I. COUNTRY SIZE, SPECIALISATION PATTERNS AND GROWTH

1. Indivisibility of Public Goods and Infrastructure Services
Most public goods and infrastructure services are usually characterised by their
indivisibility. As a result, the cost of public services per capita is usually higher than in larger
economies. Limitation of scale economies may also force states to provide –often on a subsidized basis– a wide array of goods and services that are now typically offered by private sectors in larger economies.

2. Firm Size and Production Costs
Private activities are faced with the same difficulties, because the smallness of the
domestic market implies that economies of scale cannot be achieved. The new trade theory
shows that trade flows in processed products –those more likely to promote industrialisation and growth– are determined by economies of scale and specialisation rather than by comparative cost advantages associated with factor endowments. Whereas economies of scale and scope may still be exploited in tradable sectors by specialising in a narrow range of products and designs – certainly at the cost of greater vulnerability to the external shocks that may affect the markets for those products—, this is not true of non-tradable sectors, for which the market is, by definition, domestic. To the extent that non-tradable goods and services are inputs for production in tradable sectors –including such activities as domestic financing and marketing services— the absence of economies of scale in the production of the former will spill over into the competitiveness of the latter. Moreover, economies of scale or of scope in tradable sectors may be difficult to attain. This is the result of minimum efficient size requirements even in highly specialized plants and the additional costs caused by a lack of complementary tradable activities (e.g., higher costs arising from the need to bring inputs from abroad, a lack of joint trading or advertising channels, less learning from the experience of other firms). The role of complementary activities and firms illustrates a further point: to the extent that economies of scale are external to firms, the agglomeration of production in a few locations would tend to be the rule, generating a spatial hierarchy in which small size is certainly a disadvantage. This point has long been made by regional economics and has recently been emphasised by the literature on economic geography.

3. Market Structure, Employment and Adjustment Costs
Smallness also determines production and market structures. Being mainly composed of
small firms, the domain of viable production alternatives is naturally more limited in small
economies. Small firms are also financially weak and tend to be viewed by financial agents as
more risky borrowers. They are thus more vulnerable to shocks than larger enterprises, including those which compete with them in international markets. On the market side, high unit costs and small market size naturally tend to create monopoly situations. The size of labor markets matters too, and has adverse consequences for both suppliers and demanders. Because the pool of human capital is naturally limited, firms must compete for scarce labor skills and may have difficulty in finding the full range of skills they require in the labor market. On the other hand, specialised workers have very few employment alternatives. This is particularly acute when industries have to restructure. Thus, social costs associated with
structural adjustment are not transitional in small economies, because alternative domestic
employment is at best scarce, and at worst non-existent.

5. Advantages and Disadvantages of Size in Practice
The observation of actual data yields a mixed confirmation of these theoretical predictions. Size matters for developing countries. Small economies worldwide tend to grow at a
slower pace and have lower per capita income levels than their larger neighbours. But this
relation is not linear in terms of either income level or country size. Small developed countries are not significantly different than large industrialised economies in terms of growth and income, and very small developing economies grow faster and have higher incomes than other small and medium-sized developing countries.

On the other hand, small developing states are not small enough for their economy to rely only on exports of a few commodities or services, and their size is not large enough to reap the benefits of economies of scale or to successfully diversify into dynamic products. These small countries are therefore the most vulnerable to the challenges of globalisation and run the risk of been caught in a development trap.Very small economies (fewer than one million inhabitants in 1990) have enjoyed a higher rate of growth in their per capita gross domestic product (GDP) than medium or larger economies (more than 10 millions habitants). Caught in between, small economies (between one and ten millions) have had the worst performance.

Specialization patterns have clearly played an important role in economic performance.

II. STRUCTURAL VULNERABILITY
Transcending development levels, smaller countries are consistently more vulnerable to
external shocks than larger ones. Thus, vulnerability is the other relevant facet –besides growth
and income– for analysing the relationship between country size and economic welfare in the
context of open, globalised economies. Vulnerability is attributable to interrelated geographic
(country size and location), demographic and economic factors.

1. Geographic and Demographic Factors
The conjunction of geographic and demographic factors leads to higher population
density and increases the pressure on already limited domestic resources, in particular water and
arable land, and threatens fragile ecosystems. Location in tropical areas prone to natural disasters
(hurricanes, earthquakes or volcanic activities) compounds the problem. In many of the region's
small states, natural disasters are recurrent and affect a large proportion of the national
population and economy. In some cases, particularly in small island developing states, the
economic damages have exceeded the economies’ annual GDP. In the face of such catastrophes,
the capacity of national authorities to cope domestically with the costs of reconstruction is
limited.
2. Trade and Capital Account Shocks
Economic characteristics of smaller economies are another source of risk. In particular,
their level of openness may entail a high degree of vulnerability to external shocks.
Dependence on trade preferences has been a further source of vulnerability over the past
decade.

