American commodity exporters, rais-
ing TFP has proved a challenge. Higher productivity growth is
crucial, however, for the whole region and would also increase
incentives to invest further in human and physical capital.
Achieving faster productivity growth entails more than
fostering innovation and technological development. Low
productivity has many causes. It is often the unintended
result of market distortions (such as labor market rigidities
that impede hiring or tax regimes that induce poor deci-
sions) and bad policies (for example, inadequate regulation
and supervision of the financial sector or unsustainable fis-
cal policies). These distortions weaken incentives for innova-
tion, discourage competition, and prevent efficient allocation
of resources from the less productive to the more efficient
firms. Thus, designing a policy agenda to unleash productiv-
ity is a difficult task and entails country-specific measures.
The authorities should consider such policies as
strengthening the business climate, for example, by sim-
plifying the tax system;
improving the enforcement of contracts and access to
credit information;
strengthening entry and exit regulation to facilitate the
reallocation of resources to new and high-productivity sec-
tors; and
improving infrastructure.
In Central America and the Caribbean, efforts are also
needed to tackle high debt levels and weak competitiveness,
which are other factors behind the lukewarm growth perfor-
mance there.
The road ahead will be bumpy for the economies of
Latin America and the Caribbean. As the stimulus from an
extraordinary external environment dissipates and some sup-
ply bottlenecks (associated with natural constraints on labor)
kick in, the growth momentum in the region is unlikely to be
sustainable unless TFP performance improves significantly.
Thus, fostering productivity remains a key priority for the
whole region: for commodity exporters to prevent a return
to growth lower than they achieved in the past decade and
for noncommodity exporters to overcome their historically
low growth potential. These difficulties may actually open up
opportunities for better policies and structural reforms that
could lead to refreshingly new periods of higher economic
growth and better living standards.
Africa
Europe
Western Hemisphere
Sources: IMF, World Economic Outlook database; and World Bank, World Development Indicators database.
Note: The list is limited to developing economies that are members of the IMF. Small states have populations less than
1.5 million, while microstates have fewer than 200,000 people. Upper-middle-income countries have per capita annual incomes of
between $4,086 and $12,615; lower-middle-income countries of between $1,036 and $4,085; lower-income countries $1,035 or
less based on the World Bank Atlas method. The table does not include high-income and advanced-economy small states, which
include Bahrain, Brunei Darussalam, Cyprus, Estonia, Equatorial Guinea, Iceland, Luxembourg, Malta, and San Marino.
Sarwat Jahan and Ke Wang
Can they overcome their size-related
vulnerabilities and grow faster and
more consistently?
Schooners crossing the Seychelles.
Finance & Development September 2013 45
A common problem
Small states have one common prob-
lem: they face constraints because of
their size.
For starters, because they have tiny
populations, the states cannot spread
the fixed costs of government or busi-
ness over a large number of people
that is, they cannot achieve economies
of scale in the same way that larger
states can. The result of these disecon-
omies of scale, as economists call them,
is high costs in both the public and pri-
vate sectors.
Their small size also seems to be
reflected in a number of macroeco-
nomic characteristics:
Narrow production base: Although
their economies are not uniformsome
are commodity exporters, others are
service based (mainly tourism or finan-
cial services)all of them face problems
establishing a competitive economic base. And where they do
compete, it is typically in one or two goods or services, leaving
them vulnerable to ups and downs in a handful of industries.
Tourism accounts for more than half the foreign earnings for
many of the Caribbean islands. Similarly, many small states
in the Pacific depend on one product for most of their export
earnings. In the Solomon Islands, for example, about half of
export earnings come from logging.
Big government: Measured by the ratio of government
expenditures to GDP, small states tend to have bigger gov-
ernments than do larger states. This is partly a reflection of
the diseconomies of scale that make the provision of pub-
lic goods and services more costly than in larger states. In
addition, a large share of expenditures is relatively inflex-
iblesuch as those directed to all-too-common natural
disastersor hard to reduce, such as the public wage bill.
The high level of expenditure has often led to high levels of
debt (see Chart 2).
Poorly developed financial sector: About half of the small
states have gained prominence as offshore financial centers.
But financial institutions in offshore financial centers typi-
cally serve nonresidents. In general, the domestic financial
sectors lack depth, are concentrated, and do not provide their
citizens with adequate access to finance. The financial sec-
tors are dominated by banks, whose high lending rates often
hinder investment. Also, because the private sectors in small
states are so tiny, commercial banks often end up financing
the governmentrisking their soundness by becoming heav-
ily exposed to one borrower. This has also complicated eco-
nomic policy actions meant to lower the debt. In the highly
indebted Caribbean countries, for example, commercial
banks and nonbank financial institutions hold two-thirds of
domestic public debt. In bigger countries, government debt
is usually owned by a variety of individuals and by financial
and nonfinancial institutions.
