Growth Challenges for Small Economies: Issues &

Prospects forthe Caribbean

Robert Read Lancaster University Management

School, UK

The Growth Performance of Small Economies

In spite of the many growth challenges that they face, small economies are disproportionately represented in the World Bank’s two highest income categories – High and Upper Middle Income. This demonstrates that, regardless of these challenges, many have been highly successful in delivering growth and incomes to their citizens.

Small economies in the Caribbean Region rank 2nd behind those in Western Europe in terms of their growth performance and income levels.

Determinants of Growth in Small Economies

The principal factors in the success of small economies (growth rates and income levels) are:

• Openness of economies to trade, capital and labour flows.

• International competitiveness founded strongly on domestic comparative advantage, notably human capital as well as natural resources.

• Sectoral specialisation – tourism, financial services and natural resources.

• Location: Proximity to dynamic global regions (e.g., US and Europe).

Sectoral Specialisation in Small Economies

Three sectors are key to economic growth success and higher incomes. All are present in the Caribbean (to varying extents):

• Tourism: limited value added (low wages) but high employment effects.

• Financial Services: high value added (high wages) and employment effects.

• Natural Resources: high value added (high wages) but limited employment effects.

Manufacturing makes a limited contribution except in ‘larger’ economies while greater dependence upon Agriculture has lower growth and income effects.

Three Types of Caribbean Economies

Type 1 (High Growth/High Income):• Strong tourism (US-oriented) and financial

services sectors, with little agriculture. High levels of private investment and low inflation rates. Worst hit by the global downturn.

Type 2 (Moderate Growth/High Income):• More reliant upon tourism (Europe-oriented)

but with much less financial services.Type 3 (High Growth/Lower Income)• Larger, generally more remote with a greater

dependence on manufacturing and agriculture. Best performance since the global downturn.

Openness & Growth Volatility in Small Economies

Small size necessitates (‘structural’) openness to the global economy but has important implications:

• Economic growth: 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.

• Integration with the global economy more than compensates for the destabilising effects of external shocks.

• Domestic policy-making: openness limits policy autonomy, particularly with respect to the exchange rate. Reducing openness however, is likely to reduce growth and incomes.

Growth Strategies & Resiliencein Small Economies

Resilience is the resource capacity to deal with the impact of external shocks (economic and natural):

• Exposure to growth volatility is expected to be greatest for economies that have achieved the most growth success.

• Specialisation in high growth sectors tends to reduce the impact of growth volatility (but still affected by the global crisis – tourism and financial services).

• Growth success increases resilience capacity.

Growth volatility and a lack of resilience are therefore primarily a key challenge for poorer less well-managed small economies.

Improving Economic Performancein Small Economies

Growth, international competitiveness and resilience capacity can be enhanced by improving domestic economic performance:

• Raising domestic productivity.• Increasing domestic value added. • Generating additional high value

product/export niches.• Improving local supply linkages/reduce import

dependence.• Diversifying export markets.• Creating a sovereign ‘Resilience Fund’.

Diversifying Export Markets

There is limited potential in small economies to diversify their income generating activity so as to reduce their heavy reliance upon key sectors and the impact of external shocks. Further, many are very reliant upon ‘traditional’ export markets, primarily in Europe.

A key path forward is to secure new export markets for existing products and services. This offers growth potential as well as reducing exposure to market-specific (but not sectoral-specific) external shocks.

Improving Local Supply Linkages

The development of local supply linkages in small economies is constrained by narrow/shallow economic structures and a lack of absorptive capacity. 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 niche products, such as organics.

• Tourism: generally highly import dependent with low levels of local value added. Potential for improved linkages in local sourcing of food, handicrafts and support services – including the local or Caribbean ‘experience’.

Enhancing Resilience:Openness, FDI & Local Linkages

Foreign direct investment (FDI) offers an important additional means to enhance local supply-side capabilities and resilience in small economies because inflows bring technology, know-how enhanced value added, greater competitiveness and market access.

Inflows of FDI to small economies are unexpectedly high given their size, primarily because of their high level of openness. A fundamental policy issue for small economies however, is not attracting inflows but rather maximising the local growth effects of FDI.

Enhancing Growth & Resilience Capacity :

Promoting Human Capital Formation

The most important asset of small economies are their people: 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. Several critical issues:• 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.

Concluding Comments

• Small economies face a range of challenges but many have achieved growth and high incomes. The Caribbean is a success story.

• Openness to trade and vulnerability to natural disasters exposes them to greater growth volatility.

• Openness critical to growth and building resilience capacity.

• Growth-enhancing policies (diversification, improved local linkages etc.) should reduce growth volatility and build resilience capacity.

• Need to build up reserves/reduce debt to improve resilience capacity to deal with future economic and natural shocks.