3. Macroeconomic Policies
The shallowness of domestic financial sectors, low domestic savings rates, and reduced
margins for changes in relative prices due to strong links between domestic and international
prices exacerbate the traditional macroeconomic constraints faced by open developing
economies. Under these conditions, it is more difficult to cushion shocks by resorting to internal
financing or devaluing the currency. More than anywhere else, macroeconomic policy has been
geared towards controlling inflation and preserving nominal exchange rate parity, two closely
interwoven targets in small open economies.

4. Fiscal Vulnerability
In a framework where monetary policy is determined by the exchange rate regime and the
domestic financial sector has little depth, the scope for autonomous fiscal policy is naturally
reduced. Additionally, in many small countries current government income is quite dependant on
trade tax revenues, and public investment depends largely on official assistance.
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Obviously, the situation is potentially worse for those countries which are both dependent
on trade taxes and face a relatively large fiscal deficit.
In any case, countries that are the most heavily dependent on trade taxes will have to
adopt alternative measures in the medium term at least. A VAT or some combination of
alternative taxes would have to be considered, although they may be politically difficult to
implement.





III. FACING THE CHALLENGES AND SEIZING THE OPPORTUNITIES
structural conditions in smaller economies impose particular
constraints, calling for specific measures by national governments and multilateral (regional or
international) bodies to create greater margins of flexibility for national and regional
development strategies aimed at overcoming these constraints.
1. The Role of National Economic Policies
a) Macroeconomic policies
The size of smaller economies and their traditional openness determine, to a great extent,
their style of macroeconomic policy and their manoeuvring room. In particular, incomplete
domestic markets and shallow financial sectors amplify shocks and tend to reduce the scope for
autonomous monetary policies. This is especially true when both trade and capital accounts are
very open. Nevertheless, even in this context, there are still options available which small
economies have generally failed to explore. In particular, with notable exceptions, very open
smaller economies have been reluctant to manage the exchange rate as a macroeconomic policy
variable and have thus been more prone to stick to rules-based and nominally anchored
macroeconomic policies, which tend to shift all the burden of adjustment to domestic income.
Macroeconomic policy in a globalised world should not be tied solely to the reduction of
inflation, especially when it is accompanied by an increase in the volatility of growth. Macroeconomic stability should be pursued with a broad
view of stability in mind, which includes not only price but also real economic stability and
sustainable balance of payments accounts. This means, first of all, loosening the tight link
between balance-of-payments performance and the monetary policy stance. This could be
accomplished by providing greater exchange-rate flexibility in order to mitigate external
disequilibria.
Given the restrictions associated with thin financial and currency markets, and the closer
connections between domestic prices and nominal exchange rates characteristic of small
economies, the options for flexibility are limited to fixed but adjustable pegs, crawling pegs or
floats with strong central bank intervention. There are several arrangements for
macroeconomic and financial co-ordination that are, nonetheless, attractive, including:
macroeconomic surveillance based on agreed common macroeconomic targets (reserve to
imports cover, external debt service levels, ratios of budget deficit and public sector debt to
GDP, and a degree of exchange rate stability under “normal” circumstances), common standards for prudential regulation and supervision, and a programme to create a
regional capital market. Under any exchange rate arrangement, countries should not rule out the
use of capital account regulations for macroeconomic purposes.
Macroeconomic stability, in the broad sense in which we use this term, and long-term
economic growth not only hinge up on competitive exchange rates and moderate real interest
rates, as a result of more flexible policies, but also depend on sound fiscal systems that provide
the necessary resources for the public sector to do its job and on deep financial markets.
A corollary of this policy package is the need to adopt medium-term fiscal frameworks
that allow for the use of suitable instruments, particularly broad tax stabilisation funds that will
facilitate counter-cyclical fiscal management. It is also necessary to strengthen the fiscal balance
through more efficient administration together with a reduction in reliance on trade taxes and a
shift in the burden of taxation to internal sources.
Fiscal policy can be used to obtain resources from those activities that benefit from the
process of globalisation, first of all by limiting –through a regional code on fair competition– the
extension of tax holidays to attract FDI. Improvements in a country’s fiscal stance should also
strengthen national saving, a move that favours the deepening of domestic financial markets and
reduced dependence on external flows.
The key objective of financial deepening is to provide suitably priced investment finance
with sufficiently long maturities to domestic investors. In the absence of a well developed
financial market, many investors (particularly the larger ones) turn to international lenders,
thereby substituting exchange risk for maturity risk. Furthermore, use of international financing