Fixed exchange rates: Small states are more likely than
larger ones to peg their exchange rates to another currency.
Many of these small states are closely tied to a handful of
larger economies that account for most of their export earn-
ings. The peg eliminates exchange rate volatility, which
helps smooth export earnings. At the same time, small
states need to hold higher reserves than their larger breth-
rennot only to defend their currencies but also to insu-
late themselves from adverse outside events that can have
a large negative effect on their well-being. Yet most have
fewer reserves than considered optimal. The small states
also have more limited ability to conduct monetary policy.
Five of 13 small states in the Asia-Pacific region, for exam-
ple, do not have a central bank.
A BIG
QUESTION
on Small
States
Jahan, corrected 8/1/13
Chart 1
At a par
Small states and microstates are at comparable levels of development with larger states
with similar incomeswhether measured by per capita GDP or human development
indicators, such as life expectancy and education.
(per capita GDP, 2012 dollars) (Human Development Index)
Sources: IMF World Economic Outlook database; World Bank, World Development Indicators database.
Note: Microstates have populations of less than 200,000 and small states less than 1.5 million. The Others category is for states
with populations of more than 1.5 million. LML = lower-middle- and lower-income countries, which have per capita annual incomes of
less than $4,085. UMC = upper-middle-income countries, which have per capita annual incomes of between $4,086 and $12,615. In
both panels, the bars show the range between the 25th and 75th percentiles for each grouping of states. In the Human Development
Index the circle represents the median index in 2000, and the horizontal bar, 2010. The 2000 index contains data for 16 small states.
LML
UMC
Median 2012
Micro Small Others Micro Small Others
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
18,000
20,000
Micro Small Others Micro Small Others
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
LML
UMC
Median 2010
Median 2000
Jahan, corrected 8/1/13
Chart 2
Big borrowers
Compared with their larger peers, small states have higher levels of
public debt.
(public debt, 2011, percent of GDP)
Sources: IMF, World Economic Outlook database; World Bank, World Development Indicators
database and Financial Development and Structure database; and IMF staff calculations.
Note: S-UMC = upper-middle-income small states; S-LML = lower-middle- and lower-income
small states; O-UMC = larger upper-middle-income countries; O-LML = larger lower-middle- and
lower-income states. Lower-middle- and lower-income states have per capita annual incomes of
less than $4,085. Upper-middle-income states have per capita annual incomes of between
$4,086 and $12,615.
Range between the 25th and 75th percentiles
Median public debt
0
40
80
120
S-UMC S-LML O-UMC O-LML
46 Finance & Development September 2013
Trade openness: Small states are also more open to trade.
Trade-to-GDP ratios are much larger in smaller economies
than in larger ones with similar policies. Small states also
seem to have somewhat lower trade barriers. A high degree
of trade openness often leaves the small states vulnerable to
shocks from terms of trade (the prices of exports compared
with the prices of imports).
Small states face other common issues as well. Many are
located in the open ocean, which makes them prone to nat-
ural disasters (such as earthquakes and hurricanes), and,
because they are so small, typically the entire population and
economy are affected by such disasters.
Natural disasters annually cost microstates in the
Caribbean and the Pacific the equivalent of 3 to 5 percent of
GDP. At the same time, many are islands that face particular
challenges from climate change. Kiribati, for example, could
be the first country to see its entire territory disappear under
water as a result of global climate change that causes ice to
melt at the polar caps, raising sea levels.
Moreover, the remoteness of many of these countries can be a
problem because the paucity of arable land makes them depen-
dent on imported foodstuffs, which can be very expensive.
Volatility reigns
For the most part, small states have not shared in the
improved economic growth of their larger peers since
the late 1990s (see Chart 3). Large states have grown sub-
stantially faster in the 2000s than they did in the last two
decades of the 20th century, outperforming smaller states.
There are many reasons that explain why small states lag
their larger peersamong them, a brain drain, as the
best and brightest seek wider opportunities available in
larger economies. The erosion of trade preferences in the
exports of goods such as bananas and sugar also hold back
small states.