is well beyond the reach of the smaller firms that form the bulk of the industrial base in small
developing economies. Multilateral financial institutions should play a greater role in fostering
domestic and in creating regional capital markets, as we shall see below.
b) Structural strategies
Trade specialisation has witnessed the creation of a duality in the pattern
of trade specialisation between commodities-producing economies and services-based
economies. The latter type of economy has been able to withstand the impact of globalisation
more successfully than the former. The coexistence of stagnant and dynamic sectors and
economies with little connection between them has forced a restructuring of the lagging sectors
that has entailed major costs in terms of output and employment.
In small economies, a competitive group of small firms cannot be expected to emerge
spontaneously because of the lack of adequate externalities and the inherent learning processes
involved.. Policy intervention is required to
stimulate strategic change and promote alliances between existing firms that will lead to the
formation of dynamic and competitive productive and technological linkages.
. The smoother
flow of information in smaller economies, together with the possibility of closer interaction
between the public and private sectors, facilitate the design of policies aimed at building
dynamic production clusters.
Clusters associated with the development of services –particularly tourism, but also
modern services in informatics, electronic commerce and finance– are particularly attractive for
the region. Electronic commerce offers, indeed, new prospects for small, geographically isolated
economies that are enhanced by certain cultural specifics (native English-speaking
communities). This is also true of other niche markets in services, especially information-based
activities (from simple data processing to development of software) and some financial services.
Moving the maquila activities up the value-added ladder, as has been done in Costa Rica, is
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another option that should be explored. In those countries where agriculture and mining are
competitive, clusters associated with their key primary sectors are also an interesting option.
Strong investment in human capital is a key ingredient of a strategy aimed at high-valueadded
service sectors. Indeed, more broadly speaking, high levels of human capital may be
crucial to compensate for other disadvantages, including those associated with size or limited
endowments of natural resources, and have been key to the success of the smaller developed
economies in Europe. Fiscal considerations have certainly not stopped small economies,
especially countries in the Caribbean (e.g., Barbados, among others) and some small Latin
American countries (Costa Rica and Uruguay), from developing a very active public policy of
investment in human capital. In fact, as indicated above, small size promotes a closer association
between the State and its citizens and should favour less bureaucratic forms of allocating public
funds.
The mix of an investment strategy, strong human capital accumulation and a broad
macroeconomic framework could help to improve the competitiveness of exports by diversifying
their base, which is one the greatest challenges for smaller Caribbean economies. Progress on
these fronts will require major institutional and organisational efforts to formulate and implement
active investment strategies. Not only were the pre-existing systems of government intervention
in productive development dismantled or severely curtailed in most of the countries during the
economic liberalisation phase, but such systems would, in any case, be ill-suited to the new
environment. In this area, as in others, it is necessary to “invent” new institutions, whose
management will no doubt require an intensive learning process. These institutions should
comprise various combinations of horizontal and selective instruments, depending on each
country’s context, to be chosen on the basis of strategic visions shared by both public and private
sectors.

2. Open Regionalism and International Mechanisms to Support the Development of Small
Economies

 International labour mobility and links between migration and development
Smaller economies are especially vulnerable to structural shocks, and adjustments have a
particularly strong impact on domestic labour markets. The social costs associated with
globalisation are particularly difficult to absorb on a purely national basis. Promoting greater
international labour mobility is thus a clear priority for smaller economies. On the other hand,
the diseconomies of scale characteristic of labour markets in small economies indicate that firms
must look at regional or even international markets to find the required labour skills. This
represents an additional argument for greater international labour mobility.
Labour migration not only smoothes out the social costs of adjustment and guarantees
access to the required pool of skilled workers: it provides much-needed external resources to
cash-constrained economies. The benefits of return migration are equally evident. Professionals
who studied abroad and joined the labour force in their host countries, or nationals who have
completed their working life abroad, are returning to their countries to set up business or retire in
the region.
One of the priority items on the international agenda should therefore be to forge
agreements that will increase labour mobility and strengthen the governance of international
migration. The main objective here should be the conclusion of a global agreement on migration
policy. A first step in this direction is the ratification of the International Convention on the
Protection of the Rights of All Migrant Workers and Members of their Families, approved by the
United Nations General Assembly in 1990.
Broadening the commitments made in regard to temporary mobility of workers within the
framework of the WTO General Agreement on Trade in Services is another important objective.
One of the priorities in this area is to secure greater commitments on the part of industrialised
countries with respect to services that are intensive in low-skilled labour, in which developing
countries may have comparative advantages.
Access to a regional pool of skilled labour, as well as to a regional capital market, is
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particularly important in small economies, as Sir Alister McIntyre has emphasised. 5 There is
also a wide range of bilateral conventions and negotiations that can help to provide greater
opportunities for international migration. All of these agreement should seek to increase
temporary and permanent labour mobility and to move forward on the issues closely related to
migration, such as social security and the recognition of individuals’ academic and vocational
qualifications.
Home countries of migrants can also seek to benefit from this process in various ways.
One way is to improve the flow of remittances and to provide for their use for development
purposes (e.g., through special provisions for saving by migrants in their home countries and
solidarity funds through which migrants can contribute to their community of origin). Another is
the use of links with emigrants to give their home countries the benefit of their scientific,
professional and entrepreneurial skills. Promoting return migration with a view to the
establishment of firms based on the experience of migrants abroad is also an interesting
alternative.
5 “The quality of regional arrangements regarding factor markets, particularly for labour services, will be a more
important determinant of investment and export expansion than national economic policy regimes, even although
these are important in themselves. Entrepreneurs will be looking for regional pools of capital and skilled labour,
particularly in the professional and semi-professional categories. This would be an essential ingredient in absorbing
the technology underpinning the New Economy.”, McIntyre, op.cit., p. 16.