But perhaps the most telling problem these states face is
volatility. Small states have been plagued by highly erratic
economic growth, which in the long run impedes growth,
worsens income inequality, and increases poverty. During
the 2000s, small states have had noticeably higher growth
volatility than their larger counterpartsand lower growth
rates. Their current accountsmainly the difference between
what the small states export and what they importare con-
siderably more volatile than those of larger states with similar
income levels. This may reflect higher terms-of-trade volatil-
ity, which has a greater effect on small states because of their
greater trade openness. In the fiscal sector, greater volatility
is seen in both revenue and expenditures. Revenue volatility
is typically linked to greater reliance on trade taxes, which
wax and wane as trade rises and falls. Expenditure volatility
is often associated with lumpy capital spending, spending
responses to natural disasters, and a lack of discipline related
to weak governing capacity.
Making the best of it
Small states can, however, compensate for their size-related
problems by taking steps to exploit their advantages and off-
set their disadvantages. In general, these states should pursue
the following:
Sound economic policies: The best cure for volatility is
preventionthrough strong policies. For example, revenue
volatility can be lessened by reducing dependence on trade
taxes. Small states have begun to look at other sources of
revenue, and many have successfully adopted value-added
taxes. Their introduction in the microstates of the Caribbean
has reshaped the revenue structure and eased revenue col-
lection. Expenditure volatility can sometimes be reduced
through public sector reforms that seek to improve gov-
ernance and make fundamental structural reforms in the
economy. Volatility in the external sector can be reduced by
diversifying exports and trading partners. Although a tiny
state, Samoa has successfully diversified its export products
and marketsafter a taro leaf blight in the 1990s showed the
importance of reducing dependence on one crop.
In addition to reducing volatility, small states must foster
stability. Steps to increase financial services should be paired
with careful supervision by the appropriate legal and supervi-
sory authorities to ensure financial stability. Given their greater
exposure to external shocks, small states should accumulate
adequate reserves or budget extra spending for potential disas-
ters as well as explore insurance coverage.
Regional integration and cooperation: One way to off-
set the size disadvantage is to create bigger markets through
regional integration. Such initiatives are most advanced in
Jahan, corrected 8/1/13
Chart 3
How they grow
Most microstates and small states lagged their larger peers in
per capita GDP growth.
(real per capita GDP growth, 200011, percent)
Sources: IMF World Economic Outlook database; World Bank, World Development Indicators
database; and IMF staff calculations.
Note: Microstates have populations of less than 200,000 and small states, less than
1.5 million. The others category is for states with populations of more than 1.5 million. LML
= lower-middle- and lower-income countries, which have per capita annual incomes of less
than $4,085. UMC = upper-middle-income countries, which have per capita annual incomes
of between $4,086 and $12,615. The vertical bars show the range of GDP growth between the
25th and 75th percentiles for each grouping of states.
LML
UMC
Median
Micro Small Other Micro Small Other
0
1
2
3
4
5
Small states have not shared in
the improved economic growth of
their larger peers.
Finance & Development September 2013 47
the Caribbean. For example, the Eastern Caribbean Currency
Unions Regional Government Securities Market aims to
integrate existing national securities markets into a single
regional market, helping to exploit economies of scale in
financial markets. Similarly, the Eastern Caribbean Central
Bank uses a reserve account of contingency funds to assist
member countries facing economic difficulties, including
those caused by natural disasters.
Involvement of the international community: Small
states can also involve international institutions and
development partners in identifying common solutions
to regional problems. The World Bank, for example, has
helped to set up a multicountry risk pool and an insur-
ance instrument for damages caused by natural disasters.
Similarly, the World Trade Organizations Aid for Trade
initiative has encouraged trade-related regional infrastruc-
ture. Internationally agreed debt-restructuring and -relief
mechanisms, such as the Heavily Indebted Poor Countries
Initiative and the Multilateral Debt Relief Initiative, have
helped some small states reduce their debt burden. Financial
assistance is often crucial for small states. To weather natu-
ral disasters and other external shocks, small states have
used a number of IMF financing instrumentsincluding
the Rapid Credit Facility, a type of emergency assistance.
Perhaps most important, international institutions can pro-
vide technical assistance and training tailored to the needs
of individual states.
Policies matter most
Size does create constraints, but effective policies can help
small states overcome them. For example, Mauritiusa
small, remote island state off the coast of eastern Africa
was deemed a strong candidate for failure by Nobel Prize
winning economist James Meade in the 1960s. It depended
on one crop, sugar; was prone to terms-of-trade shocks; had
high levels of unemployment; and lacked natural resources.
But the country proved Meade wrong. It progressed to a
well-diversified middle-income economy that earns revenues
from tourism, finance, textiles, and advanced technology
as well as sugar. Whether measured by per capita income,
human development indicators, or governance indicators,
Mauritius is among the top African countries. The prudent
policies Mauritius adopted fueled its transformation. For
example, it attracted foreign direct investment to help spur
its industries and built strong institutions to support growth.
Small states can, in fact, tackle their vulnerabilities.